POE/U5 Topic 1 Theories of factor pricing
Factors of production can be defined as inputs used for producing goods or services with the aim to make economic profit.
In economics, there are four main factors of production, namely land, labor, capital, and enterprise. The price that an entrepreneur pays for availing the services of these factors is called factor pricing.
An entrepreneur pays rent, wages, interest, and profit for availing the services of land, labor, capital, and enterprise respectively. The theory of factor pricing deals with the price determination of different factors of production.
The determination of factor prices is always assumed to be similar to the determination of product prices. This is because in both the cases, the prices are determined with the help of demand and supply forces. Moreover, the demand for factors of production is similar to the demand for products.
However, there are two main differences on the supply side of factors of production and products. Firstly, in product market, the supply of a product is determined by its marginal cost of production. On the other hand, in factor market, it is not possible to determine the supply of factors on the basis of marginal cost.
For example, it is difficult to ascertain the exact cost of production for factors, such as land and capital. Secondly, the supply of factors of production cannot be readily adjusted as in the case of products. For instance, if the demand for a land increases, then it is not possible to increase its supply immediately.
Concept of Factor Pricing:
Factor pricing is associated with the prices that an entrepreneur pays to avail the services rendered by the factors of production. For example, an entrepreneur needs to pay wages to labor, rents for availing land, and interests for capital so that he/she can earn maximum profit. These factors of production directly affect the production process of an organization.
In context of an economy, these four factors of production when combined together produce a net aggregate of products, which is termed as national income. Therefore, it is important to determine the prices of these four factors of production. The theory of factor pricing deals with the determination of the share prices of four factors of production, namely land, labor, capital and enterprise.
In other words, the theory of factor pricing is concerned with the principles according to which the price of each factor of production is determined and distributed. Therefore, the theory of factor pricing is also known as theory of distribution. According to Chapman, the theory of distribution, “accounts for the sharing of the wealth produced by a community among the agents, or the owners of the agents, which have been active in its production.”
There are two aspects of each factor of production, which are as follows:
- Price Aspect:
Refers to the aspect in which an organization pays a certain amount to avail the services of factors of production. For example, wages, rents, and interests constitute the price of factors of production.
- Income Aspect:
Refers to another aspect in which a certain amount is received by a factor of production. For instance, rents received by a landlord and wages received by labor constitute the income generated from the factors of production.
Generally, it is assumed that factor pricing theory is similar to product pricing theory. However, there are certain differences between the two theories. Both the theories assume the determination of prices by the interaction of two market forces, namely demand and supply.
However, there are differences in the nature of demand and supply of factors of production with respect to that of products. The demand for factors of production is derived demand, while demand for products is direct demand. Moreover, the demand for the factors of production is joint demand.
This is because a product cannot be produced using a single factor of production. On the other hand, the supply of products is closely related with the cost of production, whereas there is no cost of production for factors. For example, there is no cost of production for land, labor, and capital. Therefore, the factor pricing is separated from product pricing.
Theories of Factor Pricing:
The theory of factor pricing is concerned with the principles according to which the price of each factor of production is determined and distributed. The distribution of factors of production can be of two types, namely personal and functional. Personal distribution is concerned with the distribution of income among different individuals.
It is associated with the amount of income generated not with the source of income. For example, an individual earns Rs. 20,000 per month; this income can be earned by him/her by wages, rents, or dividends. On the other hand, functional distribution is associated with the distribution of income among different factors of production as per their functions.
It is concerned with the source of income, such as wages, rents, interests, and profits. In regard of distribution of factors of production, there are two theories, namely marginal productivity theory and modern theory of factor pricing.