Unit 5: Price Determination of Factor of Production

Profit: The reward of the entrepreneur is called profit. In other words, it is defined as the reward that an entrepreneur gets in return for his or her function of taking risk or bearing uncertainty in business.

Risk Theory of Profit:

The Risk Theory of Profit was developed by the American economist, Prof. Hawley, in 1907. According to this theory, the entrepreneur earns profit because he undertakes ‘risks’. Hawley points out that the most essential function of the entrepreneur is risk-taking. Risks are inherent in all types of production. Risks are assumed to be unpleasant and irksome. Therefore, no one would like to bear the risk unless he expects a reward for it. Hence, profit is the reward of risk. The higher the risk, the greater will be the expected reward and vice-versa. In the words of Hawley, “Risk bearing is the special function of an entrepreneur. None would be prepared to undertake the hazard of production unless he expects to earn a profit. Profit is thus the price of risk bearing.”

In simple words, Hawley has cleared that it is the risk-taking function of the entrepreneur which is the basis of profit. The real producer of the output is the entrepreneur and not the other factors of production, as the other factors—land, labour, and capital—are paid fixed remuneration. They are mere ‘means of production’. In the absence of the entrepreneur, they remain unutilized. Thus, a reward must be given to the entrepreneur for taking risks. The reward is called profit.

Criticisms:

• Not a reward for all types of risks: This theory does not make the distinction between insurable risks and non-insurable risks. Insurable risks cannot be the reason for the emergence of profit.
• Reward for reducing risk: According to Prof. Carver, an entrepreneur does not receive profit because he bears the risk, but he avoids the risk by his intelligence and ability.
• No direct relation between risk and profit: There is no direct relationship between the amount of risk and profit. It is not necessary that occupations having higher risk should give more profits.
• Narrow theory: Critics point out that risk-bearing is not the only function of an entrepreneur. He has to perform several decision-making functions regarding the management and output in the industry.

Ricardian Theory of Rent:

The repeated content can be found Ricardian theory of rent.

Criticisms:

The criticisms of Ricardian theory of rent are as follows:

• No original and indestructible power of the soil: The main criticism of this theory is that the power of the soil is neither original nor indestructible as pointed out by Ricardo. By constant cultivation, even the most fertile pieces of land lose their fertility.
• Historically wrong order of cultivation: Ricardo assumes that land is cultivated in order of fertility, i.e., from the most fertile to the least fertile. But land is generally cultivated according to the situation. Thus, the order of cultivation laid down by Ricardo is not always followed in practical life.
• Rent arises for all factors of production: Ricardo believed that rent is paid for the use of original and indestructible power of the soil. Therefore, rent is paid for land only. But modern economists are of the view that rent is paid for any factor of production which has perfectly inelastic supply.
• Rent enters into price: According to Ricardo, rent does not enter into price. However, modern economists are of the view that an individual producer has to pay for the services of land he has used. Therefore, it is included in the cost of production, hence it affects the price and rent enters into price.
• Marginal land: Ricardo’s concept of no rent land or marginal land is not necessarily found in any country of the world. It is just an imaginary concept.

Theory: Classical theory of interest is also known as Demand and Supply Theory of Interest. This theory was originally developed by the old classical economists. Later, it was refined and popularized by neo-classical economists like Marshall, Pigou, Walras, Taussing, and Knight. According to this theory, interest is the price paid for the use of capital. Like prices of other commodities, the price of capital, i.e., the rate of interest, is determined by the demand and supply of capital.

Demand for Capital: Demand for capital arises from investment. Investment is inversely related to the rate of interest. Thus, the demand curve for capital slopes downward to the right, which indicates that the higher the rate of interest, the lower will be the demand for capital and vice-versa.

Supply of Capital: The supply of capital comes out of people’s savings. Saving is positively related to the rate of interest. Thus, the supply curve for capital slopes upward to the right, which indicates that the higher the rate of interest, the greater will be the supply of capital and vice-versa.

Determination of Rate of Interest: The rate of interest is determined at the point where demand for capital (investment) equals the supply of capital (saving) as shown in the following table and diagram.

It is clear from the above table that as the rate of interest increases from 2% to 4%, the demand for capital declines from Rs. 30,000 to Rs. 10,000, while the supply of capital increases from Rs. 10,000 to Rs. 30,000. When the rate of interest is 3%, the demand for capital is just equal to the supply of capital, i.e., Rs. 20,000. Hence 3% is the equilibrium rate of interest.

Figure:

In the given figure, X-axis represents demand for and supply of capital and Y-axis represents the rate of interest. DD is the demand curve for capital and SS is the supply curve of capital. These two curves intersect at point E. Thus, 3% is the equilibrium rate of interest. At 4% of rate of interest, supply is greater than demand; this leads to a decrease in the rate of interest. Similarly, at 2% rate of interest, demand is greater than supply; this leads to an increase in the rate of interest. Hence, 3% is the equilibrium rate of interest which will come to stay in the market. If any change in the demand for capital and/or supply of capital comes out, the curve will shift accordingly and the equilibrium rate of interest will also change.

Criticisms:

The main criticisms of the classical theory of interest are as follows:

• Saving and investment equality: The rate of interest does not bring about the equilibrium between saving and investment. Keynes says that the equality between saving and investment is brought about by the changes in the level of income.
• Unrealistic assumption of full employment: The classical theory assumes the prevalence of full employment which is unrealistic in the real world. Keynes firmly believed that in the actual world resources are not fully employed and there is less than full employment.
• Indeterminate theory: The classical theory is indeterminate. It says that the rate of interest is determined by the demand and supply of capital. But the supply of capital varies with the general level of income. The classical explanation is thus confusing.
• Saving is not the only source of capital: The classical theory does not take into account the past hoardings and bank credit in the determination of the rate of interest. Its explanation of the supply of saving is, therefore, inadequate.
• Monetary factors ignored: The theory neglects the monetary influences in the determination of the rate of interest. Keynes says that the rate of interest is a monetary phenomenon. It is determined by the demand for and supply of money. The classical theory is, therefore, a partial explanation of the determination of the rate of interest.

Wages Fund Theory:

The Wage Fund Theory was propounded by Adam Smith. Later, it was developed and popularized by J.S. Mill. According to him, wages are determined by the ratio of the labour force to capital stock. He said that a certain fixed proportion of the capital of a country was set apart for payment as wages of labour. According to this theory, at any time, a fixed proportion of capital is allotted for the payment of wages to labour. This proportion is called the wages fund.

Labour force means the number of workers willing to work at the existing wage rate, i.e., the labour supply. Wages at any time are determined by the ratio between the number of workers and the capital that forms the wages fund. Therefore, the level of wages depends on two quantities:

1. The wages fund; and
2. The number of workers willing to work.

Hence, the level of wages can be obtained simply by dividing the wages fund by the number of workers. That is,

$$ \text{Level of wage} = \frac{\text{Wage Fund}}{\text{Number of Workers}} $$

This relation shows that wages vary directly with the size of the wage fund and inversely with the number of workers. It means the general rate of wages will increase only if the wages fund increases or the supply of labour diminishes. Since the increase in the wages fund is a slow process, because savings increase slowly, if the workers want to increase the rate of wages, they must restrict the number of their children.

Criticisms:

The main criticisms of the Wage Fund theory are as follows:

• Unable to explain the origin of wage fund: This theory does not explain how the wage fund arises and why it remains fixed. Given the wages fund and number of workers, it only explains the process of determination of wages.
• One-sided theory: According to this theory, wages can be increased by decreasing the supply of labour. But wages can also be increased by increasing the wage fund. Therefore, this theory is one-sided.
• Unscientific concept: According to this theory, the wage of the labour is given from the wage fund only. But wages can also be given from the national income. Thus, this theory is unscientific.
• Wrong concept of permanent wage fund: This theory takes the wage fund to be permanent. But this concept is wrong. With increases in the price level, the wage rate should also be increased. So, to increase the wage rate, the wage fund should also be increased.
• Wage rate is not determined by capital: Actually, wages do not correspond to the total amount of capital available. In some countries, wages are high even though capital is scarce.

Profit: The reward of the entrepreneur is called profit. In other words, it is defined as the reward that an entrepreneur gets in return for his or her function of taking risk or bearing uncertainty in business.

Uncertainty Bearing Theory of Profit:

Uncertainty Bearing Theory of Profit was first developed by the American economist Prof. F.H. Knight in 1921 AD. It is an improvement on Hawley’s theory of profit. According to Prof. Knight, profit arises on account of uncertainty-bearing rather than the risk-taking function of the entrepreneur. He says that there are certain risks which can be foreseen or forecasted. Thus, they are not risk proper. Knight divides the risks into two kinds:

• Insurable risks: Risks about which certain predictions and estimates are possible can be insured; they are called known risks or insurable risks. For example, predictions regarding fire, accidents, theft, etc., are easily possible. Therefore, these risks are insured. Actually, after insurance, they do not remain risks at all.
• Non-insurable risks: Some risks cannot be predicted, so they cannot be insured. This is why they are called unknown or non-insurable risks. These risks create uncertainties, and the entrepreneur bears these uncertainties or unknown risks. These risks are the following:
  • Competition risks: Arise from the possibility of new firms entering the industry.
  • Technological risks: Arise from the possibility of newly-installed machinery becoming obsolete (outdated) due to the discovery of some new process.
  • Risk of government intervention: Such as price control, tax policy, import and export restrictions, etc., which may result in profit or losses.
  • Business cycle risks: Arise because of the occurrence of business depressions when prices fall much more than costs.

These risks create uncertainties in the occupation, and an entrepreneur gets profit only because of bearing these uncertainties. Profit of the entrepreneur depends on the level of such unknown risks or uncertainties.

Criticisms:

Uncertainty Bearing Theory of Profit is criticized as follows:

• No profit despite uncertainty-bearing: According to this theory, profit is the reward for uncertainty-bearing. But critics point out that sometimes an entrepreneur earns no profit despite uncertainty-bearing.
• Incomplete theory: Profit is not a reward only for bearing uncertainty. According to critics, there are also other causes of profit in addition to uncertainty-bearing, such as initiating, coordinating, bargaining, etc. Thus, it is an incomplete theory of profit.
• Uncertainty is not a separate factor of production: Knight assumes that like land, labour, capital, etc., uncertainty is also a separate factor of production, which is not correct.
• Unable to explain monopoly gain: The theory does not suit well to expose the phenomenon of monopoly profit, where there is the least uncertainty involved in a monopoly business.

Subsistence Theory of Wages:

Subsistence Theory of Wages was propounded by Quesnay, a French economist, and later it was developed by David Ricardo. This theory of wages is also called the ‘Iron Law’ of wages. This theory is associated with the Malthusian Theory of Population. According to this theory, workers should be paid at minimum subsistence level – the level which will be just sufficient to maintain their minimum standard of living. If they are given higher wages than the minimum subsistence level, they will become well off. They are encouraged to marry more wives and to have a large family. Supply of labour, thus, increases and it exceeds the available demand. When supply exceeds the demand for labour at the prevailing wage rate, the wage tends to reduce to the minimum subsistence level.

In the same way, if workers are paid below the minimum subsistence level, they would be unable to join their hand to mouth. Starvation, disease, malnutrition, death etc. will be the result. This will reduce the labour supply, and demand for labour exceeds the available supply at the prevailing wage rate. Wage, thus, tends to increase to the minimum subsistence level.

In this way, wages over the long-run will be equal to the minimum subsistence level. If workers are paid above or below the minimum subsistence level, market mechanism would automatically bring it to the minimum subsistence level in the long-run.

Criticisms:

The subsistence theory of wages is criticized as follows:

• Basis of exploitation: This theory ignores the productivity aspect and argues that workers should be paid at minimum subsistence level whatever be the production and productivity.
• Fails to explain wages variation: This theory has failed to explain the wage variation of workers. A professor and a doctor cannot be paid the same wages as a farm worker, although the subsistence requirement is basically the same. Similarly, workers with high efficiency and high productivity will certainly get more wages than unskilled ones.
• Unrealistic: This theory is based on unrealistic assumptions that the supply of labour increases with an increase in the wages of the workers. But critics point out that increased wages can improve the standard of living of the workers and not their supply alone.
• Ignores the demand side: This theory is one-sided. It has ignored the demand side. Only the supply side has been overemphasized.
• Subsistence level not specific: Subsistence level depends on several factors such as physical condition, nature of work, habit and custom, etc. of the workers. That’s why it may differ from worker to worker.
• Ignores the role of trade union: This theory ignores the influence of Trade Unions on wages. Trade unions play an important role in the determination of wages. Sometimes, it can increase wages much beyond the level of subsistence.