Micro Project

The theory of factor pricing National income represents the total amount of money that factors of production earn during the course of a year. This includes, mainly, payments of wages, rents, profits and interest to workers and owners of capital and property. The national product refers to the value of output produced by an economy during the course of a year. National product, also called national output, represents the market value of all goods and services produced by firms in a country. Because of the circular flow of money in exchange for goods and services in an economy, the value of aggregate output (the national product) should equal the value of aggregate income (national income).factor pricing mean how the price id distribute. Consider the adjoining circular flow diagram describing a very simple economy. The economy is composed of two distinct groups, households and firms. Firms produce all of the final goods and services in the economy using factors services (labor and capital) supplied by the households. The households, in turn, purchase the goods and services supplied by the firms. Thus goods and services move between the two groups in the counterclockwise direction. Exchanges are facilitated with the use of money for payments. Thus when firms sell goods and services, the households give the money to the firms in exchange. When the households supply labor and capital to firms, the firms give money to the households in exchange. Thus, money flows between the two groups is shown in diagram.

For example, a person go for job in a firm .and he gets job. Than he works in firm and produce more things. As a reward he gets pay. Owner of the firm supply these products in the market on the demand of peoples. And the person who get the job in this firm and produce things and get reward.afcource he need house hold products to live life. Then he bought products from the market. In his way his pay go back to the owner of the firm. So the flow of income is going on forever.

Why a sepert theory of factor pricing What id demand The relationship between price and the amount of a product people want to buy is economists call the demand This relationship is inverse or indirect because as price gets higher, people want less of a particular product The same information can also be plotted on a graph, where it will look like the graph below.2

If the demand of some commodity increase than the supplyer increase the supply of the commodity.

Price of factor of production is determined like the price of a commodity by the equilibrium of forces of demand and supply. Let’s take a look into how and why production costs can change. A company may need to increases wages if laborers demand higher salaries (due to increasing prices and thus cost of living) or if labor becomes more specialized. If the cost of labor, a factor of production, increases, the company has to allocate more resources to pay for the creation of its goods or services. To continue to maintain (or increase) profit margins, the company passes the increased costs of production on to the consumer, making retail prices higher. Along with increasing sales, increasing prices is a way for companies to constantly increase their bottom lines and essentially grow. Another factor that can cause increases in production costs is a rise in the price of raw materials. This could occur because of scarcity of raw materials, an increase in the cost of labor and/or

an increase in the cost of importing raw materials and labor (if the they are overseas), which is caused by a depreciation in their home currency. so when the demand of any commodity increased than the supplier must increase the supply of this commodity. in the case of commodity it is possible. But in the case some factor of production it is not possible for example if the demand of land increase or the rent of the land than increase in the supply of land immediately is impossible. So we come to the conclusion that though the value of the commodities and the prices of the factors of production are determinedly demand and supply yet in the case of supply of factor of production it is difference. to know about it there is need of sepert theory of production. The Supply Curve You now have to start thinking, not as a consumer, but as a producer. Producers combine various factors of production - land, labour and capital - to make output that they wish to sell. In producing goods and services costs are going to be incurred and the price received by sellers will reflect those costs plus an element of profit. The price they receive therefore can be split up into these four elements - wages, rent, interest and profit, so called factor incomes. If you pay 35p for a Mars bar, that 35p represents a contribution to all these elements; 10p may be the cost of the ingredients; 5p the administration and promotion costs; 7p the cost of the labour that goes into making it and in running the company; 9p may be the contribution to the cost of all the machinery and buildings used by the company leaving 4p as the element of profit. (These figures are only for illustration purposes). It follows therefore that if producers are going to increase output they are going to incur some additional costs - raw materials and so on and so may want to receive a higher price in order to persuade them to offer more. In general we would expect a supplier to be willing to offer more items for sale at higher prices than lower prices. We say there is a positive relationship between price and supply and the supply curve slopes upwards from left to right.

The government may also increase taxes to cover higher fuel and energy costs, forcing companies to allocate more resources to paying taxes.

Marginal Productivity Theory Neo-Classical Version In economics, the theory that firms will pay a productive agent only what he or she adds to the financial earnings of the firm. Developed by writers such as John Bates Clark and Philip Henry Wicksteed at the end of the 19th century, marginal productivity theory holds that it is unprofitable to buy, for example, a man-hour of labour if it costs more than it contributes to its buyer's income. The amount in excess of costs that a productive input yields is the value of its marginal product; the theory posits that every type of input should be paid the value of its marginal product.

What is marginal productivity theory? In economics, the marginal product or marginal physical product is the extra output produced by one more unit of an input (for instance, the difference in output when a firm's labor is increased from five to six units). Assuming that no other inputs to production change, the marginal product of a given input (X) can be expressed as: MP = ΔY/ΔX = (the change of Y)/(the change of X). "Political Economy, you think, is an enquiry into the nature and causes of wealth -- I think it should rather be called an enquiry into the laws which determine the division of produce of industry amongst the classes that concur in its formation. No law can be laid down respecting quantity, but a tolerably correct one can be laid down respecting proportions. Every day I am more satisfied that the former enquiry is vain and delusive, and the latter the only true object of the science." (David Ricardo, "Letter to T.R. Malthus, October 9, 1820", in Collected Works, Vol. VIII: p.278-9). "It is the purpose of this work to show that the distribution of income to society is controlled by a natural law, and that this law, if it worked without friction, would give to every agent of production the amount of wealth which that agent creates." (John Bates Clark, Distribution of Wealth, 1899: p.v) "Please forget or disregard what John Bates Clark wrote about marginal productivity and do not blame modern theorists for what our predecessors may have "intended". The intention of marginal productivity theories in modern theory is not the explanation of factor prices." (Fritz Machlup, "Reply to Professor Takata", Osaka Economic Papers, 1955) Although some Neoclassicals have agreed to this Classical definition, most have taken on the Austrian definition of economic earnings in terms of

opportunity costs. If a producer wishes to secure the employment of a particular factor, it has to pay that factor at least what it might receive in alternative employments. This is the opportunity cost of the factor. So, if a factor is paid $7 an hour by a particular producer and could find alternative employment only for $5 an hour, then the factor's opportunity cost (and thus its economic earnings) are $5 and its surplus earnings are $2.

Explanation of the Theory, To see the issues involved, it is best to be clear with an example. Suppose that we have an enterprise which uses one unit of land which can produce ten units of output. Adding a unit of labor, we applying successive laborers to a field, we have the following.

Demand for factor resources:Qty. of Labor

Total Product

Average Product

Marginal Product

One Laborer

10

10

10

Two Laborers

18

9

8

Three Laborers

24

8

6

Let us assume (for the sake of argument, for this is not implied), that the average product represents the actual contribution of the laborer to total output. So, one laborer alone contributes 10 units of output, two laborers contribute 9 each, three laborers contribute 8 each. But, except for the first case, the factors are not paid what they contribute: they are paid the marginal product. Thus, when there are two laborers, each contributing 9, each of them only receives 8 units in wage payments. When there are three, each contributing 8, they each only receive 6 units in wage payments. If laborers are paid their marginal product, we hardly have "moral justice" in this case! Of course, the perceptive should have noticed immediately that the product exhaustion theorem does not hold in this example as the sum of factor payments is less than the total product. That is because we have not assumed constant returns to scale in this example. Under constant returns to scale, the marginal product will be equal to average product and so, in that case, the payment to a factor in our example will indeed be equal to its contribution and thus Clarkian "moral justice" is achieved.

But the lesson should be clear: "moral justice" does not arise merely from paying factors their marginal product; that could be unjust if we do not have constant returns. But if constant returns to scale applies, then paying workers their marginal products may be considered just. Economists assume that firms attempt to maximize their profits. One question that might be asked is whether the employment of an additional unit of labor raises or lowers a firm's profits. To analyze this, recall that: Economic profits = total revenue - total costs When an additional worker is hired, total revenue will rise (under most practical situations). On the other hand, total costs rise as well. The increase in revenue results in an increase in profits while the increase in costs lowers the level of profits. Thus, the addition of an additional worker will increase profits only if the additional revenue resulting from this labor is greater than the additional costs. Profits will decline if costs increase by more than revenue. To examine this issue, economists rely on two measures: •

The marginal revenue product (MRP) of labor, and

•

The marginal factor cost (MFC) of labor.

Rule for Employing a factor of Production, An entrepreneur is to maximize profits. While hiring any resources, he compares the revenue product of a factor with the additional cost he has to pay. So long as the marginal revenue product is greater than the marginal cost of the factor, he will continue to hiring it. When the MRP of the factor is equal to its MC, he will stop engaging more labour.The firm at this point will be in equilibrium and maximizing profit.

Least-Cost Combination of Resources, Economic theory is based on the reasonable notion that people attempt to do as well as they can for themselves, given the constraints facing them. For example, consumers purchase things that they believe will make them feel more satisfied, but their purchases are limited (at least in the long run) by the amount of income they earn. A consumer can borrow to finance current purchases but must (if honest) repay the loans at a later date. In economic terms, profit is the difference between a firm's total revenue and its total opportunity cost. Total revenue is the amount of income earned by selling products. In our simplified examples, total revenue equals P x Q, the (single) price of the product multiplied times the number of units sold. Total opportunity cost includes both the costs of all inputs into the production process plus the value of the highest-valued alternatives to which owned resources could be put.

In the long run, under condition of perfect competition, If the labor market is perfectly competitive, each buyer and seller of labor is a price taker. In this case, the firm faces a perfectly elastic labor supply curve (as noted in Chapter 2 of your text and in the mini-lecture for Chapter 2). Since the wage is constant at all levels of labor use in this market structure, the marginal factor cost of labor is just the market wage. If workers are paid $7 an hour, the marginal factor cost of an additional hour of labor is $7. The relationship between marginal factor ost and the level of labor use is illustrated below.

The diagram below combines the MRP and MFC curves for a firm in a perfectly competitive labor market. Notice that the MRP curve will be downward sloping ad have this same basic shape regardless of whether the output market is perfectly or imperfectly competitive. The only difference is that MRP will be lower when the output market is imperfectly competitive (since MR < P in this case).

The diagram above can be used to determine the profit-maximizing level of labor use. Suppose that the firm chooses to employ Lo workers. At this level of labor use, MRP > MFC. The firm can increase its profits in this case by increasing the level of employment (since the additional revenue generated by an additional unit of labor exceeds the cost of this additional labor). If it hires L' workers, however, the additional cost of the last unit of labor exceeds the additional revenue generated by this labor. In this case, the firm could increase its profits by hiring fewer workers. Profits are maximized at a level of labor use equal to L*. Profits would be lower at any alternative level of labor use.

ASSUMPTIONS OF THE MARGINAL PRODUCTIVITY THEORY Following are some of the assumptions on which the marginal productivity depends on: 1-MOVING OF FACTORS:

It is assumed that the various factors of production can be moved from one use to another. 2-APPLICATION LAW OF DIMISHING RETURN: It is assumed that law of diminishing returns applies also to the organization of business. 3-PERFECT COMPETITION: It is assumed that the reward of each factor of production is determined under conditions of perfect competition and full employment. In other words it is said that there exists a perfect competition both in goods and factor markets.

CRITICISM OF THE MARGINAL PRODUCTIVITY THEORY Following criticisms have been subjected to the marginal productivity theory:

1-SUSPENSION OF LAW OF DIMINISHING RETURN: In the theory it has been assumed that along with increase in the units of labor the MP of labor goes on to fall. But practically such law can be suspended

with the help of better technology, improved seeds and modern management devices. 2-Non-EXISTENCE OF PERFECT COMPETITION: In this theory it has been assumed that there exists a perfect competition both in goods and factor market. Accordingly, the prices of the labor in labor market and the prices of goods in the goods market remain the same. But it is not so. Now day's good markets are characterized by the monopolies, cartels and monopolistic competition. While the labor market are also imperfect because of trade unions. In such situations neither price of goods nor the price of factors will remain the same. 3-LABOR AND CAPITAL ARE NOT PERFECT SUBSITUTES: In the theory it has been assumed that all the factors of production are perfect substitutes to each other. But it is not so. In certain cases the factors have to be employed in the fixed proportions, irrespective of their MPs. 4-LABOR IS NOT HOMOGENOUS: In this theory it has been also assumed that the efficiency of all the units of labor same. But it is not true. Some labor is more efficient as compared to others. 5-NO FULL EMPLOYMENT: In the theory it has been assumed that there is full employment in the economy. But in the actual life the full employment is like a dream. 6-CONCEPT OF MP IS WRONG:

The biggest objection on this theory is this, MP cannot be assessed. It is so because that the production of any good is the result of join efforts of all the factors of production. As in the production of cloth, the labor, land, capital and entrepreneurs all contribute. It is difficult to find the contribution of an additional labor in the total production of cloth.

EQUILIBRIUM OF A FIRM UNDER PERFECT COMPETITION Perfect competition is a market structure where a uniform price is charged for all the units of a good. It has the following silent features: 1-HOMOGENITY: In the perfectly competitive market all the units of the good are homogenous and identical. In other words, in such market the units of a good sold do not have any type of real or imaginary differentiation. 2-LARGE NUMBER OF BUYERS AND SELLERS: In perfect competition there are large number of buyers and sellers. Hence neither the buyers nor the sellers can unite themselves to influence the price. 3-PERFECT KNOWLEDGE: In a competitive market every seller is very well aware of with the price prevailing in the market. Hence neither there is a possibility of over changing nor will any

body pay more prices

SHORT RUN EQUILIBRIUM OF THE FIRM UNDER PERFECT COMPETITION FIRM'S EQUILIBRIUM By firm's equilibrium we mean the determination of such output where firms profit are maximized; of if it has to face the losses they must be minimized. A firm is said to be in equilibrium when MR=MC. This is called the necessary condition for firm's equilibrium and the sufficient condition states that a firm is in equilibrium where MC must cut MR below

DIFFERENT POSSIBILITIES OF FIRM'S EQUILIBRIUM UNDER PERFECT COMPETITION

Different condition is faced by a firm under perfect competition many times. Some of them are here: 1-ABNORMAL OR ECONOMIC PROFITS 2-NORMAL PROFITS 3-LOSSES 4-ABNORMAL PROFITS OR SHUT DOWN

In normal profits the firm is said to be in equilibrium where MR=MC.

In this situation a firm is said to be in equilibrium

where the MC curve cuts MR from the below side. Here MC=MR=AR (P)>AC. MC=Marginal cost

AR=Average revenue

MR=Marginal revenue

AC=Average cost

Some time the firm faces loss. In this type of situation sometime firm has to close this situation will

know as the shutdown. As the equilibrium requires that either profits are maximized or losses be minimized.