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What are the factors of production?

Factors of production are the inputs into the production process.

They are usually categorised as:


What is meant by the production function?

We can incorporate all factors of production into a production function:

Q = f (L, K, N)
where Q is output, L is labour, K is capital and N is Land.


What are amounts and prices of factors?

The price and quantity of factors of production is assumed to be determined by supply and demand in a market in the same way as goods.

BUT, the demand is a "derived demand" i.e. it is dependent on what happens in the product market.

The demand for goods in the goods market has an effect on how many people can be employed making those goods.


When is there no super-normal profit?

If the market is perfectly competitive then the expenditure on goods (P*Q*) goes directly towards the incomes of factors of production, i.e. there is no super-normal profit.


What are the differences between goods and factor markets?

Another difference between goods and factor markets is that the agents have swapped round:

Factor markets: Households sell, firms buy
Goods markets: Households buy, firms sell


What is meant by the demand for factors of production?

Long-run: all factors of production are variable. It is possible for firms to change between factors to gain an optimal mix.

Short-run: all but one factor is fixed. We shall assume that this can be any factor.

As in the rest of this course we are going to concentrate on the short-run and ignore what happens in the long run.


What are alternative views of profit maximisation?

Firms tend to maximise their profits where
Marginal Revenue = Marginal Cost

This can be interpreted in two ways:

The firm adjusts its output up to the point where Marginal Revenue = Marginal Cost 

The firm adjusts its variable factor (which is producing the output!) up to the point where Marginal Revenue = Marginal cost.


How do we sum up when we maximise profits?

In general a firm will employ a factor up to the point where the addition to revenue from an additional unit of the factor is equal to the additional cost for that extra unit of the factor.

i.e. Marginal Revenue = Marginal Cost in terms of the goods market


Assuming a Competitive Factor Market

This means that there are no monopoly suppliers or monopsonistic buyers of the factor. In this case:

The additional revenue for a unit of input is the additional amount produced (i.e. the Marginal Product) multiplied by the price of that additional amount (i.e. the price of the output p).

The additional cost per unit of input is simply the price of the factor (call it C).


What are marginal factor costs?

Therefore profits are maximised when:
C = MP p

where C is the factor price, MP is the marginal product of the factor and p is the output price.

This can be applied to all factors, e.g.
Labour: w = MPL p
Capital: r = MPK p
Note that the left-hand-side are marginal factor costs


What is the Value Marginal Product?

Note that in the case of labour we are ignoring the “efficiency wage” and assuming that the price of labour is equal to the wage rate.

Note also that the factor price is assumed to be given - the firm can only change the amount produced.

Jargon: MP p is often known as the “Marginal Value Product"


What is the demand curve for factors of production?


As the amount of the factor employed increases then the MP for that factor decreases.

If p (the output price) is constant then the MVP (MP p) decreases as well.

As the factor price (C) decreases then the amount of the factor that can be employed increases because C = MP p.

Therefore the demand curve for factors of production slopes downwards.


What is the supply of factors of production?

The supply of capital and land/natural resources tends to be fairly fixed in the short term.

Natural Resources


What is the supply of labour?

The supply of labour depends on three factors:

The size of the population

The labour force

Hours worked

The wage rate is the reward for working, but it acts as an opportunity cost for leisure.

It is also assumed that work is a "bad" and that leisure is a (normal) "good".


What are the income and substitution effects?

If the wage rate rises then two things may happen:

The income effect: workers feel better off because of the increased income and so do not feel the need to work (as much).

The substitution effect: workers work more because the opportunity cost of not working has increased.

These effects work in the opposite direction.


How does this converge to the equilibrium?

A similar bidding story can be told about convergence to equilibrium.

If the wage is too high then it is bid downwards by workers wanting to get a job in the industry.

If a wage is too low then it will be bid up by firms wanting to attract employees.