Factor Demand Curve of a Firm (With Diagram)

Factor Demand Curve of a Firm:

Under competitive market, factor demand curve of an industry is derived by summing up the demand of a factor by each individual firm at different given prices. Firms being price taker will demand a quantity where value of its MPP (i.e. VMP) equalizes with the wage level.

Following Figure-14.3 (a) depicts different factor prices, as provided by industry to a price-taker firm. In each case, firm will demand a quantity of factor where it’s VMP = price. For example, at OM price, the firm will demand MM₁ quantity of the factor, the M₁ point being located on the VMP curve of the firm. Likewise, quantity demanded of the factor will be NN₁ at ON price, PP₁ at OP price and so on.

However, if the factor price goes up beyond the maximum value of average product (VAP), say OA, the firm will not demand any quantity of the factor as the factor price exceeds the value of average product.

Hence, it can be argued that the VMP curve below the maximum of VAP curve will only constitute the factor demand curve of a firm. In the figure, the factor demand curve will be represented by M₁R₁ portion of the VMP curve.

Following the similar procedure, one can derive the factor demand curve of all the firms in the industry.

Slope of Factor Demand Curve:

The Figure-14.3 (a) further reveals that the factor-demand curve of the firm slops downward. It implies that price of the factor and its demand is inversely related. A fall in factor price will lead its demand to expand and vice versa.

It further shows that the factor demand curve so derived for a firm has tilted towards Y-axis. It is because of a less responsive factor demand vis-a-vis a change in factor price. This can be explained as below.

As the factor price will fall, all the firms will demand more quantity of the factor to enhance their output. Hence, the market supply of the product will increase which will push the product price down. As a result, VMP of the factor, which is a multiplication of the product-price and MPP, will fall.

This will drag the VMP curve down and hence will dampen the factor demand. As such, increase in factor demand will be by a smaller margin. This can be shown by a downward sloping factor demand curve tilting towards the Y-axis rather than a straight line.

The above Figure-14.3 (b) in this regards shows the initial VMP curve of the firm as VMP₁. If the factor price is OM, the factor demand of the firm will be represented by MM₁. Let us now consider a fall in factor price to the level ON. As a result, the firm should demand a higher factor quantity, the NN₂ on the VMP₁.

However, the increased supply of product will lower its price and, hence, the VMP curve of the firm will itself shift down from VMP₁ to VMP₂. As such, the firm will demand a slightly lower quantity of the factor, NN₁ in place of NN₂.

The factor demand curve of the firm will be formed by joining point M₁ and N₁ rather than point M₁ and N₁. This has been shown as d₁d₁ curve in the figure which is not only downward sloping but also tilting towards the Y-axis.

The Industry Demand Curve:

A horizontal summation of the factor demand curves of all the firms will provide the industry demand curve of the factor, as shown in Figure-14.3 (c).

Let us consider an industry consisting of only two firms, A and B. Their respective factor demand curves are derived following the procedure explained above. They are shown as d_Ad_A and d_Bd_B for firm A and firm B respectively.

The industry demand curve is depicted as D_A+B. It is a horizontal summation of the factor demand of both the firms at each price. Such an industry demand curve will indicate the total demand of the factor at a given factor price when all the firms of an industry are considered collectively.

Determinants of Factor Demand:

Demand of a factor service by a firm depends upon following determi­nants:

1. Derived Demand:

Since a factor contributes in the production of a product, its demand is defined as derived demand. More the demand of the product more will be its production and, hence, more will be demand of the factor services required to produce the product.

2. Price Elasticity of Product:

Factor demand being the derived demand will also be influenced by the price elasticity of the product. Higher the price elasticity of the product, more sensitive will be the factor demand to a change in factor price and vice versa.

3. Proportion of Expenditure:

If the proportion of expenditure on a factor by a firm is large, its demand will be more responsive to the change in factor price and vice versa.

4. Factor Productivity:

Factor productivity, which can be indicated through the value of MPP for a firm, will fall as more and more units of a factor are employed. Thus, a firm will demand more units of a factor only at a falling factor price.

5. Factor Substitutability:

A firm will always explore the possibility of substituting one factor with other. This will depend upon the factor productivity and the relative factor prices.

The firm usually replaces an expensive factor with a cheaper one. For example, in labour surplus developing countries like India, firms tend to replace capital for labour since wage rate is usually low than that of the cost of capital. Such tendency will increase the demand of labour and will subdue the demand of capital.