Chapter Four: Pricing of Factors of Production and

Income Distribution
Introduction: Difference between product market and factor market.
 In product market we deal with determination of price and quantity of output.
 In factor market (input market) we deal with the determination of prices and
employment of inputs.
 In both markets the forces of demand and supply determine the prices

consumers demand commodities because of the utility or satisfaction they receive

in consuming the commodities, firms demand inputs in order to produce the goods
and services demanded by the society.
That is, the demand for an input is a ‘derived demand’; it is derived from the
demand for the final commodities that the input is used in producing.
4.1 Factor pricing in a perfectly competitive market
 This a situation where both product and factor markets are perfectly
competitive market.
 We consider two types of a firm demand for factor (input)
i. the short run demand of a firm for an input (demand for a single
variable input) and
ii. the long run demand for an input (i.e., the demand of a firm for a
variable factor when there are several variable factors).
 4.1.1. The demand for factors of production
4.1.1.1. The demand for one variable productive factors
 Regardless of time period, a firm’s demand for an input shows the
quantities of the input that the firm would hire at different levels of
input price.

o According to the marginal concept, a profit- maximizing firm will continue

to hire an input as long as the extra income (receipt) from the sale of the
output produced by the input is larger than the extra cost of hiring the
input.
 Our discussion centers on the following important concepts.

o The change in output resulting from the use of an additional unit of a

productive factor is known as the marginal product of the input (MPi).
𝜕𝑇𝑃
𝑀𝑃𝐼 = .
𝜕𝐼

 where TP stands for total product and I stands for the units of the
input.
 Because this extra contribution is measured in physical units (kilograms
of wheat, meters of cloth, etc.), the marginal product is also called the
marginal physical product (MPP).
• To convert such an extra contribution to monetary terms, we multiply
the marginal physical product of the factor by the market price of the
output (PX).
• The monetary value of the contribution of an extra unit of an input is
called the value of marginal product of the input (VMPi). That is, VMPi =
MPPi * PX.
• The extra income of a firm from the sale of the output contributed by an
additional unit of an input is termed the firm’s marginal revenue product of
that input.
• This extra income is given by the marginal (physical) product of the input
(MPPi) times the marginal revenue of the firm from the sale of the units of
the output (MRX). That is, MRPi = MPPi * MRX.

The extra expense a firm incurs to purchase (or rent) an additional unit of a factor of
production is the firm’s marginal expenditure on the factor, that is
𝜕𝑇𝐶
𝑀𝐸𝐼 = .
𝜕𝐼
When the firm is a perfect competitor in the product market, its marginal
revenue is equal to the commodity price (MRX = PX). Consequently, the firm’s
marginal revenue product equals the firm’s value of marginal product, i.e.,
MRPi = VMPi.
For concreteness, if the variable input we are dealing with is labor, then
MRPL (= MPPL* MRX) = VMPL (= MPPL*PX).
Profit maximizing condition:
In general, a profit-maximizing firm in any kind of market structure should
hire an additional unit of labor as long as the MRPi exceeds the marginal
expenditure on the input. In the case of a firm that is a perfect competitor in
both the product and factor markets, profit is maximized at a point where
MRPi = VMPi = Pi, where Pi is input price.
Critical assumption: the law of variable proportion or the law diminishing marginal
returns. This is a short run property of production.
o a rational firm operates in the second stage of production where the MPPL is
declining but positive.
o A downward sloping MPPL multiplied by a fixed output price gives a downward
sloping VMPL curve.
o Multiplying a downward sloping curve by a constant is just like scaling the curve
up (if the constant is greater than 1) or down (if the constant is less than 1).
Fig 4.1: Equilibrium of a Firm in Perfectly Competitive Product
and Input Markets
The graph that shows this relationship between the wage rate
and the quantity demanded (hired) of labor is the demand
curve.
Thus, for a firm that is perfectly competitive in both the labor
and product markets, the short run demand for labor is given by
the VMPL (which is the same as MRPL in this case). In general,
under perfectly competitive product and labor markets, a firm’s
demand for a single variable input is the value of marginal
product of the input (VMPi = MRPi)
Fig 4.2: The Demand of a Firm for Labor in the Short Run
 4.1.1.2. The demand for several variable inputs

o This is the case when demand of a firm for a variable factor when there are
several variable inputs.
o Assume that all inputs are variable inputs. The long run process.
o When there are more than one variable factors of production, the VMPi curve
does not represent the demand for the input. That is, a firm’s demand for
labor is no more the same as the VMPi in long run.
o This is because, in the long run, various resources are used simultaneously in
the production process so that a change in the price of one factor leads to
changes in the employment (use) of the other factors as well.
Let us assume that the price of labor (the wage rate) falls.
Then this fall in wage rate has three effects: a substitution
effect, an output effect, and a profit-maximizing effect.

Fig 4.3 Substitution, Output and Profit Effects of a Fall in Wage Rate
o The movement from e0 to e1 is the substitution effect. This shows that
the firm would substitute the cheaper labor for the relatively more
expensive capital even if it were to produce the original level of output
(X0).
o Thus, because of the substitution effect of the wage fall, the
employment of labor will rise from L0 to L1 while that of capital falls
from K0 to K1.
when wage rate falls, the firm can hire more of the two
factors (L and K) with the same expenditure. Hence, the firm
produces a higher level of output with more labor and capital
(L2 and K2) and, therefore, the movement from e1 to e2 is the
output effect.

Point e2 is not the final equilibrium of the firm because keeping the total
cost/expenditure constant does not maximize its profit. The fall in wage rate results in a
shift in the firm’s marginal cost curve downward (or to the right). This change in
marginal cost is shown by the movement from MC1 to MC2 in Figure 3.4 below. With the
new marginal cost, the firm’s profit maximizing level of output increases from X1 to X2.
Figure 4.4: Fall in Wage Rate Reduces the Marginal Cost of Production of a Firm

The movement from e2 to e3 is the profit effect (or the profit-maximizing effect).
Assuming that labor and capital are gross complements (more
of complementary inputs than they are substitutes), the
output and profit effects more than offset the substitution
effect.
The overall effect of a fall in wage rate is an increase (and
rightward shift of) the MPPL (curve).
The discussion on the substitution, output and profit effects of a wage
change above is of a subsidiary purpose.
It just intermediates the change in wage rate and the response in the
quantity demanded of the input (labor).
Our main interest is on the relationship between the two variables –
wage rate and level of employment.
Figure 4.5: Shifts in VMPL Curve and Equilibrium of a Firm
 The locus of equilibrium points (points A, B and C) as
they are indicated in the above figure 4.6- is the demand
curve for labor by the firm when several variable factors
are used.
 That is, the long run demand of a firm for labor (for an
input in general) is not the same as the VMP curve of the
input, but derived from changing (shifting) VMP curves.
Figure 4.6: Shifts in VMPL Curve and Equilibrium of a Firm
 4.1.1.3. Market demand for a factor or an input
 The market demand curve for an input is derived from the demand
curves for the input by individual firms.
 Nevertheless, it is not the simple horizontal summation of the
demand curves of the individual firms.
 This is because when the price of an input (say labor) falls, not only
this firm but also other firms will employ more of this factor and
other (complementary) inputs to expand production.
 Thus, the supply of the final commodity increases and consequently
its price falls (See Figure 4.7).
Figure 4.7: The Effect of Fall in Input Price on Commodity Price
 Since the MRPL = MPL times MR (which is equal to the
commodity price in perfectly competitive product market), the
reduction in commodity price will cause each firm’s MRPL (=
VMPL) curve and the demand curve for the input to shift down
or to the left.
 In general, the market demand curve for an input is then derived
by the horizontal summation of the individual firms’ demand
curves for the input after the effect of reduction in the commodity
price has been considered (see Figure 4.8 below).
 (a) A Firm’s Labor Demand Curve (b) Market Demand Curve for Labor

Figure 4.8: Deriving the Market Demand for an Input

  If the fall in commodity price were not taken into account, and if a
simple horizontal summation were taken, it would lead to an
overestimation of the market demand for labor (which joins points A
and B' in panel (b) of Figure 4.8 above).

Take away points:

 We derived both the short run (SR) and long run (LR) demand for a
factor or an input by a firm (a single producer) followed by
 Derivation of market demand for a factor.
 Now let us close the demand side analysis of factor market by
describing some factors that affect the demand for a factor of
production.
The amount of an input demanded depends on:
 The price of the input under consideration (wage rate)-negatively related.
 The marginal physical product (MPP) of the factor (productivity of a factor)
(+ly).
 The price of the output (commodity) final product price (PX) (+ly).
 The amount of other factors that are combined with the factor (+ly if it rise
MPPL).
 The price of other factors (+ly for substitute factor, -ly for complementary
factor).
 Technological progress: technological progress could increase or decrease the
demand for an input depending on whether it increases or decreases the MPP
of the factor.
 A technological progress that raises the productivity of labor (more than that
of capital), will increase the demand for labor, and vice versa.
 4.1.2. Factor supply and factor prices
4.1.2.1. The supply of labour by an individual worker.
Consider the following Reality:
 Each no two individuals possess and supply identical amount of labor.
 There is a difference in the quantity of labor supplied- each may supply
different quantities of hours for work.
 Each workers are not identical in quality- workers are not homogenous-
heterogeneity of workers.
 Jobs are also not the same.
 Therefore, we observe different wages (prices) paid to suppliers of factor
(workers).
 But, to simplify our analysis we make the following assumptions:
 Workers are identical and there is a single wage determined or established.
 Determinants of labor supply
 In general, the main determinants of the total labor service supplied
(in a particular market or economy) include:
 The price of labor (wage rate) that prevails in the market;
 The tastes of consumers, which define their trade-offs between leisure
and work;
 Population size in a broader sense (and more specifically, size of the
working-age population);
 The labor force activity (participation) rate; and
 The occupational, educational and geographical distribution of the
labor force.
 The wage rates in other occupations.
o The relationship between the quantity supplied of labor and the
first factor in the above list – the wage rate – defines the labor
supply (function or curve).
o The other determinants (in the list) are considered as factors that
shift the supply curve – shifters of supply curve of factors.

The Work-Leisure Decision Model (Neoclassical) –the building block for

derivation of individual labor supply.
The model regards workers as having the objective of utility
maximization in which preferences of a worker and budget constraints
are key concepts.
Assumptions Underlying the Model
1. There are only two possible uses of time: labor and leisure.
2. Each individual selects the combination of hours of work and leisure
that maximizes his or her level of satisfaction (utility).
Given these assumptions and the basic economic concepts of opportunity
cost and choice:
 For individuals who are working, the opportunity cost of an additional
hour of leisure time is the (market) wage rate.
 An individual will choose not to work if the value he/she places on
leisure time exceeds the market wage.
 Constrained Optimization
o The supply of labor by an individual depends on the individual’s
preference for leisure and work.
o The preference of the individual between leisure and work (where
work is valued for and in terms of the income it generates) can be
represented by a well-behaved indifference map (a set of
indifference curves).
o An indifference curve is a graph of alternative combinations of
goods that provide a given level of satisfaction (utility).
o The substitutability between income and leisure is assumed
imperfect.
o That is, the marginal rate of substitution of leisure for income
(MRSL,Y) – the amount of income sacrificed for an extra unit of
leisure, holding utility constant – declines as the individual has
more and more of leisure.
 The individual attempts to achieve the highest possible level of utility,
defined by U = f (Y , L), however the choice among alternative levels of
income (Y) and leisure (L) is restricted due to two constraints: a time
constraint and a goods constraint.
 A time constraint: the total amount of time available (T) is divided into
hours of work (H) and hours of leisure (L): T = H + L.
 A goods constraint: using the definitions of H, L and T above along
with w = wage rate, P = price index, Y = real income (output), and
assuming that all the income of the individual comes from labor, the
goods constraint is given by: PY = wH. This equation states that total
spending (PY) must equal earnings (= wH).
 The equation wT = PY + WL is called a full-income constraint.
 This equation states that full (potential) income (wT) equals the
total explicit costs of goods and services (PY) plus the total
implicit cost of leisure time (wL).
An alternative form of the full-income constraint is given by:

𝑊 𝑊
𝑌=− 𝐿+ 𝑇.
𝑃 𝑃
The above represents the individual's budget constraint. It shows
the relationship that exists between hours of leisure and real income.
The budget constrains is expressed in the form of slope-intercept.
 The intercept of the budget constraint on the vertical axis equals:
𝑤
𝑇. (= the real value of full income), And
𝑝

the slope of the budget constraint equals:

𝑤
− (= the negative of real wage rate).
𝑝
 Worker’s equilibrium or maximization of satisfaction

o The equilibrium (optimal) allocation of time between leisure and

work (income) is found at the point of tangency of the indifference
curve and the budget line.
o In other words, equilibrium is achieved when the slope of the
budget line equals the slope of the indifference curve.
𝑊 𝑊
Equilibrium point is equal to − = −𝑀𝑅𝑆𝐿,𝑌 . Or = 𝑀𝑅𝑆𝐿,𝑌 .
𝑃 𝑃

This is shown by point E in Figure 4. 9 below

Figure 4.9: An Individual’s Allocation of Time between Leisure and Work
 Having seen how the individual worker reaches equilibrium, now
let us shift our intention to the derivation of labor supply curve- a
curve that shows the relationship between wage rate and hours of
work supplied.
 In general, a wage change has two effects: the substitution effect and
the income effect.
 Consider a rise in the market wage rate.
 In short, an increase in wage rate leads an individual to work more,
i.e., substitution effect renders wage rate and hours of work to be
directly related.
 Thus, the substitution effect of the wage increase always operates to
make the individual’s supply of labor curve positively sloped.
 Assuming leisure to be a normal good, a higher wage will generally
induce individuals to consume more leisure time (and reduce hours
of work).
 This is the income effect resulting from a wage increase. Thus, the
income effect of the wage increase always operates to make the
individual’s supply of labor curve negatively sloped.
If we assume that leisure is a normal good, an increase in the wage will
cause the quantity of labor supplied to:
 Increase if the substitution effect is larger than the income effect,
and
 Decrease if the income effect is larger than the substitution effect.
This may result in a backward-bending labor supply curve (as
illustrated below).
Figure 4.10: The Supply of Labor by an Individual
 4.1.2.2. The market supply of labour

 The market supply of labor is the summation of individual

supplies of labor.
 Although there is a general agreement that the supply curve of
labor by single individuals exhibits the backward bending
pattern, it is usually the case that the market supply is upward
sloping (not backward bending).
 This because: some people prefer to work less hours at higher
wage rates,
 Some other people prefer to work more hours at higher wage
rates.
 Moreover there are new entrant or job switchers or local worker
mobility in the short run that joins the labor force as wage rate is
greater than reservation wage for many people-their by
increasing the overall labor supply.
 In the long run there is population growth due to births and
migration.
 Figure 4.11 below shows the possibility of simultaneously
having backward-bending supply of labor by individuals and an
upward sloping market supply of labor.
Figure 4.11: Backward Bending Individual Labor Supply Curves and
an Upward Sloping Market Supply of Labor
 4. 1.2.3. Factor pricing

o Given the market demand and the market supply of an input, its
price is determined by the intersection of the two curves.
o The following figure depicts the equilibrium wage rate and quantity
(employment level) of labor.
o The equilibrium price and quantity of any other resource is
determined in the same way – by the intersection of demand and
supply.
Figure 4.12: Input Price Determination

The equilibrium wage rate is w* and the employment level is L*.

 4.2. Factor pricing in imperfectly competitive markets
4.2.1. Monopolistic power in product market

 The analysis of this market relies on two basic assumptions:

 The firm uses a single variable factor – labor – whose market is
perfect. That is, the wage rate is given and thus an individual firm
faces a perfectly elastic supply of labor.
 The firm has monopolistic power (is not a price-taker) in the product
market.
 This implies that the demand curve for the product of the firm is
downward sloping.
 Recalling the definitions of the VMPL (= MPPL.PX) and the
MRPL (= MPPL.MRX) from the previous section, we see
that the VMPL > MRPL for the kind of firm we are
assuming.
That is, MRX < PX

MRX * MPPL < PX* MPPL

MRPL < VMPL.
Consequently, the marginal revenue curve lies below the demand
curve (i.e., MR < P) at all levels of output.
Figure 4.13: MRPL < VMPL under Imperfectly Competitive Product Market
 4.2.1.1. Demand of the firm for a single variable input
 Assume the firm uses two factors one variable factor (labor) and one
fixed factor (capital (K) .
 The firm maximizes its profit with respect to the units of labor it
employs-maximize profit by altering the employment level of
variable input.
 Given the firms demand curve PX=f1(QX) and production function
QX=f2(L, 𝐾).
 Profit function is the given as:
𝜋 = 𝑇𝑅 − 𝑇𝐶.
 The objective of the firm is to maximize the
𝜋, 𝑤𝑖𝑡𝑕 𝑟𝑒𝑠𝑝𝑒𝑐𝑡 𝑡𝑜 𝑡𝑕𝑒 𝑣𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝑖𝑛𝑝𝑢𝑡 𝑙𝑎𝑏𝑜𝑟 𝑕𝑒𝑟𝑒 .
Equilibrium conditions:
FOC: Necessary condition:

𝜕𝜋
= 0.
𝜕𝐿
𝑀𝑅𝑃𝐿 = 𝑊
SOC: Sufficient condition:

𝜕2𝜋
< 0.
𝜕𝐿2
 Thus, the firm maximizes its profit by hiring to a point where the marginal
revenue product of labor is equal to the wage rate.

Figure 4.14: Equilibrium of a Firm and the Demand of the Firm for a Single Variable
Input (Labor).

 Joining the equilibrium points like e1, e2 and e3 (which correspond to different
market wage rates) gives MRPL as a demand curve that relates wage to labor
employment.
4.2.1.2.Demand of a Firm for a Variable Factor When There Are Several
Variable Factors (the long run demand curve for factor)

 When two or more variable factors are used in the production process
(i.e., in the long run), the demand for a variable factor is not its MRP
curve.
 Nevertheless, it is formed from equilibrium points on shifting MRP
curves.
 Figure 4.15 facilitates the derivation of the long run demand for an
input (specifically for labor).
Figure 4.15: Demand of the Firm for a Variable Factor when there are
Several Variable Factors
The firms demand curve for labor is not 𝐴𝐴′ , 𝑏𝑢𝑡, 𝑖𝑡𝑠 𝐴𝐵 𝑐𝑢𝑟𝑣𝑒. Since a fall in
wage rate results in three effects : substitution, output and profit effects. The net
result of these effects is a shift in MRPL curve to the right leading to a new
equilibrium at B.
4.2.1.3. Market demand and supply of factors
Market demand:
o If the firm is not a pure monopolist (not the only the seller of the
product):
 Then the market demand for a factor is the summation of the
demand of the individual firms (given that we have more than one
firm) after the impact of a fall in wage rate on final commodity price
is taken into account.
o If the firm is a pure monopolist (the only the seller of the product):
 the market demand curve is the simple horizontal summation of
individual demand curves (the price of final commodity is unique
and likely not affected).
Market supply of factor:
 The monopolist face perfectly elastic supply curve of a factor.
 This firm and the perfectly competitive firm are alike with regard to
the resource supply they face.
 Both are price-takers in the input market; their difference is in the
product market.
 Thus, the market supply of labor is the summation of the supply
curves of individuals, as derived earlier.
 As in the previous case, a single firm faces a horizontal labor supply
curve while the market supply of labor is upward sloping.
 So are the supplies of other factors (for a single firm and for the
market).
 Factor Pricing
 The market price of the factor is determined by the intersection of the
market demand and the market supply.
 When a firm possesses a monopolistic power in the product market, the
factor is paid its MRPi, which is smaller than VMPi (what the input
could have been paid if this firm were a perfect competitor).
 This effect is called monopolistic exploitation.
 It represents the difference between the amount a factor is paid under
perfect competition and the amount the same factor is paid under the
imperfection introduced here.
Figure 4.16: Monopolistic Exploitation at the (a) Firm’s Level, and (b) Market
Level
 4.2.2. Monopolistic power in the factor market (monopsony)

o Here we will consider the case where (the market is imperfect in both
markets) some degrees of imperfection characterize both the factor
and product markets – where a firm has some power in the market
for its product and in the market where it purchases productive
factors.
4.2.2.1. A monopolist using a single variable factor
Demand curve for monopsony is given by MRPL. Which the same as the
demand curve for labor of a firm which has monopoly power in product
market.
o Here the firm is larger than the previous ones we discussed.
o The supply curve is not perfectly elastic like the perfect competitive
or monopolist firm in the product market.
o the firm is the only buyer of the input (a monopsonist).
o The supply of labor this firm faces has a positive slope: as the
monopsonist expands the use of labor, it must pay a higher wage
rate.
o The supply of labor shows the average expenditure or price that the
monopsonist must pay at different levels of employment.
Important terminology to know here.
o Total expenditure on labor employment: obtained by Multiplying

the price of the input by the level of employment- gives the total
expenditure of the monopsonist on the input (TEL = w.L).
o Average expenditure of monopsonist: obtained by dividing the total
expenditure to the amount labor units employed.
𝑇𝐸𝐿 𝑊∗𝐿
o 𝐴𝐸𝐿 = = = 𝑊.
𝐿 𝐿

 Note that w is not a constant in this case, but depends on (or a

function of) the level of employment (L): w = f(L).
 w = AEL = f(L) The supply of labor the monopsonist faces.
The slope of this labor supply function, dw/dL , is positive (i.e., dw
/dL > 0).

Equilibrium of a monopsonist in the short run

o The relevant magnitude for the equilibrium of the monopsonist is

not the wage rate or the average expenditure on labor rather the

marginal expenditure of purchasing an additional unit of the factor.

o the equilibrium of the firm, the firm realizes the maximum profit

when it equates the MEL to its MRPL as shown in Figure 4.17 below.
Figure 4.17: Equilibrium of a Monopsonist Using a Single Variable Factor
The three models together/comparing the three markets we have been
discussed.

Figure 4. 18: Monopsonistic Exploitation

4.2.2.2. A monopolist using two or more variable inputs (the long run
Equilibrium condition).

Equilibrium condition:
For perfectly competitive market:
𝑀𝑃𝑃𝐿 𝑤 𝑀𝑃𝑃𝐿 𝑀𝑃𝑃𝐾
= or = .
𝑀𝑃𝑃𝐾 𝑟 𝑤 𝑟

For the monopsonist:

𝑀𝑃𝑃𝐿 𝑀𝑃𝑃𝐿
=
𝑀𝐸𝐿 𝑀𝐸𝐾
Key Insights:
o Perfect Competition (Both Markets) → Firms take prices as
given, and factor demand depends on VMP.
o Monopoly in Product Market, Competitive Factor Market →
Factor demand is lower than in perfect competition because
marginal revenue is lower than price.
o Monopsony in Factor Market → Firm hires fewer factors and
pays lower prices compared to a competitive market, restricting
employment and output.
 4.2.3. Bilateral monopoly

 Bilateral monopoly arises when a single seller (a monopolist) faces a

single buyer (a monopsonist).
 In this model, we assume that: all firms are organized in a single
body that acts like a monopsonist (the only buyer of labor services);
while all laborers are organized in a labor union that acts like a
monopolist (a single seller of labor services).
 Hence, bilateral monopoly is a model in which the participants are
two monopolies, one on the supply side and one on the demand
side.
READING ASSIGNMENT ON BILATERAL MONOPOLY.
FOCUS ON:
 whether the solution to bilateral monopoly is determinate or
indeterminate.
 The demand curve for labor of a monopsonist firm.
 The supply curve of a monopolistic worker (Labor union).
 The role of market forces on determining the equilibrium wage
rate and equilibrium level of labor employment.
4.3. Elasticity of factor substitution, technological progress and income
distribution.

If we assume that there are two factors of production – L and K – for

simplicity, their shares are defined as:
𝑤. 𝐿
𝑆𝑕𝑎𝑟𝑒 𝑜𝑓 𝑙𝑎𝑏𝑜𝑟 =
𝑉
𝑟𝐾
𝑆𝑕𝑎𝑟𝑒 𝑜𝑓 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 =
𝑉
Where:
w = wage rate
r = rental price of capital
L = quantity of labor employed
K = quantity of capital used
V = the value of the total output produced in the economy.
Elasticity of Factor Substitution and the Shares of Factors of
Production
THE ELASTICITY OF FACTOR SUBSTITUTION (𝜎). The elasticity of
factor substitution measures the ease with which one factor of production (e.g.,
labor) can be substituted for another factor (e.g., capital) while maintaining the
same level of output.
A measure of the degree of responsiveness (of K/L ratio to changes in w/r

ratio). Mathematically, it is defined as:

𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐𝑕𝑎𝑛𝑔𝑒 𝑖𝑛 𝑡𝑕𝑒 𝐾 𝐿 𝑟𝑎𝑡𝑖𝑜

𝜎=
𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐𝑕𝑎𝑛𝑔𝑒 𝑖𝑛 𝑡𝑕𝑒 𝑀𝑅𝑇𝑆𝐿,𝐾
The relative factor share is conventionally defined as the ratio of the
share of labor to that of capital.

𝑆𝑕𝑎𝑟𝑒 𝑜𝑓 𝐿𝑎𝑏𝑜𝑟 𝑤𝐿 𝑉
Relative Factor Share (RFSh)= =
𝑆𝑕𝑎𝑟𝑒 𝑜𝑓 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑟𝐾 𝑉

𝑤𝐿 𝑤 𝑟
⇒ 𝑅𝐹𝑆𝑕 = =
𝑟𝐾 𝐾 𝐿
The factor shares depend on the state of technology that defines the
production function, the nature of technical progress and on the relative
factor prices, i.e.,
𝐼𝑛𝑐𝑜𝑚𝑒 𝐷𝑖𝑠𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛
𝑤
= 𝑓 𝑃𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑜𝑛 𝐹𝑢𝑛𝑐𝑡𝑖𝑜𝑛 , , 𝑇𝑒𝑐𝑕𝑛𝑖𝑐𝑎𝑙 𝑝𝑟𝑜𝑔𝑟𝑒𝑠𝑠
𝑟
Elasticity of Factor Substitution and the Shares of Factors of Production
elasticity of factor substitution (σ): measure the degree of
responsiveness (of K/L ratio to changes in w/r ratio).
 In perfectly competitive input markets, the firm is in equilibrium when it chooses the

input combination at which MRTS LK  w r . This reduces our definition of elasticity of

factor substitution to:

d(K/L) (w r)
 .
d (w / r) (K L)

Note that the sign of σ is always non-negative.

Question: Why elasticity of factor substitution always positive? Justify
your response with numerical example.
Case 1: If σ = 0, then it is impossible to substitute labor for capital or vice
versa.
 This case of perfect complements. The best example is the Leontief
type production functions.
 Resources used in fixed proportions and cannot substituted for one
another.
 Isoquant for this production is represented by L-Shaped curve.
Case2: If σ = ∞, then there is a perfect substitutability between factors. An
example of this is the linear production function, where one input can be
traded for another at a constant rate.
Case3: If σ > 0 (but finite), then factors of production are substitutes but
only to a limited degree (extent).
An example is the Cobb-Douglas type production functions (where σ =
1).
In this case of finite positive elasticity, there are three categories of
substitutability between factors:
σ = 1 implies a unitary substitutability: a percentage change in (w/r)
ratio brings about a proportionate change in (K/L) ratio.
σ < 1 implies an inelastic substitutability: a percentage change in (w/r)
ratio brings about a less than proportionate change in (K/L) ratio.
σ > 1 implies an elastic substitutability: a percentage change in (w/r)
ratio brings about a more than proportionate change in (K/L) ratio.
There is an important relationship between the values of σ and the
distributive shares of factors.
Case 1: If σ < 1, firms are not very sensitive to a change in relative factor
prices and a given percentage change in (w/r) ratio results in a smaller
percentage change in (K/L) ratio. an increase in (w/r) ratio raises the relative
(distributive) share of labor.
Case2: If σ > 1, a given percentage change in w/r ratio results in a more than
proportionate percentage change in K/L ratio, so that the relative share of
labor decreases.
Case3: If σ = 1, a given percentage change in w/r ratio results in an equal
percentage change in K/L ratio, so that the relative share of labor remains
unchanged.
 Technological Progress and Income Distribution

o Assuming a constant production function does not indicate reality.

o Because technological change takes place continuously and this will
cause shifts in the production function, leading to changes in the K/L
ratio and the elasticity of substitution.
o Technological progress makes an isoquant representing a given level
of output shift downwards, implying that the same level of output can
be produced with smaller quantities of inputs.
Technological progress can be:
 neutral,
 labor deepening (capital-saving), or
 capital deepening (labor-saving).

1. Technological progress is neutral if, at a constant K/L ratio, the

MRTSLK remains unchanged.
o Since MRTSLK = w/r at equilibrium, it follows that when
technological progress is neutral both the K/L ratio and w/r ratio
are unchanged.
o Consequently, the relative factor shares remain unchanged.
2. Technological progress is labor deepening if, at a constant K/L ratio,
the MRTSLK increases. This occurs if technological progress increases
the productivity of labor (MPL) more than that of capital (MPK). In
this case the relative share of labor increases and that of capital decreases.

3. Technological progress is capital deepening if, at a constant K/L

ratio, the MRTSLK declines. This takes place if technological progress
raises the productivity of capital (MPK) more than that of labor (MPL).
 a capital deepening technological progress causes the share of labor
to decrease and that of capital to increase (in relative terms).
K

R
R

a
a
X
b X
X' b
c c X'
X''
X''

(a) Neutral Technological Progress:/Slope of (b) Capital Deepening Technological

X at a/ = /Slope of X‘ at b/ = /Slope of X'' at Progress: /Slope of X at a/ > /Slope of
c/ X’ at b/ > /Slope of X” at c/
K
 OR is a ray whose slope shows a
constant K/L ratio.

R In each of the three cases (panels):

 Points a, b and c show points of
a
production at the given constant
X
b K/L ratio as technological
X' progress takes place.
c

X''  X, X' and X'' represent the same

amount of output (under different
states of technology).
(c)Labor Deepening Technological Progress:
/Slope of X at a/ < /Slope of X' at b/ < /Slope of
X'' at c/.

Figure 4.19: Different Types of Technological Progress

THANK YOU VERY MUCH