rentwagesinterestandprofit-111101072509-phpapp02

8/13/2019 rentwagesinterestandprofit-111101072509-phpapp02

1/52

Rent, Wages, Interest and Profit

UNIT 5


2/52

Goods or services, which contribute in producingsomething, are called the factors of production. The majorfactors of production as classified by economists are land,

labor, capital and entrepreneurship. The factors of production are rewarded for their

contribution to the production of goods and services. Thereward for land is rent, for labor it is wages, for capital it is

interest and the reward for entrepreneurship is calledprofit.

Determination of factor prices is different from thedetermination of product pricing which is based on the

demand and supply of products. The reason is that unlike products, factors of production

have a derived demand and also joint demand as theycontribute in a combined way in the production of goodsor services


3/52

Moreover, the supply of factors of production is alsodifferent from the supply of goods as the cost ofproduction with regard to factors of production is

difficult to estimate. On the other hand, modem economists believe that

factors of production can also be priced based on theforces of demand and supply in a manner similar to

the determination of product prices. While determining the demand for any factor of

production, profit maximization acts as the principleand the market demand is determined by summing

up the demand from all the firms. The supply of factors of production in a market is

determined by summing up the supply of factors ofproduction from all the factor owners in the market.


4/52

THEORIES OF FACTOR PRICING Factor pricing means the price paid for the services

rendered by the factor of production but not the

price of the factor itself. As goods are produced through the combined efforts

of the factors of production, the income earnedthrough sale of products or remuneration for

services is distributed among the four factors ofproduction.

Theories of factor pricing suggest the ways to

distribute the income among the factors ofproduction.

The process of income distribution can be done intwo ways. They are: personal distribution and

functional distribution.


5/52

Personal Distribution: In this form of income distribution,the national income of a country is distributed among theowners of various factors of production such as rent forland rented, wages for labor, interest on the capitalinvested, and profit for entrepreneurship.

Thus, the pattern of individual income generation is studiedunder personal distribution.

Functional Distribution: Functional distribution of income

distribution deals with the distribution of income amongthe four factors of production - land, labor, capital, and theentrepreneur.

It lays emphasis on the sources of income for factors ofproduction such as rent for land, wages for labor, interestfor capital, and profit for entrepreneur.

There are two theories for functional income distribution.They are the macro theory of distribution and micro theoryof distribution (Theory of factor pricing).


6/52

Macro & Micro theory of distribution Macro theory of distribution:

Macro theory of income distribution deals with the distribution

of national income among the factors of production. Thisprocess of national income distribution can be termed as macrodistribution.

The macro theory of distribution helps determine the relativeshares of different factors of production and also deals with the

effects of economic development on those relative shares. Micro theory of distribution theory of factor pricing:

Micro theory of income distribution concentrates on individualsunlike macro theory which deals with aggregates of a nation.This theory of factor pricing determines the ways to distributerewards for factors of production.

Basically two micro theories are considered for thedetermination of factor prices. They are: marginal productivitytheory of factor pricing and modem theory of factor pricing


7/52

Marginal Productivity theory of Factor Pricing:

Many economists have contributed to the

development of the marginal productivity theorydetermining the rewards for various factors of

production.

David Ricardo initially used the theory todetermine rent for land. The statement of

marginal productivity theory as given by J.B. Clark

is, "Under static conditions, every factor including

the entrepreneur would get remuneration equal

to its marginal product.


8/52

Demand for factors of production is derived from thedemand from firms for the same. Since factors ofproduction are utilized in the production process, theirdemand is based on their productivity.

As the productivity of a factor increases, its price alsoincreases. Marginal Physical Productivity (MPP) is thechange in the total physical product or production, whenone more unit of anyone factor of production is addedwhile other factors are kept constant.

Marginal Value Product (MVP) is the monetaryrepresentation of the MPP i.e., MVP =MPP x Price.

Marginal Revenue Productivity (MRP) is the change in thetotal revenue for the producer when an additional unit of a

factor of production is employed while the quantity ofother factors is kept constant.

Average Revenue Productivity (ARP) is the average revenueperunit of a factor of production.


9/52

Marginal productivity theory is developed as an

explanation to the following points:

Reward of each factor unit is equal to itsmarginal productivity.

Reward for each factor of production will be the

same in every use. In the long-run, under perfect competition, each

factors of production will get its remuneration

that will be equal to its Marginal RevenueProductivity (MRP) which also equals its Average

Revenue Productivity (ARP)


10/52

Modern theory of Factor Pricing As the marginal productivity theory of factor pricing was based on

impractical assumptions, and concentrated only on demand side

ignoring the supply side, the modern theory of factor pricing wasdeveloped to explain the determination of factor prices. In fact, the

modem theory considered both the demand side and supply side to

determine prices for factors of production.

Demand side Demand for factors of production is derived demand or

indirect demand unlike the demand for goods which is direct. The

demand for a factor of production is based on the contribution of the

factor with regard to the production of a good, which can be termed

as the productivity of the factor.

The demand for a factor of production also depends on the demand

for the goods produced using the factor.

By aggregating the individual demands or marginal revenue

productivity (MRP) curves of all firms in the market, the market

demand curve for a factor of production can be obtained.


11/52

This marginal revenue productivity curve for a factorof production is subject to changes in demand andto the changes in the quantity demanded.

Changes in demand for a factor of production maybe due to the following reasons:

Change in demand for the final product producedusing the factors of production.

Change in productivity in terms of quality orquantity being produced.

Change in the prices of substitute or complementaryfactors used in the production process. For example,

demand for labor and machines are interrelated andfirms may utilize more or less of one of them, if therelative price of either of the factors of productionincreases against the other.

MEANING OF RENT


12/52

MEANING OF RENT Rent can be termed as the reward for land which is one of the

four factors of production. For economists, the term 'land'

indicates natural resources like ground water, forests, rivers, oil

fields, mineral deposits, etc., apart from the physical soil.

Since land is a natural product and cannot be reproduced, the

supply of land is permanently fixed and in general perfectly

inelastic. Usually the term rent refers to the payment made to

the owner of the factor to use the same for a specific period of

time.

Here, the term land includes any material asset which has a

fixed supply. For instance, payment made to use a house,vehicle, or machine is termed as rent.

However, economists term it as 'contract rent' as it includes

return on capital invested in material assets. 'Economic rent' is

the term used by economists to refer to the payment made forusa e of land.


13/52

In fact there are variant views aired by economists with regard to the

concept of rent. Some of them are rent as a differential surplus,

scarcity rent, and quasi-rent.

Rent as a Differential Surplus: David Ricardo (Ricardo), a British

economist, defined rent as, "the price paid for the use of original andindestructible powers of the soil." Ricardo explained rent as differential

surplus which indicates that rent is the surplus of revenue over costs

which arises due to differences in the level of fertility or usability of

land. Higher rent can be earned by the landowners, if the quality of land is

better.

Scarcity Rent :

According to modem theory of factor pricing, the scarcity of land actedas the basis for the concept of rent. According to the theory, rent

would arise even if all lands are of equal quality.

The modem theory further suggested that rent does not determine

price but is determined by price i.e., when the prices are high, high

rent is charged and not vice-versa.


14/52

Quasi-rent :

According to Alfred Marshall (Marshall), an English

economist, rent is the income obtained due to

ownership of land and other natural resources.

Marshall opined that land is a natural resource and its

supply is perfectly inelastic considering the society as

a whole. However, for an individual person, firm, or

industry, the supply of land depends on the prevailing

rent thus it is elastic in nature.

In his view, as the supply of land is fixed, rent can beearned even in the long-run. Apart from land, other

factors which have limited supply can also earn rent

but only for a short- period of time.


15/52

THEORIES OF RENT Various economists have proposed different theories for

the origin of rent. Prominent among the theories of rent

are the Ricardian theory and the modern theory of rent.

Ricardian Theory: David Ricardo, (Ricardo) a British

economist, proposed the 'Ricardian theory of rent'. The

definition of rent as, "Rent is that portion of the produceof the earth which is paid to the landlord for the use of

the original and indestructible powers of the soil."

It can be deduced from this definition that rent arises

due to the following two reasons:

1. Differences in the productivity of various pieces of

land.

2. Situational differences.


16/52

Postulates of the Ricardian theory: Some of the basic

assumptions of Ricardian theory in relation to land, and its

demand and supply, are:

The supply of land is fixed and the existing quantity of landgifted by nature cannot be increased or decreased.

Another assumption is that original powers such as fertility of

land are gifted by God and are not due to human efforts of

any type.

Ricardo's theory of rent was based on assumption that land is

a non-perishable factor of production. The powers/qualities

of land cannot be destroyed and the fertility of land never

diminishes.

Another basic assumption is that utilization of land for

cultivation is done based on the order of fertility of land.

Most fertile land is cultivated first before using the next grade


17/52

Ricardo assumed that the law of diminishing returns or

increasing costs operates in agriculture.

It is also assumed that different lands have different

fertility levels. Land is assumed to be free gift of nature. Therefore, it

does not have cost of production.

Assumption of perfect competition is also made. Ricardo assumed the existence of margin land which is a

'no rent land'. It could be understood as the grade of

land after which no land is used.

Ricardo's theory also supposes that lands are located atdifferent locations i.e. some of them are near to the

market than others.

l i


18/52

Explanation:

Ricardo believed that rent is a surplus arising because of differences

in fertility and locations of land. Ricardo explained the origin of rent

based on the assumption that 'marginal land' exists.

Marginal land can be defined as that area of land that barely covers

its costs with the market value of its produce.

To put it differently, marginal land represents the grade of land below

the level of which no land is used. The land with better productivity

than marginal land is termed as 'intra-marginal land'. Ricardo opined

that rent is the differential surplus between the earnings of marginal

land and intra-marginal lands. Rent arises in both the two types of

farming techniques-extensive cultivation and intensive cultivation.

Extensive cultivation: In the farming technique of 'extensivecultivation', production of farm is increased by bringing more and

more land under cultivation.

Ricardo used the assumptions listed earlier to explain the origin of

rent in the extensive cultivation technique.


19/52

Intensive cultivation: Under intensive cultivation technique of

farming, the production of the land is increased by employing

increased number of labor and capital units.

Ricardo assumed the function of the law of 'diminishing returns'in agriculture. It implies that when more and more units of labor

and capital are employed after a certain stage, there is going to

be diminishing rate of increase in the production of the farm.

This indicates that rent arises even when all the plots of land areequally fertile and all the plots of land are comparable even with

regard to nearness to the market.

Ricardo believed that as the law of diminishing returns is

applicable to agriculture, the marginal product of labor andcapital will be diminishing.

Marginal product refers to the increase in the total production

when one more unit of labor and capital are employed while

other factor units are kept constant.


20/52

Modern Theory of Rent The modem theory of rent is an integrated set of ideas of

different economists such as Marshall, Joan Robinson,

and Boulding.

The modem theory improves on Ricardo's theory of rent

and extends the concept of rent which was linked to land

alone to other factors of production which have inelasticsupply in the short run.

Ricardo believed that the supply of land is permanently

fixed i.e., perfectly inelastic, and further the various lands

have different fertility levels.

The surplus produced by more fertile lands over the

marginal land is considered to be the rent.


21/52

Modern economists are of opinion that the supply of

labor, capital, and entrepreneurs are also limited when

compared to their demand and cannot be altered in the

short run.

As different lands differ in their fertility levels, other

factors of production differ in the level of efficiency and

productivity.

Therefore, an improvement was made over the Ricardian

theory to introduce the idea that apart from land, other

factors of production, labor, capital, and entrepreneur

can also earn rent. Other improvements are that since the supply of land is

fixed and is scarce, it earns scarcity rent, and further due

to difference in fertility levels of various plots of land,

the earn differential rents.


22/52

Ricardo's theory of rent provided an explanation that the

surplus which is produced by the more fertile lands above

the cost of cultivation can be considered to be the rent.

But the theory does not explain how to determine the

rent. Modern economists advocated that rent can be

determined by the forces of supply and demand similar to

the determination of prices for products and other factors

of production.

The modem theory of rent suggests that rent is

determined by the level of increase in demand for

land over its supply. As the supply of land is fixed, higherdemand for land will increase the rent of land.

Hence, modern theory of rent is also termed as the

scarcity theory of rent.

M d A l i M d i t diff d ith th


23/52

Modern Analysis ; Modern economists differed with the

view of Ricardo. They believed that rent affects the price

of produce of land in the following situations:

When land is under control of few landlords who compelfanners to pay rent on even the marginal land.

If people are more dependent on land in countries like

India, then the land owners increase the rents and the

actual rent becomes higher than economic rent.

The productivity of land differs when land is used for

production of different varieties of crops. Then the rent

affects price as there may be surplus when a particularvariety is produced while no surplus for other varieties of

crops.

The scarcity of fertile/prime land leads to rent having an

affect on price.


24/52

CONCEPT OF WAGES Labor is one of the four factors of production. In economics, the term

labor refers to both physical and mental work.

Wage is the remuneration paid for labor. Payment of wages can bedone in different modes such as time wages, piece wages, task

wages, cash wages, kind wages and service wages.

Time wages are the wages which are paid on the basis on number of

hours worked. Piece wages are the wages which are paid depending on the quantity

of output produced.

Task wages are the wages which consider accomplishment of a task

for payment of wages. Cash wages are the wages which are paid in money form.

Kind wages are the wages which are paid in the form of commodities.

Service wages are the wages which are paid through a return service

for the service rendered.

DISTINCTION BETWEEN REAL WAGES AND


25/52

DISTINCTION BETWEEN REAL WAGES AND

NOMINAL WAGES Apart from the different types of wages we have discussed till now, wages can

also be classified on the economic basis into nominal wages and real wages. The

value of wages earned by a worker is different in terms of nominal wages and realwages.

Real Wages: Organizations provide various facilities to workers apart from paying

salaries. The additional facilities such as transportation facilities, medical facilities,

accommodation, and other allowances paid in addition to the salary constitute

the real wages of workers.

Real wages or real earnings refer to the purchasing power of the worker's

remuneration i.e., the amount of necessaries, comforts and luxuries which the

worker can command in return for his services."

If the money earned by a worker is Rs. 10,000 per month, his/her nominal wage is

Rs. 10,000 but the real wage refers to the purchasing power of the money earned

i.e., how much the worker can purchase with Rs. 10,000.

Real wages serve as indicators with regard to the prosperity level of workers. If

the purchasing power of money is high, real wages are considered to be high.

Smith, a renowned economist, stated that the laborer is rich or poor, is well or ill-

rewarded in proportion to the real, not the nominal, wages of his labor.

Nominal Wages: According to Prof Thomas "nominal wages or


26/52

Nominal Wages: According to Prof. Thomas, "nominal wages or

nominal earnings refer to the amount of the wages as measured in

terms of money.

Nominal wages are also known as money wages and refers to the

payment to a worker for the service rendered in terms of money. For

instance, if an amount of Rs.I0,000 is credited to a worker's bank

account as a salary for a month that amount is referred as the

nominal wage of the worker.

Production of goods is not complete without the combined efforts ofall factors of production. Hence, successful management of business

is dependent on the successful management of all the factors of

production.

The reward for land is rent, whereas the reward for labor is calledwages. In this chapter, we will discuss about the remaining two

factors of production namely, capital and organization or the

entrepreneur.

The reward for capital is known as interest and the reward forentre reneurshi is known as rofit.


27/52

Therefore, an entrepreneur is concerned with the interest rates

because interest rates will have an impact on his business.

For instance, an increase in interest rates would cause the

entrepreneur to lower his capital requirements, and this in turnwould have an impact on the production process.

An entrepreneur uses his entrepreneurial abilities and manages all

the factors of production. In this way, he successfully accomplishes

the task of producing goods. He further makes efforts to sell these finished goods in the market.

The reward he gets for all these efforts is known as profit.

Profits motivate entrepreneurs to improve their efforts and

thereby improve the production process. Thus, profits have an impact on business practices. Therefore, an

understanding of interest and profit are crucial for the successful

management of business.

Hence, the rewards for capital and entrepreneurship are of greatim ortance to an 'entre reneur'


28/52

Subsistence theory of wages


29/52

Wage fund theory

Residual claimant theory of wages

Marginal productivity theory of wages

INTEREST


30/52

INTEREST What is Interest?

The reward for capital is known as interest. The owner of the capital receives

interest for lending his/her capital to others.

Capital can be classified into two types fixed capital and variable capital. In

fact, when we say capital, it includes both fixed and variable capital.

However, interest is the income earned only on the variable capital. Interest is

earned only on that portion of capital which is given by the owner to the

borrower.

In other words, it is the price paid by the borrower to the lender who parted

with his money.

Why do people get paid for lending their money? Money in the form of cash

provides the holder with benefit because it enables him to buy anything that he

desires.

However, if an individual lends it to another person, then he will have to wait

until he gets back his money and only then he can utilize it.

According to John Maynard Keynes, "Interest is a reward for parting with

liquidity for a specified period."

Basic Concepts


31/52

Basic Concepts Gross interest: When the borrower pays an amount to the lender

for borrowing the lender's money, the amount so paid by the

borrower is known as 'interest'.

Therefore, when people refer to interest, they generally refer to

'gross interest'. Gross interest is the total amount paid by the

borrower to the lender of the money.

Net interest: Net interest is the amount paid to 'capitalists' only

for the use of 'capital'. It is the reward paid to the capitalists

exclusively for the use of capital.

Net interest is the compensation for lending capital to others

under conditions where there is no risk or inconvenience due to

investment (investments made with no savings motive) and thelender is not required to perform any work other than lending his

money.

Therefore, net interest is a part of the gross interest. Gross

interest consists of some charges along with the net interest.

Gross Interest = Price of the Capital (Net Interest) + Reward


32/52

Gross Interest = Price of the Capital (Net Interest) + Reward

for taking risk of money lending + Reward for management of

loan + Others (such as the reward for accepting the

inconveniences involved in money lending).

Gross interest thus includes compensation for loan of capital,

compensation to cover risk of loss (either business risk or

personal risk), compensation for inconvenience of investment,

compensation for work and apprehension related to

monitoring investment.

Saving and investment: According to the theory, savings and

investment are not interdependent. It is known that the

income level changes along with the changes in investments. The changes in investment levels invariably have an impact on

the savings of individuals. Therefore, it is not correct to say

that saving and investment are independent of each other.

Li idit P f Th f I t t


33/52

Liquidity Preference Theory of Interest John Maynard Keynes (Keynes) propounded the 'liquidity

preference theory of interest'. His theory is based upon

the belief that people prefer absolute liquidity (cash) toother forms of wealth in the short run.

Keynes criticized the classical theory of rate of interest on

the grounds that they combined real and monetary factors

together.

According to Keynes, the rate of interest is purely a

monetary phenomenon. He said that determination of

interest, thus, is dependent upon the demand for andsupply of money in the economy. Keynes proposed that

interest is equilibrium between the demand for and supply

of money.


34/52

Keynes opined that a person who lends money gets the

reward called 'interest' for parting with' liquid money'.

Keynes explains, The rate of interest is the premium

which is to be offered to induce the people to hold

wealth in some form or the other than hoarded money."

According to him, interest is the incentive that drives

moneylenders to part with their money and lend it to

people.

What is liquidity preference? The liquidity feature of

money empowers us with 'purchasing power', hence,

the preference for cash to other forms of money.People's fondness for cash or liquid money is called as

'liquidity preference'.

Why do people prefer liquidity? According to Keynes people


35/52

Why do people prefer liquidity? According to Keynes, people

prefer liquidity to other forms of money because they want to

satisfy the three kinds of motives:

Transaction motive Precautionary motive

Speculative motive

Transaction motive: When people demand for liquid money

to carry out their day-to-day transactions, the demand forsuch liquidity is known as 'transaction motive'.

For example, people need money to travel from one place to

another, to buy goods and services, etc. For this, they are

required to stock some amount of cash with them. So, when

people require cash to complete their economic transactions,

the motive behind the demand for such cash is known as

transaction motive.

Precautionary motive: Since people are uncertain about


36/52

Precautionary motive:Since people are uncertain about

their future, they prefer to save money with a view to

safeguard their future.

People attempt to meet contingencies and unforeseencircumstances that may happen in the future by saving.

Hence, the demand for liquidity to safeguard their future

is known as the 'precautionary motive'.

Ex.1. Income levels of people impacts precautionary

demand for liquidity to a great extent. 2. Some people

are optimistic about their future, while others are

pessimistic. Optimistic people anticipate lesser risk in the

future when compared to pessimistic people. 3. A

farsighted person can visualize the future in advance and

makes a better analysis of the future.

Speculative motive: This is the most important motive behind


37/52

Speculative motive: This is the most important motive behind

the demand for liquidity. The motive for stocking cash here is to

take advantage of the changes in the price levels of securities

and bonds.

If people anticipate that the prices of securities will go up in the

future, hen they prefer to purchase securities now. In such a

situation, the liquidity preference of people will be low because

they like to spend cash and purchase securities (with a view to

gain profit in the future).

On the other hand, if they anticipate that the prices of securities

would go down in the future, then they prefer to hold cash.

This is because, they would like to wait and purchase securitiesin the future when the prices of the securities fall. In such a

situation, the liquidity preference of people will be high.

Hence, it can be said that the liquidity preference of people is

affected by the speculative motives.


38/52

ABSTINENCE OR WAITING THEORYOF INTEREST

AUSTRIAN THEORY OF INTEREST

LOANABLE FUND THEORY

Productivity theory of interest

PROFIT


39/52

PROFIT What is Profit? Just like rent is the reward for land, wages for labor

and interest for capital, profit is the reward for entrepreneurship.

While the rewards for other factors of production are paid by the

entrepreneur, profit is the reward received by entrepreneur

himself.

Simply put, profit is the income of an entrepreneur for utilizing

his entrepreneurial abilities and running a business.

Profit is nothing but the surplus amount left with the entrepreneur

after paying all the factors of production.

If the income earned by him is in excess of the costs incurred on

the factors of production, then the income can be called as profit.

Therefore, profit can also be defined as the difference between the

total value of output (total revenues received by the businessman)

and the total value of inputs (total costs incurred by the

businessman) of a business.

Profit =Value of Outputs - Value of Inputs

Profit is also viewed as a reward earned by the entrepreneur for performing


40/52

y p p g

the entrepreneurial

function in a business. There are other economists who believe that profit is

the reward for making innovations in business.

Basic concepts

Profit consists of two major components - gross profit and net profit.

Gross profit : Generally, people consider profit as the residual income left

with the entrepreneur after making all the payments to other factors of

production. However, it should be noted that this is gross profit. The gross profit is

arrived at after excluding all the explicit costs from the revenues received

by the business.

It does not exclude implicit costs such as rent forgone by entrepreneur for

utilizing his own land for business purposes, interest forgone on his owncapital, etc.

Gross Profit =Total Revenues - Total Explicit Costs

Gross profit thus includes those costs which go unrecorded in the books of

accounts, but which are nevertheless important to determine the profit

N t fit Th t fit b i d t b bt ti


41/52

Net profit:The net profit can be arrived at by subtracting

the implicit costs from gross profits.

This is also sometimes referred to as 'pure profit'. Net

profit is the surplus leftover after deducting explicit andimplicit costs from the sales receipts of a business.

Net Profit =Gross Profit - Implicit Costs

Thus, it can be observed that net profit is a portion of thegross profit. When a business gets zero net profit, it

means that the profit attained is just enough to meet the

explicit costs of the business.

In other words, the entrepreneur's revenues could not

payoff his efforts (or implicit costs) such as utilizing his

own resources, undertaking risk and uncertainty of

business, etc.

N l fi I i h i i h


42/52

Normal profit : It is the minimum return that an

entrepreneur receives for performing

entrepreneurial functions such as bearing risk

and uncertainty, managing other factors of

production, etc.

Abnormal or super profit:The income remaining

with the entrepreneur after subtracting all costs

(both implicit and explicit) from the revenues

received from the business. It is an excess over

the normal profit.

THEORIES OF PROFIT


43/52

THEORIES OF PROFIT Though there are several theories of profit that

attempt to explain the emergence and growth of

profit, none of the theories give a comprehensivepicture on profit.

Traditional Theories: F.A. Walker one of the

prominent non-classical economists, propoundedthe 'rent theory of profit', which was similar to

David Ricardo's (Ricardo) 'theory of rent'. Later,

Taussig and Davonport developed the 'wagetheory of profit' and proposed that like a laborer

works physically and earns his wage, an

entrepreneur works mentally and earns his wage

Walker's rent theory of profit : The 'rent theory of profit' was


44/52

y p y p

developed by Francis. A. Walker (Walker). Be advocated that different

lands earned different rents depending upon the fertility of land.

In the same way, businessmen earned 'rent of ability' called profit. He

opined that some entrepreneurs earned higher profits because oftheir greater ability to run business when compared to other

entrepreneurs.

According to him, the rent earned by more fertile or intra-marginal

lands was the difference between the total production of intra-marginal and marginal lands.

He further explained that there existed both intra-marginal

entrepreneurs and marginal entrepreneurs and that the former are

abler than the latter. Hence, the intra-marginal entrepreneurs earnedrent of ability called profit.

He opined that rent and profit are no different from each other and

just as there is a no-rent or marginal land, there is also a no-rent

entrepreneur or marginal entrepreneur.

Limitations of 'rent theory of profit':


45/52

Limitations of rent theory of profit :

Critics said that comparing profits with rent is

impracticable. Rent can never be zero and is always

positive. However, the same is not the case with profits, asprofits can be negative or zero.

One of the main opponents of Walker's 'rent theory of

profit', J.B. Clark, opined that profits occur only under

dynamic conditions. However, rent can be earned under

both static and dynamic conditions.

The theory assumes the existence of marginal entrepreneur

i.e. entrepreneurs who do not earn any profit. This is anabsurd concept because any businessman who does not

earn profits would pull back from business. Further, critics

said that just as there cannot be a 'no-rent land', there also

cannot be a 'no-profit entrepreneur'.


46/52

Several economists pointed out profits earned are

also a result of risk-bearing, innovation, etc. and

not just because some entrepreneurs are 'abler'than others.

Some economists criticized that while rent is a

fixed (or expected) income, profit on the other

hand was unknown. An entrepreneur cannot

anticipate whether he will get profits or losses in

future and its magnitude.

As land is a free gift of nature, its supply is limited.

However, the supply of entrepreneurs is not

limited and is perfectly elastic.

Modern Theories: The modem theories of profit include


47/52

Modern Theories: The modem theories of profit include

Clark's dynamic theory, Schumpeter's innovation theory,

Hawley's risk theory, Knight's uncertainty-bearing theory

among others. Dynamic theory of profit: According to him, profit is the

difference between the cost of producing goods and the

prices of these goods. In a stationary state, there is always

equilibrium between demand and supply of goods.

Hence, there is no difference between the prices of goods

and their costs, and therefore net profits do not accrue to

the entrepreneur. Under dynamic conditions, however,there is disequilibrium between demand and supply

conditions of economy. In such a state, there are often

changes in the determinants of demand and supply.

Clark said that in reality, however, there exists a dynamic


48/52

y y

economy. He said that there are bound to be unforeseen changes

in demand and supply. According to Clark, the dynamics in

demand and supply conditions could be a result of:

Changes in the quality and quantity of human wants

Changes in governmental rules and regulations regarding trade

Changes in technology that effect the production process

Rise in population Adjustments with regard to amount of capital stock with the

economy

In a dynamic economy, surplus occurs because of the frictions or

obstructions to mobility of resources and even the existence ofmonopoly element.

According to the theory, surpluses would be eliminated by the

forces of competition in the long run.

Innovation theory of profit : Joseph Schumpeter


49/52

Innovation theory of profit : Joseph Schumpeter

propounded the 'innovation theory of profit'. He

proposed that profit is the reward for the innovative

abilities of entrepreneurs. According to him, an entrepreneur who introduces

innovation in businesses process reaps benefits in the

form of profits, if the innovation proves successful in the

market.

Schumpeter defined innovation as any new process or

policy adopted by the businessman with a view to obtain

reduction in cost of production, or to improve thedemand for the product in the marketplace.

According to this theory the difference between price


50/52

According to this theory, the difference between price

and costs keep on increasing, if there are continuous

innovations in the marketplace. This is also how profits

originate. But, such profits are not stable in nature and are only

temporary. An entrepreneur can earn these profits only

in the short term. This is because his competitors too

adopt the same innovation, thus reducing the

entrepreneur's profit.

So, once again the entrepreneur has to differentiate his

products from that of competitors through innovations.This again increases the difference between the costs

and prices, thus enabling the entrepreneur to earn

profits again, until his innovations are imitated by others

and profits fall again.

Uncertainty-bearing theory: According to Frank H Knight (Knight)


51/52

Uncertainty-bearing theory: According to Frank H. Knight (Knight),

the most important function of an entrepreneur is to bear

uncertainties in business in the form of risks that cannot be insured

against. Risk can be defined as the measurable probability of the

occurrence of profit or loss situation.

With a view to differentiate between risk and uncertainty, Knight

divided risks into:

Insurable risks

Non-insurable risks

Insurable risks

According to Knight, insurable risks are those risks which the

entrepreneur can avoid through insurance. These risks can be in theform of loss of assets due to fire, accident, theft, etc.

An entrepreneur gets cover for these losses by paying a premium to

the insurance companies and reclaiming the same in the event of

mishap. Therefore, he does not have to bear uncertainties for

insurable risks.

Non insurable risks


52/52

Non-insurable risks

These risks can be in the form of changes in people's

habits, price level fluctuations, etc. Non-insurable

risks are unpredictable and unavoidable and hence

are uncertainties.

Knight proposed that profits or losses are the

rewards an entrepreneur receives for bearing theseuncertainties.

Uncertainty arises for non-insurable risks. Non-

insurable or unpredictable risks are those riskswhich are unforeseen and for which no information

is available to estimate or forecast. Also, non-

insurable risks cannot be covered under insurance

Documents

rentwagesinterestandprofit-111101072509-phpapp02