Price Determination in Factor Markets

Social valuation of domestic factors of production differs from that of tradable commodities because factors are assumed to be immobile across national borders. In principle, international migration opportunities could dominate domestic factor markets, and social factor prices would be determined externally, like tradable-commodity prices. In a country with a completely liberalized capital market, for example, no restrictions are made on domestic investment behavior. The investor is free to choose between domestic and foreign investment opportunities. Because the world capital market is much larger than the domestic market, the rate of return to investment can be considered exogenous to the domestic economy. Domestic distortions in capital markets can be ignored. Such distortions affect only the magnitude of capital imports or exports, not the social value of capital. Similarly, if the emigration of workers is particularly widespread, the domestic economy must offer wage rates equal to foreign-determined opportunity costs. Again, knowledge of domestic market divergences becomes unnecessary in the calculation of social values.

Among domestic factors, only land is universally immobile. But in most countries, international migration of labor and capital is also heavily constrained. The constraints reflect cultural differences (such as language and religious differences), prohibitive transactions costs of migration, or foreign-imposed limits on market access. Given these constraints, foreign earning opportunities for domestic factors will exert some effects on domestic factor prices, but factor prices can be considered to be determined in domestic markets.

In the simple general equilibrium model, factor supplies are assumed to be fixed. As a result, factor price determination is driven entirely by factor demand. But it is easy to incorporate some supply-side influences into social price selection. One unrealistic aspect of the vertical supply curve is its intercept with the x-axis, implying that factor prices could fall to zero without affecting factor supply. In reality, each market is probably characterized by minimum floors for factor prices, below which none of the factor is supplied. These floors can be related to subsistence income needs, the presence of minimum values of leisure time, or the costs of adjustment of and entry into the market.

Figure 7.1 illustrates the impact of a minimum subsistence wage on the market for unskilled labor. The market supply curve is represented by the right-angled supply curve ws°bAS instead of QsS. The initial demand curve is represented by D. Aggregate labor demand is QD at the minimum reservation wage. The result is unemployment equal to Qs _ QD. Wages could theoretically fall to the market-clearing level, w*, but no laborers are willing to be employed at that low, sub-subsistence wage. Unemployment can be eliminated only if demand increases, to D', for example. Such increases might result from labor-intensive technical changes, output expansion, or increased output prices. If labor supplies are increasing over time, such changes are essential if unemployment is to decline.

This case represents "natural" unemployment that cannot be attributed to any distortions or market failures. Consequently, such factors can be omitted from social factor price valuation. The factors that are fully employed create a constraint on total output, and potential national income can increase only if the supply of fully employed factors is increased. In the process, the demand for complementary unemployed factors will increase as well. But the market prices for the surplus factors will be unaffected. The opportunity costs to the economy of these factors are their reservation prices-subsistence wages for labor or the cost of preparing capital and land for productive uses.