(also known as Modern Theory of Distribution under Perfect Competition)
The modern economist discard the marginal productivity theory on the ground that it completely ignores the supply side of a factor of production. Moreover, it simply states as to how many units of a factor of production will be employed at different prices but it does not explain the real issue, i.e., the determination of the price of the factor of production. They, therefore, use the tools of demand and supply in solving the problem of determination of factor prices. Just as the price of a commodity in the market, they say, is determined by matching of demand and supply. Similarly the price of an agent of production is determined by their forces of demand and supply in the factor market.
Demand for a Factor of Production:
The demand for factors is a derived demand. They are not demanded for their own sake but their services are required for the production of other goods and services which the consumers need. For example, labor is hired because it helps in the production of the commodities. Similarly, land is not desired for itself. It is demanded for the things which it grows or for the construction of a factory or shop, etc., on it.
The demand for a factor of production, like the price of commodity, is a function of price.
How much a factor of production will be demanded in the market depends upon two parameters:
(1) The magnitude of demand and (2) the elasticity of demand for that factor.
(1) The Magnitude of Demand:
(i) If a factor of production is very important in the process of production of a particular commodity or commodities, it will have a higher demand in the factor market.
(ii) If the demand for final product is expected to be high, then the demand for all the factors which produce the product will go up.
(iii) If a factor of production has close substitutes, then its demand will not rise even if the demand for final product in which it is used increase. The reason is that the employers of factors of production would prefer to engage a substitute which is available in the market at an attractive price.
(2) Elasticity of Demand for Factors:
By elasticity of demand for factors is meant the degree of responsiveness of demand for the various factors to changes in their prices. The main propositions on which the elasticity of demand for the factors of production depends are as fellows:
(a) If the price of a factor of production forms a very small proportion in the total costs of a product, then its demand will be inelastic. If cost forms a greater proportion of the total cost, then its demand will be elastic.
(b) The demand for a factor of production also depends upon the elasticity of demand for a commodity in which it is used. If the demand for a commodity is fairly elastic, then the demand for factors which go to make the product will also be elastic and vice versa.
(c) If a factor of production is easily substitutable in the market, then its demand will be fairly elastic. In case, it is indispensable, the demand will be inelastic.
Market Demand Curve for a Factor of Production:
We have stated earlier that the demand curve for a factor is the marginal revenue productivity curve of a firm. If we add up laterally individual demand curves of all the firms, we get market demand curve for a factor. This is illustrated with the help of the curve.
In Fig. 18.3 (a) when the wage is OW1 the firm is in equilibrium at point K and the demand for the factor is OR. When wage is OW2, the firm is in equilibrium at point M. The firm engages OS units of a factor. If we sum up laterally the individual demand curves of all the firms, we get DD market demand curve for a factor (as shown in fig. 18.3 b).
It is clear from this Fig. 18.3 (b) that with the fall in wages, the demand for a factor increases and vice versa. For example, at OW1, market is OK units (in thousand) of factor are demanded. When wage falls to OW, the demand for factor increases from OK to OR. With further fail in wage to OW2, the market demand for factor increase from OR to OS. The market demand curve for a factory is a negatively sloped curve indicating inverse relationship between price of a factor and its quantity demanded.
Supply of a Factor of Production:
The supply of a factor of production can be defined as:
“A schedule of the various quantities of a factor of production that would be offered for sale at all possible prices at any one instant of time”.
We have stated earlier that the demand far various factors of production is a derived demand. Just as the supply and stock of a commodity can be different, similarly the supply and stock of a factor of production can also vary. If the supply price of a factor is high, other things remaining the same, larger will be the units of factor offered for sale. If the supply price is low, less quantity of factors of production will be supplied in the factor market. The supply of a factor to an industry depends upon the transfer earnings of the various units of factor. Another characteristic of factors of production is that they do not bear direct relation between the prices of services offered by the factors of production and their cost of production.
The supply of factors of production is very complicated because each kind of factor presents a peculiar problem of its own. Land, for example, is fixed in quantity and its total supply cannot be increased even if its price rises. However, for a particular use, its supply can be varied.
Similar is the case with labor. The total supply of labor in the country depends upon various factors, such as size of population, labor efficiency, expenses of training and education, geographical distribution, attitude towards work, etc. The total supply of labor in the country is fixed but for a particular occupation it can be increased by drawing workers from other occupations and by increasing the working hours of the labor already employed.
The supply of capital is also complicated as it depends upon the power and willingness of the people to save. The marginal efficiency of capital and the rate of interest also play a very important role in the supply of capital in the country.
In nutshell, we can say that the supply of a factor is also a function of price. The higher the price of a factor of production, other things remaining the same, the greater will be its supply and vice versa. The supply curve of a factor of production is positively inclined, i.e., its slopes upward from left to right as is shown below:
In the diagram (18.4) we measure units of a factor, say labor, along OX axis and wage on OY axis. If the wage is OP and OL workers are supplied. At wage OR, the supply of workers increases from OL to ON. The normal supply curve of a factor is positively sloped. If rises from left to right upward indicating that at higher factor prices, greater quantity of factor is offered in the factor market and vice versa.
In a perfect competitive market, there are large number of firms to demand the services of a factor of production and also large number of households, to supply the services of a factor. In such a factor market, the price of a factor is determined by the interaction of the forces and demand and supply as is shown in the figure below:
In this diagram 18.5, DD/ is the demand curve and SS/ is the supply curve of a factor, The demand and supply curves intersect at point E. The equilibrium factor price is OP. The price of a factor cannot be stable at the level higher than or lower than OP. For example, the price cannot be established at OP1. Since at price OP1, the quantity offered to supply is greater than the quantity demand (QM), therefore, the competition between the owners of the factor will force down the price to OP level.
Similarly, the price of factor cannot be determined at the level of OP2 because at this price, the supply of a factor is less than demand by M1Q1. The competition among the producers demanding the factor of production will push the price to OP level. We thus find that the reward of a factor of production is determined by the interaction of the forces of demand and supply.
The modern theory of factor pricing is criticized on the ground of its weak assumptions.
(i) The theory is based on the assumption of perfect competition in both the product and factor markets. While in reality, it is the imperfect competition which prevails in both the markets.
(ii) The theory assumes that all the unit of a factor are homogenous. But in the real life they are different from each other.
(iii) The theory assumes that different factors of production are capable of being substituted for one on other. In the real world, we find that factors of production are not close substitutes of one another.
(iv) The theory ignores the increasing returns in factor pricing.