In this article we will discuss about:- 1. Meaning and Definitions of Factor Pricing 2. Need for a Separate Factor Pricing 3. Perfect Competition during Short Period 4. Imperfect Competition 5. Criticisms.
- Meaning and Definitions of Factor Pricing
- Need for a Separate Factor Pricing
- Factor Pricing under Perfect Competition during Short Period
- Factor Pricing under Imperfect Competition
- Criticisms of Factor Pricing
1. Meaning and Definitions of Factor Pricing:
The theory of factor pricing is also called theory of distribution. The distribution may be either functional or personal. The personal distribution is concerned with the distribution of national income among various factors of production which is unequally distributed. On the other hand, the functional distribution is concerned with the remuneration paid to various factors of production in an act of production.
The factors of production, viz., land, labour, capital, entrepreneur and organisation are paid in the form of rent, wages, interest, profit and salary. Thus, the theory of functional distribution is called the theory of factor pricing.
The various definitions of the theory of distribution have been given as under:
(1) Professor Chapman has defined, “The economics of distribution accounts for the sharing of wealth produced by a community among the agents or the owners of the agents which have been active in its production.”
(2) According to Professor Seligman, “All wealth that is created in society finds its way to the final disposition of the individuals through certain channels or sources of income. This process is known as distribution.”
In the distribution part of economic theory we study the determination of reward for various factors of production. Why is the theory of demand and supply not applicable for the determination of factor price, Professor Alfred Marshall has emphasised that there is a need for a separate theory of factor pricing because the characteristics of commodities and factors of production are different.
The following are the arguments but forward for the need of a separate theory of distribution or factor pricing:
(1) The demand for a factor of production is not a direct demand as is found in case of a commodity. The demand for factors of production depends on the demand for the goods and services in which they are employed. While the demand for a commodity is a direct demand because it directly satisfies the want of a consumer. Thus, there should be a separate theory of factor pricing.
(2) The demand for a factor of production is a joint demand because two or more than two factors are jointly demanded for an act of production.
(3) Some of the factors of production are human factors, namely, labour, entrepreneur and organisation. They are not only affected by the economic factors but are also affected by the non-economic factors. In case of commodity pricing there is no involvement of human factor.
Thus, the characteristics of factors of production are different than those of commodities. Hence, there should be a separate theory of distribution for factor price determination.
3. Factor Pricing under Perfect Competition during Short Period:
The firm will be making profit, earning normal profit and incurring losses. These three situations are discussed under perfect competition with the help of the diagrams. We assume that labour as a variable factor is employed with keeping other factors constant.
The diagram shows that the factor price (wages) is determined by the industry keeping in view the total demand for and supply of labour by the industry. DD and SS are demand curve and supply curve of labour and E is the point of intersection where OW wage rate is fixed or determined and OQ is the demand and supply of labour as shown on the left portion of the diagram. On the right portion of the diagram the firm employs OQ of labour with given wage rate OW.
Wages and marginal revenue productivity (MRP) and average revenue productivity (ARP) are shown on OY-axis while units of labour on OX-axis. The AW=MW is the demand curve for the labour which is perfectly horizontal to OX-axis. ARP and MRP are average revenue productivity curve and marginal revenue productivity curve.
They are opposite to U- shaped curve. The point of equilibrium of a firm will be at the point E where marginal factor cost or marginal wage (MFC or MW) is equal to its marginal revenue productivity (MRP=MFC or MW) and the MRP curve must cut the MFC or MW from the above.
The average profit of the firm is (ARP-AW) SE and the total profit is equal to TWES. The firm is earning profit because the wages are less than the marginal revenue productivity of labour. In other words, workers are being exploited equivalent to the volume of profit TWES. Karl Marx has propounded the surplus theory of value on this ground and wrote a famous book Das Capital in 1869.
The wage rate is OW and demand for and supply of labour is OQ in the industry while on the same wage rate firm employs OQ units of labour. The point of equilibrium of the firm is at E where the MW is equal to its MRP. The wage rate OW is higher than the ARP (AW>ARP) and the firm is incurring losses. Average loss to firm is (AW-ARP) LE and the total loss to firm is WTEL. In other words, labour is getting more than what he contributes to the productivity (AW>ARP).
The firm employs OQ units of labour at given wage rate of OW and the point of equilibrium of the firm is at point E where the AW=ARP=MW=MRP. The firm is earning normal profit and it is the optimum firm that the optimum utilisation of resources is attained.
In the long run the firm will earn normal profit only because there is perfect competition in both the markets.
The point of equilibrium of the firm will be at that point where the AW=ARP=MW=MRP in the long run as shown in the diagram:
Thus, we can say that the wage rate will always be equal to marginal revenue productivity (AW=ARP=MW=MRP) in the long run but during short period there may be variations and it may result into profit, loss and normal profit.
4. Factor Pricing under Imperfect Competition:
The theory of marginal productivity is based on the assumption of perfect competition. But perfect competition is a market structure which is unrealistic and imaginary. In imperfect competition the reward paid to a factor of production will be less than its marginal revenue productivity (W<MRP).
The equilibrium of a firm under imperfect competition can be explained with the help of the following diagram:
The diagram shows wage rate and productivity on OY-axis while units of labour on OX-axis. ARP and MRP are average revenue productivity curve and marginal revenue productivity while AW and MW are average wages and marginal wages of workers. The point of equilibrium is E where the MW equals to MRP (MW=MRP). The average profit (ARP-AW) is LT and the total profit is SWTL. The firm is earning profit. But workers are exploited by the firm because they are paid reward less than their marginal revenue productivity.
5. Criticism of Factors Pricing:
The marginal productivity theory of distribution has been criticised on the following grounds:
(i) All Units of a Factor are not Homogeneous:
The theory assumes that all the units of a factor of production are homogeneous or identical. But in actual practice we see that all the units are not identical in efficiency. For example, labour can be categorised into skilled, semi-skilled and unskilled. Hence, they are not perfect substitutes.
(ii) Perfect Competition is Unrealistic:
The theory is based on the assumption that there is perfect competition in factor market and commodity market. But in actual practice we find imperfect competition. Hence, perfect competition is an unrealistic and imaginary market.
(iii) Unrealistic Assumption of Full Employment:
The theory is based on the assumption that there is full employment and no single factor of production is unemployed. But in actual practice there is less than full employment situation whether the country is developed one because a certain percentage of people are found unemployed.
(iv) Marginal Productivity is not Measurable:
The theory assumes that the marginal productivity of a factor can be measured by knowing the addition to the total production by employing an additional unit of the factor keeping other factors of production constant. The marginal productivity of entrepreneur cannot be measured because it is not divisible.
(v) Imperfect Mobility of Factors of Production:
The theory is based on the assumption that all the factors of production have perfect mobility. They will move from low rate of reward to high rate of reward industry and there will be regional and occupational mobility of labour. But in practice we see that factors of production are not only affected by the economic factors but they are also affected by the non-economic factors as well.
Labour, entrepreneur and organisation are human factors. They are affected by the non-economic factors, namely, environment, language, caste, religion, distance, etc. Hence, perfect mobility of factors is a mismanage.
(vi) Maximisation of Profit is not the Sole Object:
The theory assumes that each producer or firm aims at maximisation of profit. It is not correct because there is a cut-throat competition in the market and non-price competition is the practice prevailing in domestic and international markets. Firm tries to earn satisfactory level of profit and maintain its existence in the market.
(vii) One Sided Theory:
The theory deals with the demand side of factors of production while determining the factor prices. Professor Milton Friedmann and Samuelson have criticised the theory on the ground that it has not taken into consideration the supply side which is equally important for the determination of price of factors of production.
(viii) Long Run Explanation:
The theory explains the factor price determination during long run and it has failed to explain the short run determination of factor pricing. Professor J.M. Keynes has rightly pointed out that in the long run we all are dead and there is no economic problem. In such a situation the theory does not have utility and applicability.
(ix) Not Applicable to Entrepreneur:
The remuneration of entrepreneur cannot be determined because he is the only factor of production whose number neither can be increased nor can be reduced. In such a situation marginal productivity cannot be measured and consequently his remuneration cannot be determined.
(x) Neglects Technological Progress:
The theory of distribution has ignored the role of technological progress increasing the productivity and production. The use of latest technology and innovation have also influenced the productivity of labour and capital as pointed out by Professor J.R. Hicks and consequently the relative share of factors in national income has increased.
(xi) No Explanation of Inequalities of Income:
The theory does not explain the inequalities of incomes prevailing in various countries. If the marginal productivity of various factors of production is taken into consideration then we will see that the causes of such inequalities cannot be justified on the ground that there are several factors leading to such inequalities of income and wealth. The theory is based on the static phenomenon and fails to explain the dynamic aspect of economy which is more important and realistic.