Theory 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:

1. 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.

1. 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.

Feature

1. Derived Demand:

It is observed that the demand for a factor, unlike the demand for a commodity, is a derived demand. It means that the demand for any factor of production depends on the existence of a demand for the goods that it helps to make. Thus the demand for computer program­mers or TV repairers is growing, as more and more electronic computers or TV sets are used. The demand for college teachers increases whenever the number of students in colleges increases.

2. Joint Demand:

The demand for a factor of production is essentially a case of joint demand. It means that as one particular factor cannot produce anything, almost all the factors are demanded jointly and at a time to produce a particular thing. But, the goods are not jointly demanded except in the case of some special goods like bread and butter or rubber-stamp and stamp-pad, etc.

3. Difficulties in Changing Factor Supply:

The supply of a factor has some peculiarities. The supply of most of the goods can, in general be increased or decreased according to their demand or prices. A rise in the price of a commodity would encourage the producers to produce and supply more of the same.

But any increase in factor price such as rent or wage does not bring about an increase in the supply of land at all or an immediate increase in the supply of labour even. Similarly, a fall in the price of a commodity generally brings about a fall in its supply, but this is not so in the case of land or labour or any other factor.

4. No Full Control over the Factor Supply:

It is also observed the owners of factors do not have full control over the conditions which determine factor supply. Thus the supply of money-capital depends in large measure on the country’s national income, law and order situation, banking system etc. The suppliers of capital or savers do not have any control over these’ conditions. But this characteristic is not normally found in the case of the supply of goods.

5. A Separate Theory for Each Factor:

In general no separate theory is needed for determining the prices of different types of goods; a single theory is enough for most of the goods (except for interrelated goods like joint products, etc.). But a separate theory is needed for each and every type of factor earnings, like rent, wages, interest and profits.

6. No Homogeneous Units of a Factor:

The different units of a product may be homogeneous, but the units of a factor are not generally so Besides the cost of production of a commodity can easily be determined, but the cost for a factor, land or labour, cannot be so determined.

Owing to the above reasons a separate theory is needed for determining factor prices, but the determination of factor prices becomes more complex than the determination of the prices of goods. This happens so, because in the former case the conditions (i.e., market situations) in both factor and product markets are to be considered at the same time, but in the latter case the prices of goods are determined in different market situations assuming factor-price constant.