LONG-RUN MARKET VALUATION OF A FACTOR OF PRODUCTION

3.4 LONG-RUN MARKET VALUATION OF A FACTOR OF PRODUCTION

So far, our discussions have centered on understanding the various factors affecting the demand and supply of a factor of production. It would be quite instructive to briefly discuss the economic interpretation of the long-run market equilibrium price for a factor of production. To show this, suppose the situation in Figure 3.5 represents long-run market equilibrium condition for coal under an ideal market setting. As discussed earlier, market demand shows producers’ willingness to pay for coal at the margin; and the market supply depicts the marginal opportunity cost of extracting, refining and delivering coal to the

market. Thus, at the market equilibrium, what the producers are willing to pay for the last unit of coal, r e , is equal to the marginal opportunity cost of extracting the last unit of coal. In this sense, then, in an ideal market condition the long-run equilibrium price of a natural resource measures the marginal opportunity costs of bringing that resource to the market. Furthermore, assuming that these resources have clearly defined ownership rights, there will be no difference between social and private opportunity costs (more on this in Chapter 5 ). In this case market price reflects both social and private opportunity costs.

At this stage it is instructive to raise a fundamental question: What can be said about the market price of a natural resource as a measure of scarcity? As discussed above, under ideal market settings and where

40 MARKET SIGNALS OF SCARCITY

Figure 3.5 Long-run equilibrium price for coal

resources have clearly defined ownership rights, the long-run equilibrium price of a natural resource measures the marginal social opportunity cost of bringing that resource onto the market. Under this ideal condition, a positive price trend (see Figure 3.6 ) for a particular natural resource over a long period of time signals emerging resource scarcity. It should be noted, however, that this is a purely economic measure of natural resource scarcity. In other words, because of technological and demand factors that influence the market price of a resource, there may not be a perfect (one-to-one) correlation between observed price trends and the physical abundance of the natural resource under consideration. It is quite possible for the physical quantity of a natural resource to dwindle over time while the market price of this resource is showing a declining price trend. In other words, economic scarcity (which is measured by price) may not be the same as physical scarcity. The question is, then, assuming that we are interested in measuring physical scarcity, are there alternative measures of resource scarcity that are capable of measuring scarcity of this nature? The next section of this chapter considers this question.

There are several alternative ways of measuring economic scarcity other than by observing the price trend of a particular resource (see Figure 3.6 ). One way to do this is to compare the price of a resource (for example, coal) with the price (cost) of labor over a period of time. This price ratio serves as a measure of the opportunity cost of coal with respect to labor. Another way to measure economic scarcity is to deflate the price of coal with the price for all goods and services. This would be a measure of the real price of coal: the quantity of goods and services that one can purchase with a ton of coal.