BAQ108_Micro Economics(English)

Concepts and Theories of Rent, Interest, Profit 295 3. Measurement of Rent with Reference to Transfer Earnings To measure the rent as surplus earning of a factor in any occupation, Mrs. Robinson has introduced the concept of transfer earnings. Earlier, we referred to the concept of the minimum supply price of a factor. This minimum supply price of the factor is measured in terms of its transfer earnings. According to Mrs. Robinson, “The price which is necessary to return a given unit of a factor in a certain industry may be called its transfer earnings or transfer price.” Transfer earnings, in fact, are nothing but the opportunity cost of a factor. That is, what the factor could earn in its next best alterantive use or employment is his transfer earnings. In order to retain a factor in its particular use, it must be paid at least equal to its opportunity cost or transfer earnings, i.e., what it could earn elsewhere. Thus, transfer earnings are the minimum supply price of a factor unit in a particular industry. According to the modern concept of rent, thus, we can measure rent as follows: Rent = Surplus or differential income = Reward of a factor in a particular industry – The minimum supply price of that factor in this industry. Introducing the concept of transfer earnings in this context, we may state: Economic rent = Current earnings of a factor – Its transfer earnings. To illustrate the point, suppose a chartered accountant, employed in an industrial concern, earns a monthly salary of 2,000. If, however, he works in a commercial bank, he can earn only 1,500 a month. Then, 1,500 is this transfer earning. In the industrial concern, therefore, his salary includes an element of economic rent amounting to 500 (His current income 2,000 – his transfer earning 1,500 = Economic rent 500). Like Ricardo, modern economists, too, hold that rent is differential surplus. But, their method of measuring rent is different from that of Ricardo’s. To Ricardo, rent as a surplus is measured by the difference between the productivity of the intra-marginal land (superior quality land) over the marginal land (inferior quality land). To modern economists, economic rent is measured as surplus of current earning of a factor in a particular occupation over its transfer earnings. As such, in modern economics, economic rent is treated as a generalised concept. It is applicable to all factor’s earnings when their present earning is in excess of their normal transfer earnings. CU IDOL SELF LEARNING MATERIAL (SLM)

296 Micro Economics - I Another significance of the concept of transfer earnings is that it also explains the possible movement or mobility of a factor from one occupation to another. Suppose a college lecturer gets a salary of 800 a month. Suppose he finds a job in a bank at a salary of 1,100. Then, it is wrong to say that rent in his college salary is negative. Under ordinary circumstances, it is quite likely that he would join the bank. Now, from the joint of view of salaries in bank, we can say that his transfer earning or minimum supply price is 800. The surplus income, 300, he is likely to earn in the bank is his economic rent. It may be conclude that under conditions of perfect competition and perfect mobility, a factor tends to move towards those industries in which high economic rent can be earned. But when the supply of a factor in a highly-paid profession tends to increase, the scarcity becomes less and less intense. Consequently, remuneration, or the price of the factor in that occupation, tends to be elastic and its rent earning diminishes. Its rent becomes nil when the supply becomes perfectly elastic. The concept of economic rent in modern theory, as a surplus over transfer earnings in relation to the elasticity of supply, is illustrated graphically in Fig. 19.4. In Fig. 10.5, panel (A) refers to the case of a factor having perfectly inelastic supply. OR is the equilibrium factor price. The factor-units demanded and supplied in the industry are OQ, with reference to the original demand curve DD and the supply curve SS. The total earnings of the factor are shown by the rectangle ORPS. In this case, transfer earning being zero, the entire income is a differential surplus, and hence, is treated as rent. In the case of land, the supply price, or transfer earning, is regarded as zero because it is a free gift of nature. Again, if the land has only one specific use and it cannot be used elsewhere, then also its transfer earning is zero. When demand increases to D1D1 total earnings also rise with price as OR1P1Q, and entire earning is considered as economic rent, in view of the zero supply price. CU IDOL SELF LEARNING MATERIAL (SLM)

Concepts and Theories of Rent, Interest, Profit 297 SUPPLY PERFECTLY IN ELASTIC Y D1 S D1 D D R1 P1 P R RENT X S OQ SUPPLY LESS THAN PERFECTLY ELASTIC FACTOR PRICE Y D1 D P1 S R1 D1 D RF P SE L O G M Q Q1 X SUPPLY PERFECTLY ELASTIC Y P1 S D D1 S P EATRRNAINNSGFSER O D D1 X Q Q1 FACTOR UNITS Fig. 10.5: Economic Rent In Fig. 10.5, panel (B) represents the case of a factor with supply less than perfectly elastic. It must be noted that a factor which may be inelastic in supply in the economy as a whole, may have elastic supply of its units to a particular industry. In this way, even a land of versatile use may become relatively elastic in supplying its units to a particular use. The supply curve in this case is upward sloping, which implies that additional units of the factor will be supplied only at higher prices. Hence, the transfer earning (the minimum supply prices) rises for each additoinal unit. For instance, OG units are supplied when OE is the transfer earning or the minimum supply price. For OM units of supply of the factor, the minimum supply price rises to LM, and for OQ units it rises to PQ. Now, then PQ is the actual price of a factor, it is equal to its minimum supply price for OQ units. However, for OG units this PQ = FG price is greater than the transfer earnings EG. Thus, RSEF is the total CU IDOL SELF LEARNING MATERIAL (SLM)

298 Micro Economics - I surplus over transfer earnings, which constitute the element of rent. This induces the factor to supply more units. Gradually, the rent element tends to diminish till it gets wiped out. In this case, when OQ units are supplied at PQ price, rent is measured as follows: Total current earning = ORPQ. Total transfer earning = OSPQ. Economic rent = Total current earning – Total transfer earning.  Economic rent = ORPQ – OSPQ = RSP (shown by the shaded area). If, however, demand shifts to D1D1 the new equilibrium price is set at P1. Now, the supply of the factor also increases as transfer earnings rise. But the total rent increases as shown by the area R1SP1. Indeed, additional rent earnings amount to R1P1PR. Rent is thus determined on the basis of demand. If, however, the factor supply is perfectly elastic as shown in panel (C) of Fig. 10.5, it earns no economic rent. In this case, transfer earnings are the same as actual earnings. Hence, the rent is zero. Even if demand shifts, supply is perfectly adjusted to the increase in demand at the same minimum supply price, so the actual price also remains unchanged. hence, though the total earnings of the factor rises, the transfer earnings also rise proportionately with the increasing employment of the factor. So the rent element — a surplus — does not appear at all. In fact, it may be concluded that: 1. When the supply of a factor of production is perfectly inelastic, its entire earnings are economic rent. 2. When the supply of a factor is less than perfectly elastic, its total earning includes a part of economic rent. Greater the degree of inelasticity, greater is the element of economic rent. 3. When the supply of a factor is perfectly elastic, its entire earnings are equal to its transfer earnings. Hence, there is no element of economic rent. It follows, thus, that a factor would earn economic rent only when its supply is less than perfectly elastic. CU IDOL SELF LEARNING MATERIAL (SLM)

Concepts and Theories of Rent, Interest, Profit 299 Rent and Price Ricardo holds that rent is price-determined and not price-determining. In other words, rent does not enter into price. Modern economists contradict this view. According to the modern theory of rent, rent does enter into price. It is, thus, price-determining. Ricardo viewed the economy as a whole and so treated rent as a surplus rather than a cost. No doubt, from the community’s point of view, land being a free gift of nature, its supply price is zero. Therefore, the whole earning of land is a surplus, which becomes rent. As such, rent does not become an element in price. Modern economists do admit the validity of this point, but they point out that from the standpoint of individual firms and industries land has alternative uses. Thus, it has transfer earnings, and the transfer earnings at least must be paid to land to retain its use in a particular production. Hence, payment of rent by firms and industries is to be regarded as costs which are to be covered in the prices of the products. A point must be clarified in this context: that, from the point of view of an industry, the whole income payable to land is not rent. Of the so-called rent payment, a part constitutes transfer earnings and rest is true or economic rent, which is defined as differential surplus. Transfer earnings refer to the amount of income a piece of land can earn from its next best use. Economic rent is the amount paid to land in excess of its transfer earings. Economic rent is paid to attract the land in its present use and prevent it from being transferred to alternative uses. From industry’s piont of view, transfer- price portion of rent is price-determining because it is treated as cost or supply price of the factor land. Economic rent paid to land is price-determined. But from an individual firm’s point of view, whatever is spent to employ a factor, constitutes cost of prouction. Hence, rent paid to landlord by a firm for the use of land in the process of production is measured as cost of production. Price is determined on the basis of cost. Thus, economic rent, as well, enters into price. Interest is the price of capital. Capital as a factor of production, in real terms, refers to the stock of capital goods (machinery, raw materials, factory plant, etc.). In money economy, however, for all practical purposes, capital refers to finance or money capital, i.e., the monetary funds lent or borrowed for any purpose of expenditure from any source. In a strict narrow sense, again, capital may refer to only funds borrowed for real investment in business by the business community from financial institutions. CU IDOL SELF LEARNING MATERIAL (SLM)

300 Micro Economics - I 10.6 The Meaning of Interest Ther term’interest’ is used in two senses: (i) as a price or compenstion paid by the borrowers to the lenders of loanable funds, and (ii) as a reward to the capital as a factor of production. Classical economists like Adam Smith and David Ricardo, for instance, regarded interest as a return on capital interested. They considered it to be an income to capital just as rent is to land. Thus, classical economists measured the rate of interest in real terms. On practical considerations, however, modern economists usually treat interest as the price of borrowed money. 10.7 Gross and Net Interest The actual amount paid by the borrower to the capitalist as the price of capital fund borrowed is called the gross interest, while the payment made exclusively for the use of capital is regarded as net interest or pure interest. Gross interest includes, besides net interest or pure interest, the following elements: 1. Compensation for Risks: Giving a money loan to somebody always involves a risk that the borrower may not repay it. To cover this risk, the lender charges more, in addition to the net interest. Thus, when loans are made without adequate security, they involve a high element of risk, so a high rate of interest is charged. 2. Compensation for Inconvenience: A lender lends only by saving, i.e., by restricting his consumption out of his income which obviously involves some inconvenience which is to be compensated. A similar inconvenience is that the lender may not be able to get his money back as and when he may need it for his own use. Hence, a payment to compensate his sort of inconvenience may be charged by the lender. Thus, the greater the degree of inconvenience caused to the lender, the higher will be the rate of interest. 3. Payment of Management Services: A lender of capital funds has to spend money and energy in the management of credit. For instance, in the lending business, certain legal formalities have to be fulfilled, say, fees for obtaining moneylender’s licence, stamp duties, etc. Proper accounts CU IDOL SELF LEARNING MATERIAL (SLM)

Concepts and Theories of Rent, Interest, Profit 301 must be maintained. He has to maintain clerical staff as well. Thus, for all such sort of management services, reward has to be paid by the borrower to the lender. Hence, gross interest also includes payment for management expenses. 4. Compensation for the Changing Value of Money: When prices are rising under inflationary conditions, the purchasing power of money declines over a period of time and the creditor loses. To avoid such loss, a high rate of interest may be demanded by the lender. To sum up: Net Interest = Net Payment for the use of capital. Gross Interest = Net Interest + Payment for risk + Payment for management services + Compensation for the changing value of money. Usually, the net rate of interest is the same everywhere. In economic equilibrium, the demand for and supply of capital determine the net rate of interest. But, in practice, gross interest rate is charged. Gross interest rates are different in different cases at different places and different times and in the case of different individuals. 10.8 The Classical Theory of Interest According to the classical theory, interest, in real terms, is the reward for the productive use of the capital, which is equal to the marginal productivity of physical capital. In a money economy, however, as the physical capital is purchased with monetary funds, the rate of interest is taken to be the annual rate of return over money capital invested in physical capital assets. According to Keynes, true classical theory of interest rate is the savings investment theory. It was presented in a refined form by economists like Marshall, Pigou, Taussig, etc. Basically, the theory holds the proposition based on the general equilibrium theory that the rate of interest is determined by the intersection of demand for and supply of capital. Thus, an equilibrium rate of interest is determined at a point at which the demand for capital equals its supply. Demand for capital stems from investment decisions of the entrepreneur class. Investment demand schedule thus reflects the demand for capital, while the supply of capital results from CU IDOL SELF LEARNING MATERIAL (SLM)

302 Micro Economics - I savings in the community. Savings schedule thus represents the supply of capital. It follows that savings and investment are the two real factors determining the rate of interest. In technical jargon, the rate of interest is determined by the intersection of investment demand schedule and the savings schedule. At the equilibrium rate of interest, total investment and total savings are equal. It should be noted that the theory assumes real savings and real investment. Real savings refer to those parts of real incomes which are left unconsumed to provide resources for investment purposes. Real investment implies use of resources in producing new capital assets like machines, factory plants, tools and equipments, etc. It means investment in capital goods industries in real terms. Demand for Capital Demand for capital comes from entrepreneurs who wish to invest in capital goods industries. In fact, demand for capital implies the demand for savings. Investors agree to pay interest on these savings because the capital projects, which will be undertaken with the use of these funds, will be so productive that the returns on investments realised will be in excess of the cost of borrowing, i.e., interest. In short, capital is demanded because it is productive, i.e., it has the power to yield an income even after covering its cost, i.e., interest. The marginal productivity curve of capital thus determines the demand curve for capital. Indeed, the marginal productivity curve is, after a point, a downward-sloping curve. While deciding about an investment, the entrepreneur, however, compares the marginal productivity of capital with the prevailing market rate of interest. Marginal productivity of capital = the marginal physical product of capital × the price of the product. Given the marginal productivity, when the rate of interest falls, the entrepreneur will be induced to invest more till marginal productivity of capital is equal to the rate of interest. Thus, investment demand expands when the interest rate falls and it contracts when the interest rate rises. As such, investment demand is regarded as the inverse function of the rate of interest. In symbolic terms: I= f (r), in which I <0 r where, I = investment demand, r = rate of interest, and f = functional relationship. Fig. 10.6, panel (A), illustrates an investment demand schedule in graphical terms. CU IDOL SELF LEARNING MATERIAL (SLM)

Concepts and Theories of Rent, Interest, Profit 303 Y Y INVESTMENT-FUNCTION SAVING-FUNCTION R1 S R2 RATE OF INTEREST R1 RATE OF INTEREST R2 O Q1 Q2 XO Q1 Q2 X INVESTMENT SAVING Fig. 10.6: Investment and Savings Functions It can be seen that when the rate of interest is OR1, the investment volume is OQ2. When the interest rate falls to OR2, investment volume rises to OQ2. It follows that the investment demand curve is a downward-sloping curve. Supply of Capital Saving is the source of capital formation. Therefore, supply of capital depends basically on the availability of savings in the economy. Savings emerge out the people’s desire and capacity to save. To some classical economists like Senior, abstinence from consumption is essential for the act of saving while economists like Fisher stress that time-preference is the basic consideration of the people who save. In both the views, the rate of interest plays an important role in the determination of savings. The classical economists commonly held that the rate of saving is the direct function of the rate of interest. That is, savings expand with the rise in the rate of interest and, when the rate of interest falls, savings contract. In symbolic terms, the saving function may be stated as follows: S= f (r), in which S <0 r where, S = volume of savings, r = rate of interest and f stands for functional relationship. Fig. 10.5. panel (B) illustrates the savings schedule in graphical terms. CU IDOL SELF LEARNING MATERIAL (SLM)

304 Micro Economics - I The savings schedule refers to the quantum of savings at alternative rates of interest. When the rate of interest is OR1, OQ1 is the savings; when the interest rate rises to OR1, savings expand to OQ2 level. The saving function or the supply of savings curve is an upward-sloping curve. It must be noted that savings and investment, referred to in the above functions, are in real terms. Equilibrium Rate of Interest The equilibrium rate of interest is determined at that point at which both demand for and supply of capital are equal. In other words, at the point at which investment equals savings, the equilibrium rate of interest is determined. This is shown in Fig. 10.7. Y RATE OF INTEREST S R OQ X SAVING AND INVESTMENT Fig. 10.7 Determination of Interest Rate In Fig. 10.7, OR is the equilibrium rate of interest which is determined at the point at which the supply of savings curve intersects the investment demand curve, so that OQ amount of savings is supplied as well as invested. This obviously implies that demand for capital (OQ) is equal to the supply of capital (OQ) at the equilibrium rate of interest (OR). Indeed, the demand for capital is influenced by the productivity of capital and the supply of capital. In turn, savings are conditioned by the thrifty habit of the community. Thus, the classical theory of interest implies that the real factors, thrift and productivity, in the economy are the fundamental determinants of the rate of interest. CU IDOL SELF LEARNING MATERIAL (SLM)

Concepts and Theories of Rent, Interest, Profit 305 Criticisms Keynes is a firm critic of the classical theory of the rate of interest. Major criticisms levelled against the classical theory are as follows: 1. Keynes attacks the classical view that interest is the reward for saving. He points out that one can get interest by lending money which has not been saved but has been inherited from one’s forefather. Similarly, if a man hoards his savings in cash, he earns no interest. Further, the amount of savings depends not only on the rate of interest but also on the level of income, and hence the rate of interest cannot be a return on saving or waiting. According to Keynes, interest is purely a money phenomenon, a payment for the use of money and that the rate of interest is a reward for parting with liquid cash (i.e., dishoarding) rather than a return on saving. 2. Keynes further maintains that the classical theory of interest is indeterminate and confusing. It involves a circular reasoning as follows: r = f (S,I), However, S = f (r) ............................. (direct function), and I = f (r) ............................................... (inverse function). Hence, we cannot know the rate of interest unless we know the savings and investment schedules, which, again, cannot be known unless the rate of interest is known. Thus, the theory fails to offer a determinate solution. 3. Further, the classical theory looks upon money merely as a medium of exchange. It does not take into account the role of money as a store of value. It assumes that income not spent on consumption should necessarily be diverted to investment; it ignores the possibility of saving being hoarded. These factors make the classical theory unrealistic and inapplicable in a dynamic economy. It fails to integrate monetary theory into the general body of economic theory. 4. According to the classicists, the rate of interest is an “equilibriating” factor between savings and investment. In the view of Keynes, “The rate of interest is not the price which brings into equilibrium the demand for resources to invest with the readiness to abstain from present consumption. It is the price which equilibrates the desire to hold wealth in the form of cash with the available quantity of each.” CU IDOL SELF LEARNING MATERIAL (SLM)

306 Micro Economics - I 5. Keynes also points out that equality between saving and investment was brought about by changes in the level of income and not by the rate of interest, as asserted by the classical economists. 6. It has been pointed out that the classical interest theory is narrow in scope in so far as it ignores consumption loans and takes into account only the capital used for productive purposes. 7. The classical theory also ignores the vital role played by the supply of money-created money and bank credit-in the determination of the rate of interest. According to it, if there is an increase in the demand for investment, the saving schedule remaining unchanged, the rate of interest will rise. But today, savings are supplemented by credit and the rate of interest may not rise even though investment demand may have increased. 10.9 The Loanable Funds Theory of Interest The Swedish economist Knut Wicksell expounded the loanable funds theory of interest, also known as the neo-classical theory of interest. The loanable funds theory is an attempt to improve upon the classical theory of interest. It recognises that money can play a dynamic role in the saving and investment processes and thereby cause variations in the level of income. Thus, it is a monetary approach to the theory of interest, as distinguished from that of the classical economists. In fact, the loanable funds theory synthesises both the monetary and non-monetary aspects of the problem. According to the loanable funds theory, the rate of interest is the price that equates the demand for and supply of loanable funds. Thus, fluctuations in the rate of interest arise from variations either in the demand for loans or in the supply of loans or credit funds available for lending. This implies that interest is the price that equates the demand for loanable funds with the supply of loanable funds. Loanable funds are “the sums of money supplied and demanded at any time in the money market.” The supply of “credit” or funds available for lending would be influenced by the savings of the people and the additions to the money supply (usually through credit creation by banks) during that period. Thus, the supply of loanable funds is constituted by the savings (S) plus net new money (new money supply resulting from credit creation by commercial banks). Thus, S + M is the total supply of loanable funds. CU IDOL SELF LEARNING MATERIAL (SLM)

Concepts and Theories of Rent, Interest, Profit 307 The demand side of the loanable funds, on the other hand, would be determined by the demand for investment, plus the demand for hoarding money. It should be noted here that if the hoarded money increases, there would be a corresponding curtailment in the supply of funds. Similarly, an increase in dishoarding will lead to an increase in the supply of loanable funds. In short, thus, the demand for loanable funds is constituted by the investment expenditure — a demand for investible fund (I) plus net hoarding (H), i.e., the demand for loanable funds for use as inactive cash balances. Thus, I + H is the total demand for loanable funds. Thus, according to the loanable funds theory, the rate of interest is determined when the demand for loanable funds (I + H) and the supply of loanable funds (S + M) balance each other. Evidently, the loanable funds theory is wider in scope than the classical theory. The classical theory considers the rate of interest as a function of saving and investment only. Symbolically: r = f (I, S), where, r denotes the rate of interest, I stands for investment and S for saving. The loanable funds theory regards the rate of interest as the function of four variables: savings (S); investment (I); the desire to hoard (H); and the money supply (M), i.e., newly created money or bank credit (including money dishoarded). Symbolically: r = f (I, S, M, H). It is interesting to note here that Wicksell, when he formulated his theory, regarded bank credit — a constituent of loanable fund supply — as interest inelastic, for he believed bank credit creation depends upon the liquidity position of the banks and is not affected by changes in the interest rate. Thus, he considered the money supply (M) schedule to be constant in loanable funds. He took into account investment demand only and neglected the hoarding aspect of money. But other economists later on refined the Wicksellian theory of loanable funds and took into consideration the tendency to hoard, the (H) variable. Furthermore, in the refined version, the (M) schedule is not regarded as interest-inelastic or constant. It was felt that is incorrect. The banks will be less wiling to create credit if the rate of interest is low, and they will be inclined to expand credit when the rate of interest is high. Thus, the bank credit or money supply (M) schedule was considered to be interest-elastic by the later economists. CU IDOL SELF LEARNING MATERIAL (SLM)

308 Micro Economics - I The loanable funds theory can best be illustrated by means of diagram (Fig. 10.8). Y M H S RATE OF INTEREST P S+M R1 E R O Q1 Q X LOANABLE FUNDS Fig. 10.8: Loanable Funds Theory The supply of side of the loanable funds is composed as under: 1. The M curve represents the supply of money — bank credit (including dishoarding). It slopes upward indicating that the supply of bank credit is interest-elastic. 2. The S curve represents the different amounts of saving available at different levels of the rate of interest. It slopes upward indicating that there is a direct relationship between the volume of savings and the rate of interest. The higher the rate of interest, the higher the volume of savings and vice versa. 3. The S + M curve represents the total supply of loanable funds available at different rates of interest. It has been obtained by combining together the S and M curves. The S + M curve also slopes upward, indicating that the higher the rate of interest, the higher the supply of loanable funds, and vice versa. The demand side of loanable funds is considered as under: 1. The curve I represents the investment demand for savings. It slopes downward, indicating an inverse relationship between the volume of investment and the rate of interest. That is to say, the higher the rate of interest, the lower the investment demand, and vice versa. CU IDOL SELF LEARNING MATERIAL (SLM)

Concepts and Theories of Rent, Interest, Profit 309 2. The curve H represents the tendency to hoard money (or the level of hoarding) at different levels of the rate of interest. It also slopes downward, showing that the higher the rate of interest, the lower the hoarding (of idle cash balances), and vice versa. 3. The curve I + H represents the total demand for loanable funds at different rates of interest. It has been obtained by combining together the I and H curves. The I + H curve also slopes downwards, because the lower the rate of interest, the higher is the demand for loanable funds, and vice versa. The I + H (loanable funds demand) curve and the S + M (loanable funds supply) curve intersect at point E, which indicates the level of the market rate of interest (OR). Thus, the rate of interest is determined by the intersection of the demand for loanable funds and the supply of loanable funds. This diagram also serves to explain the difference between the classical theory and the loanable funds theory. In the classical theory, the interest rate is determined by the intersection of the S + M and I + H curves. In the diagram, thus, the classical rate of interest would be OR1 whereas, according to the loanable funds version, it is OR. Moreover, at the rate given by the loanable funds version, there is a discrepancy between savings and investment expenditure. This discrepancy is equal to the algebraic sum of net money (M), and net hoarding (H). Thus, the loanable funds theory shows that the money no longer plays a passive or neutral role. Its inclusion on the supply side brings the rate of interest down to OR, as against OR1 in real terms. The diagram also elucidates the Wicksellian distinction between the natural rate of interest and the market rate of interest. OR1 is the natural rate of interest, at which saving equals investment in real terms, while OR is the market rate of interest at which the demand for loanable funds equals the supply of loanable funds, in money terms. Thus, the loanable funds theory represents an improvement over the classical theory in the following respects: 1. The loanable funds theory is more realistic than the classical theory. The former is stated in real as well as money terms, whereas the latter is state only in real terms. The rate of interest is a monetary phenomenon. Therefore, a theory stated in money terms seems more realistic. CU IDOL SELF LEARNING MATERIAL (SLM)

310 Micro Economics - I 2. The loanable funds theory recognises the active role of money in a modern economy, while the classicists regarded money as a passive factor — a veil. 3. The loanable fund theory takes into account bank credit as a constituent of money supply, influencing the rate of interest. This was overlooked by the classicists. 4. On the demand side, the loanable funds theory recognise the role of hoarding (inactive cash balances) as a factor influencing the demand for loanable funds. This was not at all considered by the classicists. Criticisms The following shortcomings of the loanable funds theory are noteworthy: 1. Hansen criticises the loanable funds theory for not providing us with a determinate solution to the problem of the rate of interest. The supply schedule of loanable funds is composed of saving plus net additions to loanable funds from new money and the dishoarding of idle balances. But, since the ‘saving’ portion of the schedule varies with the level of disposable income (in the Robertsonian sense, ‘yesterdays’ income’), it follows that the total supply schedule of loanable funds also varies with income. Therefore, the rate of interest cannot be known unless the level of income is known; and the level of income cannot be known unless the rate of interest is known. Thus, like the classical theory, this theory is also indeterminate. 2. Furthermore, according to the loanable funds theory, the supply of loanable funds is sometimes increased by a release of cash balances, and sometimes diminished by an absorption of savings into cash balances. This gives the impression that the cash balances of the community can be increased or decreased. This, however, is not actually the case. The total amount of cash balances of the community is, at any time, fixed and necessarily equal to the total amount of money supply. The members of a community may, of course, attempt to increase or decrease the total amount of their cash balances, but such an attempt cannot result in an actual increase or decrease in the amount of cash balances. It can only result in a change in the velocity of circulation of money. This, no doubt, would result in an increase or decrease in the supply of loanable funds. Thus, the basic contention of the loanable funds theory that an attempt to change the volume of cash balances results in a change in the supply of loanable funds is correct. But, the way in which it is presented is not quite satisfactory. CU IDOL SELF LEARNING MATERIAL (SLM)

Concepts and Theories of Rent, Interest, Profit 311 3. Some critics have objected to the way monetary factors have been combined with real factors in the loanable funds theory. How, the critics argue, can real factors, like saving and investment, be combined with monetary factors, like bank credit and liquidity-preference? 4. It has also been pointed out that this theory exaggerates the effect of the rate of interest on savings. Critics argue that people usually save not for the sake of interest but out of precautionary motive, and, in that case, saving is interest-inelastic. 10.10 The Concept of Profit In a capitalist system, profit is the primary measure of the success of a business firm. Profit is the reward earned by an entrepreneur for his contribution to the process of production. The concept of profit entails several different meanings: 1. Profit may mean the compensation received by a firm for its managerial function. It is called ‘normal profit’ which is the minimum sum essential to induce a firm to remain in business. 2. Profit may be looked upon as a reward for the true entrepreneurial function. It is the reward earned by the entrepreneur for bearing risks. It is termed as supernormal profit for analytical reasons. It is also a functional reward. 3. Profit may imply monopoly profit. It is earned by a firm through extortion because of its degree of monopoly power in the market. It is not related to any useful, specific function. Thus, monopoly profit is not a functional reward. It is, therefore, socially unjustifiable. 4. Profit may sometimes be in the nature of a windfall. It is an unexpected reward earned by a firm just by a mere chance, say, like an inflationary boom. It is socially unjustified because it is also an undeserved, sweatless (idle) reward as it is not earned for any specific function rendered by the entrepreneur. 5. Profit covers all non-labour income and implicit returns. In economic theory, profit usually means this functional earning of an entrepreneur. Thus, normal and supernormal profits are important concepts. CU IDOL SELF LEARNING MATERIAL (SLM)

312 Micro Economics - I Nature of Profit Profit is the earning of an entrepreneur. To the economist, the most significant point about profit is that it is a residual income. However, the term ‘profit’has different connotations in the accounting sense and in the economic sense. In the accounting sense, when total cost is subtracted from total revenue or total sales receipts of the firm, the residual is termed as profit. Thus, Profit = Total Revenue – Total Cost. In the accounting sense also, profit is measured in the same fashion. But conceptually, there is a sharp difference in its measurement. In the accounting sense practice, when total cost is measured, only explicit costs, i.e., contractual payments made to different factor inputs by the firm are considered. These include wages, salaries, expenses on raw materials, fuel and power, rents, and interest. To these inputs, cost of depreciation charges are added. In the economic sense, when the total costs are measured, we include explicit as well as implicit costs. Implicit costs refer to costs which are to be deemed and imputed as costs when a firm uses its own capital, for which obviously no interest is payable to anybody. Similarly, the entrepreneur provides managerial service for which he does not receive any remuneration by way of salary. In a true economic sense, therefore, implicit and explicit rents are included in the cost of production. Hence: Profit = Total Revenue – Total explicit and implicit costs. Professors Savage and Small, therefore, define profit as “what remains of the firm’s revenue after all inputs have been paid.” In this way, in the economic sense, profit is looked upon as a surplus, i.e., a surplus of a firm’s total receipts over its total costs (explicit plus implicit). Profit is the return to entrepreneurial ability. However, a minimum sum essential to retain the entrepreneur in a given line of production is termed as ‘normal profit’. This normal profit is treated as a part of the cost of production. Hence, normal profit is not true economic profit. In the true economic sense, profit, i.e., economic or pure profit, is the total revenue left after all costs – explicit, CU IDOL SELF LEARNING MATERIAL (SLM)

Concepts and Theories of Rent, Interest, Profit 313 including normal profit – are paid. In this sense, economic profits are residual. Thus, when economists talk of profits, they always mean economic or pure business profit, which is in excess of normal profit. Another important feature of profit is that, being a residual income, it may even be negative. Negative profit is called loss. When total cost exceeds total revenue, there is loss or negative profit. It is only the entrepreneur who has to suffer a negative reward. Apparently, profit cannot be calculated in advance because it is uncertain, variable and unpredictable by nature. Profit can be measured only when it is realised. It is thus a term basically used in the ex-ante sense. Viewing the balance sheet of any joint stock company, we can know the apparent rate of profit on capital inverted for the past years. But, we cannot know the rate of profit in future years well in advance due to a high degree of uncertainty involved in business. In short, the following are the distinctive features of profit as a factor reward: 1. It is not a predetermined contractual payment. 2. It is not a fixed remuneration. 3. It is a residual surplus. 4. It is uncertain. 5. It may even be negative. Other factor rewards are always positive. 6. It is widely fluctuating, while other factor incomes are generally stable over a period of time. 10.11 Gross Profit and Net Profit In ordinary parlance, profit actually means gross profit. It is the surplus of total revenue over total money expenditure incurred by a firm in the production process. Gross profit, thus, includes many items of input, service and their miscellaneous costs. So it cannot be regarded as profit in the real sense. Thus, though profit is residual income, the whole of it is not pure economic profit which is a return for the risk-bearing function of the entrepreneur. CU IDOL SELF LEARNING MATERIAL (SLM)

314 Micro Economics - I Gross profit includes the following items: 1. Imputed costs like maintenance and depreciation charges. To arrive at net profit, these are to be deducted from gross profit. 2. Implicit returns, such as implicit rent, implicit wages, and implicit interests for the factors — land, labour and capital — owned and supplied by the entrepreneur himself. In many business firms, the entrepreneur uses his own land, invests his own capital, and also he himself works as manager. 3. Normal profit is also the implicit cost of entrepreneurial input. It is the imputed minimum return for the entrepreneur’s organisational function. 4. Non-entrepreneurial profit includes windfall gains, monopoly gains, etc., which accrue to the entrepreneur as a result of change events and market imperfections. This profit element is not related to entrepreneurial ability in the strict sense. 5. Net profit is the pure economic profit earned by the entrepreneur for his services and efficiency. In short: Gross profit = Net profit + implicit rent + implicit wages + implicit interest + normal profit + depreciation and maintenance charges + non-entrepreneurial profit. Thus, it follows that: Net profit = Gross profit – (implicit rent + implicit wages + implicit interest + normal profit + depreciation and maintenance charges + non-entrepreneurial profit). Indeed, Net profit = economic profit or pure business profit. It is the reward earned exclusively by the entrepreneur for his entrrepreneurial functions, which are: 1. Efficiency in the Organisation of Business: He coordinates different factors of production — land, labour, capital — in the production process. By efficient organisation, he minimises the costs of production and is, therefore, entitled to super-normal profit. 2. Risk-Bearing Function: Pure business profit is the reward for risks borne by the entrepreneur. The entrepreneur alone bears the risks involved in the business, so he is entitled to a pure profit. CU IDOL SELF LEARNING MATERIAL (SLM)

Concepts and Theories of Rent, Interest, Profit 315 3. Innovating Function: Profit is also the reward earned by the entrepreneur for innovations. He may adopt new techniques, new products, new markets, in order to earn excess profit. It is the net profit which may be positive or negative. Negative profit means a loss. 10.12 Dynamic Theory of Profit J.B. Clark originated the ‘Dynamic Theory of Profit’. In his view, dynamic changes in the economy should be regarded as the fundamental cause of the emergence of profits. Clark defines profit as the difference between selling price and costs resulting on account of changes in demand and supply conditions. Briefly, profit is the surplus over costs. Clark held that in a stationary state having static economic conditions of demand and supply, there can be no real or pure profit as a surplus. In a stationary economy, the quantum of capital invested, methods of production, managerial organisation, technology, demand pattern, etc., remain constant. Under competitive conditions, thus, price tends to equal average costs; hence, the surplus is zero. So, no pure profit. However, there may be some frictional profits emerging due to frictions in the system. But, this cannot be regarded as real profit. J.B. Clark Profit is the outcome of dynamic changes in the economy. It is, thus, a dynamic surplus of the dynamic economy. A dynamic modern economy is full changes. According to Clark, the following ‘general’ changes cause profit to emerge: 1. Increase in population 2. Changes in tastes and preferences 3. Multiplication of wants 4. Capital formation 5. Technological advancement and 6. Changes in the form of business organisation. CU IDOL SELF LEARNING MATERIAL (SLM)

316 Micro Economics - I On account of these changes the economy tends to be dynamic. Demand and supply conditions are altered. Some entrepreneurs may attain advantageous business positions against others and may reap a surplus over costs, as a real profit. In short, those who take advantage of a changing situation can earn real profits according to their efficiency. Inefficient and careless producers who fail to move with dynamic changes may not get any real profit and may even incur losses. Clark’s dynamic theory of profit has an element of truth in it as it emphasises the dynamic aspect of profit. But, is has been criticised on the following counts: 1. According to Taussig, Clark’s theory gives an artificial dichotomy of ‘profit’ and ‘wages of management.’ 2. Clark’s theory suggests that all dynamic changes lead to profit. Critics, however, point out that only unpredictable changes would give rise to profits. Predictable changes will not cause surplus to emerge on account of precise adjustments. 3. Clark’s theory indicates that in a stationary state, there is only a frictional profit. But, the concept of frictional profit is vague. Rather, normal profit is earned in a stationary state. 4. Clark’s theory does not stress the element of risk involved in business due to dynamic changes. Thus, the best course is to combine elements of risk/dynamic changes to understand the true nature of profit in a modern economy. 10.13 Risk and Uncertainty-Bearing Theory of Profit Risk and uncertainty-bearing theory is the modern theory of profit. In the history of economic ideas, there are two stages in the development of theory: 1. The risk-bearing theory of profit, and 2. The uncertainty-bearing theory of profit. The former was presented by Hawley which had many shortcomings. Prof. Knight made an improvement over it and presented a refined version called ‘uncertainty-bearing’ theory. CU IDOL SELF LEARNING MATERIAL (SLM)

Concepts and Theories of Rent, Interest, Profit 317 The Risk-Bearing Theory of Profit The classical and neo-classical economists did recognise that risk is inherent in any business. J.S. Mill, for instance, mentioned about the hazard or risk of enterprise. Marshall also regarded risk- bearing as a unique function of the entrepreneur. But, it was Prof. Hawley who categorically attributed profit to the compensation payable to the entrepreneur for his risk-bearing function. To Professor Hawley, since the entrepreneur undertakes the risks of the business, he is entitled to receive profit as his reward. In fact, the chance to make a profit induces businessmen to run the risk of loss. If there is no hope for substantial profit, no one will be willing to risk money by investing it in a business. Profits are commensurate with risks. The more risky the business, the higher is the expected profit rate. Professor Holland has empirically investigated the rate of profit on capitalisation earned by business firms, with a view to discovering whether the spectrum of profit rates of business can be explained by the risk factor. He concludes: “The riskier the industry or firm the higher its profit rate.” But, he also warns that this is a tentative finding; therefore, much remains to be refined and tested in depth. The following criticisms have been levelled against the risk theory: 1. There can be no functional relationship between risk and profit. Those who undertake high risks in certain business may not necessarily earn high profits. 2. To some critics, like Carve, profit is based not on the entrepreneur’s ability to undertake the risks of business, but rather on his capability of risk-avoidance. 3. The theory disregards many other factors attributable to profit and just concentrates on risks. The Uncertainty-Bearing Theory of Profit It is a refined and improved version of Hawley’s risk-bearing theory, propounded by Prof. Knight. According to Prof. Knight, profit is the reward to the entrepreneur for uncertainty-bearing. CU IDOL SELF LEARNING MATERIAL (SLM)

318 Micro Economics - I Profit is earned by the entrepreneur when he is capable of making successful decisions about the business under conditions of uncertainty owing to dynamic changes. Knight defines pure profit as “the difference between the returns F.H. Knight actually realised by the entrepreneur and the competitive rate of interest of interest on high-class gilt-edged securities.” According to Knight, pure profits are linked with uncertainty and risk-bearing. He, however, classifies risk into: (i) insurable risks, and (ii) non-insurable risks. Of the many risks involved in the business, some risks are predictable because they are certain and hence are insurable. For instance, fire, theft, flood accident, etc., are risks in business, but these can be insured. Thus, business loss arising out of such risks are covered by insurance. Hence, in a modern economy, insurable risks are not the real risks attributed to entrepreneurial functions. True entrepreneurship lies in bearing non-insurable risks and uncertainties. Unforeseeable risks are non-insurable. According to Stonier and Hague, the difference between insurable and non- insurable risks lies in the fact that there is a possibility of statistical prediction of the probability of some events while there are certain events whose probability of occurrence cannot be predicted statistically. For instance, the probability of fire or accident, in general, can be estimated quite precisely by statisticians. Hence, the insurance companies calculate the risk and offer insurance policies at premiums which cover the amount of claims they might have to pay. So, the insurance company does not bear the actual risk. Similarly, entrepreneurs avoid risks by insuring against them. Again, the insurance premiums paid by them are treated as costs of production, which are covered in the price of the product. Thus, it follows that profit cannot be the reward for such insurable risks. But there are risks which are uncertain and incalculable. Such risks being unpredictable, no insurance company would be willing to cover them. Such non-insurable risks are: 1. Demand Fluctuations: In a dynamic economy, changes in demand for a product may result from a change in the size and age structure of the population, change in fashion, change in distribution of income, etc. When demand fluctuates, the firm’s revenue also changes. There cannot be insurance against these changes. A sudden decrease in demand may cause a great loss to a firm; but such losses are non-insurable. CU IDOL SELF LEARNING MATERIAL (SLM)

Concepts and Theories of Rent, Interest, Profit 319 2. Trade Cycles: In a capitalist economy, prosperity and depression are two major facets of modern business. During prosperity, a handsome profit may be reaped. But, during a depression, there is overall contraction of economic activities, leading to a sudden rapid decrease in demand for goods and resources, causing widespread losses. Recession and depression lack periodicity, hence alterations in the revenue and cost conditions of firms, influenced by such phenomena, cannot be predicted nor can they be insured against. 3. Technological Changes: When technology advances, a firm has to adopt a new technology to retain its competitive strength. And technology has a direct bearing on the cost of production. Discarding old techniques, etc., leads to a loss which cannot be insured against. 4. Competition: Most of the markets are monopolistically competitive and there are no strong barriers to entry. Entry of new firms means a cut in the existing market share possessed by old firms. Competition from new rivals, then leads to a fall in price and diminution of profit. But, there cannot be any insurance against the risks of competition. Again, no one can predict when exactly a new firm will enter the market and what will be its competitive strength. 5. Structural Changes: In a dynamic economy, there are constant changes in consumer tastes, income, prices of substitutes, population growth, advertising, etc. These structural factors may continually alter the sales of firms, so that a high degree of uncertainty about business is created, which is not insurable. 6. Changes in Government Policies: Government’s economic policies — industrial, fiscal and monetary, etc. — are always uncertain and unpredictable. Changes in government’s economic policies widely affect business situations; for instance, when high taxes are imposed on certain goods, people’s preferences may alter, so sales of such goods may decline. If government relaxes its import policy, producers of import substitutes will face keen foreign competition, and may also experience a decline in their sales. Similarly, changes in licensing policy may alter the degree of monopoly power and sales position of many existing firms. Again, when, say, the Reserve Bank adopts a tight money policy by raising the bank and interest rates, cost conditions of many firms and their expansion project may be adversely affected. 7. Outbreak of War: War affects business in a very uncertain manner — yet, nobody can predict a war. CU IDOL SELF LEARNING MATERIAL (SLM)

320 Micro Economics - I All these risks are uncertain and unforeseeable, and so are uninsurable. It is the main function of the entrepreneur to bear all such uncertainties of business. These uncertainties are distinct from risk, which is predictable and insurable. They coincide with risk which is unpredictable and uninsurable. Thus, all true profit is an exclusive reward to the entrepreneur for making business decisions for his firm under unpredictable, uncertain dynamic economic conditions. In short, Knight’s theory implies that: 1. Profit is the reward for uncertainty-bearing. 2. The unmeasurable risks are termed as uncertainty. These unmeasurable risks are true hazards of business. 3. Pure profit is, however, a temporal and unfixed reward. It is tuned to uncertainty. Once the unforeseen circumstances become known, necessary adjustment would be possible. Then, pure profit disappears. Criticisms 1. Knight’s theory has been criticised on the following counts: 2. In fact, it is business ability rather than atmosphere of uncertainty which leads to a high reward of profit. 3. Knight fails to distinguish between ownership and control in modern joint-stock companies, where shareholders are the owners but business control is in the hands of salaried managers. The concept of profit and entrepreneurial function in such cases is not suitably exposed by the theory. 4. The theory does not suit well to expose the phenomenon of monopoly profit, when there is least uncertainty involved in a monopoly business. 5. Above all, the uncertainty element cannot be quantified to impute profit. To sum up: “the modern theory of profit regards the entrepreneur’s contribution to the process of production as that of bearing non-insurable risks and uncertainties.” CU IDOL SELF LEARNING MATERIAL (SLM)

Concepts and Theories of Rent, Interest, Profit 321 Concluding Remarks Pure profits are the reward for bearing risks and uncertainties. In a purely competitive market of a static economy, where the risk of uncertainty is absent, in the long-run, when industry attains equilibrium, there exists no pure profit. Since there is no uncertainty about the future and the entrepreneur has to repeat the same process of production without any risk, there is no profit in the true sense, i.e., profit as residual income. There is no residual surplus because price = average cost, and the marginal revenue product of entrepreneurship tends to be zero. It follows that in the long-run, in a static economy, there is only normal profit. There may be other implicit profit such as wages of management, when an entrepreneur himself renders the services in place of a manager, to conduct the business affairs. Again, there may be implicit interest to be earned by the entrepreneur for his own capital invested in the business. All these elements, though residual incomes as surplus or revenue over the explicit cost of hte firm, should not be regarded as pure profits because these are not earned as reward for risk-taking. Pure profits are earned as the reward for the entrepreneurial function of uncertainty-bearing. Ours is a dynamic world having a high degree of uncertainty and provides a source of earning pure profits even in the long-run. 10.14 Summary This chapter has made us a clear picture about rent, Quasi rent, Ricardo holds that rent is price determined and non price determining. Quasi rent refers not to the whole of income but to the short- term extra income and by a factor in excess of its normal return classical economists like Adam Smith and David Recardo, for instance regarded interest as a return on capital interested. They considered it to be an income to capital just as rent is to land. According to loanable fund theory, the rate of interest is the price that equates the demand for and supply of loanable funds. Profit is the earning of an enterpreneur i.e. profit = total revenue – total cost. Net profit is the pure economic profit earned by the enterpreneur for his sources and efficiency. Profits are commensurated with risks. The more risks the business, the higher is the expected profit rate. According to Prof. Knight, profit is the reward to the entrepreneur for uncertainty bearing. CU IDOL SELF LEARNING MATERIAL (SLM)

322 Micro Economics - I 10.15 Key Words/Abbreviations  Rent  Contract rent  Economic rent  Loanable fund theory  Profit  Net profit cross profit  Risk and undertainty  Role of profits. 10.16 Learning Activity 1. Discuss and comment on Rent i.e. land rent, shop rent in complete. Residence, mall etc. interest of bank, money lender etc. -------------------------------------------------------------------------------------------------------- -------------------------------------------------------------------------------------------------------- 2. In today’s modern life what is your view to earn a good profit. Discuss it and prepare a list of small scale or large scale business/industry. -------------------------------------------------------------------------------------------------------- -------------------------------------------------------------------------------------------------------- 10.17 Unit End Questions (MCQs and Descriptive) A. Descriptive Types Questions 1. Critically examine Ricardian theory of rent. 2. State and explain the modern theroy of rent. CU IDOL SELF LEARNING MATERIAL (SLM)

Concepts and Theories of Rent, Interest, Profit 323 3. (a) Define interest. (b) What are the functions of interest? 4. Distinguish between gross interest and net interest. 5. Critically examine the classical theory of interest rate. 6. Explain the liquidity preference theory of interest of Keynes. What are its shortcomings? 7. (a) Explain briefly the concept of liquidity preference. (b) What part does it play in the determination of the rate of interest? 8. “Interest is the reward for parting with liquidity.” Discuss. 9. Write notes on: (i) Loanable funds theory of interest. (ii) Time-preference theory of interest. (iii) Productivity theory of interest. 10. (a) Define profits. (b) What are the main sources of profit? 11. “Profits are a reward for risks and uncertainty-bearing.” Discuss. 12. Explain the dynamic theory of profit. B. Multiple Choice/Objective Type Questions 1. Rent is the reward for __________. (a) Land (b) Labour (c) Capital (d) Farmer 2. Economic Rent is __________. (a) A different supply (b) Farmer’s reward (c) Landlord chance (d) None of these CU IDOL SELF LEARNING MATERIAL (SLM)

324 Micro Economics - I 3. Rent arises due to ___________. (a) scarcity on land (b) Ownership right (c) Government prescription (d) People ready to pay 4. Quasi Rent __________. (a) s short-run temporary surplus earning (b) Delayed payment of rent (c) Permanent TR (d) None of these 5. Interest is the price of __________. (a) Bank balance (b) Business (c) Capital (d) All of these 6. Loanable funds Theory of Interest was coined by __________. (a) Pigon (b) J.R. Hicks (c) Marshall (d) Knut Wickcall 7. Profit is a reward to __________. (a) the nation (b) Filvn industry (c) The profit sector (d) The entrepreneur 8. The dynamic Theory of profit was originated by __________. (a) Marshall (b) J.B.Clark (c) J.B.Say (d) J.R. Hicks CU IDOL SELF LEARNING MATERIAL (SLM)

Concepts and Theories of Rent, Interest, Profit 325 9. Uncertainty bearing Theory of profit was developed by __________. (a) F.H. Knight (b) Hantrey (c) Samuelson (d) Friedman Answers 1. (a), 2. (b), 3. (a), 4. (b), 5. (c), 6. (d), 7. (d), 8. (b), 9. (a) 10.18 References 1. Stonier, A.W. and Hague, D.C., “A Textbook of Economic Theory”, (4th ed.) p. 310. 2. In economic literature, Marshall is classified as a neo-classical economist. 3. Savage, C.I. and Small, J.R., “Introduction to Marginal Economics”, p. 22. 4. Stonier and Hague, 4th edition op. cit., p. 359. 5. Ibid., p. 359 6. Ibid., p. 367 CU IDOL SELF LEARNING MATERIAL (SLM)

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