How the price of a factor of production is determined by the forces of demand and supply?

The marginal productivity theory of factor pricing is Incomplete by itself. It suffers from many defects. This theory gives too much importance on demand but neglects the supply side of a factor of production. The modern economists hold that the factor price is determined by the forces of demand and supply of factors as it is in case of commodity market. Thus the principle of factor pricing of commodity is applicable to the pricing of factors in the factor market. This theory (modem theory) analyses various factors affecting both the demand and the supply side. Thus it is made clear that the forces of demand and supply are the two determining forces in factor pricing.

Demand Side:

The demand for factors is not the same as that of consumer goods. The demand for factor is indirect. In other words the demand for factor is derived one. Factors help in producing consumer goods. If the demand for other goods rises, it will give rise to the demand for factors. Factors are employed more and more so long as their marginal productivity equal price. As the marginal productivity of a factor diminishes with every additional use, the producer will be prepared to offer lower price to the additional factors.

Thus the demand curve of a factor takes the shape according to shape of marginal revenue productivity curve. At higher wages, the employment is less and at lower. Price employment of factors is higher. Then the demand curve takes the same slope as it is in case of a traditional demand curve for other goods. For determining the .factor price the individual demand curve of a firm is not important. What is important is the industry’s demand curve. The Industry demand curve is the lateral summation if demand curves all the firm in the factor market.

Supply Side:

The supply of factors is also different from that of goods. The supply of other goods rises with the rise in price. The change Elementary Economic Theory & National Income Accounting 127 is immediate. But the supply of factors of production is not so simple and sudden. Price is not the only factor that governs the supply of a factor. There are so many things which affect the supply.

The supply of labour for an industry is elastic. Likewise the supply of Land is inelastic for the society as a whole but it is elastic for the individual use. The supply of capital is more or less dependent on price. The supply of capital. To Keynes supply of capital also does not depend on the rate of interest but it also depends on of income. But for the sale of simplicity we assume that the market supply curve of a factor is upward sloping. Its slope is positive.

Determination of Equilibrium price for a factor:

Factor remuneration is determined at the level where the demand and supply equate each other. The price of factor of which the demand for and supply of a factor are equal is known as equilibrium factor price. In the diagram given below DD is the demand curve and SS is the supply curve of a factor. At point E, the demand for and supply of a factor are equal. Point E is the point of equilibrium. The factor price is OP. If the price of a factor rises to OP, the supply will be greater than demand. If the price of the factor is less than the equilibrium price i.e. at OP₂ price the supply is less than demand. Hence the equilibrium factor cost is determined by the interaction of the forces of the demand and supply in the factor market.