Factor payments (economics)
Encyclopedia
Payments made to scares resources, or the factors of production in return of productive services.They are also categorized according to the services of the productive resources being rewarded.As wages are being paid for services of labor,interest is paid for the services of capital, rent is paid for the services provided by the land and profit is for the factor of payment to entrepreneurship..
Economy is dependent on the production of goods and services, hence factors of production are required for the production of goods and services. They are broadly divided in the three factors of production Land
, Labor, Capital
. Land is the primary factor of production. Labor is the specific factor of production and payment is made in the form of wage. Capital is regarded as secondary factor of production as it can be manipulated by economic activity. Payment received would in the form of interest. Later Entrepreneurship was added as the fourth factor of production. It earns profit to the Entrepreneur.
Factors of production are owned by household and they supply these factor of production to firms and in return earn wages, interest,rent and profit.Household buy goods and services with this money.
In economics
, factor payments are the income
people receive for supplying the factors of production
: land, labor, or capital.
, no capital market
, no foreign sector. Households own all the factors of production , that is land
, labor, capital
. These factors of production are sold to the firms to produce goods and services through factor markets. Firms make use of these resources and provide goods and services to the household through product markets.However the exchange of goods and services and factors of production
takes place with the help of the financial flows which moves in the reverse direction.As the households purchase goods and services from firms it is their consumption expenditure which in tern becomes income or profits for the firms. On the other hand when firms buy factors of production
from the households they pay factor payments in the form of wages, rent
, interest
.
, wage
, interest
and profit..The prices for factor of production depends upon demand
and supply
of that particular factor of production. We assumed that the factor of production in economy are fixed and hence the factor supply curve is vertical.Equilibrium of factor payments is determined by the intersection of downward-sloping factor demand curve and vertical supply curve. To understand the optimal factor payments we would determine through their respective markets i.e. the market clearing prices of the factors of production. There are three major factor of production Land, Labor, Capital.
To understand the optimal factor payments we would determine through their respective markets i.e. the market clearing prices of the factors of production. There are three major factor of production Land, Labor, Capital.
(MPL). The marginal product of labor is defined as the extra unit of output that the firm produces from hiring one extra unit of labor.
MPL=F(K,L+1)-F(K,L)
The above equation states that Marginal Product of labor is the difference of output produced from one extra unit of labor and the output produced from original quantity of labor.This production function function has the function of diminishing marginal product which means that the marginal product of labor decreases as the amount of labor increases,and as the amount of labor increases the production function becomes flatter i.e. diminishing marginal product.
. Which means that the firm compares the extra revenue earned from increased production that results from the added labor which ultimately leads to the higher higher spending on wages.let us understand with the following example
Let
denote wages rate that the labor receives.
s denote the hours of labor services that household supplies to labor market.Thus the households receives 
samount of income from providing labor services.Now let 
d denote the labor services that the firm demands from labor market.Thus the firm pays 
damount of wage for providing labor services.Quantity produced in the economy will be given by 
s =
d. Thus the firm profit will be given by gross revenue less wage payments.
s-
d=
d-
d
Now if we increase the labor input it has two effects first the output will increase by the marginal product of labor
as extra hour of work is provided.Therefore the gross sales revenue will be given by
second the wage rate for the firm increases by 
It is clear that in order to maximize profit firm will expand employment level upto the level where marginal product just equals wage rate.
Now if we divide the above equation with general price level then we obtain
here
is the real wage
rate.At that point the contribution done by the last unit of labor will be just equal to output MPL.Thus we can conclude that the wages paid would we equal to Marginal Product of labor.
and demand
for capital determines the optimal interest rates. The rate of interest that is determined by the intersection of investment and saving is the price of investible resource (capital). The demand for capital is done by the entrepreneur for further investment and for the productive purpose. But the productivity of capital is dependent on the law of variable proportion. Which means as more and more of capital is employed the productivity from capital goes on decreasing. Therefore the entrepreneur will employ only capital upto that level where the rate of interest is equal to the Marginal productivity of capital(MPK).
where MPK is the Marginal productivity of capital and R/P is real rental for capital. It shows that demand for capital is inversely related to rate of interest.There are many other factors which affect the demand for capital. On the other hand supply of capital is positively related to the the rate of interest. As the rate of interest increases the savings increases and vice-versa. Thus the entrepreneur will employ the capital where MPK is equal to real price of capital.
The optimal rate of interest rate is determined by the intersection of demand
and supply
curves. If the rate of interest rises above the equilibrium
interest rates the demand for the investment will decline and the supply of savings will increase. As there is excess of savings than demand in the economy the market forces will bring the interest rate to the original interest rates.Now, if the interest rates fall below the optimal level then the there is excess of demand than supply in the economy and hence, the market forces will adjust the interest rates..
it was called The ricardian theory of rent. Ricardo defined rent as that portion of produced of the earth which is paid to the landlord for the use of the original and indestructible powers of the soil. However later on the modern theory of rent was developed by the modern economists.tThe main difference between the Ricardian theory and this theory was that, ricardian theory used the difference between surplus enjoyed from superior land to the inferior land. In the modern theory the rent was determined by the demand and supply forces in the market like the other factors of production
.Demand for land means total land demanded by the economy as a whole.Demand for land like others depends upon the marginal revenue productivity. Rent paid by the economy will be equal to the marginal revenue productivity which is also subject to law of diminishing returns. this suggests that the demand curve like any other demand curve will be downward sloping.It shows that the demand for land and rent are negatively related. On the other hand supply of land for an economy is fixed that is it is perfectly inelastic.
This theory was first developed by Edgeworth, Chapman, Stigler,Stonier. This theory is also depended upon the marginal revenue productivity.
It is also called Marginal Product and Capital demand.Let us consider example, The main objective of firm is to maximize profit. As we know that profit would be difference between the revenue and costs
.Where the revenue would be equal to the price of the good multiplied by the output of the firm
. On the other hand the costs of the firm include labor costs
, capital costs
,rent cost if any.Now if we substitute our production function
. Then we would see that the profit of the firm is depended on factor prices and factor inputs.
.Hence firm would choose the that optimal level of factor inputs that would maximize profit of the firm.
Economy is dependent on the production of goods and services, hence factors of production are required for the production of goods and services. They are broadly divided in the three factors of production Land
Land
Land may refer to:*The part of the Earth that is not covered by water**Ecoregion*Landscape*Landform, physical feature comprises a geomorphological unit*Land , a factor of production comprising all naturally occurring resources*Land law...
, Labor, Capital
Capital
A capital city is the area of a country, province, region, or state considered to enjoy primary status; although there are exceptions, a capital is typically a city that physically encompasses the offices and meeting places of the seat of government and is usually fixed by law or by the constitution...
. Land is the primary factor of production. Labor is the specific factor of production and payment is made in the form of wage. Capital is regarded as secondary factor of production as it can be manipulated by economic activity. Payment received would in the form of interest. Later Entrepreneurship was added as the fourth factor of production. It earns profit to the Entrepreneur.
Factors of production are owned by household and they supply these factor of production to firms and in return earn wages, interest,rent and profit.Household buy goods and services with this money.
In economics
Economics
Economics is the social science that analyzes the production, distribution, and consumption of goods and services. The term economics comes from the Ancient Greek from + , hence "rules of the house"...
, factor payments are the income
Income
Income is the consumption and savings opportunity gained by an entity within a specified time frame, which is generally expressed in monetary terms. However, for households and individuals, "income is the sum of all the wages, salaries, profits, interests payments, rents and other forms of earnings...
people receive for supplying the factors of production
Production, costs, and pricing
The following outline is provided as an overview of and topical guide to industrial organization:Industrial organization – describes the behavior of firms in the marketplace with regard to production, pricing, employment and other decisions...
: land, labor, or capital.
Circular Flow of National Income
Let us study with the help of Circular flow of income how flow of goods and services between household and firms are balanced by flow of factor payments made in exchange of them. Circular flow of income in two sector economy where there is no governmentGovernment
Government refers to the legislators, administrators, and arbitrators in the administrative bureaucracy who control a state at a given time, and to the system of government by which they are organized...
, no capital market
Capital market
A capital market is a market for securities , where business enterprises and governments can raise long-term funds. It is defined as a market in which money is provided for periods longer than a year, as the raising of short-term funds takes place on other markets...
, no foreign sector. Households own all the factors of production , that is land
Land
Land may refer to:*The part of the Earth that is not covered by water**Ecoregion*Landscape*Landform, physical feature comprises a geomorphological unit*Land , a factor of production comprising all naturally occurring resources*Land law...
, labor, capital
Capital
A capital city is the area of a country, province, region, or state considered to enjoy primary status; although there are exceptions, a capital is typically a city that physically encompasses the offices and meeting places of the seat of government and is usually fixed by law or by the constitution...
. These factors of production are sold to the firms to produce goods and services through factor markets. Firms make use of these resources and provide goods and services to the household through product markets.However the exchange of goods and services and factors of production
Factors of production
In economics, factors of production means inputs and finished goods means output. Input determines the quantity of output i.e. output depends upon input. Input is the starting point and output is the end point of production process and such input-output relationship is called a production function...
takes place with the help of the financial flows which moves in the reverse direction.As the households purchase goods and services from firms it is their consumption expenditure which in tern becomes income or profits for the firms. On the other hand when firms buy factors of production
Factors of production
In economics, factors of production means inputs and finished goods means output. Input determines the quantity of output i.e. output depends upon input. Input is the starting point and output is the end point of production process and such input-output relationship is called a production function...
from the households they pay factor payments in the form of wages, rent
Rent
Rent may refer to:*Renting, a system of payment for the temporary use of something owned by someone else ; the payments for such use are typically referred to as "rent"...
, interest
Interest
Interest is a fee paid by a borrower of assets to the owner as a form of compensation for the use of the assets. It is most commonly the price paid for the use of borrowed money, or money earned by deposited funds....
.
Factor Prices
Distribution of national income is determined by factor payments(factor prices).Factor payments include rentRent
Rent may refer to:*Renting, a system of payment for the temporary use of something owned by someone else ; the payments for such use are typically referred to as "rent"...
, wage
Wage
A wage is a compensation, usually financial, received by workers in exchange for their labor.Compensation in terms of wages is given to workers and compensation in terms of salary is given to employees...
, interest
Interest
Interest is a fee paid by a borrower of assets to the owner as a form of compensation for the use of the assets. It is most commonly the price paid for the use of borrowed money, or money earned by deposited funds....
and profit..The prices for factor of production depends upon demand
Demand
- Economics :*Demand , the desire to own something and the ability to pay for it*Demand curve, a graphic representation of a demand schedule*Demand deposit, the money in checking accounts...
and supply
Supply
*Supply , the amount of a product which is available to customers*Supply, as in confidence and supply, the provision of funds for government expenditure...
of that particular factor of production. We assumed that the factor of production in economy are fixed and hence the factor supply curve is vertical.Equilibrium of factor payments is determined by the intersection of downward-sloping factor demand curve and vertical supply curve. To understand the optimal factor payments we would determine through their respective markets i.e. the market clearing prices of the factors of production. There are three major factor of production Land, Labor, Capital.
To understand the optimal factor payments we would determine through their respective markets i.e. the market clearing prices of the factors of production. There are three major factor of production Land, Labor, Capital.
The Labor Market
As we know that the firm will hire only optimal amount of labor that will maximize profit , this optimal quantity of labor depends upon the marginal product of laborMarginal product of labor
In economics, the marginal product of labor also known as MPL is the change in output that result from employing an added unit of labor. More generally, in defining marginal product, other inputs to production are held constant...
(MPL). The marginal product of labor is defined as the extra unit of output that the firm produces from hiring one extra unit of labor.
MPL=F(K,L+1)-F(K,L)
The above equation states that Marginal Product of labor is the difference of output produced from one extra unit of labor and the output produced from original quantity of labor.This production function function has the function of diminishing marginal product which means that the marginal product of labor decreases as the amount of labor increases,and as the amount of labor increases the production function becomes flatter i.e. diminishing marginal product.
The optimal wages for Labor
The demand for labor is dependent on the theory of marginal product of laborMarginal product of labor
In economics, the marginal product of labor also known as MPL is the change in output that result from employing an added unit of labor. More generally, in defining marginal product, other inputs to production are held constant...
. Which means that the firm compares the extra revenue earned from increased production that results from the added labor which ultimately leads to the higher higher spending on wages.let us understand with the following example
Let
denote wages rate that the labor receives.s denote the hours of labor services that household supplies to labor market.Thus the households receives samount of income from providing labor services.Now let d denote the labor services that the firm demands from labor market.Thus the firm pays damount of wage for providing labor services.Quantity produced in the economy will be given by s =d. Thus the firm profit will be given by gross revenue less wage payments.s-d=d-dNow if we increase the labor input it has two effects first the output will increase by the marginal product of labor
Marginal product of labor
In economics, the marginal product of labor also known as MPL is the change in output that result from employing an added unit of labor. More generally, in defining marginal product, other inputs to production are held constant...
as extra hour of work is provided.Therefore the gross sales revenue will be given by
second the wage rate for the firm increases by It is clear that in order to maximize profit firm will expand employment level upto the level where marginal product just equals wage rate.Now if we divide the above equation with general price level then we obtain
here
is the real wageReal wage
The term real wages refers to wages that have been adjusted for inflation. This term is used in contrast to nominal wages or unadjusted wages. Real wages provide a clearer representation of an individual's wages....
rate.At that point the contribution done by the last unit of labor will be just equal to output MPL.Thus we can conclude that the wages paid would we equal to Marginal Product of labor.
Theory of Interest
In the classical theory supplySupply
*Supply , the amount of a product which is available to customers*Supply, as in confidence and supply, the provision of funds for government expenditure...
and demand
Demand
- Economics :*Demand , the desire to own something and the ability to pay for it*Demand curve, a graphic representation of a demand schedule*Demand deposit, the money in checking accounts...
for capital determines the optimal interest rates. The rate of interest that is determined by the intersection of investment and saving is the price of investible resource (capital). The demand for capital is done by the entrepreneur for further investment and for the productive purpose. But the productivity of capital is dependent on the law of variable proportion. Which means as more and more of capital is employed the productivity from capital goes on decreasing. Therefore the entrepreneur will employ only capital upto that level where the rate of interest is equal to the Marginal productivity of capital(MPK).
where MPK is the Marginal productivity of capital and R/P is real rental for capital. It shows that demand for capital is inversely related to rate of interest.There are many other factors which affect the demand for capital. On the other hand supply of capital is positively related to the the rate of interest. As the rate of interest increases the savings increases and vice-versa. Thus the entrepreneur will employ the capital where MPK is equal to real price of capital.
The optimal rate of interest rate is determined by the intersection of demand
Demand
- Economics :*Demand , the desire to own something and the ability to pay for it*Demand curve, a graphic representation of a demand schedule*Demand deposit, the money in checking accounts...
and supply
Supply
*Supply , the amount of a product which is available to customers*Supply, as in confidence and supply, the provision of funds for government expenditure...
curves. If the rate of interest rises above the equilibrium
Equilibrium
Equilibrium is the condition of a system in which competing influences are balanced. The word may refer to:-Biology:* Equilibrioception, the sense of a balance present in human beings and other animals...
interest rates the demand for the investment will decline and the supply of savings will increase. As there is excess of savings than demand in the economy the market forces will bring the interest rate to the original interest rates.Now, if the interest rates fall below the optimal level then the there is excess of demand than supply in the economy and hence, the market forces will adjust the interest rates..
Theory of Rent
This theory was first developed by the great economist David RicardoDavid Ricardo
David Ricardo was an English political economist, often credited with systematising economics, and was one of the most influential of the classical economists, along with Thomas Malthus, Adam Smith, and John Stuart Mill. He was also a member of Parliament, businessman, financier and speculator,...
it was called The ricardian theory of rent. Ricardo defined rent as that portion of produced of the earth which is paid to the landlord for the use of the original and indestructible powers of the soil. However later on the modern theory of rent was developed by the modern economists.tThe main difference between the Ricardian theory and this theory was that, ricardian theory used the difference between surplus enjoyed from superior land to the inferior land. In the modern theory the rent was determined by the demand and supply forces in the market like the other factors of production
Factors of production
In economics, factors of production means inputs and finished goods means output. Input determines the quantity of output i.e. output depends upon input. Input is the starting point and output is the end point of production process and such input-output relationship is called a production function...
.Demand for land means total land demanded by the economy as a whole.Demand for land like others depends upon the marginal revenue productivity. Rent paid by the economy will be equal to the marginal revenue productivity which is also subject to law of diminishing returns. this suggests that the demand curve like any other demand curve will be downward sloping.It shows that the demand for land and rent are negatively related. On the other hand supply of land for an economy is fixed that is it is perfectly inelastic.
Theory of profit
Profit is the another important factor in factor payments.This theory was first developed by Edgeworth, Chapman, Stigler,Stonier. This theory is also depended upon the marginal revenue productivity.
It is also called Marginal Product and Capital demand.Let us consider example, The main objective of firm is to maximize profit. As we know that profit would be difference between the revenue and costs
.Where the revenue would be equal to the price of the good multiplied by the output of the firm. On the other hand the costs of the firm include labor costs, capital costs,rent cost if any.Now if we substitute our production function. Then we would see that the profit of the firm is depended on factor prices and factor inputs..Hence firm would choose the that optimal level of factor inputs that would maximize profit of the firm.See also
http://en.wikipedia.org/wiki/Factors_of_production- Law of rentLaw of RentThe law of rent was formulated by David Ricardo around 1809, and this is the origin of the term Ricardian rent. Ricardo's formulation of the law was the first clear exposition of the source and magnitude of land rents, and is among the most important and firmly established principles of economics. ...
- Economic rentEconomic rentEconomic rent is typically defined by economists as payment for goods and services beyond the amount needed to bring the required factors of production into a production process and sustain supply. A recipient of economic rent is a rentier....
- Factors of productionFactors of productionIn economics, factors of production means inputs and finished goods means output. Input determines the quantity of output i.e. output depends upon input. Input is the starting point and output is the end point of production process and such input-output relationship is called a production function...
- Marginal product of laborMarginal product of laborIn economics, the marginal product of labor also known as MPL is the change in output that result from employing an added unit of labor. More generally, in defining marginal product, other inputs to production are held constant...
- Circular flow of incomeCircular flow of incomeIn economics, the terms circular flow of income or circular flow refer to a simple economic model which describes the reciprocal circulation of income between producers and consumers...
- Diminishing returnsDiminishing returnsIn economics, diminishing returns is the decrease in the marginal output of a production process as the amount of a single factor of production is increased, while the amounts of all other factors of production stay constant.The law of diminishing returns In economics, diminishing returns (also...
- Marginal efficiency of capitalMarginal efficiency of capitalThe marginal efficiency of capital is that rate of discount which would equate the price of a fixed capital asset with its present discounted value of expected income....
- David RicardoDavid RicardoDavid Ricardo was an English political economist, often credited with systematising economics, and was one of the most influential of the classical economists, along with Thomas Malthus, Adam Smith, and John Stuart Mill. He was also a member of Parliament, businessman, financier and speculator,...
- IS/LM modelIS/LM modelThe IS/LM model is a macroeconomic tool that demonstrates the relationship between interest rates and real output in the goods and services market and the money market...