Factor pricing Theory.pdf

This PPT contains matter of Factor Pricing theory for Managerial economics/Business economics/Micro economics students.

1. Factor pricing
Dr. Ruchi Jain
Associate Professor
Department of Financial Studies
IIS(deemed to Be University),Jaipur(Rajasthan)

2. Meaning
•Also called Theory of Distribution.
Distribution
Functional
Remuneration paid to
various factors of
Production in an act of
production.
The factors of Production viz.
Land---Rent
Labour---Wages
Capital---Interest
Entrepreneur--Profit
Personal
Distribution of National
income among various
factors of production which
is in equally distributed.
Theory of factor Pricing

3. Marginal Productivity Theory of Distribution
•Also called the General Theory of Distribution.
•It determines the reward for various factors of
production.
•The theory has been developed by Jevens,
Wicksteed, Marshall,Walras, Mrs. Joan Robinson,
J.R.Hicks.

4. Explanation
•According to MP theory of distribution the price of a
factor of production depends upon its productivity
and it is determined by its marginal productivity.
•The price/remuneration of factor = Marginal
Productivity(perfect competition).
Long
period
•The price/remuneration of factor = Marginal Productivity
•The price/remuneration of factor > Marginal Productivity
•The price/remuneration of factor < Marginal Productivity
Short
period
Marginal Product is also called Marginal Physical Product(MPP):
It is an addition to the Total Product (TP) or Total Physical product(TPP) by
employing an additional unit of factor of production keeping other factors of
production constant

5. Firm wants to maximize its profit---it is possible only when
when marginal Productivity high Price paid is less
Price of factor αproductivity of factor
Higher productivity---Higher PriceLower productivity--Lower Price
An individual firm demands for a factor according to its productivity.
The demand for various factors of production is derived demand.

6. •The profit will be earned when marginal productivity
of factor is equal to its marginal cost.
Price of Factor<Marginal
Productivity
Firm will earn more proift, will
employ more units of factor
Law of diminishing return will
apply
Reward= marginal productivity
Price of Factor>Marginal
Productivity
Firm will incur losses, will
employ less units of factor
Will continue to employ less
till
Reward= marginal productivity
Reward for a factor
should be given
according to its
marginal productivity
MP f= MC f

7. Accto MP theory the share
of each factor of production
from NI = MP
In the position of
equilibrium the MP of a
factor in all uses will be
equal and the reward will
be same.
If it does not happen then
factor will move to those
uses where they will get the
higher remuneration
The productivity of factors
will increase where the low
reward is paid
Then the situation will
emerge where the marginal
productivity of factors of
production in all the uses or
industries will be equalised
The reward will be equal to
their marginal productivity.
The law of substitution will
operate and according
cheaper inputs will be used
in the place of dearer
inputs.
The process of substitution
will stop till the prices of
inputs are equalisedto
their marginal
productivities
Thus, Each factor of
production will be
remunerated equivalent to
its Marginal productivity.

8. Conditions for Equilibrium
The Marginal productivity of any factor is
equal in all the uses or Industries.
Each factor of production should have equal
marginal productivity of other factors of
production in an industry.
The remuneration of a factor of production =
its marginal productivity and during long
period it will be = its average productivity.

9. Components of Marginal Productivity
•Marginal productivity is an addition to total productivity by
employing an additional unit of a variable input keeping the
other factors of production fixed.
Marginal
Productivity
Marginal Physical
Productivity
(MPP)
Marginal Revenue
productivity (MRP)
Value of Marginal
Physical
productivity (VMP)

10. Marginal Physical Productivity(MPP)
When the additional unit of factor of production is increased keeping other factors of
production constant the addition in Total Physical Product is called Marginal Physical
Product(MPP).
The MPP changes according to the operation of law of variable proportions.
In the beginning MPP increases and reaches at its maximum and thereafter it
decreases with increase in the units of variable input. The shape is inverted U.
MPP=
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11. Marginal Revenue Productivity(MRP)
The marginal Revenue Productivity of a factor is the price of
output which is sold in the market by employing an additional
unit of a factor keeping other factors of production is
constant.
MRP= MPP x MR
Where MRP= marginal revenue productivity
MPP= marginal Physical Productivity
MR= Marginal Revenue
Under perfect competition there is single price of the factor
of production and output. Hence , the MRP can be calculated:
MRP= MPP x P

12. Value of Marginal Physical Productivity (VMP)
•The value of MPP multiplied by the price of a
commodity can be calculated as given under;
VMP= MPP x Price or AR
Where VMP= Value of Marginal Physical Productivity
MPP= Marginal Physical Productivity
AR= Average Revenue

13. Calculation of MPP, MRP and VMP(Perfect Competition)
Units of
Variable
inputs
(labour)
Total
Physical
Productivity
(TPP)
Marginal
Physical
Productivity
(MPP)
Price Valueof
Marginal
Productivity
(VMP)
Total
Revenue
Productivity
Marginal
Revenue
Productivity
(MRP)
(1) (2) (3) (4) (5)=3 x 4(6) =2 x4(7)
1 5 5 5 25 25 25
2 12 7 5 35 60 35
3 24 12 5 60 120 60
4 34 10 5 50 170 50
5 42 8 5 40 210 40
6 48 6 5 30 240 30
7 52 4 5 20 260 20
8 54 2 5 10 270 10

14. Calculation of MPP, MRP and VMP(Imperfect Competition)
Units of
Variable
inputs
(labour)
Total
Physical
Productivity
(TPP)
Marginal
Physical
Productivity
(MPP)
Price Valueof
Marginal
Productivity
(VMP)
Total
Revenue
Productivity
Marginal
Revenue
Productivity
(MRP)
(1) (2) (3) (4) (5)=3 x 4(6) =2 x4(7)
1 5 5 5 25.00 25 25
2 12 7 4.5 31.50 54 29
3 24 12 4 48.00 96 42
4 34 10 3.5 35.00 119 23
5 42 8 3 24.00 126 5
6 48 6 2.5 15.00 120 -6
7 52 4 2 8.00 104 -16
8 54 2 1.5 3.00 81 -23

15. Average Revenue Productivity(ARP)
•It is calculated on the basis of total revenue
productivity and the number of units of a
variable input dividing the TRP by the number
of units of a variable input as given below:
•ARP=
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16. Marginal Factor Cost (MFC)
•When a factor of production is given remuneration it is
income from the point of view of input but it is a cost of
production from the point of producer.
•Under perfect competition the price of a factor of production
will remain the same whether one unit is employed.

17. Assumptions of the Theory
All the units of an Input are Homogenous
Perfect Mobility of Factors of Production
Perfect Competition in Factor Market and
Commodity Market
Proportion of Inputs is Variable
Full Employment
Long Run Theory
Marginal Productivity is Measurable
Maximisationof Profit
Operation of Law of Diminishing Returns

18. Criticism of the theory
All units of a Factor are Not Homogenous.
Perfect competition is unrealistic
Unrealistic Assumption of Full Employment
Marginal Productivity is Not measurable.
Imperfect Mobility of Factors of Production
Maximisationof profit is Not the sole object
One sided theory
Long run explanation
Not applicable to entrepreneur
Neglects Technological Progress
No Explanation of Inequalities of Income