Price Determination of Factors of Production

The Four Factors and Their Rewards

• Production uses four factors — land, labour, capital, and entrepreneurship. Each factor is paid a specific reward (price) for its service: land earns rent, labour earns wages, capital earns interest, and entrepreneurship earns profit. The determination of these four rewards is called factor pricing. In Nepal: a farmer in Terai pays rent to use land
• a tea shop worker in Patan receives a wage
• a bank charges interest on a loan to a Kathmandu factory
• the owner of the tea shop keeps the profit (or bears the loss) for organising the business and taking risk.

Rent: Classical and Modern View

• Rent is the reward paid to land for its use. The classical view (Ricardo) says rent is the payment for the original and indestructible powers of the soil — fertility of land and climate. The modern view says rent is the surplus earned by a factor over its opportunity cost (transfer earning). For example, in Morang a farmer earns Rs 5,000/katha from paddy
• if the next best use (sugarcane) gives Rs 3,000, the economic rent = 5,000 − 3,000 = Rs 2,000. Contract rent is the agreed amount written in the contract
• economic rent is the surplus above opportunity cost.

Ricardian Theory of Rent (David Ricardo, 1817): Ricardo explained rent as arising from differences in the fertility of land. As population grows, society cultivates the most fertile land first (Grade A), then less fertile (Grade B), then even poorer (Grade C). Grade A produces the most, Grade C the least. Marginal land (the poorest land just brought under cultivation) earns no rent — its output just covers cost. The extra output of better land over marginal land is the rent. So rent is price-determined, not price-determining — the price of wheat is set by the cost of production on marginal (no-rent) land, and better land earns rent because it costs the same to cultivate but produces more.

Wages: Money Wage vs Real Wage

Wage is the reward for labour. Money wage (nominal wage) is the amount of money received (e.g. Rs 15,000/month — the legal minimum wage in Nepal since Shrawan 2079). Real wage is the purchasing power of that money — the quantity of goods and services it can buy. If money wage rises by 10% but prices rise by 12%, real wage has actually fallen. Nepal's minimum wage of Rs 15,000/month (basic Rs 8,500 + dearness allowance Rs 6,500) applies to all formal-sector workers; but many informal-sector workers still earn less.

1. Subsistence Theory (Iron Law of Wages, by Lassalle): wages tend to settle at the minimum level needed for workers to survive and raise a family. If wages rise above subsistence, workers have more children, labour supply rises, and wages fall back. If wages fall below, workers die, labour supply falls, and wages rise. Like an "iron law" it always pushes wages back to subsistence.
2. Wage Fund Theory (by J.S. Mill):** the wage fund is the amount employers have set aside to pay workers; wage rate = wage fund ÷ number of workers. To raise wages, either increase the wage fund (through more saving and investment) or reduce the number of workers

Interest: Classical Theory. Interest is the reward for capital — the price paid for using someone else's money. Gross interest includes net interest + reward for risk + reward for inconvenience + reward for management. Net interest is the pure reward for the use of capital alone. The Classical Theory of Interest (by Marshall, Fisher, etc.) says the interest rate is determined by the demand for capital (investment) and the supply of capital (savings). Investment demand is inversely related to interest rate (lower rate → more investment); saving is directly related (higher rate → more saving). The equilibrium interest rate is where saving = investment. Nepal Rastra Bank (NRB) uses its policy rate (currently around 5%–7% in 2081 BS) to influence this balance — when NRB lowers the policy rate, commercial banks can borrow more cheaply, increasing money supply and lowering market interest rates.

1. Risk-Bearing Theory (Hawley, 1893): profit is the reward for bearing business risks (fire, theft, market fluctuation, competition). Higher risk → higher profit.
2. Uncertainty-Bearing Theory (Knight, 1921): profit arises from non-insurable uncertainty** — risks that cannot be predicted or insured (changes in demand, technology, fashion). Insurable risks (fire, theft) are normal costs; only non-insurable uncertainty earns profit. Knight's theory is more refined — it explains why some risks give only normal cost while uncertainty gives profit