Class 3
 Factor Markets refers to the markets where services of the
factors of production are bought and sold
 Labor Markets
 Capital Markets
 The markets for raw materials
 The market for management and entrepreneurial resources.
 The demand for and supply of factors
 Rent
 Wages
 Interest
 Economic profit
 The demand for a factor is derived (Indirect)
 There is demand for land because there is demand for rice.
 The supply of factors of production
 Depends on the system of property rights
 The toil trouble involved in the work
 (Depends on the leisure preference)
 In the free market (no government intervention and trade
union pressure) the price of the factors of production are
dependent on supply and demand.
 Output determination  commodity pricing
 Income distribution factor pricing
 Two types of income distribution
 Functional distribution of income (Micro)
 Personal distribution of income (Macro)
 Each factor is paid on the basis of the function performed
by it.
 Land owners – Rent
 Workers – Wage
 Suppliers of financial capital – interest
 Entrepreneurs – profit.
 Two main theories of factor price determination
 Supply Demand Theory
 The marginal productivity theory of factor demand
 When wages increase
 Labor increases
 This suggests that an individual firm pays a factor on the
basis of its Marginal product
 MR = MC
 However, there are other factors. A rupee spent on labor
cannot be spent on capital
 Therefore firms have to choose their best option.
 This it the law of EQUI-MARGINAL RETURN
 Commercial Rent – Payment for the use of property
 Economic Rent – Is the reward for the uses of the services of
the land.
 The Supply of the land is perfectly inelastic because the





quantity available is fixed and determined by nature.
Supply has no influence in the determining of rent.
Demand is the only determinant of rent
Perfectly inelastic – so as demand increases/decreases rent
will increase/decrease.
Economic Rent offers no incentive system.
Since Land is a gift of nature , any payment received by the
owner is called PURE or ECONOMIC RENT
 Labor Unions try to increase wages in 3 ways
 They try to increase the demand for labor by increasing
productivity
 By advertising union made products
 By lobbying for the restriction of imports
 Increase wage by restricting the supply of labor
 High initiation fees
 Long apprenticeships
 Require that firms higher only union workers.
 Increase wages by bargaining with employees
 Threats of strikes
 Go slow campaigns.
 The wage rate refers to the earning per hour of labor.
 The wage rate divide by the price index gives the “Real
Wage Rate”
 The level of real wages depends on the productivity of labor
 Real wages are higher
 The greater the amount of capital available (hedge fund
managers)
 The more technology available (scientists)
 The availability of natural resources (oil)
 By adding each firms demand for labor we get the Market
demand for labor
 The market supply for labor depends on the
 Size of the population
 The proportion of the population in the labor force
 The state of the economy
 The level of real wages
 Competitive equilibrium real wage rate is determined by
the intersection of the market demand and supply curves.
 Then the firm hires labor until the MR = the wage rate
 You give me Rs 2000 today and in a year I will give you
Rs 500 as interest and the original Rs.2000
 (500/2000)*100 = 25%
 Bank interest is 8%
 So my economic profit is (25-8) = 17%
 Banks sets Savings rates and Borrowing rates – and
the bank keeps the difference as revenue.
Rate of Interest = Interest *100
Principal
 Profit is a return on entrepreneurial ability or a reward for
risk taking.
 Economic role of profits
 Profits as a signal to a resource owner
 Profits are economics signals letting people know to enter markets or
in cases of losses to leave markets.
 Profits are motive for efficiency
 Gives incentive to firms to reduce cost
 Profits as reward
 The prospect of earning rewards are the driving force behind
development
 Innovation
 Profit is the prime mover of capitalistic economies.