Theory of Factor Pricing
- Factor pricing deals with the determination of prices for the four factors of production — land (rent), labour (wages), capital (interest), and entrepreneurship (profit). This unit covers the concept and types of rent including the modern theory
- wages and the marginal productivity theory
- interest and the loanable funds and liquidity preference theories
- profit including the dynamic and innovation theories.
In this chapter
Introduction to Factor Pricing
Factor pricing deals with the theory of factor price determination. There are four factors of production — land, labour, capital, and organisation — each earning a reward: rent, wages, interest, and profit respectively. Economists have developed various theories for the determination of each factor's price, collectively called theories of factor pricing.
Rent
Rent is the payment made to the landlord by a tenant for the use of land — the gift of nature. There are two types: Contract rent is the total payment a tenant makes to the landlord (commercial rent, including economic rent, service charges, depreciation, and profit). Economic rent is the payment made only for the use of land — the pure rent. In the classical view (Ricardo), economic rent is the amount paid for the use of the 'original and indestructible powers of the soil'.
Contract rent decomposition
Modern Theory of Rent
The modern theory of rent (Marshall, Joan Robinson, Boulding) is based on the concept of transfer earnings — the minimum payment required to keep a factor in its present use. Economic rent is the surplus earned above transfer earnings: Rent = Actual Earning − Transfer Earning. Transfer earning is what the factor could earn in its next-best alternative use. The amount of rent depends on the elasticity of supply of the factor.
Modern theory of rent
Rent and Elasticity of Factor Supply
| Supply Elasticity | Transfer Earning vs Actual | Economic Rent |
|---|---|---|
| Perfectly elastic (E_s = ∞) | Transfer = Actual | Zero (no rent) |
| Perfectly inelastic (E_s = 0) | Transfer = 0 | Entire earning is rent |
| Less than perfectly elastic | Transfer < Actual | Part of earning is rent |
Wages
Wages are the reward for labour — the payment for human physical and mental effort. Nominal wage (money wage) is the amount of money received. Real wage is the purchasing power of that money — what it can actually buy, considering the cost of living. The marginal productivity theory of wages states that under perfect competition, a firm hires labour up to the point where the wage equals the marginal revenue product (MRP) of labour: W = MRP_L = P × MP_L. A profit-maximising firm will not pay a worker more than the additional revenue the worker generates.
Wage equals marginal revenue product of labour
Collective Bargaining and Minimum Wages
In reality, wages are often set above the market-equilibrium level through collective bargaining (trade unions negotiating with employers) or government-imposed minimum wages. While this benefits employed workers, it may create unemployment if the wage is set above the equilibrium. The effect depends on the elasticity of labour demand.
Interest
Interest is the reward for capital — the price paid for the use of capital, usually expressed as a percentage per annum. The loanable funds theory (neo-classical, developed by Wicksell, Ohlin, Robertson) states that the interest rate is determined by the demand for and supply of loanable funds. Demand comes from investors (firms borrowing to invest); supply comes from savings, dishoarding, and bank credit. The liquidity preference theory (Keynes) states that interest is the reward for parting with liquidity — the rate is determined by the demand for money (liquidity preference, with three motives: transactions, precautionary, and speculative) and the supply of money.
Interest determination — loanable funds and liquidity preference
Keynes's Three Motives for Liquidity Preference
- Transactions motive — holding money to meet day-to-day payments (proportional to income).
- Precautionary motive — holding money for unforeseen emergencies (also proportional to income).
- Speculative motive — holding money to take advantage of future changes in interest rates and bond prices (inversely related to the interest rate).
Profit
Profit is the reward for entrepreneurship — the residual income left after paying all other factors (rent, wages, interest). It is the most uncertain and variable of all factor incomes. Business profit (accounting profit) = Total Revenue − Explicit Costs. Economic profit = Total Revenue − (Explicit + Implicit Costs) = Total Revenue − Economic Costs. Economic profit is always less than or equal to business profit because it includes implicit costs (opportunity costs).
Business profit vs economic profit
Theories of Profit
Major Theories
- Dynamic theory (Clark) — profit arises from dynamic changes in the economy: population growth, technology, consumer preferences, and capital accumulation. In a static economy, there is no profit (only wages, rent, interest).
- Innovation theory (Schumpeter) — profit is the reward for innovation — introducing a new product, method, market, source of supply, or new organisation. Profits are temporary — they disappear once competitors imitate the innovation.
- Risk-bearing theory (Hawley) — profit is the reward for bearing the risks of business. Higher risk justifies higher expected profit.
- Uncertainty-bearing theory (Knight) — profit arises from non-insurable uncertainty (not from measurable risk, which can be insured).
Why Profit is Different
Unlike rent, wages, and interest — which are contractual and known in advance — profit is residual and uncertain. The entrepreneur bears the risk of loss in exchange for the chance of profit. This is why profit can be negative (loss) while other factor incomes cannot.
Practice Problem
A firm employs 10 workers at a wage of Rs 500/day. The average product of labour is 50 units and the price of output is Rs 20. (a) Calculate the total revenue, total wage bill, and the marginal revenue product of the 10th worker (assuming MP of the 10th worker = 30 units). (b) Should the firm hire more workers, fewer workers, or stay at 10? Justify using the marginal productivity theory.
Ricardian Theory of Rent
- David Ricardo (1817) developed the classical theory of rent. According to Ricardo, rent is the payment for the original and indestructible powers of the soil. It arises not because land is productive but because land is scarce and differs in fertility and location. Rent arises due to: (1) scarcity of land — the supply of land is perfectly inelastic
- (2) differences in fertility — better land produces more at lower cost
- (3) diminishing returns — as population grows, poorer land must be cultivated. The marginal land (no-rent land) is the least productive land in use. Better land earns rent equal to the cost advantage over marginal land. As population grows and demand for food rises, even poorer land is brought under cultivation, and rent on all previously used land rises.
Ricardian Rent: Differences in Fertility
| Grade of Land | Cost of Production (Rs/qt) | Price (Rs/qt) | Rent (Rs/qt) |
|---|---|---|---|
| A (Best) | 800 | 1,200 | 400 |
| B (Medium) | 1,000 | 1,200 | 200 |
| C (Marginal) | 1,200 | 1,200 | 0 (no rent) |
Keynesian Liquidity Preference: Three Motives
- Transactions motive — people hold money to make day-to-day purchases. The demand is proportional to income: L1 = kY. As income rises, transactions rise, so more money is needed
- Precautionary motive — people hold money to cover unforeseen emergencies (illness, accidents). Also proportional to income: L2 = k2Y
- Speculative motive — people hold money to take advantage of future changes in interest rates and bond prices. When interest rates are expected to fall (bond prices to rise), people hold bonds; when rates are expected to rise (bond prices to fall), people hold money. This is inversely related to the interest rate: L3 = −hr. Total demand: L = L1 + L2 + L3 = kY − hr
Real-Life Example: Nepal's Factor Markets
In Nepal, factor prices vary dramatically by geography. Land rent in Kathmandu Valley (prime location, high demand) is far higher than in remote Humla (marginal land, low demand) — a clear illustration of Ricardian rent. Wages differ by sector: a garment factory worker in Kathmandu earns ~Rs 15,000/month, a construction worker in Gulf ~Rs 30,000/month, and a software developer ~Rs 50,000+/month. Interest rates charged by informal moneylenders in villages (36–60% per year) are far higher than commercial bank rates (10–15%), reflecting risk and limited competition. Profit varies: a tea shop owner in a busy area earns more than one in a quiet street.
Memory Aid: Factor Rewards
Remember the four factors and their rewards with this mnemonic: LLCE → RWIP — Land → Rent, Labour → Wages, Capital → Interest, Entrepreneurship → Profit. In Nepali: भूमि→भाडा, श्रम→ज्याला, पुँजी→ब्याज, उद्यमशीलता→नाफा।
Key Terms and Definitions
- Rent: Payment for the use of land (gift of nature) — भाडा: भूमि (प्रकृतिको उपहार) को प्रयोगका लागि भुक्तानी।
- Contract rent: Total payment by tenant (includes economic rent + charges) — सम्झौता भाडा: प्रयोगकर्ताको कुल भुक्तानी।
- Economic rent: Payment for land only (pure rent) — आर्थिक भाडा: केवल भूमिको लागि भुक्तानी (शुद्ध भाडा)।
- Transfer earning: Minimum payment to keep a factor in present use — स्थानान्तरण आय: कारकलाई वर्तमान प्रयोगमा राख्न न्यूनतम भुक्तानी।
- Wages: Reward for labour — ज्याला: श्रमको प्रतिफल।
- Real wage: Purchasing power of money wage — वास्तविक ज्याला: मुद्रा ज्यालाको क्रय शक्ति।
- MRP: Marginal Revenue Product = P × MP — सीमान्त आय उत्पादन।
- Interest: Reward for capital — ब्याज: पुँजीको प्रतिफल।
- Liquidity preference: Keynes's demand for money (3 motives) — तरलता प्राथमिकता: किन्सको मुद्रा माग (३ उद्देश्य)।
- Profit: Reward for entrepreneurship (residual income) — नाफा: उद्यमशीलताको प्रतिफल (अवशिष्ट आय)।
- Innovation theory (Schumpeter): Profit = reward for innovation — नवप्रवर्तन सिद्धान्त: नाफा = नवप्रवर्तनको प्रतिफल।
- Dynamic theory (Clark): Profit arises from dynamic changes — गतिशील सिद्धान्त: नाफा गतिशील परिवर्तनबाट उत्पन्न।
Practice Problem
A factor of production earns Rs 10,000 per month in its present occupation. Its next best alternative occupation pays Rs 6,000 per month. (a) Calculate the transfer earning and economic rent. (b) If the supply of this factor is perfectly inelastic, what would be the economic rent? (c) If the supply is perfectly elastic, what would be the economic rent?