Factor prices play an important role since they determine how resources are distributed among producers. When the factor prices increase their demand reduces. Likewise when the factor prices decrease producers demand for more factors of production. Some people earn their incomes through wages and salaries and hence they are earning income by selling labor. Others such as people who own stock in companies sell physical capital. Lastly, there are those who earn their income from rents of their own lands. Factor prices can therefore determine how income is distributed in an economy. For instance, the US economy has more people earning their income by supplying labor than any other factor. Therefore wage rates increase with other factors remaining constant; labor will have the largest share of the total income (Krugman & Wells, p. 509-512).
Marginal productivity and factor demand
In a typical economy, the decisions made are always about cost and benefit. Producers and consumers are always comparing the extra benefit they will get by incurring an extra cost. This extra benefit is known as marginal benefit and this extra cost is called marginal cost. Producers can determine whether to employ an extra factor if the cost of that factor is less than the benefit to be obtained. Therefore if you subtract the extra cost from the benefit, you get a profit. However if the cost is higher, then it will result in a loss. This underlines the general rule that explains that a profit-maximizing profit-taking producer employs each factor of production up to the point at which the value of the marginal product of the last unit of the factor employed is equal to the factor’s price (Krugman & Wells p. 513-516).
Change in factor prices determines changes in factors of productions’ demand along the demand curve. However, there are factors that determine the shift of the demand curve. First, there is change in the prices of goods because factor demand is derived demand. If the price of the goods produced by a given factor increases, assuming that the factor cost remains constant, the producer will be able to make more profit using the same factor. This will lead to a shift in the factor demand curve, because the marginal benefit has increased, and hence, the producer will employ more factors to maximize profit. This results in a rightward shift in demand curve. Secondly, change in the supply of other factors can also shift the demand curve. For instance, acquiring more land can lead to an increase in the labor demanded -outward shift while a decrease in the same will lead to a decrease in the amount of labor demanded, which is a leftward shift (Krugman & Wells p. 516-517).
Lastly, changes in technology can shift the demand curve either way. Increase in technology can lead to a decrease in labor demand because machines now perform their functions. On the other hand, increase in technology can lead to an increase in demand for labor and land because more can now be produced and hence more laborers and land are needed. A factor’s last unit adds value to a product and this is regarded as the marginal product’s equilibrium value. A factor’s last unit adds value to a product and this is regarded as the marginal product’s equilibrium value. As such, the wage rate of a perfect market is deemed as the value at the equilibrium level of the labor’s marginal product. This is also true for other factors of production. Krugman & Wells (p. 518-521) therefore suggest that utilization of a factor of production is limited does not extend the point where the factor’s marginal product is at par with its equilibrium price.
This leads to the marginal productivity theory of income distribution which states that each factor is paid the value of the output generated by the last unit of that factor employed in the factor market as a whole (which is its equilibrium value of the marginal price). However, some wage disparities fault this theory. The first one is market power whereby workers through workers’ unions can bargain for higher wages than the equilibrium wage rate. Secondly, efficiency wages whereby employers can give special treatment (higher wages) to their employees to get special services from them and to reduce their chances of leaving. Lastly is discrimination whereby two employees with the same qualification can be paid different wages based on their race or gender. For instance, women receive less income compared to their male counterparts with the same qualification (Krugman & Wells p. 521-528).
The supply of labor
The supply of labor is always determined by the time a person is willing to allocate to work compared to other activities. A rational person will make that decision by making a marginal comparison. He will compare the marginal utility of using one dollar and the marginal utility of one hour in leisure time. If the marginal utility of an hourly wage is higher of the two, then he will commit an extra hour of labor to gain an extra dollar – substitution effect. However if the marginal utility of one more hour of leisure time is higher than an hourly wage, then he will commit the hour to leisure time -income effect. The general rule therefore is that a person will attain a labor supply optimal choice when his marginal utility of one hour of leisure is equal to the marginal utility he gets from the goods that his hourly wage can purchase (Krugman & Wells p. 528-533).
Krugman Paul and Wells Robin. Economics. New York, NY: Worth Publishers, 2010.