Economy

Modern Theory Of Factor Pricing

Marginal productivity theory was discarded by the modern economists.

“Marginal productivity theory does not explain the determination of wages, rent or interest. On the contrary, it simply explains how factors of production are hired by the firms, once their prices are known.”

Samuelson,

“No economist would claim that marginal productivity theory is complete as yet, even as a purely academic structure of framework, its postulates are unduly rigid and narrow.”

Fasser

Similarly, it was termed as “static theory” because it ignores the role of technical changes. It was also termed as “one-sided theory” because it focuses just on demand side and ignores supply side.

Hence modern economists criticized marginal productivity theory harshly and they introduced a comparatively comprehensive theory for the determination of prices and employment of factors of production.

Lets State

“Other things remaining the same, the price and employment of a factor of production is determined by the equality of its demand and supply in the factor market. If there is some deviation, it is a temporary situation and through automatic mechanism, the same optimum price and employment level of the given factor is attained”.

Assuming

Perfect competition

There is perfect competition in the product and factor market.

Homogeneity

All units of a given factors are homogeneous.

Perfect Substitutes

All factors are perfect substitute to each other.

Perfect Mobility

There is perfect mobility of the factors of production.

Divisibility

All factor units are divisible.

Profit Maximization

It is the sole motive of all firms.

Law of Diminishing Returns

This law operates in the economy.

Perfect Knowledge

The buyers and sellers of the factor services have complete knowledge of the prevailing conditions.

Framework

The pricing and employment of inputs are determined by the interaction of demand and supply forces of inputs.

Demand for Input

The units of an input which a firm is willing to purchase and able to purchase at a particular price, is called demand for input.

Demand Curve for Input

It is a curve which shows the negative relationship between the price of the input and the units of input demanded. It should be noted here that the demand for an input is a derived demand because the services of an input are demanded for the production of goods.

Derivation of Demand Curve for Input

Let a firm wants to engage labour for the production of some commodity, its demand for labour curve can be derived as under, let labour is engaged as input in a market, its demand curve is derived as under:

Modern Theory Of Factor Pricing

In the given figure, panel A represents a firm VMPL or demand for labour curve while panel B shows a market’s demand for labour curve which is comparatively flatter. Both the curves shows the negative relationship between price of labour , i.e. wage rate and units of labour demanded  .

Supply of Input

The units of an input which a household is willing to sell and able to sell at a particular price, is called supply of input.

Supply Curve of Input

It is a curve which shows positive relationship between the price of input and the units of input.

Derivation of Supply Curve of Input

Labour being engaged as input, its market supply curve is derived as under:

Modern Theory Of Factor Pricing

The figure shows that as the wage rate increases the households offer more units of labour. Thus there exists a positive relationship between the price of labour (i.e. wage rate) and supply of labour.

Determination of Price and Employment of Input

The price and employment of input under consideration i.e. labour is determined by the equality of demand for labour and supply of labour. If there is some deviation, it is a temporary phenomenon and through automatic mechanism, the same optimum level is regained. See the figure.

Modern Theory Of Factor Pricing

In the given figure, price and employment of input (L) is determined by the interaction of demand and supply forces of labour. The best possible wage rate W* and employment level L* are indicated by the equality of demand and supply forces. If there is some deviation and wage rate exceeds to equilibrium wage rate, then SL > DL which shows unemployment.

It pushes down the wage rate and consequently demand for labour increases while supply of labour decreases due to lower wage rate. Eventually the optimum level of price of labour and employment of labour is regained. On the other hands, if wage rate decreases to W// higher demand for labour pushes up the wage rate and this rise in wage rate results in optimum wage rate and employment level.

Criticism on Theory

Same old Juice in New Bottle

Along with some superiority, modern theory of pricing of inputs is almost “The same old wine in new bottle” because mostly it is based on the same unrealistic assumptions of marginal productivity theory.

Perfect Competition : A Myth

It is not reality but a myth because perfect competition does not exist practically either in factor market or in product market.

No Homogeneity

All the units of a factor cannot be homogeneous.

Lack of Mobility

Factors are not perfectly mobile.

Lack of Substitutability

Perfect substitutability of factors is impossible.

Lack of Divisibility

All the factors are not divisible.

Lack of Knowledge

All the stake holders cannot have complete knowledge about all the conditions of a market.

Law of diminishing returns – Not applicable everywhere:

Law of diminishing returns is not applicable in all the sectors as it has been assumed in this theory. For example, in industrial sector, we generally observe law of increasing returns due to modern technology and innovation.

CONCLUSION

Despite above-mentioned flaws, modern theory of factor pricing is a valuable asset in Economics literature. It is considered superior to marginal productivity theory in many aspects.

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