THEORY OF

DISTRIBUTION
Unit 6

By: Rupam Jyoti Deka

 Marginal Productivity Theory of
Distribution
The oldest and most significant theory of factor pricing is the marginal
productivity theory. It is also known as Micro Theory of Factor Pricing.

What determines the prices of factors of production?

A theory which tries to answer this question and which has been fairly widely
held by professional econo­mists is known as marginal productivity theory of
distribution.
• The essence of this theory is that price of a factor of production depends upon
its marginal productivity. It also seems to be very fair and just that price of a
factor of production should get its reward according to the contribution it makes
to the total output, i.e., its marginal productivity.
• Marginal productivity theory was first put forward to explain the determination
of wages, i.e., reward for labour but later on prices of other factors of production
such as land, capital etc. also were explained with marginal productivity.

• The origin of the concept of marginal productivity can be traced to Ricardo and
West. But both Ricardo and West applied the marginal productivity doc­trine only
to land. The concept of marginal productivity is implicit in the Ricardian theory
of rent.
• But the idea of marginal productivity did not gain much popularity till the last
quarter of 19th century, when it was re-discovered by economists like J.B. Clark.
Jevons, Wicksteed, Walras and later Marshall and J.R. Hicks popularised the
doctrine of marginal productivity.
Clark’s Version of Marginal Productivity
Theory:
• J.B. Clark, an American economist who developed marginal productivity
theory of distribution in a number of articles and later on presented it
in a complete form as an explanation for “The Distribution of Wealth”.
• In order to bring out the fundamental factors at work in the mechanics
of income distribution Clark assumed a completely static society, free
from the disturbances caused by economic growth or change.
 ASSUMPTIONS

1. static society, free from the disturbances caused by economic growth

2. constant population
3. techniques of production remains the same
4. constant amount of capital
5. Perfect competition in the factor market
6. Law of variable proportions operates
7. Perfect mobility on the part of both labour and capital.
8. Labour as a homogeneous factor by taking identical labour units
• Every rational employer or entrepreneur will try to utilise his fixed amount
of capital so as to maximise his profits. For this he will hire as many labours
(labour units) as can be profitably put to work with a given amount of
capital. For an individual firm or industry, marginal productivity of labour
will decline as more and more workers are added to the fixed quantity of
capital.

• He will go on hiring more and more labour units as long as the addition
made to the total product by an extra labour unit is greater than the wage
rate he has to pay for it. The employer will reach equilibrium position when
the wage rate is just equal to the marginal product of labour, the fixed
quantity of capital.
• In the diagram, units of labour are represented on
the X-axis and the marginal product of labour on
the Y-axis. Then the MP curve shows the
diminishing marginal product of labour.
• If the prevailing wage rate which an employer must
pay is equal to OW, then it will be profitable for the
employer to go on employing additional workers
until the marginal product of labour becomes equal
to the prevailing wage rate OW.
• It will be evident from the dia, that if the prevailing
wage rate is OW, then the em­ployer will employ OL
units of labour since the marginal product of labour
is equal to OW at OL employment of labour. He
would not employ more than OL amount of labour
as the marginal product of labour falls be­low the
wage rate OW and he would there­fore be incurring
losses on the employment of additional workers
beyond OL.
• Thus, an employer would be maximising his profits by equalising the marginal
product of labour with the wage rate OW. Since perfect com­petition is assumed to
be prevailing in the labour market, an individual firm or indus­try will have got no
control over the wage rate.

• An individual firm or industry has therefore, to determine only the number of

factor units (labour in the present case) to which it has to give employment at the
prevailing wage rate.

• Since Clark has assumed a stationary state, he takes the total supply of labour
available for employment in the whole economy as given and constant. In other
words, in Clarkian analysis, aggregate supply curve of labour has been assumed to
be perfectly inelastic.

• Given the total supply of labour in the economy, the wage rate will be determined
by the marginal prod­uct of the available amount of labour as­suming that all labour
• Marginal product of labour diminishes as more
units of labour are employed in the economy,
assuming the quantities of other factors used as
unchanged. Now, if the available supply of labour
force is OL in the whole economy, the mar­ginal
product of OL quantity of labour is LE.

• The wage rate will be determined by this marginal

product LE and therefore equilibrium wage rate
which will settle down in the market will be equal
to LE or OW. At a higher wage rate O W’ the
employers will employ OL’ amount of labour
leaving LL’ amount of labour unemployed.
Unemployed workers in their attempt to get
employment will bring the wage rate down to the
level OW (=LE) at which all are employed.
• On the other hand, at a lower wage rate than OW, say OW”, the employers will
demand OL” amount of labour since at this their profits will be maximum but the
available of labour is OL. Thus, at a lower wage rate than OW the demand for labour by
the employers will be greater than the available quantity of labour. In their bid to get
more labour, competition among employers will push the wage rate up to OW at which
the employers’ demand for labour is just the same amount of labour which is actually
available.
• Thus given the quantity of labour in the country, wage rate is determined by marginal
produc­tivity of labour. One assumption which is implicit in the Clarkian marginal
productivity theory as applied to the economy as a whole is that of full employment of
labour and further that the supply curve of labour is perfectly inelastic at this full-
employment level.
• In other words, it is assumed that all the existing number of workers in the economy is
employed.
• To sum up, in Clark’s presentation, the marginal productivity of a given quantity of
available labour determines its wage rate when we consider the market as a whole.
• Thus, with a given fixed supply of labour in the market the wage rate will be
determined by the marginal product of labour.
Marshall-Hicks’ Version of Marginal Productivity Theory:

• Marshall’s version has been called by many as the marginal productivity

theory. Marshall differed with those like Clark who held that wage rate (or
for that matter, the price of any other factor) is determined by the marginal
product of labour.
• Marshall said it was wrong to regard the marginal productivity concept with
regard to wage determination as a wage theory. This is be­cause he believed
that wage rate (or any factor price) is determined by both demand for and
supply of labour. Marginal productivity concept explains only the demand
side of the problem.
• That is, given the wage rate, a rational employer will employ as many units of
labour as will equalise the wage rate with the marginal product of labour.
• At different wage rates, the employer will employ
different amounts of labour units depending
upon the corresponding amount of the value of
the marginal product.
• Thus, according to Marshall, the relationship
between the wage rate and the mar­ginal
productivity of labour provides us with the
demand curve of labour. In a complete theory for
an explanation of wage determination, the
upward-sloping supply curve of labour has also to
be introduced into the analysis.
• The wage rate at which the supply curve of labour
cuts the demand curve of labour (governed by
the marginal productivity) will be determined.
• Marshall considered marginal productivity principle as one of the two forces
that determine wages, the other force being the supply of labour.

• Marshall and Hicks believed that wages would tend to be equal to the
marginal product, but they emphasized several times that the wages are not
determined by marginal product, since like all other, marginal quanti­ties,
marginal product, together with the price (wage) is determined by the
interaction of demand and supply. Further, they considered the supply curve
of labour as upward sloping to the right.

• Marshall drew the distinction between the marginal productivity principle

which determines the demand for a factor and the marginal productivity
theory as a com­plete theory of determination of factor prices.
Clark’s V/s Marshall & Hicks Productivity
theory of distribution
• It may however be noted that in our view the difference between Clark’s
Version and Marshall- Hicks version of marginal productivity theory is not that
whereas Clark considered the demand side (i.e. marginal productivity) of a
factor and ignored the supply of labour, Marshall and Hicks consid­ered the
roles of both of them as the determinants of wage rate.

• The real difference is that while Clark considered supply curve of labour as
perfectly inelastic at full-employment level, Marshall and Hicks considered it
as upward-sloping to the right indicating as wage rate (i.e. price of the factor)
rises, its quantity supplied increases.
WAGE DETERMINATION UNDER
IMPERFECT COMPETITION
 Wage Determination under Imperfect Competition:
• In the world of reality there exists imperfect competition rather than perfect
competition. Therefore, Mrs. Joan Robinson and Prof. Pigou gave the wage
rate determination under the conditions of imperfect competition.
• There can be various forms of an imperfect market, including monopolistic
competitive market, oligopoly, and monopoly.
• Here, we will focus our discussion of wage determination in context of
monopsony. In case of monopsony, there is only one buyer of a factor of
production, which is labour in this case. This single buyer has no competitor
in the market.
• Therefore, the position of the buyer is very strong as compared to labor.
Monopsony can also take place when a single employer employs a huge labor
force for a particular job type. In this case, the employer would have a control
on setting the wages for that particular job.
• The wage rate determination can be explained under
two heads:

(a) Perfect competition in product Market and Monopsony in

the Labour market.

(b) Monopoly in the product Market and Monopsony in

Labour Market.
(a) Perfect Competition in Product Market and
Monopsony in Labour Market:
• When there is a single buyer of labour in the
market, monopsony is said to exist in the labour
market. If there is an increase in monopsonist’s
demand for labour, wage rate will follow the E
same path which in turn tends to increase the
average and marginal wage rate. It can be R

shown with the help of a diagram. P

• In Fig. units of labour have been measured on

X-axis while wages on Y-axis. ARPL=MRPL is the
average revenue product and marginal revenue
product curves. AW(ACL) and MW(MCL) are the
upward sloping average wage and marginal
wage curves indicating that if the monopsonist
wishes to employ more and more labourers, he
has to offer the higher wage rate.
• The monopsonist firm is in equilibrium at point E. At point E both the
conditions of equilibrium are fulfilled i.e. marginal wage should be equal
to marginal revenue product and the marginal revenue product curve
must cut the marginal wage curve from above and then lies below it.
Thus, at this equilibrium level, he will employ OX units of labour and OP
wage rate will be determined.

• Since wages are less than marginal revenue productivity, means that the
monopolist exploits the labour. Thus, in this equilibrium the monopsonist
earns the supernormal profits equal to the area W 2EPW3 . Therefore, it
can be concluded that imperfect competition in the labour market results
in the exploitation of labour.
 (b) Monopoly in Product Market Monopsony
in Labour Market:
• When there exists monopoly in product market
and monopsony in labour market then there is
difference between marginal revenue product
and value of marginal product. Value of
marginal product refers to the product of MPP
and the price of the commodity. It can be
explained with the help of a figure.
• In Fig. MRP is the marginal revenue product
curve and VMP is the value of marginal product
curve. The VMP curve is above the MRP curve.
The monopsonist is in equilibrium at point E.
The monopsonist employs ON units of labour
and wage rate OW is determined in the market.
• Monopoly in the product market and monopsony in the
factor market leads to the double exploitation of labour, i.e.,
monopolistic exploitation and monopsonistic exploitation. At
this equilibrium level monopolistic exploitation is EK while
the monopsonistic exploitation is equal to FK.
ROLE OF TRADE UNIONS,
COLLECTIVE BARGAINING IN WAGE
DETERMINATION
TRADE UNION, COLLECTIVE
BARGAINING & WAGE
The primary goal of trade unions is to maintain and improve workers’ terms and
conditions, particularly workers who are members of the union, through
collective bargaining with employers.

• Trade union gets existence under monopolistic competition. The trade union
bargains with the employer on the issue of wage rate.
• Generally, trade unions negotiate wages to be given to labor with employers.
• This process of negotiating wages is called collective bargaining.
 Marginal Productivity Theory of Wages
• According to this theory, mar­ginal revenue
productivity (MRP) curve is the employers’
demand curve. Consider Fig. where MRP is the
marginal revenue productivity curve of labour. If
ON is the available supply of labour, OW is the
equilibrium wage rate. Now, if the wage rate is
increased to OW’ by the collec­tive bargaining of
trade unions, N’N amount of workers would be
rendered unemployed.
• If these unemployed workers are free to compete, they would press down the
wage back to OW. If these NN’ workers are, for one reason or the other, not free
to compete, they will continue to remain unemployed. It is thus clear that, even
according to marginal productivity theory, trade unions are unable to raise
wages without creating unemployment.

• Though the marginal productivity approach to the wage fixation was maintained;
it was however extended to the conditions of imperfect competition wherein
scope for trade unions and collective bargaining in raising wages was shown.

• Moreover, there has been the emergence of two kinds of theories known as
institutional and psychological theories of wage determination under trade
unions. These theories do not try to reconcile the marginal productivity
Approach with the role of collective bargaining in the context of imperfect
competition, but instead assign an eminent role to trade unions and collective
bargaining in the wage determination
Bargaining Approach to Wages and Trade
Unions:
• Bargaining approach to wages was developed which indicated a scope
for collective bargaining within the framework of marginal pro­
ductivity theory. Trade union gets existence under monopolistic
competition. The trade union bargains with the employer on the issue
of wage rate.
• Generally, trade unions negotiate wages to be given to labor with
employers.
• This process of negotiating wages is called collective bargaining.
Determination of wage rate with the help of
the collective bargaining process:

• In Figure, ARP represents the average net

revenue productivity curve and MRP
represents marginal net revenue productivity
curve.

• IC1, IC2, IC3, IC4, and IC5 show indifference

curves at different wage rates with respect to
the satisfaction of trade unions. It can be seen
from Figure that an increase in the wage rate
would result in the increase of satisfaction
level of trade unions.
• In this case, trade union would prefer the wage rate at point P where
indifference curve is tangent to ARP. At point P, the wage rate is OW4 and
number of labor is OM. In case the wage rates goes up from OW4, then the
employer would suffer losses and he/she needs to close his/her unit.

• Therefore, it is not beneficial for the employer as well as for the union. This
makes OW4 an upper limit for deciding on the wage rate. According to
classical economists, the wage rate can be determined by market forces only
and there is no contribution of trade unions in the increase of wages. If the
trade unions try to increase the wage rate, the employers need to reduce the
number of workers.
 Rise in Wage Rate and Labour Efficiency:
• To begin with, static assumptions of marginal pro­ductivity theory have been
dropped. It is accepted that marginal productivity curve is employer’s de­mand
curve and that, given the marginal produc­tivity curve, the increase in the
wage rate by trade union power will lead to the creation of unemploy­ment.
• But it is pointed out that when the wage increase is achieved through a
successful bargain­ing, the marginal productivity curve may not re­main the
same but may shift above due to the rise in efficiency of workers brought
about by the higher wage.
• When the efficiency and therefore the
marginal productivity curve rises due to the
increase in wages of the workers the
unemployment may not be created as a result
of the increase in the wage rate secured by the
trade union.
• This is shown in Fig. 33.16. Initially the
marginal productivity curve is MRP and the
equilibrium wage is OW and employment is
ON. Now suppose the wage is raised to OW’ by
the successful collective bargaining of the
trade union. If the marginal productivity curve
MRP remains unchanged, then at OW’ wage
rate, CW’ men will be employed, which means
that AW’ number of men will be rendered
unemployed.
 Raising of Wages by Trade Unions

• According to the Marginal Productivity

Theory of Wages with its assumptions of
perfect com­petition and the given supply of
labour, trade unions cannot succeed in raising
wages or can­not succeed in raising wages
without creating unemployment.
• But if the rise in wage brings about a sufficient increase in efficiency and
productivity so that the marginal productivity curve shifts upward to the
dotted position, then unemployment will not be created. It will be seen from
the Fig. 33.16 that with the marginal revenue productivity curve MRP’, ON
men are employed at the higher wage rate OW’.
• We thus see that if we consider the effect of the wage bargain on the
increase in efficiency or marginal productivity, then the trade unions can
succeed in raising wages without creating unem­ployment.
• Again, the increase in wages may force the employers to improve the
efficiency of produc­tion process in which case also the marginal productivity
curve shifts upward and as a result at the increased wage rate the same men
may be employed.
Role of Trade Unions in Raising Wages
under Monopsony:
• It is evident from above that under perfect competition and in the
framework of the marginal productivity theory conceived in dynamic
terms, there is a good room for collective bargaining to raise wages.
• The monopsonist, working on the marginal produc­tivity principle
equates marginal revenue product of labour with the marginal wage
to be in equilibrium labour.
• In such a situation wage rate (i.e., average wage) determined is less
than the marginal revenue productivity.
• It will be seen from Fig. that, under
monopsony, wage rate OW and
employment ON is determined. Under such
circumstances if workers organise
themselves into trade unions, they can
achieve increase in the wage rate without
creating unemployment, indeed the
employment will increase for some
increases in the wage rate.
• When the trade unions come into existence, the supply of labour is channelled
through it and the bargaining with the employer is on the basis of ‘all or
nothing’ at a particular wage rate de­manded, that is, no supply of labour will be
offered below the demanded and/or mutually agreed wage rate and the whole
sup­ply of labour will be offered at the mutually agreed wage.
• This means, in other words, that the supply curve of labour under trade union
becomes perfectly elastic at the demanded or mutually agreed wage rate.
• It is seen from Fig that if the trade union succeed in getting higher wage rate
OW, the supply curve of labour becomes horizontal or perfectly elas­tic shape at
the agreed wage level OW’ the new supply curve of labour will coin­cide with
the marginal factor cost curve.
• It is seen that, given the wage rate equal to OW and the labour supply curve W’
F, the employer’s equilibrium will be at point F, at which employment ON’,
which is greater than ON, will be offered by the employer.
• It should be carefully noted that a powerful trade union can raise the wage
rate even up to OW” that is equal to the marginal value product NE at the
original level of employment ON. When the wage rate OW’ is fixed under
collective bargaining and as a consequence the supply curve of labour or
marginal factor cost curve W”E becomes perfectly elastic at the level OW”,
the employer’s equilibrium will be at ON, the original level of employment.
• Thus, under conditions of monopsony, a strong trade union can raise the
wage rate to the level of value of marginal product NE without the fear of
creating unemployment. In the absence of trade union, the monopsonist
would exploit the workers to the extent of LE or WW”.
• It is, therefore, clear that the workers by organising themselves into trade
unions and thereby collectively bargaining with the employer, can raise the
wage rate to remove monopsonistic exploitation by the monopsonist.
MODERN THEORY OF RENT
 Modern Theory of Rent

• Modern theory of rent does not confine itself to the reward of only land as a
factor of production.
• Rent in modern sense can arise in respect of any factor of production, and
not merely land. Rent is a surplus. In the sense of surplus, rent is a payment
in excess of transfer earnings.
• Transfer earnings mean the amount of money which any particular unit could
earn in its next best alternative use. Suppose a piece of land under cotton is
yielding Rs. 150 and its next best use wheat fetches Rs. 100. The transfer
earnings are Rs. 100 and, therefore, in its present use it is giving a surplus of
Rs. 50.
• We can also define transfer earnings as the minimum sum which must be paid for
a unit of a factor of production in order to induce it to stay in its present use or
employment. In the above example, a sum of Rs. 100 at least must be paid for the
land under cotton in order to retain it under cotton; otherwise it will shift to
wheat, which is its next best alternative use where it can fetch Rs. 100.

• Actually, this piece of land is earning Rs. 150, i.e., Rs. 50 extra or in excess of its
transfer earnings. This is economic rent. Economic rent in this sense is thus the
difference between the present earnings and the transfer earnings.

• This concept of rent is applicable not merely to land but also to all factors of
production i.e. labour, capital and entrepreneur’s earnings too. They can all earn
economic rent in the sense that the modern economists use the term ‘rent’.
How Rent arises:

• Rent in the sense of surplus arises when the supply of land, or for that
matter that any other factor service, is less than perfectly elastic.
• According to modern theory, economic rent is a surplus which is not peculiar
to land alone. It can be a part of income of labour, capital, entrepreneur.

• According to modern version rent is a surplus which arises due to difference

between actual earning and transfer earning.

Rent = Actual Earning - Transfer Earning.

• The major features of the modern theory of rent are as under:

1. Rent can be a part of the income of all factors of production.

2. Amount of rent depends upon the difference between actual earning and
transfer earning.
3. Rent arises when supply of the factor is either perfectly inelastic or less
elastic.
DETERMINATION OF RENT OF LAND OR SCARCITY THEORY OF RENT:
• Modern economists opined that rent arises due to scarcity of land. Scarcity of
land means that demand for land exceeds its supply. Rent will be determined
at a point where demand for land is equal to its supply.
• Demand for Land:
• Land has derived demand. It means that demand for land depends on the
demand for agricultural products. If demand for food grains increases,
demands for land will also increase and vice-versa. Moreover, demand for
land is influenced by its marginal productivity. It means as more and more
land is used its MP1 goes on diminishing.
• Supply of Land:
• Supply of land is fixed. Its supply is perfectly inelastic. It means, increase in
the price of land will not evoke any increase in its supply.
• In the dia, units of land have been measured on X-
axis and rent on Y-axis. SS is the supply curve of
land which is parallel to Y-axis indicating that the
supply of land remains fixed. Rent will be
determined at a point where the demand and
supply of land are equal to each other.
• Initially DD is the demand curve which intersects
the supply curve at point E. At this point,
equilibrium rent OR is determined. Now, if the
population rises which gives boost to the demand
for food, the demand curve shifts to D’D’ and the
equilibrium will be at point E’ and the rent will rise
to the extent of OR’.
• Similarly, if the demand curve shifts to D” D” and
the new equilibrium point will be E” and the rent
will fall to OR”.
Rent as the Difference between Actual Earnings and Transfer Earnings:
• According to modern economists rent is the difference between actual
earning and transfer earning. Rent can be a part of income of factors of
production. But, these factors will earn rent only when their supply is less
than perfectly elastic.

• Thus, from elasticity point of view, there are three possibilities, i.e.:
• 1. Supply of factors of production is perfectly elastic.
• 2. Supply of factors of production is perfectly inelastic.
• 3. Supply of factors of production is less than perfectly elastic.
 (i) When Supply is Perfectly Elastic:

• When change in demand at existing rate is followed by corresponding

change in supply, then the supply is said to be perfectly elastic i.e. such a
factor is not scarce. At the existing rate, any amount of that factor is
available. Therefore, its actual earning and transfer earning will be equal.

Actual Earning – Transfer Earning = Zero

• In Fig 6 the supply curve of the factor of production is
represented by SS which is horizontal straight line. It
means all factors are available at price OS. DD is the
demand curve.
• The demand and supply curves intersect each other at
point E. ON is the quantity of the factor used and price is
OS. The total earnings are OSEN.
• Since, transfer earnings are equal to actual earnings i.e.
OSEN, there is no surplus and, thus, no rent. If this firm
does not pay the price, the factor units will be shifted to
other uses and earn there as much, because present
earnings equates the transfer earnings. In this way, we
may conclude that if the supply is perfectly elastic, then
there exists no surplus and hence no economic rent.
(ii) When the Supply is Inelastic:

• Inelastic supply of a factor indicates that any increase or decrease in demand

is not followed by the supply. In such a case, transfer earnings will be zero
and the difference between actual earning and transfer earning will be equal
to actual earning. Therefore, all the actual earnings will be called rent.

• Rent = Actual Earning (Since Transfer Earning is zero)

• In Figure 7, SS is perfectly inelastic supply curve of
land which indicates that if price of land falls to zero
even then supply remains OS. It means the transfer
earnings of land are zero.

• DD is the demand curve. As both the demand and

supply curves intersect each other at point E, price
OP is determined. Since transfer earnings are zero,
the total earnings (OSEP) represent the economic
rent.
(iii) When the Supply is less than elastic:
Less than perfectly elastic supply means that the transfer earnings of all the factor units
are not equal. Mrs. Joan Robinson used the concept of ‘Transfer Earnings’ to explain the
amount of rent earned by a factor unit in a particular use. She defines transfer earnings
as the price which is necessary to retain a given unit of a factor in a certain industry.

• This can be shown with the help of the following table:

• From the figure, on o x and on o y-axes,
Quantity of Land and price of factor are
measured respectively. Where SS curve is
positively sloped means not perfectly elastic. SS
curve indication what quantity of the factor will
be available at various prices. In other words, It
shows the transfer earnings of different factor
units. Thus, transfer earning of 4th unit of
factor is AA’ where as the price is OP. In other
words AA’ amount must be paid to the 4th unit
of Land to keep the factor in the same industry.
So, this price (AA’) is the minimum price. Hence,
surplus or rent unit factor of Land is EA’. It is
assumed that all factor units are equally useful
for the industry.
• Hence, the price of all factor units in the industry will be same for the B th unit of
factor. Transfer earning of Bth unit is BB’ and the price is OP hence surplus is FB’. In
the same manner economic rent or surplus of other units can be calculated except
Dth unit of Land, all other previous factors are earning economic rent differently
according to their transfer earnings.
• From the figure, at point N, DD & supply curve intersects and OD is the equilibrium
quantity o y the factor used and the equilibrium price is all factors are OPND where
as the transfer earnings are O S N D. If we deduct the transfer earnings, we get
PNS; dotted area is called economic rent.
• From the above figure, one theory is obvious that the units of Land having larger
earnings in other uses need to be paid higher prices to attract them to the present
industry or occupation and those with smaller earnings in the other uses need to be
paid relatively smaller prices to attract them into the present industry or occupation.
In this way, modern theory is also called Demand and supply theory of Rent.
Liquidity preference theory of interest
 Liquidity preference theory of interest
• The Liquidity Preference Theory was propounded by the Late Lord J. M.
Keynes.
• According to this theory, the rate of interest is the payment for parting with
liquidity.
• Liquidity refers to the convenience of holding cash. Everyone in this world
likes to have money with him for a number of purposes. This constitutes his
demand for money to hold.
• The sum-total of all individual demands forms the demand for money for
the economy. On the other hand, we have got a supply of money consisting
of coins plus bank notes plus demand deposits with banks. The demand and
supply of money, between themselves, determine the rate of interest.
• According to Keynes, the rate of interest is determined by the demand for
and supply of money.

DEMAND FOR MONEY:

Liquidity preference means the desire of the public to hold cash.
According to Keynes, there are three motives behind the desire of the public
to hold liquid cash:

• (1) the transaction motive,

• (2) the precautionary motive, and
• (3) the speculative motive.
(1) Transactions Motive: The transactions motive relates to the demand for
money or the need of cash for the current transactions of individual and
business exchanges.

Individuals hold cash in order to bridge the gap between the receipt of
income and its expenditure. This is called the income motive.

The businessmen also need to hold ready cash in order to meet their current
needs like payments for raw materials, transport, wages etc. This is called the
business motive.
(2) Precautionary motive: Precautionary motive for holding money refers to the
desire to hold cash balances for unforeseen contingencies. Individuals hold some cash
to provide for illness, accidents, unemployment and other unforeseen contingencies.
Similarly, businessmen keep cash in reserve to tide over unfavourable conditions or to
gain from unexpected deals.

• Keynes holds that the transaction and precautionary motives are relatively interest
inelastic, but are highly income elastic.

• The amount of money held under these two motives (M1) is a function (L1) of the
level of income (Y) and is expressed as

M1 = L1 (Y)
(3) Speculative Motive: The speculative motive relates to the desire to hold one’s
resources in liquid form to take advantage of future changes in the rate of interest or bond
prices. Bond prices and the rate of interest are inversely related to each other. If bond
prices are expected to rise, i.e., the rate of interest is expected to fall, people will buy
bonds to sell when the price later actually rises. If, however, bond prices are expected to
fall, i.e., the rate of interest is expected to rise, people will sell bonds to avoid losses.

• According to Keynes, the higher the rate of interest, the lower the speculative demand
for money, and lower the rate of interest, the higher the speculative demand for money.
Algebraically, Keynes expressed the speculative demand for money as:

M2 = L2 (r)
• Where, L2 is the speculative demand for money, and
• r is the rate of interest.
• Geometrically, it is a smooth curve which slopes downward from left to right.
• Now, if the total liquid money is denoted by M, the transactions plus
precautionary motives by M1 and the speculative motive by M2, then

M = M1 + M2.
Since M1 = L1 (Y) and M2 = L2 (r),
the total liquidity preference function is expressed as M = L (Y, r).

SUPPLY OF MONEY:
The supply of money refers to the total quantity of money in the country.
Though the supply of money is a function of the rate of interest to a certain
degree, yet it is considered to be fixed by the monetary authorities. Hence the
supply curve of money is taken as perfectly inelastic represented by a vertical
straight line.
 DETERMINATION OF THE RATE OF INTEREST:

• Like the price of any product, the rate of interest is determined at the level
where the demand for money equals the supply of money. In the following
figure, the vertical line QM represents the supply of money and L the total
demand for money curve. Both the curve intersect at E2 where the equilibrium
rate of interest OR is established.
• If there is any deviation from this equilibrium position
an adjustment will take place through the rate of
interest, and equilibrium Eii will be re-established.
• At the point E1 the supply of money OM is greater than
the demand for money OM1. Consequently, the rate of
interest will start declining from OR1 till the equilibrium
rate of interest OR is reached. Similarly at OR2 level of
interest rate, the demand for money OM2 is greater
than the supply of money OM. As a result, the rate of
interest OR2 will start rising till it reaches the
equilibrium rate OR.
• It may be noted that, if the supply of money is
increased by the monetary authorities, but the
liquidity preference curve L remains the same, the rate
of interest will fall. If the demand for money increases
and the liquidity preference curve sifts upward, given
THEORIES OF PROFIT
 Clark’s Dynamic Theory of Profit
• Definition: Clark’s Dynamic Theory of Profit was propounded by J.B.
Clark, who believed that profits arise in the dynamic economy and not in
the static economy.

• The static economy is one in which the things do not change

significantly or remains unchanged. Such as, the population and capital
remain stationary, goods continue to be homogeneous, production
process remains unchanged, and the factors of production enjoy freedom
but does not move because the marginal product in each industry remains
the same. Also, there is no uncertainty and risk.
On the other hand, a dynamic economy is characterized by the following generic
changes.

These five changes are:

• (1) The changes in the quantity and quality of human wants,
• (2) Changes in methods or techniques of production,
• (3) Changes in the amount of capital
• (4) Changes in the forms of business organization, and
• (5) The growth of population.

These changes are constantly taking place and bring about the divergence between
price and cost and thereby give rise to profits, positive or negative. If the demand
for a commodity increases due to the increase in population or increase in the
incomes of the people or due to the increase in consumers’ preferences for the
commodity, the price of the commodity will rise, and if cost remains the same,
• On the other hand, cost of production may go down as a result of the
adoption of a new technique of production, or as a result of cheapening of the
raw material, and if price remains constant or does not fall to the same extent,
the profits would emerge. Apart from the five changes mentioned by Clark,
there are other changes also which occur in the economy.

All the changes which take place and as a result of which profits arise in a
dynamic economy may be classified into two types:

(1) Innovations and

(2) External changes
1. Innovations:
• The entrepreneur earns large profits from introducing innovations such as a
new product, a new and cheaper method of production, a new method of
marketing the product, a new way of advertisement. The innovational changes
may either reduce cost or increase the demand for the product and thereby
bring profits into existence.

• Those entrepreneurs who introduce successful innovations earn large profits.

But as the innovation gets known to other entrepreneurs and they also adopt
similar other innovations, profits which arise because of a particular
innovation tend to disappear. But new innovations are being continuously
introduced by the entrepreneurs and profits continue to arise out of them.
2. External Changes:

• External changes refer to those changes which are external to the firms or
industries in an economy. These changes affect all firms in an industry or
sometimes all industries in the economy.
• Examples of external changes are breaking out of wars, occurrence of sometimes
periods of inflation and rising prices and sometimes business depression and
falling prices, changes in the monetary and fiscal policies of government affecting
favourably or unfavourably, changes in the technology of production, changes in
tastes and preferences of the consumers, changes in income and spending habits
of the people, changes in the availability of substitute products, alter­ation in the
legislative and legal environment affecting the industries, and changes in
preference between income and leisure. All these changes affect either the cost
or demand for the products and give rise to profits, positive or negative as the
case may be.
• For instance, during wars when prices of goods mount up, and costs lag
behind, the entrepreneurs make a lot of profits. Similarly, when inflation
occurs due to the increased demand for goods caused by the rising incomes,
increasing population and expansion in the money supply, huge profits
accrue to the firms.

• On the contrary, when period of depression comes due to the fall in effective
aggregate demand, firms suffer huge losses and some may go into
liquidation. During periods of depression all prices, rents, wages and interest
tend to fall but because of the non-contractual nature, profits fall sharply and
may even become negative.
Schumpeter’s Innovations Theory of Profits
• The Innovation Theory of Profit was proposed by Joseph. A. Schumpeter, who
believed that an entrepreneur can earn economic profits by
introducing successful innovations.
• Successful innovations as important dynamic changes and as source of profit
have been. But since innovations have been singled out as a very important
factor responsible for the occurrence of profits to the entrepreneurs it requires
to be dealt with separately.
• It has been held by Joseph Schumpeter that the main function of the
entrepreneur is to introduce innovations in the economy and profits are reward
for his performing this function.
• Now, what is innovation? Innovation, as used by Schumpeter, has a very wide
connotation. Any new measure or policy adopted by an entrepreneur to reduce
his cost of production or to increase the demand for his product is an
innovation.
Thus innovations can be divided into two categories:

(1) First types of innovations are those which reduce cost of production, or in
other words, which change the production functions. In this first type of
innovations are included the introduction of a new machinery, new and
cheaper technique or process of production, utilization of a new source of
raw material, a new and better method of organizing the firm, etc.

(2) Second types of innovations are those which increase the demand for the
product, or in other words, which change the demand or utility function. In
this category are included the introduction of a new product, a new variety
or design of the product, a new and superior method of advertisement,
discovery of new markets etc.
• If an innovation proves successful, that is, if it achieves its aim of either
reducing the cost of produc­tion or enhancing the demand for a product, it
will give rise to profit. Profits emerge because due to successful innovations
either cost falls below the prevailing price of the product or the
entrepreneur is able to sell more and at a better price than before.

• It should be noted that profits accrue not to him who conceives innovation,
nor to him who finances it but to him who introduces it. Further, when­ever
any new innovation is to be introduced, it always calls for a new combination
of factors or reallocation of resources.
• When an entrepreneur introduces a new innovation, he is first in a
monopoly position, for the new innovation is confined to him only. He
therefore makes large profits. When after some time others also adopt it
in order to get a share, profits will disappear. If the law allows and the
entrepreneur is able to get his new innovation e.g., new product patented,
then he will continue to earn profits.

• But in a competitive economy and without patent laws, the existing

competitors or the new firms will soon adopt any successful innovation
and profits would be eliminated. But in a competitive and progressive
economy the entrepreneurs always continue to introduce new innovations
and thus profits continue emerging out of them.
 Knight’s Uncertainity Theory of Profit
• Definition: The Knight’s Theory of Profit was proposed by Frank. H. Knight,
who believed profit as a reward for uncertainty-bearing, not to risk bearing.
Simply, profit is the residual return to the entrepreneur for bearing the
uncertainty in business.

• According to professor Knight, profit is the reward for uncertainly-bearing

and not of risk-taking in a business. According to him there are two kinds of
risk which entrepreneur has to bear.

(1) 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 entrepneur to a profit.

(2) On the other hand, there are some risks which are unpredictable and
unforeseen and so they are non-insurable.
• For instance, if the demand for the product of at entrepneur suddenly comes
down due to changes in fashions, tastes, etc. then he may not be able to
cannot be statistically measured are called by Knight, as uncertainly-bearing
risks.

• Profits, according to him are the reward of uncertainty-bearing rather than

risk-taking which is insurable.