Class 10 Economics

Introduction

Various factors of production are used to produce goods and services. Land, capital, labour, and enterprise (organisation) are the four main factors of production. A payment or compensation must be provided to each of these factors for their contribution to the production process. For using land, capital, labour, and organisation in production, the respective rewards paid are Rent, Interest, Wages, and Profit. This chapter studies the concept of the rewards received by each factor of production and the various theories that explain how these factor prices are determined. The concept of factor pricing is illustrated in Chart 4.1 below:

Chart 4.1: Factors of Production and Their Rewards

(A) Rent

In the ordinary sense, rent refers to a fixed charge or payment made for the use of factors such as land, buildings, or machinery. According to classical economists, rent refers specifically to the payment made to the owner of land for its use.

According to classical economist David Ricardo, rent is derived only from land. In his view, rent is the payment made by a tenant (farmer) to the landlord for using the original and indestructible powers of the soil. In other words, it is the payment (in money or kind) made by a tenant to a landlord for utilising the natural fertility of the land.

Rent is primarily divided into two types: Economic Rent and Gross Rent (Contract Rent).

(i) Economic Rent

In the classical view, economic rent refers to the payment made exclusively for the use of the original and indestructible powers of land. The landowner receives this economic benefit simply by virtue of owning the land.

In the modern view, the concept of economic rent is broader. According to this view, economic rent is not limited to land but can arise from any factor of production. According to Prof. Boulding: “Economic rent is a payment to a factor of production in excess of the minimum amount needed to keep it in its current use.”

Example: If a worker needs a minimum daily wage of Rs. 1,500 to remain in their current job, but actually receives Rs. 2,000 per day, then the extra Rs. 500 earned above the minimum is the worker’s economic rent.

(ii) Gross Rent (Contract Rent)

Gross Rent is also called Contract Rent. It is determined by the agreement or contract between the owner of a factor and the user of that factor. The payment made by a user to a building owner for a building, to a landowner for land, or to a machine owner for a machine is called Gross Rent.

Example: If a landlord and a tenant agree to a monthly rent of Rs. 5,000 for a room, that amount is the Gross Rent.

The differences between Economic Rent and Gross Rent are shown in Table 4.1 below.

Ricardian Theory of Rent

The theory of rent formulated by classical economist David Ricardo is known as the Ricardian Theory of Rent. He presented this theory in his 1817 book On the Principles of Political Economy and Taxation. It is also called the Classical Theory of Rent.

Ricardo argued that rent is derived only from land. According to him: “Rent is that portion of the produce of the earth, which is paid to the landlord for the use of the original and indestructible power of the soil.”

Thus, rent is the payment made by a tenant to the landlord for using the land, and it arises from land alone.

The Ricardian Theory of Rent is based on the following key assumptions:

1. Rent arises only from land.
2. Land is a free gift of nature.
3. The supply of land is fixed and perfectly inelastic.
4. The theory is based on long-run concepts.
5. Land has its own original and indestructible powers.
6. Land is used only for cultivation — it has no alternative use.
7. There are differences in the fertility of land.
8. The most fertile land is cultivated first.
9. The law of diminishing returns applies to agricultural land.
10. The market is perfectly competitive.

Ricardo explained his theory of rent through two cultivation systems: Extensive Cultivation and Intensive Cultivation.

Extensive Cultivation System:

Under the extensive cultivation system, the most fertile land is cultivated first; then progressively less fertile land is brought under cultivation. Ricardo imagined plots of land of equal size in the same area, each with different levels of fertility, on which equal units of capital and labour are applied. He classified the land plots into four grades — A, B, C, and D — in descending order of fertility:

$$A > B > C > D$$

According to Ricardo, Grade A land is cultivated first. As the population grows, cultivation extends to Grades B, C, and D. Grade D land is the Marginal Land, where total production equals total cost and no surplus (rent) is generated. Land that yields more output than marginal land is called Intra-marginal (Extra-marginal) Land.

The formula for calculating rent based on land fertility is:

$$\text{Rent} = \text{Output of Intra-marginal Land} – \text{Output of Marginal Land}$$

Criticisms of the Ricardian Theory of Rent:

1. Land does not have truly indestructible powers — its fertility can be increased or reduced through human effort.
2. Land is not used only for cultivation; it has many alternative uses (for buildings, industries, etc.).
3. The assumption of rent-free (zero-rent) marginal land is unrealistic in the real world.
4. The assumption of perfect competition is unrealistic — real markets are imperfect.
5. The law of diminishing returns does not always apply; modern technology can increase output even with the same inputs.
6. Rent is not derived from land alone — in the short run, other man-made factors (such as machinery) can also earn a form of quasi-rent.
7. Rent arises not only because of differences in soil fertility but also because of the scarcity of resources.

(B) Interest

In the ordinary sense, interest is the additional payment made by a borrower to a lender for using their money or capital over a specified period of time. It is the extra amount paid for using capital in the production process.

According to economist Thomas Mayer: “The price for the use of loanable funds is called interest.”

According to economist J. M. Keynes: “Interest is the reward for parting with liquidity for a specific period of time.”

In summary, interest is the additional payment made by the borrower (user of capital) to the lender (owner of capital) for using the capital over a given period. Interest is primarily divided into two types: Gross Interest and Net Interest.

(i) Gross Interest

The total amount paid for the use of capital or money is called Gross Interest. It is the total payment made by the borrower to the lender for using the capital for a fixed period. In everyday usage, the word “interest” generally refers to Gross Interest.

Gross Interest includes the following elements:

$$\text{Gross Interest} = \text{Net Interest} + \text{Risk Premium} + \text{Management Premium} + \text{Inconvenience Premium}$$

where:

• Net Interest = the pure price for using the capital.
• Risk Premium = compensation for the lender’s risk that the money may not be returned or a loss may be incurred.
• Management Premium = compensation for the lender’s effort in managing, administering, and recovering the loan.
• Inconvenience Premium = compensation for the discomfort or difficulty the lender faces in lending out their capital.

Example: If you lend money to a friend at 10% interest, composed of 5% net interest + 2% risk premium + 2% management premium + 1% inconvenience premium, the total 10% is the Gross Interest.

(ii) Net Interest

The pure price paid for the use of capital or money — excluding all additional elements — is called Net Interest (also called Pure Interest). It does not include the risk premium, management premium, or inconvenience premium. Therefore, it is only a part of Gross Interest.

$$\text{Net Interest} = \text{Gross Interest} – (\text{Risk Premium} + \text{Management Premium} + \text{Inconvenience Premium})$$

Example: If the total 10% gross interest on a loan consists of 2% risk premium + 2% management premium + 1% inconvenience premium, the remaining 5% is the Net Interest.

The differences between Gross Interest and Net Interest are shown in Table 4.3 below.

Classical Theory of Interest

The theory of interest developed by classical economists (including Adam Smith, David Ricardo, and J. B. Say) is known as the Classical Theory of Interest. According to this theory, interest is the reward for saving. The rate of interest is the price of capital, determined by the interaction of the demand for capital and the supply of capital. Here, the demand for capital means the demand for investment, and the supply of capital means the supply of saving.

This theory is also called the Real Theory of Interest and is popular under the name “Theory of Demand for and Supply of Saving.” Its key assumptions include:

1. Interest is the price (reward) of saving.
2. Saving depends on the rate of interest.
3. It is based on the assumption of full employment.
4. There is an inverse relationship between demand for investment and the interest rate, and a direct relationship between the supply of saving and the interest rate.
5. Money acts only as a medium of exchange (neutrality of money).
6. The level of income is constant.

i. Demand for Investment (Demand for Capital):

Entrepreneurs and investors demand capital to invest in capital goods. When the interest rate in the market is high, the demand for capital for investment is low; when the interest rate is low, the demand is high. Therefore, there is a negative (inverse) relationship between the demand for capital and the interest rate.

$$\text{Interest Rate} \uparrow \implies \text{Demand for Investment} \downarrow$$

$$\text{Interest Rate} \downarrow \implies \text{Demand for Investment} \uparrow$$

ii. Supply of Saving:

Saving is the income left over after deducting consumption expenditure. Savers supply savings in the hope of receiving interest. When the market interest rate is high, the supply of saving increases; when it is low, the supply of saving decreases. Thus, there is a positive (direct) relationship between the supply of saving and the interest rate.

$$\text{Interest Rate} \uparrow \implies \text{Supply of Saving} \uparrow$$

$$\text{Interest Rate} \downarrow \implies \text{Supply of Saving} \downarrow$$

iii. Determination of the Rate of Interest:

According to the Classical Theory of Interest, the equilibrium rate of interest is determined by the interaction of the demand for investment and the supply of saving — at the point where the two are equal.

Criticisms of the Classical Theory of Interest:

1. According to Keynes, interest is not the price of saving but the reward for giving up liquidity.
2. The theory assumes that saving depends only on the interest rate, but in reality, saving also depends on the level of income.
3. The assumption of full employment is incorrect — full employment rarely exists in the real world.
4. The interest rate and the level of income are mutually dependent, which this theory ignores.
5. The source of investment is not only saving — it can also come from inherited wealth, dividends, etc.
6. Saving is made not only for investment but also for precautionary motives and speculation.

(C) Wages

Generally, wages refer to the payment given to a worker for performing physical or mental work. Such payment is made by agreement on the basis of hours worked, daily, monthly, or some other basis.

According to Prof. Benham: “A wage may be defined as the sum of money paid under contract by an employer to a worker for services rendered.”

Wages are primarily divided into two types: Nominal (Money) Wages and Real Wages.

(i) Nominal Wages (Money Wages)

The wages received by a worker in the form of money or cash for the work performed are called Nominal Wages or Money Wages. These are measured in monetary units. For example, if a teacher receives a monthly salary of Rs. 50,000 for teaching, that amount is nominal wages.

(ii) Real Wages

The total quantity of goods and services that a worker’s money wages can purchase is called Real Wages. These are evaluated based on the purchasing power of money. For example, the goods and services that a teacher can buy with their Rs. 50,000 monthly salary represent their real wages. Additional non-cash benefits (fringe benefits or employee benefits) received along with nominal wages are also considered part of real wages.

The formula for calculating the Real Wage Rate is:

$$\text{Real Wage Rate} = \frac{\text{Money Wages}}{\text{Price Level}} \times 100$$

Factors Determining Real Wages:

The main factors that determine real wages are:

1. The price level of goods in the market (in Nepal, the price level is measured by the Consumer Price Index – CPI).
2. The money wages received by the worker.
3. Additional benefits and perquisites, such as:
   • Housing and clothing allowances.
   • Medical, healthcare, education, transport, and insurance benefits.
   • Regularity, security, and nature of the job.
   • Potential for additional income and the work environment.
   • Career development and promotion prospects, and the social prestige of the job.
   • Timely salary payment, and employment opportunities for family members.

The differences between Nominal Wages and Real Wages are shown in Table 4.5 below.

Subsistence Theory of Wages (Iron Law of Wages)

The Subsistence Theory of Wages was formulated by David Ricardo and other classical economists. German socialist philosopher Ferdinand Lassalle named it the “Iron Law of Wages.” According to this theory, the wages paid to workers should be just enough to meet their basic necessities of life. The minimum wage needed to cover workers’ basic needs is called the subsistence wage.

If wages rise above the subsistence level, workers become more prosperous, marry earlier, and have more children. This leads to population growth, an increase in the supply of labour, competition among workers for jobs, and ultimately wages fall back to the subsistence level:

$$\text{Wages rise} \rightarrow \text{Workers prosper, marry, have more children} \rightarrow \text{Population grows} \rightarrow \text{Labour supply increases} \rightarrow \text{Competition among workers} \rightarrow \text{Wages fall back to subsistence level}$$

If wages fall below the subsistence level, workers face hardship and poverty, disease and famine reduce the population, the supply of labour decreases, employers compete to hire workers, and wages rise back to the subsistence level:

$$\text{Wages fall} \rightarrow \text{Workers face poverty, disease, death} \rightarrow \text{Population falls} \rightarrow \text{Labour supply decreases} \rightarrow \text{Employers compete for workers} \rightarrow \text{Wages rise back to subsistence level}$$

In this way, whether wages are above or below the subsistence level, they will always return to the subsistence level in the long run.

Criticisms of the Subsistence Theory of Wages:

1. This theory focuses only on the supply of labour and completely ignores the demand side.
2. The argument that workers should receive only subsistence-level wages encourages the exploitation of labour.
3. The theory ignores wage differences based on the division of labour and specialisation of skills.
4. It overlooks the role of trade unions in wage determination.
5. There is no empirical evidence to show a direct correlation between wage levels and population growth; in many developed nations, wages are high but population growth rates are low.
6. This theory cannot motivate workers to perform better or be more productive.

(D) Profit

In general terms, profit is the income received by an entrepreneur for their entrepreneurial activity. It is also the reward for the entrepreneur as a factor of production. An entrepreneur earns profit as compensation for bearing the risk in production or business. In a capitalist economy, profit is the primary motivating force for entrepreneurs.

According to Henry Grayson: “Profit may be considered as a reward for making innovations, a reward for accepting risk and uncertainties, and market imperfections.”

According to Jacob Oser: “Profit is the residual income of the business after all explicit and implicit wages, interest, and rent have been met.”

Legitimate profit is regarded as the return for the entrepreneur’s hard work and enterprise. Profit is what remains after paying all other factors of production. Unlike rent, interest, and wages — which are fixed and always positive — profit is not predetermined. It can be positive, zero, or even negative. A negative result is called a loss.

Profit is divided into two types: Gross Profit and Net Profit.

(i) Gross Profit

Gross Profit is what is commonly meant when the word “profit” is used in business. It is also called Business Profit. It is the income remaining after deducting all direct (explicit) costs from Total Revenue. The formula is:

$$\text{Gross Profit} = \text{Total Revenue (TR)} – \text{Explicit Cost}$$

Explicit Costs are the direct payments made by an entrepreneur for factors of production not owned by them (e.g., rent, hired labour wages, interest on borrowed capital).

(ii) Net Profit

In economics, profit specifically refers to Net Profit. It is the difference between Gross Profit and Implicit Costs. Implicit Costs are the costs of using factors of production owned by the entrepreneur — for which no direct cash payment is made (e.g., the rent value of the entrepreneur’s own land, the interest value of their own capital). Net Profit is also called Pure Profit or Economic Profit.

$$\text{Net Profit} = \text{Gross Profit} – \text{Implicit Cost}$$

The differences between Gross Profit and Net Profit are shown in Table 4.6 below.

Risk Bearing Theory of Profit

This theory was formulated by American economist F. B. Hawley in 1893. According to Hawley: “The profit of an undertaking is not the reward of management or coordination but of the risk and responsibility.”

According to this theory, bearing risk is the primary and most important function of the entrepreneur. If an entrepreneur does not take risks, there will be no profit. Entrepreneurs take risks in anticipation of high profits. Higher risk means a greater possibility of profit, while lower risk means a lower possibility of profit.

Criticisms of the Risk Bearing Theory of Profit:

1. Profit is earned not only from bearing risk but also from the entrepreneur’s organisational and coordination activities.
2. Profit is a reward not just for bearing risk but also for reducing risk successfully — lower risk can also lead to profit.
3. According to economist F. H. Knight, insurable risks do not generate profit.
4. There is no empirical evidence to conclusively show that riskier enterprises always earn higher profits.