Theory of Factor Pricing | NEB Class 12 Economics

This chapter covers factor pricing: how rent, wages, interest and profit are determined for land, labour, capital and entrepreneurship.

Introduction to Factor Pricing

Introduction

Different types of goods and services are produced in an economy. The production of goods and services are possible because of the factors of production. Traditionally, four types of factors of production are used in the production process i. e. Land, labor, capital, and entrepreneurship. These factors of production incur certain costs and these costs are the prices of the factors. Rent is paid for the land, the wage for labor, interest for capital and profit for entrepreneurship. Different types of economic theories have been developed for the determination of the price of each factor of production. These theories are called theories of factor pricing.

Meaning of Rent and Types of Rent

In general sense, the payment received by an owner of any real assets in return for its use for a particular period of time is called rent. In economics, rent refers to the payment for the use of services of those factors of production which are fixed in supply such as land and also to the payment which are variable in supply such as capital goods, variables, machines, building, etc.

            According to classical economist David Ricardo, “Rent is earned only from the land and rent is the payment received by the landlord for the use of original and indestructible power of soil”.              Modern economists state that rent is earned from all the factors of production. There are mainly two concepts of rent which are explained below:-

1. Contract rent:-

The rent that we mean in our daily life is called contract rent. It is also called gross rent. Contract rent is the actual payment made on the factor owner for the use of factor for a period of time. For example- payment made to the owner of the house, owner of the land, owner of machinery and equipment, etc. by its users. It is determined by the agreement made between two parties i. e. owner and renter of the factor.

2. Economic rent:-

In economics, rent refers to economic rent. It is a part of contract rent which is paid to the owner for the use of factor. Classical economist David Ricardo argued that economic rent is earned only from the land. It refers to that part of the payment made by a tenant to landlord only for the use of land.

            According to the modern economists, not only land but other factors of production also earn rent. They define economic rent as the surplus of current earning over transfer earning. Current earning is the earning of a factor of production from its current use and transfer earning is the earning of the factors of production from its alternative use.

Contract Rent vs Economic Rent

Difference between the contract rent and economic rent:-

Ricardian / Classical Theory of Rent

The Ricardian theory of rent was developed by David Ricardo in his book, “Principles of Political Economy and Taxation” published in 1817 A. D. According to him, “Rent is that portion of the produce of the earth which is paid to the landlord for the use of original and indestructible power of soil”.               This theory has the following assumptions:-

• Rent is earned only on land.
• The land is fixed in supply.
• The land possesses indestructible and original power.
• Land can be used only for farming.
• Land can be used only in diminishing order of their fertility.
• Law of diminishing returns operates in the land.
• Land differs in quality.
• Perfect competition prevails in the market.
• More population increases more productivity.
• Existence of marginal land.
• It is based on the long-run concept.

Ricardian theory of rent can be developed by intensive technique and extensive technique. The process of rent formation on both techniques is explained below:-

1. Rent under extensive cultivation:-

Extensive cultivation is a type of farming under which farm production is increased by using more and more plots of land. Ricardo assumes 4 grades of land which are equal in size but different in quality. Grades of land A, B, C, and D are ranked in diminishing order of their fertility. People cultivate on grade A land because it is the most fertile. If the demand for food grains is more, then people cultivate in successive grades of land B, C, and D. Grade D land is called marginal land because it is least fertile and covers just the cost of production. Each grade of land is cultivated by using the same unit of labor and capital.

Under extensive cultivation, rent is the surplus produced of intramarginal land over marginal land. So, all grades of land which produce more than the marginal land earn rent. Rent under extensive cultivation can be explained with the help of the following schedule and diagram:-

  In the above figure, the grades of land and production are measured along X-axis and Y-axis respectively. The amount of rent earned by different grades of land A, B, C, and D are shown by the shaded area. The production from the land D covers just the cost only. So, land D is called marginal or no rent land. So, rent under extensive cultivation is the surplus product of intra-marginal land over the production of marginal land.

2. Rent under intensive cultivation:-

Intensive cultivation is a type of farming under which the quantities of labor and capital are used successively on the same plots of land to increase production. In this case, the rent arises due to the operation of the law of diminishing returns in the cultivation of land. This law states that if more and more units of labor and capital are employed on a given plot of land per unit of time, the total product increases at a diminishing rate. When first, second, third, and fourth units of inputs are used successively on the same plots of land, the last dose of labor and capital employed on land is called marginal units and previous doses are called intra-marginal units. The surplus of output on these intra-marginal units over the marginal unit is called rent.

Rent under intensive cultivation can be explained with the help of the following schedule and diagram:-

 In the above figure, the doses of input and production are measured along the x-axis and y-axis respectively. The shaded area represents the rent obtained by using different doses of input. It is because, under intensive cultivation, the rent is the difference between the output produced by an intra-marginal dose of input and the marginal dose of input. The production from the fourth dose covers just the cost only. It earns no rent.

Criticisms of Ricardian Theory of Rent:-

1. No original and indestructible power of soil:- The ricardian theory assumes that the land possesses original and indestructible power. This view is not acceptable because the productivity of land can be increased through scientific techniques. Fertility can be destroyed by intensive use of land, soil erosion, flood, drought, and so on.

2. No single use of land:- Ricardo assumes only one use of land. The land has no next best alternative. However, in real life, land can be used to grow various types of crops, for industrial purposes or real estate purposes.

3. The wrong assumption of ‘no rent land':- Ricardian theory of rent assumes the existence of land which is available free of rent but in real life, nobody can obtain any land which is free of rent. Likewise, a plot of land regarded as marginal land for 1 crop maybe intra-marginal land for other crops.

4. The wrong assumption of perfect competition:- Ricardian theory of rent assumes the existence of competition in the land market. But in real life, the market that we find in land is imperfect competition. Similarly, the landlord may charge the monopoly rent.

5. Wrong idea of application of the law of diminishing returns:- Ricardian theory of rent is based on the application of the law of diminishing returns in agriculture production. But the production can be increased at an increasing rate by the use of improved technology, irrigation facility, modern fertilizers, hybrid and improved seeds.

6. All the factors of production earn rent:- Ricardo assumes that the land is the only one factor of production that earns rent. According to modern economists, all the factors of production earns rent.

7. Rent arises due to scarcity:- Ricardo opines that rent arises due to the differences in fertility and situation of land. In critics view, rent arises not only because of the land's fertility and situation but also due to the scarcity of land.

Concept of Wages and Types of Wages

Wage:-

Wage is the price paid to the labor for the use of his/her service in the production. In economics, the wage is the reward paid to the worker for his/her mental or physical work.

               According to F. Benham, “A wage may be defined as the sum of money paid under contract by an employer to the worker for services rendered.”                 There are mainly two concepts of wage which are explained as follows:-

1. Money wage or nominal wage:-

Money wage is the wage received by labor in the form of money. It is also known as nominal wage. Money wage does not include extra facilities provided to the labor like accommodation, health care, children education allowance, transportation facilities, clothes allowance, insurance facilities, etc.

2. Real wage:-

Real wage refers to the wage in terms of goods and services. It is the sum of goods and services that money wage can buy and extra benefits of labor’s occupation i.e. the number of necessaries, comfort, and luxury supply, etc. Real wage depends on various factors like money wage, price level, extra earning possibility,  nature of work, regularity and security of work, working environment, etc.

Money Wage vs Real Wage

Differences between money wage and real wage:-

Subsistence Theory of Wages

Subsistence theory of wages:-

                The subsistence theory of wages is developed by David Ricardo and other classical economists. This theory is based on the Malthusian theory of population. The subsistence theory of wages is also known as “Iron law of wages”. According to this theory, wages are determined by the cost of production of labor or subsistence level. The wages so determined will remain fixed at the subsistence level even in the long run. Wages paid to workers are just sufficient to fulfill their basic needs and they don’t have surplus income.

                  The following are the assumptions of the subsistence theory of wage:-

• Population increases at a faster rate.
• Food production increases at a slow rate.
• There is no existence of a trade union.
• The cost of production of labor is equal to subsistence wages.
• This theory is based on the long-run concept.                        

If wages rise above the subsistence level the prosperity of workers increases which will encourage workers to marriage sooner and to have a large family and thus, population increases. This will increase the labor supply. The increased competition among workers for employment causes wages to fall again to the subsistence level.

         Similarly, if wages fall below the subsistence level, there will be no prosperity. People will have less interest in marriage and birth. They will suffer from malnutrition, disease, and starvation, etc. and this may lead to death. This will lead to a decrease in the size of the population and thereby the supply of labor. The demand for labor exceeds its supply and wages tends to rise to the subsistence level which leads to maintaining wages ultimately at the subsistence level in the long run.

Criticisms:-

1. Ignores the demand side of labor:-                Subsistence theory of wages has emphasized on the supply side of the labor market and neglected the demand side in determining the wage. So, this theory is one-sided.

2. Exploitative:- According to this theory, the wage paid to the labors should be at the subsistence level whatever will be their productivity. This theory exploits the labor because they might produce more than they are really paid.

3. Fails to explain the difference in wage:-                    This theory asserts that the wages of all the workers are fixed at the subsistence level. However, wages can differ from person to person, occupation to occupation, a place to place and time to time.

4. Ignores the role of trade union:- This theory ignores the role of a trade union but the workers make collective bargaining for their benefits through trade unions.

5. No direct relationship between wage level and population:- According to this theory, the population increases if the workers are paid more than the subsistence level of wage and vice-versa but the shreds of evidence show that population in developed countries does not increase even if there is an increase in the wage level.

6. Pessimistic theory :- This theory is pessimistic because it excludes all the possibilities of improvement in the economic condition of the labor.

Wage Fund Theory of Wages

The wage-fund theory was first suggested by Adam Smith but the entire credit for formulating the theory goes to J. S. Mill. He has formulated this theory in his famous book “Principles of Political Economics” published in 1848 A. D. The wage-fund theory is regarded as a complementary rather than substitute to subsistence theory of wage.

                  According to this theory, wages depend upon the relationship between the supply of population and the capital available to employee workers. The population refers to the number of laboring classes and the capital refers to the number of funds to be used for the payment of wages. Thus, the available funds for wages are fixed at any given time which is called wage fund and the only way to increase wages is to reduce the numbers of laborers to be paid.

                 Level of wage = Wage paid/ Number of workers.                         The wage-fund theory has the following assumptions:-

• Capital is fixed and it is built from the saving of the previous period.
• Wage fund is rose before the employment of workers.
• The level of wage is fixed after the employment of a worker.
• The units of labor are homogeneous.
• Workers are paid equal wages.
• The wage level is flexible to the change in the number of workers employed.
• Money works only as a medium of exchange.
• There exists a direct relationship between the level of wage and wage fund an inverse relationship between the level of wage and the number of workers.

The determination of wage level under the wage-fund theory of wages can be explained with the help of the following schedule and diagram:-

The above table and diagram show the inverse relationship between the number of workers employed and the level of wage, keeping the wage fund constant. The number of workers and the level of wages are measured along Y-axis and X-axis respectively. The curve shows that, as the number of workers increases, the wage level decreases and vice versa.

Criticisms of the wage-fund theory of wages:-

1. Fails to explain the difference in wage:- According to this theory, all the workers get the same level of wages. But in reality, the wage paid to workers differs from person to person, a place to place, occupation to occupation, and time to time.

2. The wrong assumption of a homogeneous unit of labor:- Units of labor are not homogeneous as assumed by this theory. They differ in skill, knowledge, education, strength, productivity, etc.

3. Neglects efficiency and productivity of labors:- This theory has neglected the efficiency and productivity of laborers in determining the wage rate. A higher wage should be provided to efficient workers and lower to the inefficient.

4. Wage fund is not raised before employing the workers:- According to this theory, the wage fund is raised before employing the workers. However, it is raised on the basis of workers employed.

5. Money is not only the medium of exchange:- This theory has taken money only as a medium of exchange. But, money has effects on production, employment, investment, etc.

6. Unable to explain the source of wage fund:- This theory does not explain how the wage fund arises and why it remains fixed. It only states that the wage rate is found by dividing the given wage fund by the number of workers.

7. Wrong concept of permanent wage fund:- This theory takes the wage fund to be permanent. But, with the increase in the price level, the wage rate should also be increased.

$$\text{level of wage} = \frac{\text{wage fund}}{\text{No. of workers}}$$

Concept of Interest and Types of Interest

Interest:-

Generally, interest refers to the payment made by a borrower of the fund to the lender for the use of the fund in a specific time period. In economics, interest is the price paid for the use of the borrowed fund to spend on the purchase of capital assets used in production.

According to J. M. Keynes, “Interest is the reward for parting with liquidity for a specific period of time.” According to Seligman, “Interest is the return from the fund of capital.” There are two concepts of interest which are explained as follows:-

1. Gross interest:-

Gross interest is the total amount paid by a borrower to the moneylender in return for the capital borrowed for a period of time. It is also known as total interest. The gross interest that a lender receives is the aggregate of net interest and other charges. Net interest is the price paid by a borrower to the lender only for the use of capital. Other charges include the returns for risk, returns for management, and inconvenience charges. Thus, the addition of net interest, return for risk, return for management and the return for inconvenience is gross interest.

2. Net interest:-

The term interest in economics does not refer to the gross interest but to the net interest. Net interest is also known as pure interest. It is the price paid only for the use of capital or money. Net interest is that part of the gross interest that is exclusively paid for the use of capital. Net interest is normally the same during a period of time in different markets. In order to calculate the net interest, the payments for risk, management, and inconvenience are to be deducted from the gross interest.

Gross Interest vs Net Interest

Basis	Gross interest	Net interest
1. Definition	It is the total amount paid by a borrower to the lender in return of the capital borrowed for a period of time.	It is the price paid by a borrower to the lender only for the use of capital.
2. Calculation	It can be calculated by summing up net interest and other charges.	It can be calculated by deducting other charges from gross interest.
3. Dimension	It is a broad concept.	It is a narrow concept.
4. Interest rate variation	The rate of gross interest differs in the market.	The rate of net interest remains almost the same in the market.
5. Use	It is a practical concept which is applicable in real life.	It is purely a theoretical concept which has no practical application.
6. Determination	It is determined by several factors beside demand for and supply of the capital.	It is determined by the demand for the capital and supply of the capital.

Classical / Real Theory of Interest

The theory of interest propounded by classical economists is known as the classical theory of interest. It is also known as the real theory of interest because it explains the determination of interest rate by the real factors i.e. demand for saving and supply of saving. According to classicists, the rate of interest is the price paid for saving to invest in capital and it is determined by the forces of productivity and thrift. The interaction between the downward sloping demand curve for saving and upward-sloping supply curve of saving determines the rate of interest.

The classical theory of interest is based on the following assumptions:-

• There is full employment of factors of production.
• Demand for saving to invest inversely varies with the rate of interest.
• Supply of saving positively varies with the rate of interest.
• Law of diminishing returns operates on the marginal productivity of capital.
• Demand for saving is raised up to the point where marginal productivity of capital equals the rate of interest.
• Saving depends on the capacity and willingness to save.
• Level of income is given.
• Money works only as a medium of exchange and it has no other effects.

The classical theory of interest can be explained under the following headings:-

1. Demand for saving:- Demand for saving arises from the desire of entrepreneurs to invest in capital goods. The desire for investment in capital goods depends on the marginal productivity of capital and the rate of interest. It will be profitable for entrepreneurs to invest in capital goods as the rate of interest falls. Therefore, there exists an inverse relationship between the rate of interest and demand for saving. This will give the downward sloping curve for the saving.

Symbolically, D=F(r) and f' < 0

2. Supply of saving:- The supply of saving comes from individuals' saving. It is a surplus income overconsumption. Individuals save their part of income for their future reference or to get reward by supplying saving volume in the market. The volume of savings depends on the rate of interest. At the higher level of interest, there will be a higher supply of saving and vice-versa. So, it gives positively sloped supply curve of saving.

Symbolically, S=F(r) and f' > 0

According to the classical theory of interest, the equilibrium rate of interest is determined by the interaction of demand for saving and supply of saving for interest. The process of determination of the equilibrium rate of interest can be explained by the help of following schedule and diagram:-

In the above schedule and diagram, we can see that when the rate of interest increases, people are willing to supply more saving to invest and at a low rate of interest they will supply less. But at the low rate of interest, demand for saving is high and vice-versa. The interest rate is determined at that point where the demand for saving and supply of saving are equal. In the diagram above, ‘e’ is the equilibrium point where demand for and supply of saving interact with each other. The interest rate here is determined at 5%.

Criticisms of the classical theory of interest:-

1. Interest is not the price paid for saving to invest :- According to the classical theory, interest is the price paid for saving to invest in capital. But, Keynes defines interest as the reward for parting with liquidity.

2. Rate of interest does not bring equality of saving in investment :- The classical theory of interest says that the change in the rate of interest brings about the equality of saving and investment. But, Keynes opines that the equality between saving and investment is brought by the change in the level  of income.

3. Unrealistic assumption of the full employment equilibrium :- The classical theory of interest is based on the assumption of the full employment equilibrium. However, Keynes views that the full  employment equilibrium is the abnormal situation and cannot be found in the real world.

4. Indeterminate theory:- Keynes has remarked the classical theory of interest as indeterminate theory. Since saving depends upon the level of income, it is not possible to know the rate of interest unless the level of income is known beforehand. Lower interest rate will increase the volume of investment and thereby increases output, employment, income and saving. The classical theory of interest has no solution for this. So, it is indeterminate theory.

5. Narrow in scope :- The classical theory assumes that saving is only used for investment purpose. However, saving is also used for consumption, transaction, precautionary and other purposes. So, classical theory of interest is narrow in scope.

Concept of Profit and Types of Profit

Profit:-

Profit is a factor income that is enjoyed by an entrepreneur for taking risks and bearing uncertainties. Profit cannot be fixed in advance of the production. It is the residual amount left over after all the other factor incomes have been paid.

                  According to Henry Grayson, “Profit may be considered as a reward for innovations, a reward for accepting risks and uncertainties, and market imperfections.”                    Profit is the residual income of the business after all the explicit and implicit wages,  costs, interest, rent have been paid. Implicit and explicit costs are those costs which occur in a company after a business transaction. Explicit costs are those costs that are recorded in business documents. They are also known as direct or accounting costs. Implicit costs are generally described as opportunity cost or the loss of an opportunity in a given time or situation. They are not really shown or recorded as cost. They are also known as implied costs or economic costs. The profit as a reward of the entrepreneur, the fourth factor of production, has the following features:-

• Profit is earned by the entrepreneur as a reward for bearing risk and uncertainty.
• Profit is a residual income and not a contractual income.
• Profit may be positive, zero, or negative while all the other factors are always positive.
• Profit is not a fixed income.
• Profit fluctuates over a period of time.

                           Following are the two concepts of profit:-

1. Gross profit:-

The difference between the total revenue and total explicit cost is called gross profit. Gross profit is also called business profit. It is the residual part of the total revenue of a firm which is available to it when all the payments to the factors of production and all the obligations (liability) i.e. tax, depreciation, etc. have been met.

                   Symbolically,                             Gross profit = Total revenue – Explicit cost The main components of gross profit are rent, wage, interest, depreciation, insurance charges, net profit, etc.

2. Net profit:-

Net profit can be defined as the difference between total revenue and the total cost including both explicit and implicit cost. It is also known as economic profit or pure profit or just profit. The net profit is the amount obtained by deducting implicit costs, depreciation charges, insurance charges from total revenue.

               Symbolically,                         Net profit = TR-TC

The main components of net profit are the reward of risk-taking, reward for uncertainty-bearing, reward for ability, the reward for innovations, monopoly gains, and windfall gains.

$$\text{Gross profit} = \text{total revenue} - \text{explicit cost}$$

$$\text{Net profit} = \text{Gross profit} - \text{Implicit cost}$$

Gross Profit vs Net Profit

Gross Profit Vs Net Profit

The differences between Gross Profit and Net profit are discussed below.

Risk Theory of Profit

Risk theory of Profit:-

 The American economist, Professor Frederick Barnard Hawley has put forward the risk theory of profit in his book “Enterprise and productive process” published in 1907 A.D. According to this theory, the main function of an entrepreneur is risk-taking. An entrepreneur coordinates various factors of production and these factors are paid their contractual payments. There is a time lag between the production of goods and their sales. During this time lag, various changes take place. There occur different risks during this change period. The entrepreneur will undertake this risk and gets a reward in return. This reward is known as profit.

             According to Professor Hawley, “The profit of an undertaking is not the reward of management or coordination but of the risk and responsibility.”              He has stated that there is a proportional relationship between risk and profit. Prof. Hawley pointed out 4 types of risk that an entrepreneur may have to take. They are replacement risk, risk proper, uncertainties, and obsolescence. The real producer of the output is the entrepreneur and not the other factors of production because they are paid fixed remuneration. It is for undertaking all the risk that the entrepreneur is rewarded with profit. Therefore, the residual income left after paying the costs to the factors of production is profit.

Criticisms of Risk theory of profit:-

This theory neglects the difference between insurable risk and uninsurable risks. According to Professor Knight, those risks which are uninsurable gives rise to profit not all types of risks.

1. The reward for reducing risk:- According to Professor Carver, an entrepreneur does not receive profit because of taking the risk but because of avoiding risk by using his/her intelligence and ability.

2. No proportional relation between risk and profit:- Critics have pointed out that risk and profit are never proportional. Sometimes more risky enterprise may enjoy low profit than less risky business.

3. Narrow theory:-  Critics have pointed out that profit is not only the reward for the risk-taking function of an entrepreneur but also the reward for the organizational and coordinating ability of the entrepreneur.

Uncertainty Bearing Theory of Profit

Uncertainty Bearing Theory Of Profit:-

The uncertainty-bearing theory of profit was propounded by the American economist Prof. F. H. Knight in his book risk, uncertainty, and profit, published in 1921 A. D. This theory is an improvement over Hawley's risk theory of profit. Prof. Knight has focused and explained the uncertainty and distinguished it from risk. According to him, the risk is a situation in which the statistical probability of an outcome can be determined and can be minimized or reduced to naught (zero). According to Knight, profit is the reward of bearing uncertainties which are not insurable but the risk can be insured.

Professor Knight has distinguished between insurable risk and uninsurable uncertainties as follows:-

1. Insurable risk:-

The risks which are predictable and can be insured against on payment of an insurance premium are known as risks. E.g.:- Risks of a factory caught fire, theft or accident, etc. The insurable risk will not give any reward to an entrepreneur.

2. Uninsurable uncertainties:-

The risks which are unpredictable or uninsurable are known as uncertainties. E.g. :- Reduction in demand, change in government policies, increase in competition, etc. An entrepreneur bears these uncertainties and gets a reward in return which is called profit. The risks which cannot be predicted are explained as follows:-

a. Uncertainty in market condition:- The change in demand and supply conditions in the market lead the entrepreneur to uncertainty.

b. Competitive uncertainty:- When new firms enter the market, it increases competition among themselves and the profit of existing firm will become uncertain.

c. Innovation:- Due to the introduction of new technology, machines and capital goods need to be replaced before they become obsolete. Thus, the uncertainties of entrepreneur increases due to innovations.

d. Economic policies:- Economic policies can be classified into microeconomic policy and macroeconomic policy. Because of the change in these policies, the entrepreneurs may get windfall gains or suffer losses.

e. Business cycle:- The business cycle also called the trade cycle is a common feature of a capitalist economy. It refers to the fluctuation in the economic activity which changes aggregate demand and aggregate supply. Consequently, business uncertainties of the entrepreneur grow.

Criticisms of the uncertainty-bearing theory of profit:-

1. No profit despite uncertainty-bearing:- Critics pointed out that sometimes an entrepreneur earns no profit even after taking uncertainties.

2. Incomplete theory:- Profit is not the reward for bearing uncertainties. According to critics, other causes like coordinating, bargaining, etc. also give profits. So, it is an incomplete theory of profit.

3. Not applicable in case of a joint stock company:- The shareholders of joint stock companies who are entitled to a profit, do not perform any functions of an entrepreneur.

4. Unable to explain monopoly profit:- This theory does not suit well to expose the phenomenon of monopoly profit, where there is very less uncertainty involved in a monopoly business.