According to tradition, rent arises only from land but according to modern economists, it arises not only from land but arises from all factors of production i.e. labor, capital and organization too. There are 2 concepts of rent. They are:
1. Contract rent:
1. Contract rent:
The contract rent is the amount paid by the user to owner of any factor of production like land per unit of time for the use of the factor of production. It is determined by the user and owner themselves in the contract. It is always positive. During the contact the owner and user may have different terms of contract. The contact rent is usually paid per unit of time and it is revised periodically. For example if a business man takes 2 ropani of land from a farmer paying Rs 50000 per year to build a market center then Rs 50000 is contract rent.
- 2.Economic rent:
The difference between total incomes from the use of factor of production hired and contract rent or opportunity cost is called economic rent. It is also defined as excess earning from the use of factor of production over the contract rent.
Mathematically,
It can be negative, positive or zero
If total earning > contract rent, economic rent is +ve
If total earning < contract rent, economic rent is -ve
If total earning = contract rent, economic rent is 0
3. Quasi rent:
The rent that occurs in the short run and disappears in the long run is called quasi rent. This type of rent arises mainly because of scarcity of the factors of production. The scarcity is caused by loss of skill, knowledge, technology etc.
Ricardian theory of rent
According to David Ricardo, rent is portion of produce of earth paid to the landlord for the use of original and indestructible power of soil. It means the rent is paid by the user to the owner of land. It is paid for the use of fertility of soil. Fertility of soil is naturally determined and not changeable. Rent is directly proportional to fertility of soil. However, least fertile land used for cultivation has no rent. The land is called marginal land.
Assumptions
Ø Rent arises only from land.
Ø Land is used for agricultural (maize) production.
Ø Agricultural production starts from the most fertile land and expands to the least fertile land.
Ø Supply of land is limited and fixed by nature. It can’t be created and destroyed.
Ø Fertility differs from place to place and rent is directly related to fertility.
According to David Ricardo, the people firstly choose most fertile land for cultivation. If such type of land is already occupied they expand production to the less fertile land. Rent arises only due to scarcity of land. It can be explained with the help of table and figure as following.
Type of land
|
Harvesting (per acre)
|
Rent
|
A
|
100 tons
|
10-40 = 60
|
B
|
80
|
80-40 = 40
|
C
|
60
|
60-40 = 20
|
D
|
40
|
40-40 = 0
|
Let there be an island inhabited with 4 types of land A,B,C and D. the harvesting per acre from the types of land are 100, 80, 60 and 40 tons respectively, if 1st group of people go to the island, they choose type a land. Since the land isn’t occupied by other people they obtain it free of cost. If 2nd group of people go to the land and find type A land already occupied they either choose type B land free of cost of hire the Type A land paying 20 tons per acre rent. If 3rd group of people go to the land and find type A land and type B already occupied they either choose type C land free of cost of hire the Type B land paying 20 tons per acre rent or type A land paying 40 tons per acre rent. If 4th group of people go to the land and find type A land and type B and type C land already occupied they either choose type D land free of cost of hire the Type C land paying 20 tons per acre rent or type B land paying 40 tons per acre rent or type A land paying 60 tons per acre rent. In this way, rent goes on increasing with the expansion of agricultural production from most fertile land top least fertile land.
Criticisms
1. Land is used for trade, manufacture, recreation, animal husbandry too.
2. Fertility changes from time to time. Fertility can be increased by using fertilizers and irrigation too.
3. Cultivation is not always started from most fertile land. Land is chosen with respect to location, physical facilities and so on.
4. Rent is determined by supply and demand of land too not only by fertility.
5. Marginal land too has the rent.
6. Rent arises from all factors of production.
Wage
The amount of money paid to employees per unit of time for mental or physical services provided by them is called wage. The unit of time may be a year, month, day, or hour. The wage may be paid as per the contract between employer and employee. It may be in any form like salary, wage bonus, commission, allowances, royalty, fee etc. Wage is the factor income of labor. The persons who obtain wage are called laborers. The laborer is paid wage because of following reasons:
· In doing works, there is physical or mental exertion. Against this exertion the workers must be compensated.
· To do work the workers must have physical and mental strength. For strength they have spend money on food, education, skills and so on.
· The workers need refreshment and rest to regain the working strength for which they should be compensated.
· The workers have sacrificed leisure to do work. To compensate against it too, they must be paid wage.
There are two concepts of wage. They are:
Money wage:
The amount of money paid to employees per unit of time for mental or physical services provided by them is called money wage. The unit of time may be a year, month, day, or hour. The wage may be paid as per the contract between employer and employee. It may be in any form like salary, wage bonus, commission, allowances, royalty, fee etc. It depends upon nature of work, time required, and the qualities necessary to perform the work and so on.
Real wage:
The physical quantity goods that can be purchased with the expenditure of money wage is called real wage. It is given by the ration of money wage and price level.
Real wage is directly related to money wage but inversely related to price level. If W is increased being P constant, real wage increases and vice versa. If P rises remaining W constant real wage decreases and vice versa.
It can be explained with the help of table and figure as following
Money wage (W)
|
Price level (P)
|
Real wage (1/P)
|
Rs 20000
|
Rs 100
|
200 units
|
Rs 20000
|
Rs 200
|
100 units
|
Rs 20000
|
Rs 300
|
66.67 units
|
In the above table, the real wage is decreased from 200 units to 100 and 66.67 units when money wage is constant at Rs 20000 and price level is increased from Rs 100 to Rs 200 and Rs 300 respectively. It shows the inverse relationship between real wage and price level. If we represent the real wage with respect to price level, we obtain a monotonically downwardly sloped convex curve as shown below:
Subsistence theory of wage
The subsistence theory of wage is also known as “iron law” of wage. It was so named by physiocrats like Lassalle, a German economist and Quesnay, a member of school of economists and developed by David Ricardo. The theory of population, expounded by Malthus was also based on this “iron law”. According to this theory, wages tend to remain at the subsistence level. Wages paid to workers is just sufficient to fulfill their basic needs. Workers don’t have surplus income. If wages rises above this level, this leads to an increase in the population because the increased prosperity of workers will encourage the workers to marry sooner and increase population. This will increase labor supply. The increased competition among workers for employment causes wages to fall again to the subsistence level. Likewise, if the wages fall below the subsistence level, there will be fewer wages and no prosperity. People will have less interest in marriage. Fewer children are born. This will reduce the supply of labor. The competition for employment is reduced and wages tend to rise to the subsistence level. Finally, the wages remain at the subsistence level. The French School of economists, as the physiocrats, looked upon this theory of wages as a natural law. Quesnay had said, “Wages are fixed and reduced to the lowest level by the extreme competition of the workers“.
Criticisms
1. Ignores the demand side of labor:
This theory is one-sided. It explains the wages from the supply side only. It completely ignored the demand for labor. But if a rise in wages leads to an increase in population, the larger supply of labor may be balanced by an increase in the demand for labor.
2. No direct relationship between wage level and population:
According to this theory, population increase if the workers are paid above the subsistence level but empirical evidences show the decrease in population or its rate of growth in developed nations even if there is increased in wage level. People spend money on education, family planning, skill development too.
3. Ignores trade unions:
This theory has ignored trade unions through which the workers make the collective bargaining for their benefits.
4. Not flexible wage level:
Wages of all workers is at the subsistence level and is not flexible towards up and down. However, wages can differ from occupation to occupation and from place to place.
5. Exploitative
There is tendency toward exploitation in this theory. Because, according to the theory wages must be equal to the subsistence level, and-not for comforts and luxuries.
Wage fund theory of wage
This theory is developed by classical economist named J.S Mill. According to Mill, wage level is determined by wage fund and the number of worker’s employed. To pay the laborer, a wage fund is raised. Once the wage fund id rose, it is kept constant. The wage fund is distributed among the worker’s employed. The workers are assumed to be paid equal amount. It is because the units of labor are homogeneous. If more workers are employed each worker gets fewer amounts and if less number of workers is employed each worker gets more amount of money. The wage level is given by the ratio of wage fund and number of worker’s employed.
Mathematically,
This theory can be explained with the help of table and figure as following:
Wage fund (W.F)
|
No. of workers (N)
|
Wage level (W.F/N)
|
Rs 1,00,00,000
|
50000
|
Rs 200
|
Rs 1,00,00,000
|
100000
|
Rs 100
|
Rs 1,00,00,000
|
150000
|
Rs 66.67
|
In the above table, wage fund raised is Rs 1, 00, 00,000. When the number of workers employed is increased from 50000 to 100000 and 150000 the wage level is decreased from Rs 200 to Rs 100 and Rs 66.67 respectively. It is due to constant wage fund distributed among more workers. If we represent wage level with respect to number of workers employed we obtain a convex curve.
In the above figure, the downwardly sloped convex curve represents inverse relationship between wage level and no of workers employed.
Assumptions
1. According to this theory, wage fund is rose before the employment of workers
2. The workers are paid equally out of the wage fund
4. The wage level is flexible to the change in number of workers employed
5. Money is just a medium of exchange
Criticisms
1. Wage fund is not raised before employing the workers but is rather raised on the basis of worker’s employed
2. Wage paid to workers differs from place to place, time to time, person to person and organization to organization.
3. Units of labor are not homogeneous. They differ in skill, knowledge, strength, education, attitude etc.
4. Wage level is not flexible. Wage level fall is opposed by workers and trade unions
5. Money is not mere medium of exchange. It has effect on production, investment, employment level etc.
Interest
Interest is the amount addition to principal paid by borrower to lender per unit of time. It is paid by borrower because of different reasons. The reasons are :-
1. Inconveniency due to lending: The lender feels inconveniency in lending. The lender will have less amount of money after lending some to the borrower. To compensate the inconveniency, the lender should obtain interest.
2. Decrease in value of money: The value of money decreases with flight of time. The value of money lent is less during the time of repayment than during the time of lending. For compensating this too, the lender should get interest.
3. Cost of keeping account: The lender keeps the account of money lent to others bearing some cost. In order to compensate the cost of keeping account too the lender should obtain interest.
4. Risk in repayment: The lender feels risk in the repayment of loan even the lender will honestly repay the loan in time as per the terms of borrowing and lending. Against this risk in repayment too the lender should obtain interest.
5. Sharing of benefit form the use of money: Borrower takes benefit form the use of money borrowed. Therefore, the benefits must be shared with lender in the form of interest.
Two concepts of interest:
- Gross interest: The additional amount over the principal the borrower pays to the kinder for all of the reasons is called gross interest. The gross interest includes the payment to the lender for inconveniency due to lending, decrease in value of money, cost of keeping account, risk in repayment and sharing of benefit from the use of money borrowed. Gross interest is the sum of net interest and interest paid and inconveniency due to lending, decrease in value of money, cost of keeping account and risk inner payment.
Mathematically,
Gross interest = net interest + payment for inconveniency due to lending
+ payment for decrease in value of money + payment for cost of keeping account + payment for risk in repayment.
- Net interest: It is the addition to principal only for the sharing of benefit from the use of money borrowed. For some economists, it is the payment for decrease in value of money too. It doesn’t include payment for cost of keeping account, inconveniency due to lending and risk in repayment. If we subtract the payment for these reasons from gross interest, we obtain net interest. Therefore, net interest is always less than gross profit.
Mathematically,
Net interest = Gross profit – (payment for inconveniency due to lending
+ payment for decrease in value of money + payment for cost of keeping account + payment for risk in repayment)
Net interest = payment for of benefit from the use of money borrowed.
Or,
Net interest = payment for of benefit from the use of money borrowed + payment for decrease in value of money.
Classical theory of interest
This theory is propounded by classical economists. It is also called real theory of interest. According to classical theory of interest, interest rate is determined by the real factors like demand for capital and supply of capital. The demand for capita means the investment. It is the demand for capital goods like equipments, plants, machines, tools etc which can be used for production of goods and services. The supply of capital means savings. It is the value of goods and services left after consumption out of the income. The interest rate is determined at the point of equality between investment and saving.
Mathematically,
Equilibrium interest is given by
Savings = Investment
This theory is based upon following assumptions.
Ø Money is just a medium of exchange
Ø Money is demanded or borrowed only for investment
Ø There is perfect competition in capital market
Ø Both demand for capital and supply of capital are determined by interest rate
Demand for capital
The amount the entrepreneurs want to invest is called demand for capital. It is the amount that the entrepreneurs need to purchase capital goods like equipments, plants, machines, tools etc which can be used for production of goods and services. It is inversely related to interest rate. If the interest rate is high, entrepreneurs want to make less investment and vice versa. It is because of marginal physical productivity.
Symbolically,
In the above table, when interest rate is increased from 4% to 6% and 8% demand for capital ( investment) decreases form Rs 10 billions to Rs 8 billions and Rs 6 billions respectively. If we represent investment with respect to interest rate, we obtain a downwardly sloped curve.
In the above table, when interest rate is increased from 4% to 6% and 8% demand for capital ( investment) decreases form Rs 10 billions to Rs 8 billions and Rs 6 billions respectively. If we represent investment with respect to interest rate, we obtain a downwardly sloped curve.
Supply of capital
It is the amount available for investment. It is called savings. It is the amount left after consumption. It is the monetary value of products left after consumption. It is directly related to interest rate if interest rate is high, the people save more to earn more interest and vice versa
Symbolically,
In the above table, when interest rate is increased from 4% to 6% and 8% supply of capital ( savings) increases form Rs 6 billion to Rs 8 billion and Rs 10 billion respectively. If we represent savings with respect to interest rate, we obtain an upwardly sloped curve.
Interest rate (r)
|
Demand for capital (I)
|
Supply of capital (S)
|
4%
|
Rs 10 billions
|
Rs 6 billions
|
6%
|
Rs 8 billions
|
Rs 8 billions
|
8%
|
Rs 6 billions
|
Rs 10 billions
|
The equilibrium interest rate is given by the point of intersection of investment and savings curves. In the above figures, it is given by point E. However, the actual interest rate may be above or below the equilibrium interest rate. If it is above the level of equilibrium, saving exceeds investment. The excess supply of capital brings the interest rate down to equilibrium level. If it is below the level of equilibrium, investment exceeds savings. The excess demand for capital brigs the interest rate up to equilibrium level. It means sooner or later, the actual interest rate comes to the equilibrium level even it is above or below than it at any instant.
Criticisms
Ø Money is not veil and is not just a medium of exchange. It is asset too. More or less money has effect on investment, production, employment level etc.
Ø Money is not demanded or borrowed only for investment but also for speculation and precaution
Ø This theory is based upon diminishing marginal productivity of capital but there may be increase in marginal productivity of capital due to advancement in technology, improvement in human resource etc.
Ø Both demand for capital and supply of capital are not only determined by interest rate but also upon level of income
Ø Supply of capital comes not only from saving but also from dishoarding, depreciation fund etc.
Profit
Generally, profit is the difference between revenue and cost of production. Revenue is amount obtained from sale. Mathematically,
Profit= total revenue-total cost
Or, Ω= R-C
If R> C then, Ω >0 i.e. profit
If R
If R=C then, Ω = 0 i.e. breakeven point
Cost of production means the total amount paid to inputs used in the production. It includes wage paid to labor, interest paid to capital, rent paid to land, cost of raw materials, fuels, energies and so on. Both revenue and cost depends upon quantity produced and sold.
There are two types of cost. They are:-
Explicit cost: The cost of inputs hired or purchased is called explicit cost. It includes wages of labor hired, interest of money borrowed and invested, rent of land and building hired, cost of raw materials, fuels, energies purchased etc. These amounts are not income of the investors. These are cost to them. If we subtract explicit cost from revenue we obtain gross profit.
Implicit cost: It is the cost of inputs owned by investors themselves which are used in the production. It includes the wage or salary of investors themselves, rent of land and building of investor themselves, interest of money of investors. If we subtract both explicit cost and implicit cost from the revenue we obtain net profit.
Types of profit:
There are two types of profit. They are;
Gross profit: Excess revenue over the explicit cost of production is called gross profit. It is the difference between total revenue obtained from sale and explicit cost. Mathematically,
Gross profit = Total revenue – Explicit cost
Gross profit = Total revenue – Explicit cost
Net profit: Excess revenue over all types of cost of production is called net profit. It is the difference between total revenue obtained from sale and the sum of explicit cost and implicit cost.
Mathematically,
Net profit = Total revenue – (explicit cost +implicit cost)
Gross profit includes cost of inputs owned by entrepreneur too but net profit doesn’t include it, that’s why, net profit is always less than gross profit. If not a single input used is owned by entrepreneur, the gross profit and net profit are equal. In this case, implicit cost is equal to 0.
Causes of profit
Effective combination of other inputs: The organization brings other inputs like land, capital etc. together and combines for production, for it, organization should obtain profit as its remuneration.
Innovation: Organization brings innovation in type and quality of products, management and technology. For this the organization should earn profit.
Bargaining power: Every organization has bargaining power due to more or less control in the market, resources, and special skills and so on. For it too organization should earn profit.
Risk involved in business: There is always risk involved in business due to different reasons. For taking risk too, the organization should earn profit as compensation.
Uncertainty: Some economists consider that organization should earn profit for bearing uncertainty due to unforeseeable or non insurable risk.
Uncertainty theory of profit:
This theory is propounded by Knight. According to this theory, profit is reward for bearing uncertainty. Uncertainty is due to unforeseeable or non insurable risk. According to knight, there are two types of risk. They are foreseeable and unforeseeable. The possible loss due to foreseeable risk is avoidable with insurance. Therefore, the risks are insurable risk but possible loss due to unforeseeable risk is not avoidable with insurance. Therefore, the risks are non foreseeable risk. There are mainly four types of non insurable risk. They are
Risk due to competitors: Any business firm has the risk due to increase in number of competitors, change in their marketing strategies, improvement in their quality and management, decrease in their cost of production per unit etc. This risk is not avoidable with insurance.
Risk due to change in policy of government: The government may change its policy related to investment, export, import, taxes, and so on. Due to it, any firm may suffer loss. This risk is not avoidable with insurance.
Risk due to trade cycle: During recession and depression, most of the business firms suffer loss. This risk is not avoidable with insurance.
Risk due to technological change: Technology advances with flight of time. If any firm fails to adjust the change in technology, the firm suffers loss. This risk is also not avoidable with insurance.
Criticisms
1. Not direct relation between profit and uncertainty: Profit is not directly related to uncertainty. If the business involves high risk, there is more probability of failure and loss rather than profit.
2. Profit is reward for avoidance of uncertainty: Profits earned only if uncertainty is successfully avoided using skills, education, knowledge, experiences and so on. It is not earned mere taking uncertainty.
3. Uncertainty is not factor of production: According to this theory, uncertainty seems to be the factor of production but factor of production is organization not uncertainty.
4. Reward for all things performed by organization: Organization earns profit not only taking uncertainty but for all things it performs. They are innovation, effective combination of inputs, use of skills knowledge etc and bargaining power.
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