Factor Pricing

DR M MANJUNATH SHETTIGAR
Marginal Productivity
Theory of Factor Pricing
 The Marginal Productivity Theory is the general theory of
distribution. The theory explains how the prices of the
various factors of production (land, labour, capital and
organization) would be determined under conditions of
perfect competition and full employment.
Marginal Productivity Theory
of Factor Pricing
 According to the Marginal Productivity Theory,
the price of any factor will be equal to the value
of its marginal product.
 For example, we know that a consumer will
demand a commodity up to the point at which
its marginal utility is proportional to the price he
pays for it.
 Similarly, a firm will go on employing more and
more units of a factor until the price of the factor
is equal to the value of the marginal product. In
other words, each factor is rewarded according
to its marginal productivity.
Marginal productivity
theory of factor pricing
Marginal productivity
theory of factor pricing
 In the above diagram, when the use of resource
(say, of labour) is OQ, Marginal product of labour
is PQ and then wage rate will be OW (which is
equal to PQ)
 If the use of is OQ1, Marginal product of labour is
PQ1 and then wage rate will be OW1 (which is
equal to PQ1)
Wages
 Wages are the reward for labour.
 There are 2 concepts of wages, viz. Nominal wages
and Real wages. Nominal wages refers to wages in
terms of nominal amount of money. Hence, nominal
wages are also known as money wages. It is expressed
in terms an amount of money such as Rs 5,000 per
month, Rs 10,000 per month and so on.
 On the other hand, real wages refer to the purchasing
power of a given nominal or money wages. It refers to
the quantity of goods and services that can be bought
out of a given nominal or money wages. Then, the level
of real wages depends on two factors, viz. 1) the level
of money wages and 2) the price level.
Factors responsible for
difference in wage rates
1. Difference in efficiency:
2. Presence of noncompeting groups:
3. Immobility of labour:
4. Nature of employment:
5. Training and Qualification:
6. Productivity:
7. Regularity of employment:
8. Future Prospects:
9. Scope for extra earning:
Interest
 Interest is cost of funds borrowed/ reward for the funds
lent.

 Interest is expressed in percent terms. E.g., 5%, 10%, etc.

 There are 2 concepts of interest, viz., Nominal rate of

interest, and Real rate of interest
 Nominal rate of interest (NI) is interest in nominal amount of
money
 Real rate of interest (RI) is the rate of interest adjusted for the
rate of inflation
 RI = NI – Rate of inflation
Loanable funds theory of
Interest
 According to the loanable funds theory, interest is
the price of ‘money taken/ given on loan’ (called
loanable funds).
 The rate of interest is determined by the
interaction of the forces of demand for and
supply of loanable funds.
Loanable funds theory of
Interest
Liquidity Preference Theory of
Interest
(or the Keynesian theory of interest)

 The Liquidity preference theory of interest was put

forward by John Maynard Keynes
 The liquidity preference theory of interest is a pure
monetary theory of interest. According to it, the rate of
interest is determined by the interaction of the
demand for and supply of money.
Liquidity Preference
Theory of Interest
 Supply of money is controlled by the central bank
of the country
 Demand for money comes from the public –
individuals and institution
 Demand for money is based on 3 motives, viz.,
 a) transactions motive – to hold cash to finance
day-to-day transactions,
 b) precautionary motive – to hold cash to be able
to meet unforeseen expenditures, and
 c) speculative motive- holding liquid cash to make
speculative gains through purchase and sale of
securities.
Liquidity Preference
Theory of Interest
Theories of profit

 Risk bearing theory

 Uncertainty bearing theory
 Innovation theory
1. Risk bearing theory:
 The risk bearing theory of profit is given by F B Hawley, an
American economist. According to him, profit is the
reward received by the entrepreneur for bearing the
possible risk associated with his business.

 Bearing risk is unpleasant and irksome. Hence, only if

adequate rewards (in the form of profit) are there, will
people be motivated to be entrepreneurs.
 According to Hawley, the reward for entrepreneurship
should be higher than the expected level of risk. So
according to him profit is ‘an excess of payment above
the actuarial value of the risk’.

 Risks which entrepreneurs will have to bear include loss

due to fire, theft, accident, change in technology,
change in prices and so on.
1. Risk bearing theory:
 Criticism: The theory is criticized as follows.
 1. According to Carver, profit is earned not by bearing
risk, but by avoiding risk.
 2. According to Frank Knight, profit is actually a reward
for uncertainty bearing and not for risk taking.
 3. Profit can be better considered as a reward for
original ability of the entrepreneurs, instead of being a
reward for risk bearing.
2. Uncertainty bearing theory
Uncertainty bearing theory of profit is given by Frank Knight. According to him,
profit is the reward received by the entrepreneur for bearing uncertainty
associated with his business.

Knight argues that profit is not a reward for risk taking. Risk associated with
business can be insured against with an insurance company. However,
uncertainties associated with business are uninsurable. These uncertainties will
have to be borne by the entrepreneurs.
Uncertainties associated with business include change in price, change in
technology, new competition, market fluctuations, unfavorable government
policy and so on. Such changes in business conditions are by their very nature
unforeseen and unpredictable.

According to Knight, like waiting (in the case of savings and investment)
uncertainty bearing is also a factor of production. Profit is the reward the
entrepreneurs get for supplying the services of this factor of production, i.e.
bearing uncertainty associated with business.
2. Uncertainty bearing theory
 Criticisms: Uncertainty bearing theory of interest is
criticized as follows.

 1. This theory ignores the other vital functions of

entrepreneurs, which include leadership, innovation,
etc.
 2. Uncertainty bearing can not be considered an
independent factor of production.
 3. In modern business risk and uncertainty are
managed by the management, not by the owners.
3. Innovation theory of profit

 Innovation theory of profit is put forward by J A

Schumpeter.
 According to him, the main function of the entrepreneur is
introducing innovation.
 Profit is the reward for this.