Theory of Factor Pricing (Theory of Distribution)
The traditional factors of production are land, labour, capital, and entrepreneurship.
The payments made for the use of these factors are known as rent, wage, interest,
and profit respectively.
The branch of economics that deals with the determination of prices of factors
of production is called the Theory of Factor Pricing or Theory of Distribution.
Rent
Meaning of Rent
- Classical View: Rent is earned only by land. It is the payment made to the landlord for the use of the original and indestructible powers of the soil.
- Modern View: Rent is the excess of actual earnings over transfer earnings and can be earned by all factors.
Contract Rent (Gross Rent)
Contract rent is the total payment made by the user of a factor to its owner for
a specified period of time.
- Determined by agreement between owner and user
- Includes economic rent
- Payment for improvements
- Interest, depreciation, and maintenance charges
Economic Rent (Pure Rent)
- Payment made only for the use of land
- Ricardo’s view: Earned only by land
- Modern view: Earned by all factors as surplus over transfer earnings
Ricardian Theory of Rent
This theory was propounded by David Ricardo in his book
Principles of Political Economy and Taxation (1817).
“Rent is that portion of the produce of the earth which is paid to the landlord
for the use of the original and indestructible powers of the soil.”
Assumptions
- Land has original and indestructible powers
- Land differs in fertility
- Law of diminishing returns applies
- Perfect competition exists
- Existence of no-rent (marginal) land
Rent under Extensive Cultivation
Rent = Surplus of intra-marginal land over marginal land
Rent under Intensive Cultivation
Rent = Excess output of intra-marginal units over marginal unit
Criticisms of Ricardian Theory of Rent
- Land has no original and indestructible powers
- Land has multiple uses
- No-rent land assumption is unrealistic
- Perfect competition is unrealistic
- Rent is earned due to scarcity
- Rent enters price
Wage
Wage is the price paid to labour for its mental or physical services in production.
It may be paid on hourly, daily, monthly, or piece-rate basis.
Types of Wages
- Nominal Wage: Wage paid in monetary terms
- Real Wage: Wage measured in terms of goods and services
Real Wage = (Nominal Wage / Price Level) × 100
Subsistence Theory of Wages (Iron Law of Wages)
Developed by David Ricardo. According to this theory, wages in the long run
tend to remain at the subsistence level.
Criticisms of Subsistence Theory
- Ignores demand for labour
- Fails to explain wage differences
- Ignores role of trade unions
- Pessimistic in nature
Interest
Interest is the price paid for the use of capital.
Types of Interest
- Gross Interest: Includes net interest, risk, management, inconvenience
- Net Interest: Payment only for the use of capital
Profit
Profit is the reward received by the entrepreneur for risk-taking,
innovation, and organization.
Gross Profit
Gross Profit = Total Revenue − Explicit Costs
Net Profit (Pure Profit)
Net Profit = Total Revenue − Total Costs (Explicit + Implicit)
Quick Exam Points
- Rent arises due to scarcity
- Real wage shows purchasing power
- Interest is price of capital
- Profit is reward for uncertainty and innovation