Rent theory

V Unit
1. Factor Pricing or theory of distribution
2. Theory of Rent
3. Theory of Wages
4. Theory of Profit
5. Theory of Interest
12/17/2016 Dr. Waqar Ahmad, Allenhouse Business School,

Factor Pricing or theory of
distribution
In the words of Chapman:
"The Economics of distribution or the pricing of
factors accounts for the sharing of the wealth produced by
a community among the agents or the owners of the agents
which have been active in its production".
In the words of Marshall:
"Free human beings are not brought up to their work on the
same principle of a machine, a house of a slave. If they were,
there would he very little difference between the
distribution and the exchange side of value".
12/17/2016 Dr. Waqar Ahmad, Allenhouse Business School

Micro economic theories of distribution
1. Marginal Productivity Theory
(Neo-Classical Version
2. Modern Theory of Factor Pricing
Under Perfect Competition

Marginal Productivity Theory
(Neo-Classical Version)
The marginal productively theory is an attempt to explain the determination of the rewards of
various factors of production in a competitive market. The marginal productivity theory of
resource demand was the work of many writers, it was widely discussed by many economists
like J.B. Clark, Walras, Barone, Ricardo, Marshall. It was improved, amended and modified
later on. The final version of the theory as stated by Neo Classical economists is given below.
Definition and Meaning:
By marginal productively theory of a factor is meant the value of the marginal physical
product of the factor. It is worked out by multiplying the price of the output per unit by units
of output.
Formula:
VMP = MP x P
Value of Marginal Product (VMP) = Marginal Physical Product x Price
The marginal productivity theory contends that in a competitive market, the price or reward of
each factor of production tends to be equal to its marginal productivity.

Assumptions:
The theory of marginal productivity is based on the following assumptions:
(i) Factor identical:
(ii) Factors can be substituted: .
(iii) Perfect mobility of factors:
(iv) Application of law of diminishing return:
(v) Perfect competition:
Criticism:
The marginal productivity theory has been subjected to scathing criticism on the
following grounds.
(i) Theory based on unrealistic assumptions:
(ii) Factors are not perfect substitutes:
(iii) Law of proportionate return:
(iv) Wage cuts does not determine demand
(v) Difficulty In the measurement of MP:
(vi) Effect of withdrawal of a factor
(vii) Factor units cannot be raised
viii) One sided
(ix) Static theory

Modern Theory of Factor Pricing
(Under Perfect Competition)
The modern economist discard the marginal
productivity theory on the ground that it completely
ignores the supply side of a factor of production.
Moreover, it simply states as to how many units of a
factor of production will be employed at different
prices but it does not explain the real issue.
i.e., the determination of the price of the
factor of production. They, therefore, use the
tools of demand and supply in solving the
problem of determination of factor prices.

Demand For a Factor of Production:
The demand for a factor of production, like the price of commodity,
is a function of price. How much a factor of production will be
demanded in the market depends upon two parameters:

Supply of a Factor of Production:
"A schedule of the various quantities of a factor of
production that would be offered for sale at all
possible prices at any one instant of time".

Criticism:
The theory of factor pricing is criticized on the ground of its weak
assumptions.
(i) The theory is based on the assumption of perfect competition in both the
product and factor markets. While in reality, it is the imperfect competition
which prevails in both the markets.
(ii) The theory assumes that all the unit of a factor are homogenous. But in the
real life they are different from each other.
(iii) The theory assumes that different factors of production are capable of
being substituted for one on other. In the real world, we find that factors of
production are not close substitutes of one another.
(iv) The theory ignores the increasing returns in factor pricing.

Rent

In the words of Building:
"Economic rent may be defined an any payment to a unit of production
which Is in excess of the minimum amount necessary to keep that
factor In its present occupation"
For example, the payments made by a tenant to the owner of a house,
or factory or land on weekly, monthly, or yearly basis is a rent in the
popular sense.
The modem economists do not use the concept of economic rent in
the restricted some. They apply rent to all the factors of production
which do not have a perfect elastic supply. According to them:
"Economic rent is a surplus or excess over the transfer earnings".

Theories of Rent
1. Ricardian Theory of Rent
2. Modern Theory of Factor
Pricing Under Perfect
Competition
Quasi Rent

Ricardian Theory of Rent
The theory of economic rent was first propounded by the English
Classical Economist David Ricardo (1773 -1823). David Ricardo
in his book. "Principles of Political Economy and Taxation",
defined rent as that:
"Portion of the produce of the earth which is paid to a landlord on
account of the original and indestructible powers of the soil,
Ricardo in his theory of rent has emphasized that rent is a reward
for the services of land which is fixed in supply. Secondly, it arises
due to original qualities of land which are indestructible". (The
original indestructible powers of the soil include natural soil,
fertility, mineral deposits, climatic conditions etc., etc.).

Assumptions:
(i) Rent Under Extensive Cultivation.
(ii) Rent Under Intensive Cultivation.

Rent Under Intensive Cultivation:
The theory of rent which has been discussed above
applies to Intensive margin of cultivation. The surplus
or economic rent also arises to the land cultivated
intensively. This occurs due to the operation of the
famous law of diminishing returns.
When the land is cultivated intensively, the application
of additional doses of labor and capital brings in less
and less of yield. The dose whose cost just equates the
value of marginal return is regarded marginal or no rent
dose. The rent arises on all the infra-marginal doses.

Criticism on Ricardian Theory of Rent:
(i) No Original and Indestructible Power
(ii) Wrong Assumption of 'No Rent Land’
(iii) Rent Enters Into Price
(iv) Wrong Assumption of Perfect Competition
(v) All Lands are Equally Fertile
(vi) Historically Wrong
(vii) Neglect of Scarcity Principle

Quasi Rent
The concept of quasi-rent owes its origin to Dr. Alfred Marshall.
Dr. Marshal is of the opinion that:
"It is not possible for human beings to increase the supply of land. It is
fixed by Nature. If price of a produce rises, the surface of earth cannot
be increased and if price falls, it cannot be decreased. But by appliance
of machine which are the product of human efforts, the supply can be
increased or decreased if a fairly long period of time is allowed".
"Marshall is of the view that a differential surplus
which arises from a factor of production, whose
supply is fixed for all times to come should be named
as rent but a temporary gain which a factor or
production earns due to temporary limitation of its
supply should be called quasi-rent".

How does rent of Land differ from rent of;
(a) Fisheries, (b) Mines and (c) Buildings?
(a) Rent of Land and Fisheries.
(b) Rent of Land and Mines.
(c) Rent of land and urban site land.

Wages

Wages are remuneration paid to labor in
return for the services rendered.
Benham has defined the term wages in a
restricted sense.
According to him, a wage may be defined as
a sum of money paid under contract by an
employer to a worker in exchange for service
rendered.

Various System of Wages Payments:
The remuneration of labor is paid in various manners and
under various names. It can be classified as follows:
(1) Classification According to the Class of Workers
Engaged:
(i) Salary
(ii) Pay
(iii) Wage
(iv) Fee
(2) Classification According to the Manner of Payment:
(i) Time Wages: (ii) Piece Wages:

Payments of Wages on the Basis of Form/Kinds of Wages:
On the basis of form, wages are of two kinds, nominal wage and real
wage.
(1) Nominal wages:
"By 'nominal wage' is meant the total amount of money earned by a
person during a certain period".
For instance, you employ a servant and pay him $2600 per month for
the services he renders to you. The amount which is paid in terms of
money only is named as nominal wages.
(2) Real Wages:
"Real wages refer to the total amount of satisfaction which a worker
receives in the form of necessities, comforts and luxuries in return for
the services".

Factors on which Real Wages Depends:
There are following factors that influence the real wages:
(i) Purchasing Power of Money
(ii) Opportunity of Extra Earning
(iii) Nature of Work
(iv) Future Prospects
(v) Hours of Work
(vi) Tenure of Services
(vii) Form of Payment
(viii) Expenses of Trainings
(ix) Social Status.

How are Wages Determined/Theories of Wages
Determination:
There are various theories of wages which lave been put
forward by different economists from time to time but none of
them is free from criticism. The most important theories of
wages determination are:
(1) Subsistence Theory of Wages.
(2) Wage Fund Theory.
(3) Residual Claimant Theory.
(4) Marginal Productivity Theory.
(5) Modern Theory of Supply and Demand.12/17/2016 Dr. Waqar Ahmad, Allenhouse Business School

Subsistence Theory of Wages:
The subsistence theory of wages owes its origin to Physiocratic School of France.
The theory is also named as Iron or Brazen Law of Wages. According to this theory:
"The wage in the long run tends to be equal to the minimum level of subsistence. By
'minimum level of subsistence is meant the amount which is just sufficient to meet
the bare necessities of life of the worker and his family".
Criticism on Subsistence Theory of Wages:
This theory has beep criticized on the following grounds:
(i) It is incorrect to say that when the money income of a person increases above the
subsistence level, he marries early and the birth rate increases.
(ii) The theory fails to explain the wage differences in different employments.
(iii) The third criticism levied on the subsistence wages is that it entirety ignore the demand
side of the labor and emphasizes only the supply side for the determination of the wages.

2) Wage Fund Theory:
The theory of wage fund first introduced in Economics by Adam Smith and later on it was developed by J.S. Mill. The theory
briefly explains that:
"Wages depend upon the proportion between population and capital, or rather between the number of laboring classes who work
for hire and the aggregate of what may be called the wage fund which consists of that part of circulating capital which is
expanded in the direct hire of labor".
Formula for Wage Fund Theory:
Wage Rate = Wage Fund
Total Number of Workers
If it is desired that the average rate should increase, it can be achieved in two ways. Firstly, by increasing the floating capital and
secondly by reducing the number of workers.
Criticism on Wage Fund Theory:
The theory has been subjected to a great deal of criticism by Longe, Thornton and Jevon on the following grounds:
(i) There is no special fund which is particularly meant for the payment of wages to the workers. The wages are paid out of the
national dividend which is a flow and not fixed like that of fund.
(ii) The theory is inadequate to explain the wage differences in different occupations.
(iii) The theory gives undue importance to the supply side. It makes wrong assumption that the demand for labor remains
constant.
(iv) The theory assumes that labor is homogeneous but in fact it is heterogeneous.
(v) The level of wages do not necessarily depend upon remuneratory capital. In newly developed countries, the capital available
is generally less than the established countries but there the wages are relatively higher because of the greater productivity of
each worker.

Residual Claimant Theory:
Residual claimant theory is associated with the name of American economist Walker. According to Walker:
"Wages equal to Whole product minus rent interest and profit".
Jevon has stated the theory of residual claimant in the following words:
"The wages of a working man are ultimately coincident with what he produces, after
the deduction of rent, taxes and the interest on capital".
In short, the theory states that labor receives what remains after payment of rent, interest, profit and taxes out of the national
dividend.
Criticism on Residual Claimant Theory:
The theory has been criticized by Longe and Thornton on the following points:
(i) The theory ignores the influence of supply side in the determination of wages.
(ii) If fails to explain as to how the trade unions raise the wages of the workers.
(iii) It is also point out that the residual claimant is the entrepreneur and not the labor. The labor gets his share during the process
of production of a commodity.

Marginal Productivity Theory of Wages Under Perfect Competition:
Some of the modern economics explain the determination of wages by means of
marginal productivity analysis.
According to this theory:
"Wages in perfect competition tend to be equal to the marginal
net product of a labor. By marginal net product of a labor is
meant net addition or net subtraction made to the value of the
total produce of a firm when one unit is added or withdrawn
from it".

Criticism on Marginal Productivity Theory of Wages:
The theory of marginal net product of wages has been criticized on the following
grounds:
(i) The theory assumes that there is perfect competition, among the entrepreneurs
and the wage earners while in the real world there is no such perfect competition.
(ii) The theory assumes that all units of labor engaged are perfectly homogeneous
but the fact is otherwise.
(iii) The theory also assumes perfect mobility amongst the labor but the assumption
does not held good in the real life.
(iv) The theory emphasizes on the demand side of the problem and makes a wrong
assumption that the supply of labor remains constant.
It is dear now that marginal net product theory of wages is true only under certain
assumed conditions. In. spite of the flaws which have been discussed above, it
offers a bit satisfactory explanation of the wages.

(5) Modern Theory of Wages:
Wages Determination Under Perfect Competition:
We have studied various theories which explain the
determination of wages but they all stand discredited
as they do not offer satisfactory explanation of wages.
The modern economist are of the opinion that just as
the price of a commodity is determined by the
interaction of the forces of demand and supply, the
rate of wages can also be determined in the same way
with the help of usual demand and supply analysis.
Let us now discuss in brief as to what we mean by
demand for and supply of labor.

Nominal and Real Cost of Labor:
The payment which a labor receives for his services
constitutes his income. But from the point of view of the
entrepreneur, that remuneration forms a part of the cost of
production. Just like wages, the cost of labor can also be
looked at from two points of view:
(1) Nominal Cost of Labor:
By nominal cost of labor is meant the total money wages paid to the labor for
the services.
(2) Real Cost of Labor:
Real cost of labor is measured in relation to the work performed by him.

Minimum Wage
"The smallest amount of money that employers are legally allowed to pay someone
who works for them".
Advantages/Merits of Minimum Wage:
The advantages which are claimed for fixing the minimum wage for the labor are as
follows:
(i) Ensures Minimum Standard of Living.
(ii) Effect on Efficiency.
(iii) Inefficient Employers are Eliminated.
Disadvantages/Demerits of Minimum Wage:
(i) Decrease in Efficiency.
(ii) Fixation of Minimum, Wages a Difficult Affair.
(iii) Difficulty in Enforcement.
(iv) Disorganizations in Business.
(v) Unemployment.

Interest

Definition of Interest:
"Interest is the price paid by the borrower to the lender for the use of
borrowed funds during a certain period".
In the words of Eastham:
"Interest is the payment for parting with the advantage of liquid control of
money balances".
According to Batch:
"Interest is the price paid for the use of money or credit".
It is normally expressed as a percentage on the funds loaned or borrowed.
In the words of J. M. Keynes:
"Interest is the premium which has to be offered to induce people to hold
their wealth in some form other than hoarded money".

Definition of Gross Interest:
"The interest earned on a deposit or security before the deduction of
tax".
Element Gross interest is composed of some or all of the following elements:
(i) Net Interest.
(ii) Insurance Against Risk.
(iii) Payment for Inconvenience.
(iv) Remuneration for Services.
Definition of Net/Pure Interest:
If from the gross interest, we deduct the payments made for: (a) Insurance against
risks, (b) Inconvenience and (c) For services of the lender, we are left with net or
pure interest. Net interest is, thus, the payment for loan able funds only.

Definition of Interest Rate:
"The price which a borrower pays for the use of money he does not own, and has to
return to the lender who receives for deferring his consumption, by lending to the
borrower".
Definition of Annual Percentage Rate (APR):
"The percentage cost of borrowing per year, including interest fees".
Theories of Interest/Why is Interest Paid?
There are various theories which have been put forward from time to time as to
why the interest is paid. The most important theories are:
(1) Productivity Theory of Interest.
(2) Abstinence or Waiting Theory of Interest.
(3) Austrian or Agio Theory of Interest.
(4) Loanable Fund Theory of Interest.
.
(5) Liquidity Preference Theory of Interest.
(6) Modern Theory of Interest.

1) Productivity Theory of Interest:
Definition:
Turgot and other physiocrats were of the opinion that interest is the reward for the
use of capital in production. Interest is paid, they say, because capital is productive.
The labor assisted by capital can produce more things than what they can do
without it.
Example:
For instance, a man with the help of a machine can sew more clothes than without
it. It is but Just and proper therefore that a part of the pool of wealth which the
capital has produced should go to the lender of the capital. Interest is, thus, a
payment for the productivity of capital.

(2) Abstinence or Waiting Theory of Interest:
Definition:
This theory of interest is associated with the name of Senior. According to the
theory:
"Interest is a reward for abstinence. When a person saves money from his
income and lends it to somebody else, he in fact makes sacrifice. Sacrifice in
the sense, that he abstains from consuming the whole of his income which he
could have easily spent. As abstaining from consumption is disagreeable and
painful, so the lender must be rewarded for this. Thus, according to Senior,
interest is the reward for abstinence from the use of capital on the part of the
lender

3) Austrian or Agio Theory of Interest:
Definition:
The Austrian or Agio Theory of interest was first advanced by John Rao in 1834
and later on, it was developed by the Austrian economist, Bohm-
Bowerk. According to Bohm-Bowerk:
"Interest is the premium or agio which present goods command over future
goods. The reason as to why present goods are preferred over future goods are as
follows:
Firstly, Future is shrouded in mystery and so is uncertain.
Secondly, present wants are more urgently felt than the future ones.
Thirdly, present goods posses a technical superiority over future goods.
Keeping in view all the conditions stated above, an individual prefers present
satisfaction to a future satisfaction".

(4) Loanable Fund Theory of Interest
(Neo Classical Version):
Definition:
The theory was first put forward by Wicksell and later on it was elaborated
by Ohlin, Robertson and Pigou, Myrdal etc. According to the neoclassical
economists:
"The rate of interest is determined by the interaction of the forces of demand for
loanable funds and the supply of it in the credit market".

(5) Keynesian Theory of Interest/Liquidity Preference Theory of
Interest:
Definition:
J.M. Keynes in his epoch-making book the General Theory of employment,
Interest and Money, has put forward a new theory of interest. According to
him:
"Interest is not the price for waiting. It is not the remuneration necessary to
call forth saving because a man may save money, bury it in his backyard and
get nothing from it in the way of interest. Interest is the reward for
surrendering liquidity, i.e., a reward for dispensing with the convenience of
holding money immediately available".
(i) Demand for Money:
The main components of demand for money
are as under:
(a) Transaction motive.
(b) Precautionary motive.
(c) Speculative motive.

(ii) Supply of Money:
The supply of money depends upon the currency issued by the central
bank or the policy followed by the government of the country. The supply
of money consists of currency and demand deposits. In the short run, the
supply of money is assumed to be constant.
Determination of the rate of interest.
According to J.M. Keynes:
The rate of interest is determined at a where demand for money is equal to
the supply of money.
M = Sm
M = Total demand for money.
Sm = supply of money.

(6) Modern Theory of Interest/IS-LM Curve Model:
Definition:
The Modern Theory of Interest is designated as IS-LM Curves Model. Hicks-
Hansen's, IS-IM curves model seeks to explain a case of joint determination of
equilibrium rate of interest (r) and equilibrium level of income (y).
y by the interaction of the commodity market
and money market. Since IS curve and LM curve indicate equilibrium in the
commodity market and equilibrium in the money market respectively, so the
intersection of IS curve and LM curve shows the simultaneous equilibrium in
both the commodity market and money market with equilibrium rate of interest
r and equilibrium level of national income y.

(i) Equilibrium in the Commodity Market (Real Sector), Derivation of IS
curve/Diagram:
The equilibrium in the commodity market can be determined on the basis of following
postulates:
Assumptions/Postulates:
(i) Level of Saving S is an increasing function of both the rate of interest r and level of
income y. It implies that as the rate of interest r rises, savings S also rises. Likewise, as
the level of income Y rises, saving S also rises.

(ii) Equilibrium in the Money Market (Monetary Section), Derivation
of LM Curve:
The equilibrium in the money market can be determined on the basis of following
postulate:

Simultaneous Equilibrium in the Commodity
Market and Money Market:
After having derived IS curve and LM curve, we how make use of IS-
LM curves to demonstrate simultaneous determination of both the
equilibrium rate of interest and the equilibrium level of-national
income.

Profit

Definition of Profit:
Profit is a basic concept in market economy. Profit acts as an incentive
mechanism for business investment. Higher profits provide incentives for
business growth. Profit also acts as an automatic signal for the allocation
and reallocation of scarce resources. Profit which is the hub of all economic
activities has no precise definition of its own. In fact it is the most
controversial topic of economic theory. To get an accurate idea of profit, it is
necessary to first distinguish gross profit from net profit.
Types of Profit
1. Gross Profit
2. Net Profit

Theories of Profit
There are various theories of profit which have been advanced from time to time
regarding the nature of profit in a competitive economy. Almost all of them differ
basically from one another and are inadequate to explain the actual role of profit in
the operation of free economy. The most important theories are:
(i) Hawley's Risk Bearing Theory of Profit.
(ii) Uncertainty Theory of Profit.
(iii) Rent Theory of Profit.
(iv) Marginal Productivity Theory of Profit.
(v) Dynamic Theory of Profit.
(vi) Monopoly Theory of Profit.

(1) Hawley's Risk Bearing Theory of Profit:
Definition and Explanation:
This risk bearing theory of profit is associated with the
name of F.B.
Hawley. According to him:
"Profit is the reward of risk taking in a business. During the
conduct of any business activity, all other factors of
production, i.e., land, labor and capital have their
guaranteed incomes from the entrepreneur. They are least
concerned whether the entrepreneur makes profit or
undergoes tosses".

(2) Uncertainty Theory of Profit:
According to Professor Knight:
"Profit is the reward for uncertainly-bearing and not of risk-taking in a
business".
According to him there are two kinds of risks which
entrepreneur has to bear. Some risks are of such a nature
that they can be anticipated to a fair degree of accuracy,
e.g., the risk of death, accident, etc., and so can be insured
in return for premium. The entrepreneur can include the
payment made in the form of premium in the total cost
of production, So such risks which can be calculated and
insured should not entitle the entrepreneur to a profit. On
the other hand, there are some risks which are
unpredictable and unforeseen and so they are non-
insurable.

(3) Rent Theory of Profit:
The Rent Theory of Profit is associated with the
name of American economist, Francis A Walker.
According to him:
"Profits are of the same genius as rent".

(4) Marginal Productivity Theory of Profit:
Definition and Explanation:
According to this theory:
"The earning of entrepreneur like the reward of
other factors of production can be explained by the
marginal productivity analysis".

(5) Dynamic Theory of Profit:
In the world of reality, according to J.B. Clark:
"Profit arises only in a dynamic economy. An
economy is said to be dynamic when there is a
change in the population growth or a change in
the method of production or a change in the
consumers wants, etc., A society which is without
these changes is called a static society. In a static
society only monopoly profits continue to exist.
All other economic profits are gradually
eliminated by
competition".

(6) Monopoly Theory of Profit:
There is no doubt that profits arise from dynamic
changes, innovations and from making a correct
estimate of future economic conditions. Another
view point of profit is that monopolistic and
monopolistic competition in the market also give
rise to profits. The firms under monopoly or
monopolistic competition have greater control over
the price of the product. They are the price makers
rather than the price takers. As such they raise prices
by restricting the level of output and thus keep
profit at higher level. Monopoly power, thus, is the
basic sources of business profits.

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Rent theory

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