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THE THEORY OF FACTOR PRICING
The Theory of Factor Pricing is concerned with the
evaluation of the services of the factors of production.
It deals with the determination of the share prices of four
factors of production, e.g. land, labor, capital and
organization.
Pricing of factors of Production is Functional not
Personal.
The rewards of Factors of Production is Income from the
factors of production point of view but Cost from firms
point of view.
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THE THEORY OF MARGINAL
PRODUCTIVITY
This theory was discussed by many economists like J. B.Clark, Ricardo and Marshall.
It states that in a competitive market, the price or reward
of each factor of production tends to be equal to itsMarginal Productivity.
The payment made to the factor concerned is just equal
to the value of the addition made to the total productionon account of the employment of the additional unit of afactor.
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THE THEORY OF MARGINAL
PRODUCTIVITY Terms used in the theory;
Units of Resource
Marginal Product
Marginal Revenue Product (MRP) = Product Price X MP
Marginal Resource Cost (MRC)
When both MRP and its Marginal Cost are equal, the
entrepreneur stops employing further factors of
production.
Least Cost Combination of Resources must be applied to
maximize the profit which is arrived by equalizing the
ratios between the marginal products and the prices ofdifferent factors of production.
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THE THEORY OF MARGINAL
PRODUCTIVITY
Assumptions of the Marginal Productivity Theory
Identical Products
Factors can be substituted
Perfect Mobility of Factors
Perfect Competition
Law of Diminishing Returns Applies
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THE THEORY OF MARGINAL
PRODUCTIVITY
Units ofResource TP(Output) MarginalProduct ProductPrice TotalRevenue MarginalRev. Pro.
0 0 2 0
1 7 7 2 14 14
2 13 6 2 26 12
3 18 5 2 36 10
4 22 4 2 44 8
5 25 3 2 50 6
6 27 2 2 54 4
7 28 1 2 56 2
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THE THEORY OF MARGINAL
PRODUCTIVITY
D = MRP
Resource Employed
Productivity/
Resource Price
0
MW/AWE
M
WE 2E 1
M 2M 1
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MRP Curve as Resource Demand Schedule
The MRP curve is also the Demand curve because in acompetitive market the product price and the resource
price e.g. wage is fixed.
At different wage rates firm hires corresponding number
of labour.
If we take the given table data and say that wage rate isRs.14 so only 1 labour will be hired and if wage rate is
Rs.6 so 5 labours will be hired because MRP is 14 and 6
respectively at different number of labours hired.
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THE THEORY OF MARGINAL
PRODUCTIVITY
Criticism on Marginal Productivity Theory
Units are not Homogeneous
Factors are not Perfect Substitutes
Law of Diminishing Returns
Difficulty in measurement of MP
Neglected the Effects of Supply
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MODERN THEORY OF FACTOR
PRICING
This theory was presented to solve the problem ofdetermination of resource prices which was ignored by
the Marginal Productivity theory as it only states the
units of factors of production to be employed.
This theory takes the demand and supply of each factor
and determine their prices by the equilibrium of market
demand for factors and supply of those factors.
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MODERN THEORY OF FACTOR
PRICING
Demand for Factors of Production;
Demand for factors is a Derived Demand
Demand for Factors depends upon two Parameters
Magnitude of Demand
High demand if the factor is important in production process
High demand if final product demand is high in the market
Low demand if factor has close substitute
Elasticity of Demand for Factors If factor price form small portion of total cost so its demand will be
inelastic and vice versa
Depends upon the elasticity of demand for commodity.
If factor is easily substitutable then demand will be elastic
O O O AC O
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MODERN THEORY OF FACTOR
PRICING
Supply of Factors of Production
The supply of factors of production is a complicated
topic but still it can be said that the higher the price of a
factor of production, other things remaining the same,
the greater will be its supply and vice versa.
The prices of factors of production is determined by theinteraction of the forces of demand and supply.
MODERN THEORY OF FACTOR
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MODERN THEORY OF FACTOR
PRICING
Price
Demand and Supply of the Factor
E
D
S
0
P
M
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