Demand and Supply Theory of Pricing of Factors of Production

The Marginal Productivity Theory came under severe criticism of modern economists on the ground that it ignores the supply side of a factor of production besides many other weak points. The Modem Theory of pricing of factors of production also known as “Demand and Supply Theory” gives a satisfactory answer to the problem of determining factor prices. According to the theory just as the price of a commodity which is determined by the forces of demand & supply, similarly the price of a factor of production is also determined by the demand for that factor and its supply.

Demand for a Factor of Production

The demand for a factor is not a direct demand but it is an indirect or derived demand. The demand for labour, for example, is not demand for labour himself. It is in fact, demand for goods or services which the labour produces. Thus when demand for goods increases, the demand for the factors which produce those goods would also rise. If demand for goods is elastic, the demand for factors would also be elastic. Similarly when demand for goods is inelastic, the factor which produces it will also be inelastic. The demand for any given factor of production also depends upon the availability of other factors which co-operate with this factor in the process of production. Normally the demand for and price of a given factor will be higher if the co-operating factors are available in large. A third rule regarding the demand for a factor is what when more of a factor is employed, its marginal productivity is likely to fall and hence its demand and price are also likely to become lower. The demand and price of a factor also depends upon the market price of the goods for the production of which this factor has been used. If the goods are being sold at high prices the demand for the factors would also be higher.

In the Fig-A various amounts of labour employed by an individual firm at different wage rates are shown. When wages are OW₁ the firm is in equilibrium at the point E and therefore employs ON amount of labour. As the wages go down OW₂, the equilibrium position shifts to E and total employment of the factor goes up to ON’. Similarly at the wages rate OW₃ the employment of factor goes up to ON”. The demand curve for labour is thus downward slopping as shown in Fig-B.

Now to obtain the demand curve for the whole industry, all the demand curves of the individual firms have to be summed up. Let us for the sake of illustration take that the industry consists of only three firms with the demand curves D₁, D₂ and D₃. The total demand curve of the industry would be summation of three demand curves

Supply of a Factor of Production

The supply of a factor of production depends upon a number of factors. Let us take the case of labour. The supply of labour depends upon the size and composition of population, its geographical and occupational distribution, efficiency of labour, expected income etc. But one thing that is generally true is that more of labour would be offered in the market when wages are higher compared to what is being offered at lower wage rate. It is only a general tendency which may not be true always. If at higher wage rate labour starts preferring leisure to work the supply of labour is likely to fall thus the supply curve of labour may be backward sloping. However such cases are very rare.’ Therefore for the purpose of our analysis the supply curve for labour may be treated to be upward sloping showing that more of labour is supplied when the wages go up. The supply curve is given at Fig-D.

Determination of Market Price of a Factor

After a detailed discussion on the demand and supply aspects of labour during production, let us see how wage rate is determined by their interaction. In the Fig-E, DD represents the demand curve for the factor of production say labour and SS is the supply curve. Both curves intersect each other at point E, which is the equilibrium position in factor market at which EQ is the equilibrium wage rate. If the wage rate increases to OR, demand for labour will fall and supply will rise, which may cause competition among labourers, thus the wage rate would fall resultantly. Contrary to it if the wage rate falls to OK then supply of labour will fall and demand will rise which may cause competition among producers to employ more and more labour at lower wage rate resultantly this competition would rise the wage rate and this up and down will bring it to the equilibrium level OP or QE at OQ quantity of labour.

Criticism on Demand and Supply Theory

The theory is criticized on the basis of some of its weak assumptions which are given as

The aspect of increasing return in the theory of distribution or factor pricing is completely ignored.
As the factors of production are not close or complete substitutes of each other, therefore they cannot be substituted for one another.
Homogeneity in all units of a factor of production is not possible.
Prevalence of perfect competition in’ both factor and production market is not correct because in real world it does not prevail