Unit-5 Principles of Factor Pricing POE | BBA First Year

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Principles of Factor Pricing

• Factors of production can be defined as inputs used to produce goods or services for the purpose of earning economic profits.
• In economics, there are four main factors of production, namely land, labour, capital and enterprise. The price that an entrepreneur pays for availing the services of these factors is called factor pricing.
• An entrepreneur pays rent, wages, interest and profits for availing land, labour, capital and services of the enterprise respectively. The theory of factor pricing deals with pricing of various factors of production.
• The determination of factor prices is always considered to be similar to the determination of product prices. This is because in both the cases the prices are determined with the help of demand and supply forces. Furthermore, the demand for factors of production is similar to the demand for products.
• However, there are two main differences on the supply side of factors of production and products. First, in a product market, the supply of a product is determined by the marginal cost of producing it. On the other hand, it is not possible to determine the supply of factors on the basis of marginal cost in the factor market.
• For example, it is difficult to ascertain the exact cost of production for factors such as land and capital. Secondly, the supply of factors of production cannot be adjusted as easily as in the case of products. For example, if the demand for land increases, it is not possible to increase its supply immediately.
  

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Concept of Factor Pricing

• Factor pricing is associated with the prices that an entrepreneur pays to avail of the services provided by the factors of production. For example, an entrepreneur needs to pay wages for labour, rent for acquiring land and interest for capital so that he can earn maximum profit. These factors of production directly affect the production process of an organization.
• In the context of an economy, these four factors of production when combined together produce a net aggregate of products called national income. Therefore, it is important to determine the prices of these four factors of production. The theory of factor pricing deals with the determination of share prices of four factors of production, namely land, labour, capital and enterprise.
• In other words, the theory of factor pricing deals with the principles according to which the price of each factor of production is determined and distributed. Therefore, the theory of factor pricing is also known as the theory of distribution. The principle of distribution, according to Chapman, “describes the sharing of wealth produced by a community among the agents, or owners of agents, who have been active in its production.”

Every factor of production has two aspects, which are as follows:

1. Value Aspect:

• Refers to the aspect in which an organization pays a certain amount to avail the services of factors of production. For example, wages, rent and interest constitute the prices of factors of production.

Income Aspect:

• Refers to another aspect in which a certain amount of money is obtained by a factor of production. For example, rent received by the landlord and wages received by labor constitute income generated by factors of production.
• Generally, it is considered to be the same as the pricing factor theory of the product pricing theory. However, there are some differences between both theories. Both principles of market forces, i.e. demand and supply, are inferred from the interaction of prices.
• However, there are differences in the nature of demand and supply of factors of production with respect to products. The demand for factors of production is derived demand, while the demand for products is direct demand. Furthermore, the demand for factors of production is joint demand.
• This is because a product cannot be produced using any single factor of production. On the other hand, the supply of products is closely related to the cost of production, whereas there is no cost of production for factors. For example, there are no costs of production for land, labor, and capital. Therefore, factor pricing is separated from product pricing.

Principles of Factor Pricing:

• The theory of factor pricing deals with the principles according to which the price of each factor of production is determined and distributed. The distribution of factors of production can be of two types, individual and functional. Personal distribution is concerned with the distribution of income among different individuals.
• It is not related to the source of income but the amount of income generated. For example, a person invests Rs. Earns. 20,000 per month; This income can be earned by him from wages, rent or dividends. On the other hand, functional distribution is associated with the distribution of income among various factors of production according to their functions.
• It refers to the sources of income, such as wages, rent, interest and profits. Regarding the distribution of factors of production, there are two theories, namely marginal productivity theory and modern theory of factor pricing.

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