Rent theory

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Factor Pricing or theory of distributionTheory of RentTheory of WagesTheory of ProfitTheory of Interest12/17/2016Dr. Waqar Ahmad, Allenhouse Business School,

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Factor Pricing or theory of distributionIn the words ofChapman:"TheEconomics of distribution or the pricing of factorsaccounts 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 ofMarshall:"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".12/17/2016Dr. Waqar Ahmad, Allenhouse Business School

Micro economic theories of distributionMarginal Productivity Theory (Neo-Classical Version

Modern Theory of Factor Pricing Under Perfect Competition12/17/2016Dr. Waqar Ahmad, Allenhouse Business School

Dr. Waqar Ahmad, Allenhouse Business School3

Marginal Productivity Theory

(Neo-Classical Version)Themarginal productively theoryis an attempt to explain the determination of the rewards of variousfactors of productionin 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:Bymarginal productively theory of a factoris 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 PValue of Marginal Product (VMP) = Marginal Physical Product x PriceThe 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.12/17/2016Dr. Waqar Ahmad, Allenhouse Business School

12/17/2016Dr. Waqar Ahmad, Allenhouse Business School

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 raisedviii) 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 afactor 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.12/17/2016Dr. Waqar Ahmad, Allenhouse Business School

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:Thetheory of factor pricing is criticizedon 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.12/17/2016Dr. Waqar Ahmad, Allenhouse Business School

Rent12/17/2016Dr. Waqar Ahmad, Allenhouse Business School

In the words ofBuilding:"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".12/17/2016Dr. Waqar Ahmad, Allenhouse Business School

Theories of Rent

Ricardian Theory of Rent

Modern Theory of Factor Pricing Under Perfect CompetitionQuasi Rent12/17/2016Dr. Waqar Ahmad, Allenhouse Business School

Ricardian Theory of RentThetheory of economic rentwas 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 ofrenthas 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.).12/17/2016Dr. Waqar Ahmad, Allenhouse Business School

Assumptions:(i) Rent Under Extensive Cultivation.(ii) Rent Under Intensive Cultivation.12/17/2016Dr. Waqar Ahmad, Allenhouse Business School


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 famouslaw 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 marginalorno rent dose. The rent arises on all the infra-marginal doses.12/17/2016Dr. Waqar Ahmad, Allenhouse Business School

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 Principle12/17/2016Dr. Waqar Ahmad, Allenhouse Business School

Quasi Rent

The concept ofquasi-rentowes 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 calledquasi-rent".12/17/2016Dr. Waqar Ahmad, Allenhouse Business School

How does rent of Land differ from rent of; (a) Fisheries, (b) Mines and (c) Buildings?Rent of Land and Fisheries.Rent of Land and Mines.Rent of land and urban site land.12/17/2016Dr. Waqar Ahmad, Allenhouse Business School

Wages12/17/2016Dr. Waqar Ahmad, Allenhouse Business School

Wagesare remuneration paid to labor in return for the services rendered.Benham has defined the term wagesin 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.12/17/2016Dr. Waqar Ahmad, Allenhouse Business School

Various System of Wages Payments:Theremuneration of labor is paidin 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:12/17/2016Dr. Waqar Ahmad, Allenhouse Business School

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 asnominal wages.(2) Real Wages:"Real wagesrefer to the total amount of satisfaction which a worker receives in the form of necessities, comforts and luxuries in return for the services".12/17/2016Dr. Waqar Ahmad, Allenhouse Business School

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.12/17/2016Dr. Waqar Ahmad, Allenhouse Business School

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 importanttheories of wages determinationare:

(1) Subsistence Theory of Wages.

(2) Wage Fund Theory.

(3) Residual Claimant Theory.

(4) Marginal Productivity Theory.

(5) Modern Theory of Supply and Demand.12/17/2016Dr. Waqar Ahmad, Allenhouse Business School

Subsistence Theory of Wages:

Thesubsistence theory of wagesowes 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.12/17/2016Dr. Waqar Ahmad, Allenhouse Business School

2) Wage Fund Theory:

Thetheory of wage fundfirst 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 FundTotal 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 theoryis associated with the name of American economist Walker. According to Walker:"Wages equal to Whole product minus rent interest and profit".Jevon has stated thetheory of residual claimantin 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 byLonge and Thorntonon 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.12/17/2016Dr. Waqar Ahmad, Allenhouse Business School

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.12/17/2016Dr. Waqar Ahmad, Allenhouse Business School

(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 usualdemand 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 likewages, the cost of labor can also be looked at from two points of view:(1) Nominal Cost of Labor:Bynominal cost of laboris meant the total money wages paid to the labor for the services.(2) Real Cost of Labor:Real cost of laboris measured in relation to the work performed by him.12/17/2016Dr. Waqar Ahmad, Allenhouse Business School

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.12/17/2016Dr. Waqar Ahmad, Allenhouse Business School

Interest12/17/2016Dr. Waqar Ahmad, Allenhouse Business School

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 ofEastham:"Interestis the payment for parting with the advantage of liquid control of money balances".According toBatch:"Interestis 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 ofJ. M. Keynes:"Interestis the premium which has to be offered to induce people to hold their wealth in some form other than hoarded money".12/17/2016Dr. Waqar Ahmad, Allenhouse Business School

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 withnet or pure interest. Net interest is, thus, the payment for loan able funds only.12/17/2016Dr. Waqar Ahmad, Allenhouse Business School

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.12/17/2016Dr. Waqar Ahmad, Allenhouse Business School

1) Productivity Theory of Interest:Definition:Turgotand 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.12/17/2016Dr. Waqar Ahmad, Allenhouse Business School

(2) Abstinence or Waiting Theory of Interest:Definition:This theory of interest is associated with the name ofSenior.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 lender12/17/2016Dr. Waqar Ahmad, Allenhouse Business School

3) Austrian or Agio Theory of Interest:Definition:The Austrian or Agio Theory of interest was first advanced byJohn Raoin 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".12/17/2016Dr. Waqar Ahmad, Allenhouse Business School

(4) Loanable Fund Theory of Interest (Neo Classical Version):Definition:The theory was first put forward byWickselland later on it was elaborated byOhlin, Robertson and Pigou, Myrdaletc. 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. Keynesin 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.12/17/2016Dr. Waqar Ahmad, Allenhouse Business School

(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 toJ.M. Keynes:The rate of interest is determined at a where demand for money is equal to the supply of money.M = SmM = Total demand for money.Sm = supply of money.


(6) Modern Theory of Interest/IS-LM Curve Model:Definition:TheModern Theory of Interestis designated asIS-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).This theory is designed to explain the joint determination of equilibrium rate of interest r and equilibrium level of income yby 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 rateofinterest r and equilibrium level of national income y.12/17/2016Dr. Waqar Ahmad, Allenhouse Business School

(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 rrises, 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 ofLMCurve: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 ofIS-LM curvesto demonstrate simultaneous determination of both the equilibrium rate of interest and the equilibrium level of-national income.


Profit12/17/2016Dr. Waqar Ahmad, Allenhouse Business School

Definition of Profit:Profitis 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

Gross ProfitNet Profit12/17/2016Dr. Waqar Ahmad, Allenhouse Business School

Theories of ProfitThere are varioustheories of profitwhich 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.12/17/2016Dr. Waqar Ahmad, Allenhouse Business School

Hawley's Risk Bearing Theory of Profit:

Definition and Explanation:

This risk bearing theory of profit is associated with the name ofF.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".12/17/2016Dr. Waqar Ahmad, Allenhouse Business School

(2) Uncertainty Theory of Profit:

According toProfessor 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.12/17/2016Dr. Waqar Ahmad, Allenhouse Business School

(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".12/17/2016Dr. Waqar Ahmad, Allenhouse Business School

(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".12/17/2016Dr. Waqar Ahmad, Allenhouse Business School

(5) Dynamic Theory of Profit:

In the world of reality, according toJ.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 bycompetition".12/17/2016Dr. Waqar Ahmad, Allenhouse Business School

(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.12/17/2016Dr. Waqar Ahmad, Allenhouse Business School

Thank you12/17/2016Dr. Waqar Ahmad, Allenhouse Business School

Economy & Finance

Rent theory