Chapter 19, Problem aWYWL

To determine

Howdo factors of production are traded in factor market, determining the factor distribution of income?

Concept:

Factor of production: The resources used byproducers to produce product and services. For example, land, labour, physical and human capital.

Factor distribution of income: The way the total income of the economy is divided among factor of production such as labour, land and capital.

Marginal Productivity Income Theory- Marginal productivity income theory explains that the factor of production sold in factor market is paid its equilibrium value of the marginal product. In other words, it refers to the additional value created by using the last unit of that factorin the factor market.

Explanation of Solution

A competitive profit-maximizing firm demands each factor of production till the factor’s marginal product equals its factor price. We analyze a firm’s demand for labor to answer this question. The marginal product of labor(MP_L)is the extra output produced by the firm by hiring one more unit labour, keeping the amount of capital constant.

Therefore, MP_L=f(L+1,K)-f(L,K)

In making its decision, a profitprofit-maximizing firm(assuming it takes the price as given) will hire the labor until the MP_Lis equal to the real wage rate.

This is seen as follows:

Additional revenue (R)depends on MP_L and the price of the good (P). But the firm also incurs additional cost(C) which is the wage rate. So, a firm will hire only to the point where Marginal Revenue=Marginal Cost.

i.e. P*MP_L=W

(MP_L=W/P), where wages and price are exogenously given.