What Is a Factor Price?

A factor price is a construct within economic theory that holds to the concept that the sale price set for a finished good or service is affected by the expense involved in the creation and manufacture of that product. The general idea is that the factor price is arrived at by taking into consideration all the factors of production. There is some difference of opinion regarding whether the actual demand for the product also plays a role in determining what is known as the factor or natural price of the good or service, or if the price is focused solely on the costs and incentives that motivate a company to produce the product.

As a tool in the process of production economics, the factor price can often aid in the task of determining if the production of a given good or service is worth the time, effort, and resources needed to manage the production process. Scrutiny of the all the factors that go into the process, including the cost of raw materials, labor, and the expenses incurred to operate the plant in which the goods are produced, will all provide valuable clues as to the value of the final product, at least in terms of how much the company has invested in each unit produced. From there, the idea is to determine what price must be set in order for the cost of production to be covered adequately. If that price is higher than the market will bear, then continuing production of that good is fruitless, since it will not result in the ability to recoup that investment, much less generate any profit from the sale of the units produced.

There is some difference of opinion regarding the factor price, and is if consumer demand really enters into the determination of that price. One school of thought holds that consumer demand does not really impact the factor or natural price, although it will be very important in terms of setting the retail price for the finished goods. A different thought process states that consumer demand does have an indirect impact on the factor price, since the volume of production is determined by that demand. If the production of a given good results in less cost per unit produced when that product is manufactured in higher volumes, this would mean that a lower demand would result in a higher factor price, while a higher demand would result in increased production that helps to lower the factor price.

With either application, companies would do well to consider the factor price as one tool in helping to determine if continued production of a given product is viable. Since the idea of most businesses is to offer products to consumers that generate profits for the business, knowing the factor or natural price involved in that production is key to setting retail prices that find that balance between covering the cost of production and being competitive enough to attract the attention and loyalty of consumers. Since production costs can and do change over time, periodic recalculation of the factor price is essential if the company is to continue operating with at least some amount of profit margin.