In Economics, the output and input markets are closely interred linked. Demand and supply for various commodities in the commodity market determine their prices giving a signal to the producers as to what to produce. The higher the price of a commodity, the more profitable is its production likely to be.
This in turn is likely to increase the demand for inputs to produce this commodity. The demand for these inputs together with their supply will then determine the price of inputs and the quantity of inputs used. Both these variables will in turn determine the income of the owners of factors of production which, in turn, determines the demand for goods and services.
Now, the mechanism for determining prices is the same in both the commodity and input markets. In both markets, prices are determined by the intersection of the demand and supply curves. What varies however is the determinants of demand and supply for factors vis a vis the commodities.
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Unlike commodity market, in case of factor market, we do not take actual possession of the factor. We simply buy or sell service of the factor. Further, of the roles of buyers and sellers are reversed in the two markets.
Demand for commodities and services are called a direct demand in Economics, because it directly satisfies consumer needs/wants. But, demand for a factor of production is said to be a derived or indirect demand. A factor of production is demanded not for its own sake but because it produces products which then satisfy consumer needs.
Demand for a factor is thus derived from the demand for the goods and services it helps to produce. Furthermore, factors are jointly demanded to produce of commodity. Production is not possible by just using one factor of production.
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Unlike the case of commodity market, it is difficult to assess or compare the cost of a factor of production, particularly, labour in different occupations. Further, the supply of this factor (labour) falls at higher level of wages when workers start preferring leisure to work. Furthermore, land being free gift of nature is fixed in supply. So, its supply is independent of price. We shall now proceed as follows:
(i) Determination of firm’s demand for a factor of production (say labour) in a perfectly competitive market structure in the short run.
(ii) Derivation of the demand for labour by a firm in a perfectly competitive set up in the long run.
(iii) Derivation of the aggregate or market demand for labour in the long run.
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(iv) Derivation of the individual’s supply curve for labour as well as the market supply curve for labour.
(v) Determination of equilibrium wage rate or PL.