Europa Science &Cmmerce Academy

Q. No. 20:

Answer: INTRODUCTION: Marginal productivity theory explains that prices of any factor of production depends upon marginal revenue product. Modern theory of factor pricing is actually the demand and supply theory. As prices of commodities are determined by the forces of demand and supply, the prices of factors are also governed by the same forces. STATEMENT OF THE THEORY: According to Modern Economists: Under perfect competition, the rewards of factor of production are determined by the equilibrium of demand and supply. Explanation: Demand for factors of production is derived from demand of goods. Demand of factors means the demand which a firm or organization wants to employ. While supply of factors of production means quantity of units which are available at prevailing rewards. Demand of a Factor: Demand of a factor of production depends upon following conditions: 1) Prices of other factors of production. 2) Demand for goods produced by these factors of production. 3) It depends upon technology. New discoveries and better techniques of production rises the productivity of factors. As a result demand price increases. 4) Quantity and quality of other factors of production. 5) Marginal productivity of that factor of production. Higher is the productivity, greater the demand. Less is the productivity, less is the demand.

Explain how price of a factor of production is determined under perfect competition. OR explain modern theory of factor pricing.

Economics Notes

Wage Rate

x-axis

W1 W Wo

E1 E E0 E0 y-axis

M0

M1

In the above diagram, demand for labour is measured along x-axis while wages are shown on y-axis. At point E wage rate is OW while demand for labour is OM. When wage level increases from OW to OW1, employment level falls from OM to OMo which is shown by point E1 when wage rate falls to OWo. at point Eo, demand

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Economics Notes

for labour increases to OM1. thus the slope of demand for labour curve is negative showing negative relation between wage rate and demand for labour. SUPPLY OF A FACTOR: Supply of labour means the number of workers which are offering their services at prevailing wage rate. Supply of a factor depends upon the following conditions. 1) Wage rates 2) Size and composition of population. 3) Occupational and geographical distribution 4) Mobility of labour 5) Cost of education and training. Diagram:
Wage rate y-axis W1 E E1 SL

M M1 Supply of Labour

x-axis

In the abode diagram, supply of labour is measured along x-axis while wage rate is taken on y-axis. Point E shows that when wage rate is OW, supply of labour is OM. When wage rate increases from OW to OW1, supply of labour rises from OM to OM1. the slope of SL curve is positive due to positive relation between wage rate and supply of labour. DETERMINATION OF WAGE RATE: Equilibrium wage rate3 will determined where demand for labour and supply of labour are equal. This can be explain with the help of diagram. Diagram:
Wage Rate DL < SL

y-axis W1 W W0

{ }
E DL > SL M Supply of Labour

SL

DL x-axis

In the above diagram demand and supply of labour are measured long x-axis while wage rate is taken on yaxis. Basic equilibrium takes place at point E where demand for labour curve. Intersects supply of labour curve. As a result OW is the equilibrium wage rate while OM is considered as equilibrium level of
Europa Academy Composed & Designed By: Basit butt

Europa Science &Cmmerce Academy

Economics Notes

employment. If wage rate increases form OW to OW1, supply of labour is greater than demand for labour. This situation shows shortage of demand or excess of supply of factors in labour market. If wage rate falls to OWo, demand for labour is greater than supply of labour. This situation shows excess of demand or shortage of supply in factor market. ASSUMPTIONS: Modern theory of factor pricing is based on following assumption. 1) There is perfect competition in goods and factor market. 2) There are large number of buyers and sellers in factor market. 3) All units of factors of production are homogeneous. 4) There is perfect mobility among the factors of production;. 5) Factors of production are perfectly substitutes 6) Units of factors are divisible 7) Buyers and sellers of factors services have complete and perfect knowledge about market condition. 8) Buyers and sellers of factors services have complete freedom of entry & Exit.

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