Topic Three: Factor Prices and Income Determinations

3.1. Introduction
In the last chapter of the first part of microeconomics, you were introduced with different types of
market structures for economies under different conditions. In all these market structures, you
came across on how firms determine equilibrium price and output in the product market. In this
chapter, you will learn price and output determination in the factor market.

A factor is a human or material agent which contributes something to production. A factor can be
a worker, a machine, a building or a piece of land. Every factor has some sort of stored-up
productive power which it exerts when used in production. This productive power or the actual
contribution to the production is called services of a factor. Factor services are demanded by
producers and supplied by factor owners. In economics, factors of production, which help in
producing goods and services, are classified broadly into human and non-human factors.
Factor Market: Resources (land, labor, capital, entrepreneurship) are bought and sold in a factor
market. The economic concepts of factor market are the same as for product markets. The demand
for a factor of production is derived from the demand for the good or service produced from that
resource. Product Market: Goods and services are bought and sold in a product market.
 The theory of factor pricing is not fundamentally different from the product pricing. Both
factor and commodity prices are essentially determined by the interaction of demand and
supply forces. But the main differences between the resources and product markets are:
The role of buyers and sellers are reversed i.e., firms are suppliers in product markets but
demanders in the input markets. Households and individuals are demanders in product market but
suppliers in input markets.
While consumers demand Commodities because of the utility or satisfaction they directly receive
in consuming the commodities, firms demand inputs in order to produce goods demanded by the
society. Therefore, the demand for inputs is a derived demand from the demand of the final
commodity the inputs are used in producing
 Some concept related to factor pricing
 Productivity of factor: it refers to contribution of factor in terms of output of commodity
produced by the factor. It has two aspects : average productivity and marginal productivity
 Marginal productivity of factor: it refers to additional product as result of the employment
of additional unit of a variable factor, keeping other factor constant. The term marginal
productivity has three variants:
1. Marginal Physical productivity i.e., productivity measured in terms of physical quantity. It is
addition to total production resulting from employment of one more unit of a factor production.

2. Marginal Revenue productivity i.e., Money value of physical productivity of a factor. It is

addition to total revenue resulting from employment of one more unit of a factor of production.

3. Value of Marginal Physical productivity: it is marginal physical product of product multiplied

by market price. AR=P

Under perfect competitive factor when AR is fixed for a firm AR= MR, so, there is no difference
between MRP and VMP

3.2 Factor Pricing Under Perfect Competitive Factor Market

Firms selling and hiring in perfectly competitive markets will employ each input up to the quantity
where the price per unit of the input equals the marginal product of an input times the price per
unit of the output. I.e., to the point where the value of the output produced from using additional
unit of the input equals to the price paid for the unit of the input. This will provide us a basis for
the derivation of the demand curve of an input.
3.2.1 The Demand for Factors of Production: Consider two cases
I) when labour is the only factor of production
II) When there are several variable factors
I. Demand for a single variable factor by a firm: Assumptions
The demand for labor by a firm depends on the value of its marginal productivity and the demand
curve for labor is derived on the basis of the value of its marginal productivity curve (VMPC).
The VMPL curve has the following shape due to diminishing returns to the variable factor labor.

The firm's demand curve for labor is derived under the following assumptions.
a. A single commodity Q is produced in a perfectly competitive market, which implies P is
given for all firms in the market (individual firms are price takers)
b. The goal of the firm is profit maximization
c. There is a single variable factor labour, whose market is perfectly competitive. The price
of labour to the individual firm is perfectly elastic. At the going market wage rate (W) the
firm can employ or hire any amount of labour it wants. Hence, W = MCL
d. The firm produces a single commodity, X, whose price is constant at Px.
Given these assumptions and the VMPL curve, firm's demand curve for labor can be easily derived.
Then the short run equilibrium of a profit maximizing firm will be where VMPL=W

Fig. Short-run Equilibrium of a firm

The profit maximizing firm employs an input until wage and VMPL becomes equal from the above
figure. We can easily see the relation between wages or VMPL and the demand for the input labor.
Given the equilibrium wage (We) and level of employment for labor (Le), any additional
employment of labor will make W > VMPL. Hence the firm’s profit will decrease. On the other
hand, at any employment less than Le, the total earning of the firm will be lower than the maximum.
Thus, by definition, VMPL curve is the same as labor demand curve under the single variable
factor.
There are two types of mathematical approaches to determine the equilibrium of a firm. These are:
1. The labor profit maximizing condition: the firm is said to in equilibrium when it chooses that
level of employment where the MRP or VMPL from the last unit of worker employed is equal
to the competitive wage rate i.e. Where VMPL=MRP=W
2. The output profit maximizing condition: the firm is said to be in equilibrium when it chooses
to produce that level of output where the MR from the last unit of output is equal to the cost
of producing it i.e. where
MR=MC or P=W/MPL
Numerical Example: Consider a firm employing labor at a rate of birr12 per hour to produce
commodity X which can be sold at birr 3 per unit in the market and fill all the required in the
following table; the figures in bold are givens. You can calculate the remaining figures from
the givens.
Input output MP W VMP=MRP TR TC MC=W/MPL P Profit
(L) (Q) =MPXP =PXQ =WXL
0 0 - 12 - 0 0 - 3 0
1 7 7 12 21 21 12 12/7 3 9
2 13 6 12 18 39 24 2 3 15
3 18 5 12 15 54 36 12/5 3 18
4 22 4 12 12 66 48 3 3 18
5 24 2 12 6 72 60 6 3 12

6 25 1 12 3 75 72 12 3 3
As shown in the table above, the equilibrium level of employment is 4 units of labor (where
VMPL=12=W). The profit maximizing level of output this labor produce is 22 unit (where
MR=3=MC). The maximum profit at equilibrium is birr18
3.2.2. Demand of a firm for several variable factors: labor and capital
Where there are more than one variable factors of production the VMP curve of an input is not its
demand curve. This is so because the various resources are used simultaneously in the production
of goods so that a change in the price of one factor leads to changes in the employment of others.
But again, the firms demand curve for labor can be derived from the VMP L curve. When labor is
the only variable input the number of units of labor employed is inversely related to the wage paid
for labor.

The figure shows that the firm will hire L0 workers at W0 and L1 at W1 i.e., when the wage rate
falls from W0 to W1 the firm moves from point A to point D. However, when labor is not the only
variable input, and when the daily wage rate falls from W0 to W1 the firm does not move from
point A to point D as before. Because now there are other variable inputs and disturbance has
happened to their relative input prices. To get another point on the firm’s demand curve for labor
when both L and K are variable inputs, we should see the relationship between these inputs i.e.,
whether they are complementary or substituted inputs.

We should realize that labor and capital are usually complementary inputs in the sense that when
the firm hires more labor it will also employ more capital e.g. when the firm hires more computer
programmers, it also rents more computers. Then if the quantity of labor used with various
amounts of capital increases (because of a reduction in wages), the entire VMPL curve will shift
out ward. The reason for this is that with a greater amount of labor, each unit of capital will
produce more output. On the other hand, the increase in the quantity of capital used by the firm
will shift the VMPL curve outward because each worker will have more capital to work with. This
is shown by the VMPL in the foregoing figure.
Thus, when the daily wage rate falls to W1, the profit maximizing firm will hire L2 workers (Point
B on the VMPLk=36 curve) rather than L1 workers (Point D on the VMPLk=20 curve). Thus, Point B
is another point on the firms demand curve for labor when labor and capital are both variable
inputs. Joining Points A, B and C gives the firm’s demand curve for labor.

Similarly, if capital or other inputs were substitutes of labor, the increase in the quantity of labor
used by the firm as a result of a reduction in the wage rate will cause the VMP curves of these
other inputs to shift to the left (as the utilization of more labor substitutes for, or replace, some of
these other inputs). This in turn will cause the VMPL curve to shift out ward.

Thus, whether other inputs are complements or substitutes of labor and the VMPL shifts out ward
when the wage rate falls. As a result, the firm will hire more labor than indicated on its original
VMPL at the lower wage rate.

Therefore, the demand curve will be negatively sloped and generally more elastic than the VMPL
curve in the long – run when all inputs become variable. In general, the better the complement
and substitute inputs available for labor, the greater the out-ward shift of the VMPL curve as a
result of a decline in the wage rate, and the more elastic is the dL (demand for labor). The negative
slope of dL curve means that when the wage rate falls, the profit maximizing firm will hire more
workers. The same is generally true for other inputs. That is as the price of any input falls, the
firm will hire more units of the input.

3.2.3. The market demand for a factor

The market demand curves for an input are derived from the demand curves for the input by
individual firms. Nevertheless, it is not the simple horizontal summation of the demand curves of
the individual firms. This is because when the price of an input (say labor) falls, not only this firm
but also other firms will employ more of this factor and other (complementary) inputs to expand
production. Thus, the supply of final commodity increases and consequently its price falls.
For instance, suppose there are 100 identical firms in a market that produce good X. if each of
these firms is currently hiring 10 units of labor at a wage rate of w1=30 birr per hour, then the
total(market) quantity demanded of labor will be 10*100=1000 units. If the input price (wage rate)
falls from w1=30 to w2=20, then each firm uses more of labor (and other factors) and expand its
production of X. as the supply of the commodity increases (the shift from Sx1 to Sx2 in figure, the
equilibrium price of the product will be derived down from Px* to Px**. This fall in price of the
final product, in turn, has a negative consequence on the demand for the factor.

Since the MRPL=MPL times MR (which is equal to the commodity price in perfectly competitive
product market), the reduction in commodity price will cause each firm MRPL (=VMPL) curve
and the demand curve for the input to shift down or to the left. Each firm demands, say, only 12
units of labor rather than what the individual demand curve under the ceteris paribus assumption
predicts, say, 15 units. As result, the market quantity demanded of labor at the wage rate w2=20
will be 12*100=1200 units instead of 15*100=1500 units.

In general, the market demand curve for an input is then derived by the horizontal summation of
the individual firms demand curves for the input after the effect of reduction in the commodity
price has been considered.
If the fall in commodity price were not taken into account, and if a sample horizontal summation
were taken, it would lead to an overestimation of the market demand for labor (which joins points
A and B in panel(b).

We have derived the short run and the long demands for an input by a firm and subsequently the
market demand for an input. Now, let us close our demand side analysis of the factor market by
describing some factors that affect the demand for a factor of production.

The Supply Curve of Labor

The supply curve of an input indicates the number of inputs that the owner of an input will make
available at various alternative prices. The amount that owners will provide primarily depends on
the price they will be paid. The relationship between the supply of an input and the price of the
input defines the supply curve for the input.
The supply of labor is determined by
1. Wage rate
2. The prospect of promotion and advancement.
3. Regularity of employment
4. The social status of the occupation
5. The geographical area in which the job is located.
6. The time and expense in learning a job or entering a profession.
7. The size of the population etc.
The relationship between the supply of labor and the wage rate defines the supply curve of labor.
The other determinants can be considered as shift factors of the supply curve and are assumed to
be given in the short-run.
The supply of labor by an individual

To derive the supply of labor by an individual we assume that there are only two uses to which
any person may devote his/her time; I.e., either engaging in market works at a wage rate (w) per
hour or not working. We refer non – market work as leisure, but to economics this word doesn’t
mean idleness. Based on this assumption, we derive the supply curve of the individual firm as
follows.

The indifference curves represent the preferences of the individual between leisure and income.
For example, on indifference curve II of figure above the individual is indifferent between OB
hours of leisure and BZ hours of work (which brings him an income of BN), and OC hours of
leisure and CZ hours of work (from which he earns an income CM).
When the wage rate is w1 the individual is in equilibrium by working AZ hours, earning
AA'(=0A'') income and spending 0A hours on leisure. If the wage rate increases to w2 the
individual will work more hours (BZ>AZ), will earn a higher income (BB') and will have less
hours (0B) for leisure. The supply of labour can be obtained from the locus of equilibrium points
A', B', C', etc., This supply curve is shown in figure below. The pattern of response to higher wage
rates produces a backward-bending supply curve for labour.
In the short run the market supply of skilled labour may have segments with positive and negative
slope. In the long-run the supply must have a slope, since young people will be attracted to the
markets where the wages are high and also older workers may undertake retraining and change
jobs if the wage incentive is strong enough.

The backward-bending supply curve of labour may be typical in most markets of the rich nations.
As the standard of living increases people find that unless they have time to enjoy leisure activities
it is not worthwhile to work harder in order to obtain the higher income required for more leisure.
So as incomes reach the level required for a comfortable standard of living, workers put forward
greater demands for more holidays, longer vacations, shorter work weeks, and fewer hours per
working day rather than demanding ever higher wage rates associated with longer working hours.
It seems that a positive aggregate supply of labour is the general case even for the affluent nations.
Higher wages may induce some people to work less hours, but will also attract new workers in the
market in the long run.
 3.2.6. Equilibrium price and employment of labor
Given the market demand and the market supply of an input, its price is determined by the
interaction of the two curves. The figure depicts the equilibrium wage rate and quantity
(employment level) of labor. The equilibrium price and quantity of any other resource is
determined in the same way by the intersection of demand and supply.

The equilibrium wage rate is w* and the employment level is L*. the difference between
commodity pricing and factor pricing lies in how we derive the two components supply and
demand. While the demand for a final good is direct demand (for consumption and utility), the
demand for a factor is a derived demand. It is a derived demand in the sense that the demand for
the services of the factor is based on the demand of the commodities in whose production the factor
is used. On the supply side, the difference between supply of a commodity and factor supply is
pronounced for labor.
Unlike the supply of commodities, the supply of labor is not determined by cost of production, but
involves the attitudes of individual towards work and leisure.
3.3. Factor pricing in imperfectly competitive markets
In dealing with resource pricing and employment in imperfect markets, we can classify the
imperfection in the factor markets in to four:
i) Monopoly in the product market and Competitive factor market.
ii) When both the markets are imperfect (monopolistic product market and monopsonist resource
market).
iii) When the factor market consists of bilateral monopolies.
3.3.1. Monopolistic power in the product and perfect competitive in factor market

 Demand of a Monopolistic Firm for a Single Variable Factor

Assumptions used
 There is only one variable factor of production i.e. labour
 factor market is perfectly competitive and hence the firm is price taker
 the wage rate is given and the supply of labour to the individual firm is perfectly elastic
 the firm has monopolistic power in the product market of the commodity it produces
 the demand for the product of the firm is down wards sloping and the marginal revenue is
smaller than the price at all levels output

Figure: imperfect product market and perfect factor market

Based on these assumptions, it is possible to show that demand for labour of an individual firm is
not the VMPL curve but the MRP (Marginal Revenue Product for labour) curve, which is defined
by multiplying the MPPL by the marginal revenue of selling the commodity produced. That is,
MRPL = MPPL * MRx where, MRx= marginal revenue obtained by selling the commodity X
(other variables as defined before).

Consider a firm using one variable (labor, L) and one fixed (capital, K) factor of production to
produce good X. the firm maximizes its profit with respect to the units of labor it employs.

Hence, the firm maximizes its profit by hiring to a point where the marginal revenue product of
labor is equal to the wage rate. The firms employ L1e units of labor if the market wage rate is w1.
similarly, L2e units will be hired at w2(and L3e units at w3).

Joining the equilibrium points like e1, e2 and e3(which correspond to different market wage rates)
gives MRP1 as demand curve that relates wage to labor employment.

 Demand of a firm for several factor

When two or more variable factors are used in the production process (i.e, in long run),
the demand for a variable factor is not its MRP curve. Nevertheless, it is formed from
equilibrium points on shifting MRP curves.
When the wage rate is W1, the equilibrium of the firm is achieved at point A. if wage rate declines
from w1 to w2, the firm would move from A to A’ along MRP L1 if everything remains constant.
The fall in wage rate has three effects; substitution, output and profit effects. The net result of these
effects is a shift in MRPL curve to the right leading to a new equilibrium at B. then, the curve /line
joining A and B in the figure above is the firms long run demand for labor.

 Market demand for and supply of labor

The market price of the factor is determined by the intersection of the market demand and market
supply. When a firm possesses a monopolistic power in the product market, the factor is paid its
MRPi, which is smaller than VMPi (what the input could have been paid if this firm were a perfect
competitor). This effect is called monopolistic exploitation. It represents the difference between
the amount a factor is paid under perfect competition and the amount the same factor is paid under
the imperfection introduced here.

If the two types of firms face the same market price for an input, the firm with monopoly power
in the product market would hire less units of the input. Alternatively, if firms under the two
scenarios have to use the same amount of labor (L2 in panel (a), the firm in perfect competition
pays a wage rate of w1 while the other firm pays w2. The difference, w1-w2, measures the level
of monopolistic exploitation by the firm.
3.3.2. Monopolistic market in the output and monopsony in factor market
When both the factor and product markets are imperfectly competitive, the demand for labour is
the same as in the case in which labour market is perfectly competitive but the firm has
monopolistic power in the commodity market. Thus, the demand for labour by a monopolistic firm
is the MRPL. However, the supply of labour to the individual firm is quite different i.e., it is not
perfectly elastic since the firm is now large enough to influence price of the factor. For simplicity,
we make use of the following assumptions:
 The firm is monopsonist i.e. the only buyer in the factor market
 The supply of labour has positive slope. This implies that as the monopsonist expands the
use of labour, he or she must pay higher wage as shown in figure
 The supply of labour represents the average expenditure or price that the monopsonist must
pay at different levels of employment
Total expenditure of the monopsonist is defined by price of the input multiplied by level of
employment of the input. However, the relevant magnitude for the equilibrium of the monopsonist
is the marginal expenditure of buying an additional unit of the variable input. It important to recall
that marginal expense is the change in the total expenditure of on a factor arising from hiring an
additional unit of the factor. That is, hiring an additional unit of input eases the total expenditure
on the factor by more than the price of this unit because all previous units employed are paid new
higher prices.

Hiring an additional unit of labour input increases the total expenditure on the factor by more than
the price of this unit because all the previous units employed are paid the new higher price (W).
The ME of the factor is greater than its price (W) at all level of employment. Thus, the ME
curve lies above and to the left of the SS curve (average expense curve). This implies that the
slope of the ME curve is greater than the slope of the supply of labour (S L or AEL) curve.
When the firm has a monopsony power in the input market it pays the factor a price that is less
than not only VMPL but also its MRP L. This gives rise to monopolistic exploitation, which is
something in addition to monopolistic exploitation.
 For a monopsonist buyer profit is maximum when ME=MRPL.
 Bilateral Monopoly
In this type of imperfect factor market structure, there a single seller in the product market
(monopolized output market) and single buyer in the input market (monopsonist). In addition,
there is single supplier of labor in the form of a union. Individuals supply their labor jointly under
the union. The monopsony can employ labor only from the monopoly union and the monopoly
union can supply labor only to the monopsony. For the monopsony profit is maximum where ME
= MRPL and wage is set by extending the equilibrium point to the supply curve. For the labor
union the gain from wage is maximum when MR = MC and wage is set by extending the
equilibrium point to the demand curve of the monopoly.

In Figure , the monopsonists’ (single buyer’s) demand curve is Db. It is the MRPL of the input
being demanded. From the point of view of the monopolist (labor union), this curve (Db)
represents his average revenue curve. Thus, we denote this curve as Db =ARs (average revenue
curve of seller). The sellers’s (union’s) MRs curve can be derived by the usual graphical technique.

Supply of labor facing the monopsonist is the upward sloping curve SL. This shows the average
expense (average cost) of labor to the monopsonist. From the point of view of the monopolist
(labor union), the curve SL is its marginal cost,

Given the above cost and revenue curves, we can find the equilibrium position of each participant
in the market. The monopsonist (federation of manufacturers or management of a firm) maximizes
his/her profit at point F, where his marginal expense on labor (MEb) is equal to the marginal
revenue product of labor. Thus, the monopsonist will desire to hire LF units of labor and pay a
wage rate equal to WF.

The monopolist (labor union), on the other hand, maximizes his/her profit at point U, where his/her
marginal cost is equal to his marginal revenue. Thus, the monopolist (union) will want to supply
Lu units of labor and receive a wage equal to Wu.

Since the price goals of the two monopolists cannot be realized, the price and quantity in the
bilateral monopoly market are indeterminate. That is, economic analysis cannot provide a
determinate solution to a bilateral monopoly market. The only result is the determination of upper
and lower limits to the price. The level at which price become settled depends on the bargaining
skills and power of the participants.
ELASTICITY OF FACTOR SUBSTITUTION, TECHNOLOGICAL PROGRESS AND
INCOME DISTRIBUTION

The subject matter of income distribution is the study of the determination of the shares of the
factors of production in the total output produced in the economy over a given time period. Put
differently, income distribution is concerned with how the value of the output produced with the
help of different inputs (jointly) is shared among these various inputs.

If we assume that there are two factors of production L and K – for simplicity, their shares are
defined as:

w.L
 Share of labor = and
V
r.K
 Share of capital = and
V

Where:
W=wage rate
r= rental price of capital
L=quantity of labor employed
K=quantity of capital used
V= the value of total output produced in the economy

The relative factor share is conventionally defined as the ratio of the share of labor to that of capital.
That is,

𝑠ℎ𝑎𝑟𝑒 𝑜𝑓 𝑙𝑎𝑏𝑜𝑟 𝑤𝐿/𝑉

𝑟𝑒𝑙𝑎𝑡𝑖𝑣𝑒 𝑓𝑎𝑐𝑡𝑜𝑟 𝑠ℎ𝑎𝑟𝑒(𝑅𝐹𝑆ℎ) = =
𝑠ℎ𝑎𝑟𝑒 𝑜𝑓 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 𝑟𝐾/𝑣

𝑤𝐿 𝑤/𝑟
= 𝑟𝐾 = 𝑘/𝐿

The factor shares depend on the state of technology that defines the production function, the
nature of technical progress and on the relative factor prices,
 𝑤
[𝑖𝑛𝑐𝑜𝑚𝑒 𝑑𝑖𝑠𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛] = 𝑓[𝑝𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑜𝑛 𝑓𝑢𝑛𝑐𝑡𝑖𝑜𝑛], [ ] , [𝑇𝑒𝑐ℎ𝑛𝑖𝑐𝑎𝑙 𝑝𝑟𝑜𝑔𝑟𝑒𝑠𝑠]
𝑟

Elasticity of Factor Substitution

As factor prices change, the firm will substitute a cheaper input for a more expensive one. The
profit maximizing behaviour will result in a change in the K/L ratio and, hence, a change in the
relative shares of the factors. The size of this effect depends on the responsiveness of the change
in K/L ratio to the factor price change. A measure of this responsiveness is called elasticity of
substitution.
It is the percentage change in the capital-labor ratio to the percentage in the MRTS Under perfect
competitive input market; MRTSLK is equal to the ratio of factor prices.
Δ (K/L 𝑀𝑅𝑇𝑆 𝑤
𝑒𝑡 = ∗ MRTSLK =
Δ(MRTSLK) 𝐾/𝐿 𝑟

The value of et ranges from zero to infinity, and the larger it is the greater the substitutability
between K and L.
In general, when:

 et>1, there is elastic substitutability

 et<1, there is inelastic substitutability
 et=1, there is unitary substitutability

The relationship between elasticity of substitution and the relative factor shares can be summarized
as follow

 et >1, an increase in the w/r ratio causes the share of labor relative to the share of capital
to decrease.
 et<1, an increase in the w/r ratio causes the share of labor relative to the share of capital to
increase.
 et=1, the relative share of labor remains unchanged with a rise in the w/r ratio.
Technological Progress

(a) Technological progress is neutral if at a constant K/L ratio the MRTSL,K remains unchanged.
Since in equilibrium MRTSL,K = w/r, it follows that when technological progress is neutral both
the K/L ration and the w/r ratio are unchanged. Consequently, the relative shares of factors remain
unchanged.

(b) Technological progress is capital-deepening if at a constant K/L ratio the MRTSL,K declines.
This implies that at equilibrium the w/r ration declines, that is, r increases relative to w, while K/L
remains constant. Consequently, the ratio of factor shares declines. i.e, the share of labor decreases
and the share of capital increases.

(c) Technological progress is labor-deepening if at a constant K/L ratio the MRTSL,K increases.
Then, at equilibrium, the w/r ratio increases as technological progress takes place. This implies
that the share of labor will increase and the share of capital will decrease.

In summary, the relative share of labor increases if technological progress is labor-deepening

remains unchanged, if technological progress is neutral, and decreases if technological change is
capital-deepening.