UNIT 5: FACTOR PRICING

THE MARGINAL PRODUCTIVITY THEORY OF

DISTRIBUTION

• The marginal productivity theory of distribution, as developed by J.B. Clark, at the

end of the 19th century, provides the explanation of how the price (of the
earnings) of a factor of production is determined.
• According to this theory, the price (or the earnings) of a factor tends to equal the
value of its marginal product. Thus, rent is equal to the value of the marginal
product (VMP) of land; wages are equal to the (VMP) of labour and so on.
• The neo-classical economists have applied the same principle of profit
maximisation (MC = MR) to determine the factor price. Just as an entrepreneur
maximises his total profits by equating MC and MR; he also maximises profit by
equating the marginal product of each product by its MC
Assumptions of the theory
1. Perfect competition in both product and factor markets : It means that both
the price of the product and the price of the factor (say, labour) remains
unchanged.
2. Operation of the law of diminishing returns : The theory assumes that the
marginal product of a factor would diminish as additional units of factor are
employed while keeping other factors constant.
3. Homogeneity and divisibility of the factor : All the units of factor are assumed
to be divisible and homogeneous. It means that a factor can be divided into
small units and each unit of it will be of the same kind and of the same quality.
4. Operation of the law of substitution : The theory assumes the possibility of the
substitution of one factor with the other.
5. Profit Maximisation : The employer is assumed to employ the different factors
in such a way and in such a proportion that he gets maximum profits. This can
be achieved by employing each factor up to that level at which the price of
each is equal to the value of its marginal product.
6. Full employment of factors : The theory assumes full employment for factors.
Otherwise each factor cannot be paid in accordance with its marginal product.
If some units of factor remain unemployed, they would be then willing to
accept the employment at a price less than the value of their marginal product.
7. Exhaustion of the total product : the theory assumes that the payment of each
factor according to its marginal productivity completely exhausts the total
product, leaving neither a surplus nor a deficit at the end.
Some key concepts :
1. MPP : The marginal physical Productivity (MPP) of a factor, say, of labour, is the
increase in the total product of the firm as additional workers are employed by
it.
2. VMP : if we multiply the MPP of a factor by the price of the product, we would
get the value of the marginal productivity (VMP) of that factor.
3. MRP : MPP* MR
The theory states that the firm employs each factor up to that number where its
price is equal to its VMP. Thus, wages tend to be equal to the VMP of labour;
interest is equal to the VMP of capital and so on. By equating VMP of each factor
with its cost a profit–seeking firm maximises its total profits.
LABOUR TOTAL MPP OF P (MR) TR MRP
PRODUCT LABOUR (MPP * MR)

1 8 8 10 80 80

2 15 7 10 70 70

3 20 5 10 50 50

4 23 3 10 30 30

5 25 2 10 20 20

6 26 1 10 10 10

7 26.5 0.5 10 5 5
LIMITATION/CRITICISM OF THE THEORY
• In determination of marginal product : Marginal product of any particular
factor (say, land or labour) cannot be separately determined.
• Unrealistic : the employment of one additional unit of a factor may cause an
improvement in the whole of organisation in that case the MPP of the variable
factors may increase.
• Perfect competition : The theory assumes the existence of perfect competition,
which is rarely found in the real world.
• Full employment
• Difficulties of factor substitution : Entrepreneurship is a specific factor which
cannot be substituted by any other factor.
• Emphasis on the demand side only
• Inhuman theory : the theory is often described as ‘inhuman’ as it treats human
and non-human factors in the same way for the determination of factor prices.
•
MODERN THERORY OF RENT
• According to modern economist rent is paid for the use of land. Rent is
determined by the demand for and supply of land.
• According to the present day economists, Ricardo’s theory explains why one
land commands higher rent than another. But it does not answer the basic
question? Why rent arises?
• To obtain an answer for this question, the present –day economists have
evolved what is called the scarcity theory of rent.
• According to this theory, rent arises due to the relative scarcity of land in
relation to its demand. The greater the demand for land in relation to its
supply, the higher shall be its rent.
• Rent does not arise due to differential fertility or differential situation, as
pointed out by Ricardo. Even if all the lands were equally fertile and equally
favourably situated, rent would still arise on account of the scarcity of land in
relation to its demand.
• Rent is thus, the resultant of the interaction of the forces of demand and
supply in relation to land.
• DEMAND AND SUPPLY ANALYSIS
• The demand for land is a derived demand. It is derived from the demand of
the products of land. If the demand of the products of land increases, there
will be a corresponding increase in the demand for the use of land, leading to
an increase in rent. For example, if the population of the country increases, the
demand for food increases, resulting in increase in demand for land and a rise
in its rent and vice versa.
• The supply of land on the other hand, is fixed so far as the community is
concerned, although individuals can increase their own supply by acquiring
more land from others or reduce its supply by parting with it. In other words,
the supply of land remains more or less fixed. Land presents a case of perfectly
inelastic supply.
• It means, whatever the rent, the supply of land remains the same. Land has no
supply price. Since its supply is absolutely inelastic, it does not respond to
changes in rent.
Assumptions
• Land is homogeneous
• Perfect competition
• Land is one quality.
Thus, according to the modern theory, the rent of land, like the rewards of other
factors, is determined by the equilibrium between demand for and supply of land.
In other words, it is the scarcity of land in relation to its demand that determines
rent.
• We thus reach the conclusion that land rent was determined by the demand
and supply of land. The demand is the active determinant; the supply is a
passive one.
THE QUASI RENT
• The concept of quasi- rent was introduced by Marshall to analyse the short-
term earnings of man made factors include machinery and other capital
equipment.
• An important feature of capital equipment is that their supply Is inelastic in the
short run and elastic in the long run.
• The short term earning of man made factors may be termed, to begin with, as
the surplus of total revenue after the payment to variable factors.
• In Marshall’s view, short run earning of man-made factors cannot be called
‘rent’ (in usual sense of the term) because, unlike rent, it is subject to
fluctuations in the short run.
• Short –run variation in factor payment depends on the change in the price of
the good they produce. If demand for the product increases in the short run,
its price goes up. But more of capital equipment cannot be hired to increase
production because their supply in the short run is fixed. Therefore, price of
good increases. This increases the total revenue.
• Consequently, surplus of total revenue over the cost of variable factor
increases. As a result, the surplus accruing to man- made factor exceeds their
normal earnings, i.e. their rentals.
• Similarly, when demand for the product decreases, its price goes down. As a
result, total revenue goes down. Therefore, the surplus over the variable cost
goes down, reducing the earning of the man-made factors. It may go below
the normal rate of rentals. That is, short-term earnings sometimes exceed the
normal rentals and sometimes go much below it.
• Marshall did not find it appropriate to use the term ‘rent’ for the short-run
earnings of the man-made factors. Marshall coined a new term ‘quasi rent’ for
the short term earnings.
• Quasi rent = TR – TVC
TRANSFER EARNING
• Transfer earning is also known as opportunity cost and ‘reservation price’.
Suppose a factor has alternative uses and it is put to its best use . It will not be
transferred till the earning is equal to the earning expected from the second
best use.
• Transfer earning is defined as the amount that a factor expect to earn from the
second best use. Alternatively, the transfer earning can be defined as the
amount that a factor expects to earn if transferred to its second best use.
• For example, Suppose a doctor earns Rs. 50,000 per month from his private
practice, the alternative available to him is to serve in a hospital as an
employee where he expects to earn Rs.30,000 per month.
• Thus, doctor’s transfer earning is Rs,30000 per month. He must earn a
minimum of Rs.30,000 per month to remain in his private practice. So, long as
he earns Rs.30,000 per month from his private practice, he has no incentive to
join a hospital as an employee
ECONOMIC RENT
• Economic rent is the excess of actual earning (AE) of a factor over its transfer
earning (TE). Economic rent may thus be defined as ER = AE – TE
• For example, Suppose a doctor earns Rs. 50,000 per month from his private
practice, the alternative available to him is to serve in a hospital as an
employee where he expects to earn Rs.30,000 per month.
• AE = Rs.50,000 ; TE = Rs.30,000
• ER = Rs.50,000 – Rs.30,000 = Rs.20,000
• Economic rent has a different meaning compared to the term ‘rent’ used in
common parlance. In its common usage, the term ‘rent’ means the actual
payment to the landlord, i.e., contractual rent, much of which is transfer
earning. But conceptually economic rent, means the difference between the
actual earning and transfer earning.
WAGE DIFFERENTIALS
The theory of wage rate determination is based on the assumption that labour is
homogeneous. If labour is homogeneous, and non-monetary advantages are
same in all jobs, then the price of labour tends to be the same in a perfectly
competitive market. In the real world, however, labour is not homogeneous, nor
are the different kinds of labour paid the same wages. It means that there are
wage differentials.
Wage Differentials due to heterogeneity of Labour
Labour is the most heterogeneous factor of production. Therefore, wage
differentials due to labour heterogeneity are far more common than wage
differentials caused by other factors. Wage differentials between two broad
groups of labour – skilled and unskilled.
THE NATURE AND CAUSES OF PERSISTING WAGE DIFFERENTIALS
1. Cost of education and training: The jobs needing greater investment in terms
of money and time are generally highly paid. Higher payments include
compensation for high cost of training and education. Higher salaries include
compensation for high cost of training and education.
2. Risk in performing job : Some jobs by nature involve risk to life and body.
Among riskier jobs, some are riskier than others. Highly risky jobs, e.g., jobs of
mining workers, pilots and so on, are more highly paid than the less and non risky-
jobs.
3. Hours of leisure : People in teaching profession and research, generally enjoy
longer leisure hours than people in medical and engineering profession and in
business management. That is why, perhaps, doctors and engineers are paid
higher salaries.
4. Cost of living : Cost of living varies from area to area from city to city.
5. Other factors : The other factors which contribute to the persistent wage
differentials are : 1) cost of tools and equipment required for performing the job;
2) job security 3) nature of employment (i.e., whether contractual or permanent);
5) working conditions and environment of place of work, and 6) social prestige
associated with job and so on.
Non-Compensating Wage Differentials
The non-compensatory wage differentials are those for which there is no
compensating factor. Such wage differentials arise because of the following
factors.
1. Individual qualities of labour : The differences in individual abilities and
expertise cause differences in their productivity. Therefore, there would be
differences in the reward which they can earn in the market for their services.
2. Market Imperfections : If a labour market conditions are imperfect, and
generally, they are, then workers lack adequate information regarding the
opportunities open to them. This restricts the mobility of labour to higher paid
jobs and places. Immobility of labour due to market imperfections may cause
low wage in some areas and high wages in others.
3. Differences in prices of products : The market value of a commodity
produced by a labour is one of the most important cause of wage differences.
Labour employed in industries producing low price goods tends to get lower
wages than those employed in the industries.
THEORIES OF INTEREST
CLASSICAL THEORY OF INTEREST
(SAVING INVESTMENT THEORY OF INTEREST)
• This theory analyses the demand and supply of capital from the point of view
of savings and investment. It was propounded by the old classical economists
and has been developed and refined by economists like Marshall, Pigou,
Cassels, Walras, Tausig and Knight.
• According to this theory, the rate of interest is determined by the demand and
supply of capital. The rate of interest settles at the point where the demand
for capital is equal to the supply of capital.
• Since the demand for capital arises from investments and supply of capital
springs from savings.
• The classical theory refers to saving as real saving and to investments as real
investment.
• Real saving refers to those goods which instead of being consumed are
employed for productive purposes.
• Real investment refers to the actual production of a new piece of capital – a
machine, a workshop, a factory, etc., distinct from monetary investment, such
as stocks and shares. It is on account of this fact that the classical theory is
referred to as the real, non monetary investment.
• Money does not play any direct role in the determination of the rate of
interest, according to this theory.
• Two sides of the problem of interest determination, namely, the demand for
capital (investment schedule) and the supply of capital ( saving schedule).
• Demand for capital (Investment schedule)- The demand for capital arises on
account of its productivity. But capital is not equally productive in all its uses.
In some uses, it is more productive than in others.
• Since the supply of capital is scarce in relation to its demand, it is always
employed in those uses where its return is comparatively high. If however, its
supply increases, it is put to less productive uses.
• This means that the marginal productivity of capital diminishes as more and
more of it is used for production. Therefore, the demand curve for capital
slopes downward.
• If the rate of interest rate rises, the firm will demand less capital. On the
contrary, if the market rate of interest falls, the firm will use more capital.
• Supply of capital depends on the savings of people. Level of saving depend on
capacity to save and willingness to save. Willingness to save depends on rate
of interest.
• If the rate of interest is higher, people tend to save more and vice versa. There
is a direct relationship between savings and interest. Therefore, the supply
curve of capital is upward sloping.
• Capital interest schedule

Rate of interest Demand of capital Supply of capital

10 50 90
9 60 80
8 70 70
7 60 60
6 50 50

• From the above table, we can say that the rate of interest is fixed
at 8% since demand for and supply of capital are the same at this
level.
CRITICISM
1. Equality between saving and investment was brought about by changes in the
level of income and not by the rate of interest rate.
2. Investment can increase the liquidity preference of the people - Keynes
assumed that increased investment will raise the rate of investment via
increased incomes.
3. Savings and interest are not so interest elastic as suggested by the classical.
Saving is influenced by income and investment is influenced by MEC.
4. Classical theory assumes that level of income is constant in the economy
which is unrealistic.
5. Full employment is unrealistic assumption.
6. Keynes criticises the classical economist on the ground that they ignore or
overlooks the vital role played by bank credit in increasing the supply of
money.
NEO-CLASSICAL LOANABLE FUND THEORY OF INTEREST
• This theory was originally propounded by the well- known Swedish economist,
Knut Wicksell. It was further refined and polished by a group of Swedish
economists, including Bertil Ohlin, Eric, Lindahl and Gunnar Myrdal.
• According to this theory, the rate of interest is the price of credit, which is
determined by the demand and supply for loanable funds.
• Forces behind the demand and supply of loanable funds
• Demand : Investment ; hoarding ; Dissaving
• Supply of Loanable funds : Savings; Dishoarding; Disinvestment ; Bank credit
• Demand for Loanable funds has primarily three sources i.e., government,
businessmen and consumers who need them for purposes of investment,
hoarding and consumption.
• The government borrows funds for constructing public works or for war
preparations. The businessmen borrow for the purchase of capital goods and
starting investment projects. Such borrowings are interest elastic and depend
mostly on the expected rate of profit as compared with the rate of interest.
• The demand for loanable funds on the part of consumers is for the purchase of
durable consumer goods.
• The tendency to borrow is more at a lower rate of interest than at a higher
rate of interest.
Supply of Loanable Funds
• Supply of Loanable funds is through the following sources :
• Savings (S)
• Dishoarding (DH)
• Disinvestment (DI)
• Bank credit
• If these curves DH, M and S are laterally added up, we have the aggregate
supply curve.
• The equilibrium rate of interest is determined by the interaction of the forces
of demand and supply. The interest rate is fixed at a point where the demand
and supply are equal to each other.
KEYNESIAN THEORY OF INTEREST
• Keynesian theory of interest is also known as “Liquidity preference theory”.
• Keynes define the rate of interest as the reward of parting with liquidity for the
specified period.
• Money being a medium of exchange, people hold money for carrying out
transactions. Money is held in liquid form because there is a time gap between
earning income and spending it on goods and services.
• While income is received periodically with a time gap – weekly, monthly or
annually – expenditure is made regularly. Therefore, people hold money to
meet their regular expenditure.
• In Keynesian terminology, this is liquidity preference, and in general usage, this
is demand for money.
• Accordingly, there are three kinds of demand for money.
• 1) Transaction demand for money
• 2) Precautionary demand for money
• 3) Speculative demand for money

1) Transaction demand for money : routine and planned expenditure. Similarly,

business firms hold a part of their money receipts to carry out their regular
transactions.
• Transaction demand for money depends on the level of income and it has no
relationship with interest rate. Under these conditions, transaction demand for
money can be expressed as,
M = f(Y) ; where M = transaction demand and Y= income
• Transaction demand for money increases with increases in income.
• However, since periodic income of the people is constant, they hold a constant
proportion of their periodic income for transaction purposes.
• Thus, according to Keynes,
• MT = kY
2) Precautionary Purposes : This is uncertainty in human life.
MP = f(Y)
• Since, both transaction and precautionary demands for money are the
function of income, the total transaction demand for money
(MT = MT + MP)
MT = KY
• Speculative demand for money
• Msp = f(i)
• Where, i = interest rate
• Total demand for money = Total demand for money, according to
the Keynesian theory, can be obtained by summing the transaction
and speculative demands.
• MD = MT + MSP
• MsP is inversely related to interest rate. However, if interest rate
goes down to critical level, people hold unlimited money for
speculative purpose. Keynes called it liquidity trap.
 Transaction Speculative Total Money
demand demand demand

r3 r3 r3

r2 r2 r2
Interest
rate r1 r1 r1
MSP MSP MD

0 MT 0 0 MT
Money Money Money
• Total Supply of money = Keynes assumed money supply to be given.
According to him, money supply in any country is exogenously
determined by the monetary authority, especially the central bank of
the country, e.g. Reserve Bank of India in India.
• Money supply has no relation with market forces and the interest
rate. In brief, given the national income (GDP) and monetary need of
the country, money supply remains constant over the period of
time, whatever the rate of interest.
• Determination of Interest rate
• According to Keynes, the equilibrium rate of interest is determined
at the rate at which aggregate demand of money is equal to
aggregate supply of money. That is the equilibrium rate of interest is
determined where, MD = MS
 CONSTANT MONEY DETERMINATION
SUPPLY OF INTEREST RATE

r3
r3

r2
r2
Interest
Interest
rate
rate r1
r1 MD

0 MS MS
Money 0 Money
THEORIES OF PROFIT
DYNAMIC THEORY OF PROFIT
• This theory was first propounded by the American economist, J.B.
Clark, who defined profit as the excess of the prices of goods over
their costs.
• According to Clark, profit arises due to dynamic changes in the
society or due to the fact that society is dynamic.
• Profit, according to him, cannot arise in a static society. In such a
society, the element of time is non-existent. The economic activities
of the last year would be repeated this year without any change.
There is, therefore, no risk of any kind for an entrepreneur in a static
society.
• The entrepreneur would only get wages for his labour and interest
on capital
• If the price of the commodity is higher than the cost of production,
competition would soon force it down to the level of the cost of
production so that there cannot be a gap between price and cost of
production in a static society.
• It is however possible that competition may take some time to work
itself out, and during this period price may stand higher than the
cost of production. But the profit earned by the entrepreneur during
this period would be frictional and not normal profit. Thus,
according to Clark, profit in static society either does not arise or if it
does, it is frictional profit.
• But society, as we know, is dynamic. It has always been dynamic. It is
changing every minute, every second. Several changes are taking
place in a dynamic society.
• According to Clark, five main changes are constantly taking place in
society – 1) Changes in the size of the population, 2) Changes in the
supply of capital 3) Changes in production techniques 4) Changes in
the forms of industrial organization 5) Changes in human wants
• Profit arises in a dynamic society on account of these changes. These
changes affect in the main the demand and supply of commodities,
and thus lead to the emergence of profit. These are of course,
general dynamic changes. But sometimes dynamic changes may be
introduced deliberately by the individual firms themselves. For
example, a firm by improving its production technique, may succeed
in cutting down its cost and thereby increasing its profit.
Hawley’s Risk Theory of profit : Profit is reward for risk bearing
• The risk bearing theory was developed by the American economist
prof. Hawley in his book enterprise and productive process published
in 1907.
• According to this theory profit is a reward for risk bearing and prof.
Hawley justifies in his own manner.
• Some risk are inherent in every business, this is because all business
are more or less speculative, thus profits is not reward for
differentially ability. The essential function of the entrepreneur is the
risk taking because he cannot delegate this function to anybody
else. He alone has to bear the risk and profit is a reward for risk
taking.
• As we know every business in modern time involves some risk.
• Only entrepreneur bears risk. Except entrepreneur all parties which
are connected in business activity. They are working with pre-fix
contract.
• The degree of risk varies in different business according to prof.
Hawley there is a positive relationship between risk and profit –
higher the risk greater is the possibility of profit and smaller the
risk ,lower is the possibility of profit in this way profit is a reward for
risk taking.
CRITICISM
1. Profit is a reward not for risk bearing but it is the reward for avoiding
the risk.
2. There is never a straight relationship between the extent of risk and
the amount of profit.
• There are some risks which can be ‘INSURABLE’ and hence risk is
shifted over to the insured company. Thus, the entrepreneur
therefore does not bear the risk.
• The theory overlooks other factors like monopoly, innovation,
unexpected situation etc. which can create profit.
KNIGHT’S THEORY OF PROFIT : Is a Return to Uncertainty Bearing
• Frank H. Knight treated profit as a residual return to uncertainty
bearing, not a return to risk bearing.
• Obviously, Knight made a distinction between risk and uncertainty.
• He divided risks into calculable and incalculable risks.
• Calculable risks are those, whose probability can be statistically
calculated on the basis of available data, e.g., risks due to fire, theft,
accidents, etc. Such risks are insurable.
• There remains, however, an area of risk in which probability of risk
occurrence cannot be calculated.
• For instance, there may be sudden increase in some element of cost
which may not be accurately calculated, and the strategies of the
competitors may not be accurately assessed and predicted,
technological changes, changes in govt. policies etc.
• The risk element of such incalculable events is not insurable.
• The area of incalculable risks is, thus, marked by ‘uncertainty’.
• Every business involves less or more uncertainty. It is the main function
of the entrepreneur to bear all such uncertainties of business.
• In short Knight theory implies that uninsurable risks are uncertainty of
business and profit is the reward for uncertainty bearing.
CRITICISMS
1. Uncertainty of business is not the sole determinants of profit. The
profit that an entrepreneur receives is also the reward for other
functions performed by him, such as, initiating, co-ordinating,
bargaining, etc.
2. Managerial skill rather than uncertainty which leads to higher profit.
• According to this theory, uncertainty is an reward for profit, but the
critics pointed out that sometimes an entrepreneur earns no profit
despite uncertainty-bearing. He may have borne uncertainty and yet
earned no profits.
• The uncertainty theory, like the other theories, does not furnish a
comprehensive explanation of profit, and, as such, it is inadequate.
Nevertheless, it does not in so contain an element of truth in so far
as uncertainty-bearing is an important determinant of profit.
Schumpeter’s Innovation Theory of Profit : Profit is Reward for
Innovations
• The innovation theory of profit was developed by Joseph A.
Schumpeter in 1934.
• Schumpeter theory is in several respects, similar to that of Clark. He
also attributes profits to dynamic changes, but in place of the generic
changes mentioned by Clark, Prof. Schumpeter explains profit in terms
of innovations in the productive process.
• According to him profit is the reward for innovations in a sense wider
than that of the changes mentioned by Clark.
• According to him, innovations refer to all those changes in the
production process the objective of which is to reduce the cost of
commodity, and thus, cause a gap between the existing price of the
commodity and its new cost.
• Profit can be made by introducing innovations in manufacturing and
methods of supplying the goods. Innovations may take any of the
following forms.
• 1. Introduction of a new good or a new quality of good;
• 2. Introduction of a new method of production;
• 3. Opening up or finding out a new market;
• 4. Finding and using new source of raw material, and
• 5. Organizing the industry in a different and more efficient manner.
• The main motive for introducing innovations is the desire to earn
profit. Profit is therefore, the cause of innovations. It is not only the
cause but also the effect of innovations. Because if innovation is
successful it will give rise to profit. It should, however, be noted that
a successful innovation results in the emergence of profit only for a
temporary period.
• When the profit resulting from one innovation ceases or disappears,
another innovation may take place, yielding fresh profit to the firm
in question. So innovational profits, according to them Schumpeter,
appear, disappear and reappears.
• A mere new idea does not constitute innovation unless it is put to
commercial use. A new production technique or a machine may be
conceived by a technician, but it will not be an innovation unless
some one actually puts it in practice. Profit from innovation, thus
accrues only to the entrepreneur.
•
• NATURE OF FACTOR MARKETS, MARGINAL PRODUCTIVITY THEORY OF
DISTRIBUTION, RENT-DEMAND AND SUPPLY THEORY, QUASI RENT,
TRANSFER EARNING, WAGES-REASONS FOR WAGE DIFFERENTIALS,
COLLECTIVE BARGAINING, INTEREST- CLASSICAL, NEO- CLASSICAL
KEYNESIAN, PROFIT – DYNAMIC, INNOVATIVE, RISK AND
UNCERTAINITY THEORY

•.