Pricing of Factors (Inputs) and Distribution of Income: A General View

Functional vs. Personal Distribution

• The study of how factor prices are determined is known as the theory of distribution, which can be divided into functional distribution and personal (size) distribution of income; the focus here is on functional distribution.

• Personal distribution of income refers to the distribution of national income among individuals in a society. Since national income is unequally distributed, with some individuals being rich and others poor, this theory examines how individual incomes are determined and how income inequalities arise.

• Functional distribution of income studies how the various factors of production are rewarded for the services they perform in the production process, rather than how income is distributed among individuals.

• Economists classify factors of production into four major categories: land, labour, capital, and entrepreneur. Functional distribution analyses how the prices of these factors are determined:

  • Rent = price of land.

  • Wages = price of labour.

  • Interest = price of capital.

  • Profit = price of entrepreneurship.

  • Functional distribution is therefore essentially the theory of factor pricing.

• As stated by Jan Pen, functional distribution is concerned not with individuals and their incomes but with factors of production and the remuneration received by units of labour, capital, land, and entrepreneurial activity; being an extension of price theory, it is often called the theory of factor prices.

• Personal distribution is only partly determined by functional distribution because an individual’s income depends not only on the price of the factors he owns but also on the quantity of those factors and the ownership of other productive factors.

• For example, a landlord’s income depends on:

  • The rent per acre of land.

  • The amount of land owned.

  • Any additional income from other factors, such as interest earned on money lent to others.

  • The greater the quantity of land owned, the greater the income earned at a given rent per acre.

• Individuals may receive income from multiple sources, such as rent, wages, interest, and profits; the sum of earnings from all these factors constitutes their personal income.

• Personal distribution focuses on how much income individuals receive, irrespective of whether the income originates from wages, interest, profit, pension, rent, or any other source.

• A complete theory of personal distribution must explain:

  • How rewards or prices of factors such as rent and interest are determined.

  • How different individuals come to own different quantities of productive factors.

  • Functional distribution forms only a part of the broader theory of personal distribution, which encompasses both factor pricing and factor ownership.

• In the study of factor pricing, economists do not examine the prices of factors themselves but the prices of their services or use over a period of time.

• Accordingly:

  • The theory does not explain the price or value of land itself, but the determination of rent, the price for using land.

  • It does not explain the price of a labourer as a person, since a labourer does not sell himself; instead, it explains the determination of the wage rate, the price of labour services for a period.

  • The expression “pricing of factors” is used merely for convenience; in reality, it refers to the pricing of factor services or uses.

Theory of Distribution as a Theory of Factor Prices

• In modern economic theory, the theory of functional distribution of income is treated as a special case of the theory of price. Just as product prices are determined by the interaction of demand and supply, factor prices (and hence factor incomes) are also determined by the interaction of demand and supply under perfect competition. The income earned by a factor depends on (i) the market-determined price of the factor and (ii) the quantity of that factor employed.

• Contemporary distribution theory views market forces (demand and supply) as the determinants of factor prices and incomes rather than the institutional framework such as ownership of property. It also de-emphasises the traditional association of factors with social classes:

  • Land ↔ landowners.

  • Capital ↔ capitalists.

  • Labour ↔ working class.

  • Factors are instead regarded merely as productive agents, and distribution is viewed as the allocation of functional rewards according to their contribution to production.

• The main concern of contemporary distribution theory is to explain the determination of:

  • Rent of land.

  • Wages of labour.

  • Interest on capital.

  • Profits of entrepreneurs.
    These are treated as factor prices analogous to commodity prices.

• According to A.K. Das Gupta, distribution is essentially an extension of the theory of value:

  • The problem of distribution becomes a problem of pricing factors of production.

  • Commodity values are ultimately derived from utility.

  • Factor values are derived from the productivity imputed to them through the commodities they help produce.

  • The traditional classification of factors into land, labour and capital is retained, but their connection with social classes disappears.

  • Factors are viewed independently of the institutional framework in which they operate.

• Unlike the traditional three-factor classification, modern distribution theory treats the entrepreneur as a separate factor distinct from capital. Consequently:

  • Interest on capital and profits of entrepreneurs are explained through different mechanisms.

  • Entrepreneurial profit is not simply regarded as the return to capital.

• The assumptions of contemporary distribution theory are challenged in imperfect market structures:

  • Under monopoly, monopolistic competition, and oligopoly, producers possess monopoly power.

  • They restrict output to levels where price exceeds marginal cost, earning super-normal (abnormal) profits at consumers’ expense.

  • Such profits arise from market power and exploitation, not from productive contribution.

  • Therefore, these abnormal profits cannot validly be regarded as functional income.

• Similar distortions occur in factor markets:

  • When firms possess monopsony power, they pay workers wages lower than the value of their marginal product.

  • The resulting extra profits accrue through the exploitation of labour.

  • These gains are not true functional rewards but arise from monopsony power.

• Collective bargaining by workers and other agents of production also affects income distribution:

  • It influences how income is divided among workers, capitalists and landlords.

  • Such bargaining causes actual income distribution to diverge from the functional distribution predicted by marginal productivity theory.

• Contemporary distribution theory is mainly concerned with the determination of factor prices, not with explaining the relative shares of different groups in national income or the overall distribution of the national product.

• The author argues that the question of who gets what share of the national cake cannot be explained solely through impersonal market forces or demand–supply equilibrium in factor markets. Important determinants of income distribution include:

  • Ownership of property and means of production.

  • Production relations arising from ownership patterns.

  • Power structures within society.

  • Collective bargaining strength of workers and other groups.

• By claiming that under perfect competition every factor receives remuneration equal to the value of its marginal product, contemporary theory implicitly treats the existing personal distribution of income as just and fair.

• The author rejects this implication, arguing that the highly skewed distribution of income observed in free-market economies (including India) is largely shaped by:

  • Unequal ownership of property.

  • Production relations based on such ownership.

  • Power structures in society.

  • Collective bargaining advantages enjoyed by certain classes.

• The author does not deny the importance of marginal productivity in determining incomes, but contends that institutional factors—ownership patterns, power relations, and collective bargaining—play a crucial role in shaping actual income distribution and cannot be ignored.