DETERMINATION OF FACTOR PRICES BY SUPPLY AND DEMAND
Let us suppose that perfect competition prevails in the goods and the factor markets. In such a situation let us see how the price of any factor of production is determined. Each firm takes the market price of the factor as given and determines the quantity demanded at that price from the principle of profit maximization. In this way the demand for any factor by a firm is determined. By the horizontal summation of the demand curves of all firms we can get the market demand curve of that factor. The market demand curve shows how many units of the factor will be demanded at different prices of the factor. As discussed earlier, the market demand curve of a factor is assumed to be downward sloping.
Let us now consider the supply side of the picture. In a perfectly competitive market the suppliers of the factor take the market price of the factor as given and determine the quantity supplied at that price from an optimization process.
Given the market demand and the market supply for any factor of production, its price is determined by the intersection of these two curves. In other words, given the demand and supply curves of a factor, the price of the factor will adjust to the level at which the amount of the factor supplied is equal to the amount demanded. This is shown in fig. 10.5 where DD is the demand curve and SS is the supply curve of the factor. At the price OP, both the demand and the supply of the factor are equal to ON. Hence OP is the equilibrium price of the factor determined at the point of intersection of the factor demand and the factor supply curves.
At any other price, demand and supply are not equal. It should be noted that though the price is determined by the demand and the supply curves of the factor, yet it is equal to the VMP (or MRP) of the factor. This is so because any individual firm takes the price OP as given and employs the factor up to that point where the MRP of the factor is equal to its price in order to maximize profit. Thus, in a perfectly competitive market, price of a factor is determined by the demand for and supply of that factor but is equal to the marginal revenue productivity of the factor.