From previous lessons, we have learned that factors of production are land, labour, capital and entrepreneur.
In this lesson we will look at what determines the demand for land, labour and capital.
The markets for these factors of production are similar to the markets for goods and services discussed earlier, but they are different in one important way. The demand for a factor of production is a derived demand, meaning that a firm’s demand for a factor of production is derived from its decision to supply a good in another market.
1. The Output Price
An increase in the price of the product raises the value of the marginal product of labour and therefore increases the demand for labour.
A decrease in the price of the product lowers the value of the marginal product of labour and therefore decreases the demand for labour.
2. Technological Change
Technological advance raises the marginal product of labour, which in turn raises the value of the marginal product of labor. Thus, any new technology which raises marginal product of labour will lead to an increase in the demand for labour.
However, as technology improves, demand for certain types of labour falls while demand for other types of labour rises. For example, introduction of word processors reduced the demand for typists and increased the demand for computer literate office assistants.
Technology may also allow employers to replace labour with machines.
3. The Supply of Other Factors
The quantity available of one factor can affect the marginal product of another.
Therefore, any change in the availability of another factor will likely affect the demand for labour.
The Other Factors of Production: Land and Capital
Capital is the equipment and structures used to produce goods and services.
Equilibrium in the Markets for Land and Capital
The purchase price of land or capital is the price a person pays to own that factor of production indefinitely. The rental price of land or capital is the price a person pays to use that factor for a specific period of time.
Because the wage is simply the rental price of labour, what we know about wage determination also applies to the rental prices of land and capital.
The rental price of land is determined by the supply and demand for land; the rental price of capital is determined by the supply and demand for capital. For both land and capital, the firm increases the quantity hired until the value of the factor’s marginal product equals the factor’s rental price. That means the firm will continue to hire if an increase in the net revenue could be achieved by hiring one extra unit of capital or land.
Therefore, land, labor and capital each earn the value of their marginal contribution to the production process. The purchase price of land and capital depend on the current value of the marginal product and the expected future value of the marginal product.
Linkages among the Factors of Production
In most situations, factors of production are used together in a way that makes the productivity of each factor dependent on the quantities of the other factors available. This means that a change in the supply of any one factor can change the earnings of all of the other factors.
Next topic: Labour-intensive and capital-intensive production