Chapter 18/Pricing the Factors of Production
CHAPTER 18
PRICING THE FACTORS OF PRODUCTION
The discussion of income distribution begins with this chapter. The chapter first outlines the
general theory of factor pricing, that is to say, supply and demand, with demand determined by
CHAPTER OUTLINE
PUZZLE: WHY DOES A HIGHER RETURN TO SAVINGS REDUCE THE
AMOUNTS SOME PEOPLE SAVE?
There is evidence that many savers (i.e., lenders) will save (or lend) less when the rate of
interest increases. This chapter will answer this question.
THE PRINCIPLE OF MARGINAL PRODUCTIVITY
The demand for a factor of production is typically determined by its marginal productivity
schedule.
INPUTS AND THEIR DERIVED DEMAND CURVES
The demand curve for an input is the downward-sloping portion of its marginal revenue
product curve.
INVESTMENT, CAPITAL, AND INTEREST
Investment (which is a flow) is an increase in capital (which is a stock).
The rate of interest is the price at which funds can be rented (i.e., borrowed).
The Demand for Funds
Firms will demand the quantity of borrowed funds that make the marginal revenue product of
Chapter 18/Pricing the Factors of Production
The Downward-Sloping Demand Curve for Funds
The marginal revenue product curve for an investment is negatively related to the interest
rate.
PUZZLE RESOLVED: THE SUPPLY OF FUNDS
Interest is the reward to people for saving, for forgoing present consumption.
Normally, the higher the interest reward, the higher the savings.
The Issue of Usury Laws: Are Interest Rates Too High?
Governments may attempt to limit interest rates by imposing usury laws.
THE DETERMINATION OF RENT
Because land is (virtually) fixed in supply, the market level of land rent is entirely determined
by the demand side.
Land Rents: Further Analysis
The basic notion is that capital invested on any piece of land must yield the same return as
capital invested on any other piece that is actually in use.
Any land that is exactly on the borderline between being used and not being used is called
marginal land.
Chapter 18/Pricing the Factors of Production
As the use of land increases, landlords receive higher payments from two sources:
Increased demand leads the community to employ land previously not good enough to
Generalization: Economic Rent Seeking
Economic rent is any payment made to a factor above the amount necessary to induce any of
that factor to be supplied to its present employment.
Some portion of every factor’s income will consist of economic rent in this sense, unless the
factor’s supply curve is horizontal.
Rent as a Component of an Input’s Compensation
We can divide the payment for any input into two parts.
The first part is simply the minimum payment needed to acquire the input.
An Application of Rent Seeking: Salaries of Professional Athletes
Because Dapper Dan would probably be willing to play basketball for quite a bit less than
$10 million, most of his salary is economic rent.
Rent Controls: The Misplaced Analogy
People sometimes think that rents on housing are economic rents, and that they can therefore
be lowered, without reducing the quantity supplied.
PAYMENTS TO BUSINESS OWNERS: ARE PROFITS TOO HIGH OR
TOO LOW?
Profits are a small portion of GDP.
They are the residual: what remains from revenue after all other factors have been paid.
Chapter 18/Pricing the Factors of Production
What Accounts for Profits?
In pure competition, economic profits disappear in the long run.
In the real world, however, they persist for different reasons:
1. Monopoly power
2. Risk bearing
3. Returns to innovation
Taxing Profits
We do not know how whether the observed profit rate provides more than the minimum
reward necessary to attract entrepreneurial talent into the market.
This relationship between observed profit rates and minimum necessary rewards is crucial
when we start to consider the policy ramifications of taxes on profits.
Criticisms of Marginal Productivity Theory
Some people criticize the theory for providing what is seen as a moral justification for the
status quo in income distribution.
APPENDIX: DISCOUNTING AND PRESENT VALUE
Formulas are developed and examples are shown to illustrate that the present value of a
future income stream depends inversely upon the interest rate used in discounting as well as
on the amount of time into the future that the income is received.
MARGIN DEFINITIONS
Factors of Production: land, labor, capital, and entrepreneurship.
Entrepreneurship: the act of taking the risks necessary in seeking out business opportunities.
Marginal Physical Product (MPP): the increase in output that results from a one-unit increase
in the use of the input, holding the amounts of all other inputs constant.
Chapter 18/Pricing the Factors of Production
Capital: an inventory (a stock) of plant, equipment, and other (generally durable) productive
resources.
Investment: the flow of resources into the production of new capital.
Interest: the payment for the use of funds employed in the production of capital.
MAJOR IDEAS
1. The demand for a factor of production is derived from the marginal productivity of the
factor and by the demand for the final product that the input is used to produce.
2. A profit-maximizing firm purchases the quantity of any input at which the price of the
input equals its marginal revenue product (MRP).
3. Interest rates are determined by the supply of and demand for funds. The demand for
funds depends on the marginal productivity of capital.
Chapter 18/Pricing the Factors of Production
ON TEACHING THE CHAPTER
It is easy for students to get confused with the wide array of topics presented in this chapter, so
instructors will find it useful to spend some time distinguishing the forest from the trees. The
forest is the idea that the demand for a factor of production is set by its marginal productivity.
Marginal productivity is a general concept that can be used to illuminate any number of
particular problems. Once marginal productivity is firmly understood, the particular income
flows to different factors can be seen as applications of that idea.
It is also helpful to emphasize that this chapter refers to the functional distribution of income.
These concepts will later form the basis for understanding the size distribution of income, and
PROBLEMS
1. As Farmer Biff increases the number of acres that he rents, while keeping his other inputs
constant, his total revenue varies as follows:
Acres Total Revenue
10 $60,000
20 115,000
30 165,000
40 210,000
50 250,000
60 285,000
70 315,000
80 340,000
90 360,000
100 375,000
a) If Farmer Biff can rent land at $3,200 an acre, how much land should he rent?
b) Suppose instead that the rental rate is not fixed. Rather, the owner of the land has just
80 acres, and decides to rent it all to Farmer Biff or to another farmer who has access
to the identical technology. What will the rental rate be?
c) In which of these two cases is economic rent earned? How much is the economic
rent?
Solution:
a) He should rent 60 acres (assuming fixed 10-acre increments).
Chapter 18/Pricing the Factors of Production
2. Column 1 of the table shows different investment amounts in a small country. Column 2
shows the expected rate of return made by business firms on a marginal investment, at the
different investment amounts. Column 3 shows the rate of interest required to induce
savers to supply the different investment amounts.
Marginal Interest Rate Needed
Investment Rate of Return to Induce Supply of Savings
(in $billions) (percent) (percent)
1 15 7.5
2 14 8.0
3 13 8.5
4 12 9.0
5 11 9.5
6 10 10.0
7 9 10.5
8 8 11.0
9 7 11.5
10 6 12.0
a) Draw a diagram showing the supply and demand for investment funds, and the
equilibrium interest rate and quantity.
b) At the equilibrium, what economic rent, if any, accrues to the lenders of funds?
c) Suppose a usury law restricts interest rates to a maximum of 8 percent. What amount
of investment will be made?
d) Who is helped and who is hurt by the usury law?
Solution:
a)
Chapter 18/Pricing the Factors of Production
3. Using diagrams, show how the demand or supply of a factor of production, and its
equilibrium price, will change as:
a) the price of the product produced by the factor falls.
b) the productive efficiency of the factor increases.
c) the owners of the factors agree among themselves to reduce the amount offered on the
market.
d) the government sets a price floor, below which it is illegal to allow the factor’s price
to fall.
Solution:
a) When the price of the product produced by the factor falls, its marginal revenue
product curve will shift to the left. So the demand curve for the input will also shift
b)
Chapter 18/Pricing the Factors of Production
c)
d)
4. Suppose that it costs $100,000 to drill an oil well, that one out of 10 wells finds oil, and
that each well is drilled by a separate entrepreneur. In equilibrium, what profit would you
expect successful well drillers to earn
a) if well drillers are risk-neutral?
b) if they are risk averse?
Chapter 18/Pricing the Factors of Production
c) if they prefer risk?
Solution:
a) Ten times the normal interest rate on investment.
5. The Pentagon will shortly award a procurement contract that, because of its “cost-plus”
funding practice, is almost guaranteed to provide an economic profit of $10 million to the
firm that receives the contract. Twenty firms are interested in the contract, and each
appears to have roughly an equal chance at obtaining it.
a) How much would you expect a typical firm to try to spend to win the contract?
b) What will be the eventual profit or loss for the winning firm and the losing firms?
Solution:
a) Because the payoff is $10 million, and there is a one-in-twenty chance of winning the
DISCUSSION QUESTIONS
1. What portion of the rent you pay on your room or apartment can be thought of as
“economic rent”? Does your answer depend on the time period you are thinking of?
Explain.
Suggested Answer: Student answers might vary. Some might suggest that the entire rent
they pay is economic rent. This view is of course shortsighted. The answer also depends
2. “The marginal product is determined by varying the amount of a factor of production,
while keeping all other factors constant, and measuring the change in output that results.
Land is fixed and cannot change, and therefore its marginal product cannot be observed.
Consequently, marginal productivity theory is useless as an explanation of land rents.”
Discuss.
Suggested Answer: Although the quantity of land is roughly constant, the quality of land
can vary. Plots of land do differ in geographical location, topography, nearness to
3. “Economic profit, the income an entrepreneur earns over and above the opportunity cost
of her capital and labor, is socially useless. It performs no economic function, and serves
only to make the rich richer. The government should tax it away.” Discuss.
Suggested Answer: Points of discussion should include the primary ways in which
entrepreneurs can and do drive profits above “normal” interest rate levels. Some of these
Chapter 18/Pricing the Factors of Production
4. “Usury laws, that is, effective ceilings on interest rates, perform the vital function of
keeping credit available at affordable rates to people of limited means.” Discuss.
Suggested Answer: Fears that interest rates, if left unregulated, would climb to exorbitant