Factor Price

Factor price is the price paid for the services of a factor of production, including labour, capital, and land. Factor prices determine the distribution of income among the factors and the allocation of resources among uses.

Factor Prices and Distribution

The prices of factors determine the distribution of income. Wages are the price of labour, interest is the price of capital, and rent is the price of land. The share of income that accrues to each factor depends on the quantities of the factors employed and on the prices they receive.

The analysis of factor prices is therefore central to the analysis of distribution. It explains how the gains from growth are shared among the factors, and it informs the analysis of inequality and of the effects of policy.

Marginal Productivity

In competitive markets, factor prices are determined by the marginal productivity of the factors. The demand for a factor is derived from the value of its marginal product, which is the additional output produced by employing one more unit of the factor, valued at the market price of the output.

The marginal productivity theory implies that a factor is paid the value of its marginal product. It provides a framework for the analysis of the determinants of factor prices and of the effects of changes in technology and in the supply of factors.

Factor Price Equalisation

The theory of factor price equalisation holds that trade in goods can lead to the equalisation of factor prices across countries. The mechanism is that trade in goods substitutes for the movement of factors, so that the prices of factors converge even without the movement of the factors themselves.

The theory is a striking result, and it has been influential in the analysis of the effects of trade on wages and on inequality. Its assumptions are restrictive, and the empirical evidence suggests that factor prices do not fully equalise, but the theory provides a benchmark for the analysis.

Factor Prices and Policy

Factor prices are affected by policy. A minimum wage sets a floor on the price of labour. A tax on capital income reduces the after-tax return to capital. A subsidy to research raises the return to innovation. The effects of these policies depend on the elasticities of demand and supply for the factors.

The analysis of factor prices informs the design of policy. It informs the assessment of the effects of trade on wages, of the incidence of taxes, and of the effects of technology on the demand for different types of labour. It also informs the analysis of the distributional consequences of policy.

Wages and the Labour Market

The wage is the price of labour, and its determination depends on the structure of the labour market. In a competitive market, the wage equals the value of the marginal product of labour. In a market with bargaining, the wage is determined by negotiation between employers and workers.

The institutions of the labour market affect the wage. Minimum wage laws set a floor, collective bargaining determines wages in many sectors, and the structure of unemployment benefits affects the reservation wage. The design of these institutions affects the level of employment and the distribution of income.

The relationship between wages and employment is a central question. The evidence suggests that minimum wages have modest effects on employment, that collective bargaining raises wages but can reduce employment in some circumstances, and that the effects depend on the design of the institutions and on the state of the economy.

The Return to Capital

The return to capital is the price of capital services, and it is determined by the marginal product of capital and by the supply of capital. The return reflects the productivity of capital and the scarcity of savings.

The return to capital has declined in many countries, a phenomenon that has been attributed to the accumulation of capital, to the decline in the relative price of investment goods, and to changes in the composition of investment. The decline has implications for the distribution of income and for the analysis of savings.

The return to capital is also affected by policy. Taxes on capital income reduce the after-tax return and can affect investment. The design of the tax system affects the allocation of capital and the incentive to save.

The Return to Land and Natural Resources

The return to land and to natural resources is rent, which reflects the scarcity of the resource. In the case of land, the rent reflects its location and its quality. In the case of natural resources, the rent reflects the difference between the value of the resource and the cost of extraction.

The taxation of rent is a classic topic in public finance. A tax on land is efficient, since the supply of land is fixed and the tax does not distort the decision to supply it. The taxation of natural resource rent raises issues of design and of the balance between capturing rent and attracting investment.

Summary

Factor prices determine the distribution of income among the factors of production, and their analysis is central to the study of distribution and of the effects of policy. The determinants of factor prices differ across factors and across markets.

See also

• Production Economics
• Labour Economics
• Income Elasticity of Demand