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In the traditional analysis it is assumed that there are four factors of production — land, labor, capital and entrepreneurship, The prices of these factors are rent, wages, interest and profit, respectively. According to the traditional analysis, different theories are required for the determination of different factor prices because different factors of production have different distinguished characteristics. Thus, we have theories of rent, interest, wages and profit. These theories are distinct from the theory of product pricing. However, according to the modern economists, the mechanism of determination of factor prices is not fundamentally different from the mechanism of determination of product prices. Just like product prices, factor prices are also determined by the forces of demand and supply. The demand for any factor of production is determined by the principle of profit maximization. The factor of production is determined by the firm and by summing up the demands of all the firms we get the market demand for any
factor of production. Similarly, the supply of any factor of production comes from the owners of that factor. By summing over the supplies forthcoming from all the factors' owners we get the market supply curve of that factor of production. At the intersection point of the market demand and the market supply curves the price of that factor of production is determined. This, however, happens when it is assumed that perfect competition prevails in all the goods and factor markets. The demand for a variable or factor depends on the price of the input, the marginal physical product for the factor, the price of the good produced by the factor, the amount of other factors that are combined with the factor, and the technology progress.The most important variable factors are raw materials, intermediate goods and labor. The first two types are goods and hence their market supply is derived on the same principles as the supply of any good. The supply of labor, however, requires a different approach. "The main determinants of the market supply of labor are (assuming that labor is a homogenous factor) (he price of labor, the tastes of the consumers, which define their trade-off between leisure and work, the size of the population, the labor force participation rate and the occupation, education and geographical distribution of the labor force.
Although there is general agreement that the supply curve of labor by an individual exhibits the backward-bending pattern, economists disagree as to the shape of the aggregate supply of labor. However, in the long run the supply curve must have a positive slope, since young people will be attracted to the markets where the wages are high and also older workers may undertake retraining and change jobs if the wage incentive is strong enough.
If perfect competition prevails in the goods and the factor markets, 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.