Relative factor price refers to the price of one factor of production (like labor, capital, or land) relative to the price of another factor of production. It is expressed as a ratio, comparing the cost of using one input versus another in the production process.
Understanding Relative Factor Price
In economics, factors of production are the resources used to create goods and services. The main factors are typically:
- Labor: Human effort, skills, and knowledge. The price of labor is the wage rate.
- Capital: Manufactured resources like machinery, buildings, and tools. The price of capital is often represented by the rental rate or interest rate.
- Land: Natural resources used in production. The price of land is rent.
Relative factor price helps businesses decide which inputs to use and in what proportions. For instance, if the relative price of labor increases compared to capital, firms might choose to use more machinery (capital) and less human labor.
Why is it Important?
Relative factor prices are crucial because they:
- Influence Production Decisions: They guide firms in choosing the most cost-effective combination of inputs.
- Affect Income Distribution: They determine how the total income from production is divided among labor, capital owners, and landowners.
- Impact International Trade Patterns: According to theories like the Heckscher-Ohlin model, countries tend to export goods that intensively use the factors of production they have in relative abundance (and thus, relatively lower prices).
Factors Affecting Relative Factor Prices
Changes in the economic environment can significantly alter the relative prices of labor, capital, and land. As noted in the reference, factors affecting relative prices can include:
- Changes in Employee Labor Rate: A rise or fall in wages directly changes the price of labor relative to other inputs. For example, if wages increase while the cost of capital remains stable, the relative price of labor rises.
- Differences in Production Supply: The availability or scarcity of different factors of production affects their prices. A larger supply of labor relative to capital tends to lower wages compared to the rental rate of capital. Similarly, changes in the supply of inputs for production can impact their costs.
- Changes in Government Policy: Government actions, such as minimum wage laws, taxes on capital, subsidies for certain industries, or land-use regulations, can directly influence the prices of factors of production and thus their relative ratios.
Other factors include:
- Technological Change: New technologies can make one factor more productive (increasing its demand and potentially price) or make another factor less necessary.
- Changes in Demand for Goods: If demand shifts towards goods that are intensive in the use of a specific factor (e.g., labor-intensive goods), the demand and price for that factor will likely rise relative to others.
Example of Relative Factor Price Change
Consider a scenario where the wage rate is $20 per hour and the rental rate for capital is $100 per hour:
| Factor | Price |
|---|---|
| Labor | $20/hour |
| Capital | $100/hour |
The relative price of labor to capital is $20 / $100 = 0.2. This means one hour of labor costs 0.2 times the cost of one hour of capital use.
Now, suppose wages increase to $30 per hour due to factors like increased demand or change of employee labor rate (as mentioned in the reference), while the rental rate of capital remains $100 per hour:
| Factor | New Price |
|---|---|
| Labor | $30/hour |
| Capital | $100/hour |
The new relative price of labor to capital is $30 / $100 = 0.3. The relative price of labor has increased (from 0.2 to 0.3). This change might prompt businesses to substitute away from labor and use more capital, assuming technology allows for it.
Understanding relative factor prices is key to analyzing production decisions, income distribution, and international trade patterns in economics.
