Essay on the Factor Price Theory of Distribution

In our simplified two sector model in Economics, we talk of households and firms, being the two main sectors. All the four factors of production, namely land, labour, capital and enterprise are conceived to be owned only by the households.

The households are thus the owners and sellers of these factors of production, which they supply to the firms, i.e., the buyers (or demanders) of the factor of production., The firms pay the households prices for each of the factors, which when multiplied by the total amount sold determines the total income earned by them.

The market where the factors of production are bought and sold is called the factor market. Like what happens in the commodity market, the intersections of the market demand and supply curves of the various factors of production determine the factor prices. The prices of these four factors are wages (price of labour or P_L), rent (price of land), and interest (price of capital or P_K) and profit (price of enterprise).

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The choice of technique that a firm will use depends upon the prices of these factors. If P_L is relatively lower, one is more likely to use a labour intensive technique of production and vice versa. It was earlier believed that different factors of production were owned by different classes of society, e.g., workers owned labour, capitalists owned capital and landowners owned land.

So, the prices assigned to these different resources would then determine the distribution of income amount among these three different classes of society. Hence, the analysis of input prices was also a theory of income distribution among these different groups.

The term distribution theory refers to any theory that explains how the total national income is divided among the nation’s citizens. It explains this distribution on the basis of market forces of demand and supply. On account of the resulting factor prices, the theory is also is called as a factor price theory of distribution or a market theory of resource allocation.

This theory is also referred to as marginal productivity theory of distribution, because the marginal physical product of a factor determines its demand as well as price. As this theory was first developed by a group of neoclassical economists about a century ago, it is also called as the neo-classical theory of distribution.

The theory which deals with the distribution of income among major factors of production, viz. labour, land and capital is called the theory of functional distribution. It is determined through the prices of inputs. Thus, this theory is popularly known as the theory of factor pricing.

The neoclassical economists as well as the classical economists like Adam Smith and Ricardo were interested in studying the functional distribution of income, more specifically at the effect that economic progress would have on relative factors shares (or incomes).

They were more interested in finding out whether, with economic progress, capitalists and land owners would increase in the same proportion or whether they would gain at the expense of the workers.

But modern economists are more concerned with another way of looking at the distribution of income, called the size distribution of income. This theory looks as to how total national income is distributed among various households without referring to the source of their income or their social class.

Under this theory of distributive share i.e. macro theory of functional distribution, aggregate rewards of various factors are determined in the national income. It is also known as theory of distributive shares. An individual may be deriving a large chunk of his income by selling his labour services. Wages constitute the major share of his income.

But, he may also be owning a piece of land from which he derives rental income, as well as have some savings on which he earns interest. His total income = wages + rent + interest. The size distribution of income earned by one individual may be equal to, greater, than or less than the income earned by other individuals in society.

The functional distribution of income thus refers to the share of total national income going to owners of different resources and so focuses on the source of income and in particular distinguishes between income from employment (wages) and income from property (rental income).

The size distribution of income on the other hand, refers to the proportion of total national income received by various groups and so focuses on inequality of income between different income earners irrespective of the source from which that income is derived.

It is this latter view which is gaining more importance today than the former because while class distinction between workers and landowners are important, what is more important from the economic point of view is the distinction between the haves and the have not’s.

Another important point to remember is that equality of distribution does not imply justice of distribution. If all individuals get an equal amount of the cake (national output) it may not be just because those who worked hard to produce that cake and those who didn’t work at all, are both being treated at par.

The theory we develop here is designed to explain how incomes are determined, not to evaluate whether the outcome is just or unjust. That is, we focus on the functional distribution at micro level.