UGC NET Economics Unit 1-Factor Pricing

(Unit 1 – Microeconomics)
Based on the UGC NET Economics syllabus and referenced from your uploaded MA Microeconomics textbook.

1. Introduction to Factor Pricing

Factor pricing deals with how the rewards (prices) of factors of production—land, labour, capital, and entrepreneurship—are determined in the factor market.
These rewards are:

Thus, factor pricing theory is also known as the theory of distribution because it explains how the national income is distributed among the different factors of production.

2. Meaning and Scope

The study of factor pricing focuses on:

1. Determining the price (remuneration) of each factor.

2. Understanding factor demand and supply.

3. Explaining functional distribution (income distribution among factors).

4. Analysing market imperfections and their effect on factor earnings.

It answers:

• Why do workers receive different wages?

• Why is rent earned by land?

• Why does capital earn interest?

• Why do entrepreneurs make profits or incur losses?

3. Theories of Factor Pricing

There are two broad approaches:

A. Macro Theory of Distribution

• Deals with total national income and its division among the factors.

• Concerned with the shares of wages, rent, interest, and profit in national income.

• Example: Ricardian distribution theory.

B. Micro Theory of Distribution

• Deals with the reward of a particular factor in a specific industry.

• Example: Marginal Productivity Theory of Distribution.

4. Marginal Productivity Theory of Distribution

This is the most prominent theory of factor pricing.

Assumptions

1. Perfect competition in product and factor markets.

2. Homogeneous factors.

3. Perfect mobility of factors.

4. Full employment.

5. Diminishing marginal productivity.

6. Profit-maximizing firm.

Concept

A rational firm will employ a factor up to the point where:

$$\text{Marginal Revenue Product (MRP)}=\text{Marginal Factor Cost (MFC)}$$

In a perfectly competitive factor market:

$$MFC=Price\text{ (of the factor)}$$

Thus, equilibrium occurs when:

$$\text{MRP}=\text{Factor Price}$$

---

Diagrammatic Explanation


• The MRP curve is downward-sloping due to diminishing marginal productivity.

• The MFC line (wage rate or factor price) is horizontal under perfect competition.

• The intersection determines equilibrium employment and factor price.

---

Mathematical Expression

$$MRP=MP\times MR$$

• Under perfect competition, $MR=P$, so:

$$MRP=MP\times P$$

Hence, factor price = MRP at equilibrium.

---

Implications

• Every factor is paid according to its contribution to production.

• Explains both demand and price determination for factors.

• Income distribution is based on productivity, not exploitation.

5. Concepts Related to Marginal Productivity Theory

Under perfect competition:

$$VMP=MRP=FactorPrice$$

6. Criticisms of Marginal Productivity Theory

1. Unrealistic assumptions (perfect competition rarely exists).

2. Circular reasoning – price of factor depends on product price, which depends on cost, which again depends on factor prices.

3. Static model – ignores time and technological changes.

4. Immobility of factors in reality.

5. Non-measurable productivity for collective factors (e.g., teamwork).

Despite these, the theory is foundational and forms the basis of modern factor pricing models.

7. Modern Theory of Factor Pricing

The modern approach integrates both demand and supply of factors.
A factor’s price is determined by the interaction of its demand (MRP) and supply.

Equilibrium Condition:

$$D_f=S_f$$

where
$D_f$ = Demand for factor (MRP curve)
$S_f$ = Supply of factor (upward sloping)

The intersection gives the equilibrium factor price (wage, rent, interest, or profit).

---

Determination of Factor Price

8. Theories of Individual Factor Pricing

A. Rent (Land) – Ricardian Theory of Rent

• Rent arises due to differences in fertility of land.

• Rent = Surplus over the cost of cultivation on the marginal land.

$$\text{Economic Rent}=\text{Total Revenue}-\text{Total Cost}$$

---

B. Wages (Labour) – Marginal Productivity Theory & Modern Theories

• Wages determined where:

$$MR{P}_L=W$$

• Under monopoly, wages may be below MRP.

• Modern extensions include bargaining, efficiency wage, and labour union effects.

---

C. Interest (Capital) – Classical and Modern Theories

1. Classical Theory: Interest determined by demand (investment) and supply (saving).

2. Loanable Funds Theory: Interest = interaction of demand and supply of loanable funds.

3. Keynesian Theory: Interest determined by liquidity preference and money supply.

$$i=f(LP,M)$$

---

D. Profit (Entrepreneurship) – Risk and Innovation Theories

1. Risk Theory (Knight): Profit is a reward for bearing uncertainty.

2. Innovation Theory (Schumpeter): Profit arises due to innovation and entrepreneurial dynamism.

3. Dynamic Theory: Profit results from changes in demand, technology, and organisation.

9. Modern View: General Equilibrium of Factor Markets

Using Walrasian General Equilibrium, all factor prices are interdependent:

• Each factor’s demand depends on product demand.

• Product price depends on factor costs.

• Hence, equilibrium requires simultaneous determination of all factor prices.

Mathematically, equilibrium is achieved when:

$$\sum _i{D}_i=\sum _i{S}_i\text{for all factors i}$$

10. Efficiency and Welfare Implications

11. Factor Pricing under Imperfect Competition

12. Summary Table

13. UGC NET Focus Areas

14. Key Takeaways

• Factor pricing explains income distribution across productive agents.

• Marginal productivity is the cornerstone of classical and neoclassical thought.

• Modern theories integrate demand and supply to form realistic explanations.

• Market imperfections (monopoly, monopsony, unions) alter equilibrium prices.

• Efficient factor markets ensure Pareto optimal allocation of resources.