Chapter 9 of Shawn Ritenour’s Foundations of Economics deals with something readers might think was already covered sufficiently in the earlier chapters on market prices: prices of factors of production. This is the final category of income received by market participants (in addition to profit and interest) and includes payments to providers of labor and land in production. Ritenour states that a separate chapter devoted to this topic is necessary because producer goods do not directly satisfy the wants of consumers. Moreover, the opportunity cost of producer goods is treated differently from that of consumer goods.
Supply of factors of production is determined in the same way as the supply of consumer goods, but demand is determined differently. Those who demand factors of production do so in the hope of using them to make a profit rather than deriving utility from them directly. To make a profit, entrepreneurs must not only forecast demand accurately, but also produce goods cost effectively to satisfy that demand; to do this they demand factors of production.
Because demand is always calculated at the margin, entrepreneurs demand specific quantities of factors of production based on their own forecasts of market demand for their products. Ritenour calls this the principle of “derived demand.” If demand for automobiles rises, ceteris paribus the demand for items used in the production of cars will rise as well. Conversely, when demand for automobiles falls, the demand for its factors of production will fall. “Value is imputed up the structure of production.”
The next section discusses the “marginal revenue product” (MRP) of factors of production. The MRP is “the value contributed by a relevant unit of a factor of production.” To illustrate this concept, Ritenour uses the example of a woman who runs a business that produces Hawaiian shirts and who is considering purchasing an additional sewing machine. Assuming no new employees will have to be hired to operate the machine, its MRP will be the additional number of shirts produced as a result of its use (also called the “marginal physical product” or MPP) multiplied by the price of each shirt. The law of returns (covered in Chapter 3) reminds us that past a certain point, the MRP of each additional sewing machine will decrease.
Because of time preference, an entrepreneur will not be willing to pay the full amount of a factor of production’s MRP to acquire it. Instead, the entrepreneur will only be willing to pay a discounted amount (the “DMRP”) to acquire that particular factor. The precise amount of the discount will depend on the social rate of time preference.
The overall market demand for sewing machines is determined by the MPP, MRP, and DMRP calculations of everyone who uses them in production, not just the entrepreneurs who produce Hawaiian shirts. This demand interacts with the available supply to create a market price for that factor. The price of the factor will change whenever there is a change in the factor’s marginal productivity, the price of the good produced, or the social time preference. An important point here is that the marginal productivity of a factor of production is influenced by technology as well as the availability of complementary factors used in the making of a particular good.
Ritenour concludes the chapter by noting that prices of factors of production are produced by supply and demand. Entrepreneurs negotiate these prices with the owners of the factors of production, and in a free market, the tendency is for factors of production to be directed towards their most highly valued use.