TOPIC 2: PRODUCTION ~ ECONOMICS FORM 5
Production is the process of creating utility.
In production there are four types of utilities which are form utility, time utility, place utility and possession utility.
To the general public, production refers to the process of making goods either for sale or for direct consumption. e.g.cultivation of maize partly for domestic consumption and other part for sale.
In economics, production is the process of making goods for sale. It is also known as indirect production.
Direct production refers to the process of making goods and services for direct consumption or use.
General production involves employing the factors of production by combining them to produce goods and services which aim to satisfying wants.
TYPES OF PRODUCTION
There are two major types of production these are;-
A. DIRECT PRODUCTION
Direct production is the type of production carried by a person in order directly to satisfy his or her own wants or production for own consumption. It is mainly for subsistence of which the production is very low.
B. INDIRECT PRODUCTION
Indirect production means production is not attempted to satisfy own wants directly except to a very limited extent. The production of goods is aimed for selling.
STAGES OR LEVELS OF PRODUCTION
There are three major levels of production, which are;-
Involves extraction of natural resources and making them useful in their own form to human beings.e.g Agriculture, mining, and fishing and quarrying.
The output from the primary stage is used as inputs or raw materials in the secondary stage.
Involves transforming raw materials into semi finished or finished goods. It includes;- manufacturing and construction. The output of primary production is used as inputs of secondary production. E.g. cotton produced in primary production is used in textile industries to produce clothes.
Construction includes;- construction of roads buildings, bridges e.t.c .The material used in construction industry is obtained from the primary production.
Involves provision of services production is incomplete till the final goods reach the final consumers or final users.
It involves provision of services which will enable the final goods to reach to the hands of their final users. These services are further divided into consumerism and personal service.
Consumerism refers to the service of whole sales, retailers, banks, insurance, transport etc. personal services refers to the services of doctor, advocates, teachers etc.
SPECIALIZATION AND DIVISION OF LABOUR
DIVISION OF LABOUR.
Is the process of splitting one particular job into several tasks, trade or processes.
Is the process of assigning one task or trade or process to one particular worker or a group of workers and the whole job accomplished with the help of several workers.
FORMS / NATURE OF SPECIALIZATION
1. Specialization by gender: – e.g. during the Old Stone Age, man was hunting and women were gathering.
2. Specialization by process or complex specialization. e.g In car assembling manufacturing etc.
3. Regional / territorial specialization. Different parts of the country produce different crops depending on the climatic conditions of a place.e.g. in Tanzania;-
Mwanza – cotton
Mbeya – rice
Tanga – fruits
4. Occupational specialization such as teachers, doctors, lawyers etc.
5. Specialization by product.
ADVANTAGES OF SPECIALIZATION AND DIVISION OF LABOUR
It increases output.
It improves the skills of the workers.
The workers become more efficient.
It helps to increase employment opportunities. The jobs create many tasks to be performed by several workers.
Cost per unit is reduced as the result of large scale production.
It leads to less fatigue to the workers. I.e. less tiredness due to repeating the same job now and then.
It leads to employment to a specialist. One will go to the real field for which she/he is competent.
It enables the employment of the facilities such as machines.
It is easy to train a worker in one field rather than several fields of specialization.
Time saving since it does not involve movements.
DISADVANTAGES OF SPECIALIZATION
It can lead to unemployment, due to the result of changes in demand for labour caused by changes in demand for goods or changes in technology.
Less of craftsmanship being a result of increased use of the machines. The workers’ skills are reduced due to the use of machines.
It results into high cost of production as a result of increased number of workers who have to be paid.
Boredom. Doing the same thing now and then leads to one getting bored.
Dulls the workers. The thinking capacity of the workers is reduced i.e. they are getting to know very few things but lack to know many others.
Lack of responsibilities, in case anything happens to be wrong there is no possibility of locating the sources of the fault.
LIMITATION OF SPECIALIZATION
Size of the firm.
For specialization to be economically feasible the size of the firm must be large enough to keep the specialized labour, machines or plants fully employed.
The size or extent of the market.
The size of market also presents the division of labour to take place beyond a certain unit. It shows the degree in terms of the area, length, range or size of the markets for given products or goods and services.
FACTORS AFFECTING THE EXTENT OF THE MARKET
-Lack of improved mass of communication.
Change in the population size of a given area either through natural disasters or by net migration will affect the extent of the market.
Nature of the some industries. Some industries by their nature have been less scope per division of labour ma be forced to be used for different tasks, otherwise the workers are underutilized.
Willingness and ability of a labour to work in different places and climate.
Availability of training facilities and employment security.
Nature of demand of some products. I.e. if the production are for individual demand production can take place on small scale hence limited division of labour
FACTORS OF PRODUCTION
These are resources or inputs which are used during the production process.
The factors of production are classified into;-
Refers to all unworked natural resources which are found either in or on the earth’s surface and used in the production for goods and services. It includes mineral resources, water bodies, soils vegetation etc.
FEATURES OF LAND
Land is a gift of nature. That it is not a product of human labour. It is naturally found e.g. gold deposits are naturally found.
Land cannot be moved from one place to another but land has several uses such as farming, grazing, construction etc.
Land is fixed in supply. it is not possible to measure the size of land. E.g. increase of rent will not call for more land to be available or supplied.
Other argues that land can be increased through land reclamation.
Land differ interns of fertility. It is of different grades depending on the natural fertility.
Land provides a site for production. That is all production activities are carried out on land.
Land obeys the law of diminishing marginal returns. It states that “Other factors remaining constant,” application of more and more units of variable inputs on a given fixed inputs (land), will lead to the marginal product of the variable input to diminish after s sometime”.
Labour is the human effort applying in production of goods and services to satisfy human wants.Labour is the human effort but all human effort is not labour until applying on production and rewarding considerations.
TWO TYPES OF LABOUR
(i)Manual labour:are physical effort and very small % of mental uses on application of productions works in a factory or otherwise contributes his effort. e.g Handcraft
(ii)Mental labour: These are intellectual works 70% applying mental/brain and very little effort on production of goods and services. e.g Teachers,Doctors and engineers.
FEATURES OF LABOUR
Labor cannot be separated from a labourer.
Labor is highly mobile (can move from one place to another or shift from one job to another).
Labor cannot be stored if not employed.
Labor is not homogeneous. They differ in efficiency.
The reward for labour is wages
Labor is not motivated only by material incentives but also moral incentives.
EFFICIENCY OF LABOUR OR LABOUR EFFICIENCY
It refers to the quantity and quality of output a worker can produce for a given period of time. It refers to how productive the worker is.
It is measured as the ratio between total product and number of labour employed.
Efficiency of labour is also called productivity of labour.
Efficiency of labour = (Total product)/(no .of labour employed)
FACTORS WHICH INFLUENCE PRODUCTIVITY OF LABOUR
Efficiency of other cooperating factors such as the efficiency of the working tools / capital.
Health of the workers. Hunger and sickness lower the workers efficiency.
Wage rate. High wage rate motivates a worker to become efficient.
Incentives. That the provision of incentives such as frees meals, free housing, helps to rise the efficiency of a worker.
The level of education and training. Workers who are highly educated or trained are more efficient than those who are not educated or trained.
Natural talents or abilities. Some people are born intelligent of which become more efficient.
Working conditions. Good job supervision will help in increasing the efficiency of the workers
Working experience. Workers with experience tend to be more efficient than those without experience.
Weather conditions. A bad weather condition such as drought lowers the efficiency of labour while favorable weather conditions raises the efficiency of the worker.
MOBILITY OF LABOUR
It refers to the case with which a labour or worker either moves from one geographical area to another or shifts from one employment to another.
It is the ease in which labour can move either geographically or occupationally.
TYPE OF LABOUR MOBILITY
(i) Occupational mobility. i.e. a labour moves from one employment to Another employment such as from being a doctor to teaching.
(ii) Geographical mobility. A worker moves from one working place to another working place.
(iii)Vertical mobility. Move from lower position to a higher position. This may be due to long period of education training and promotion.
(iv)Horizontal mobility. A worker moves from one work place to another work place with the same working rank or position. Example if an account leaves his present job and joins another for the same job.
IMPORTANCE OF LABOUR MOBILITY
It helps the workers to increase their earnings.i.e. Move from lower paying to the high paying jobs.
It helps to reduce the problem of unemployment. People move from areas with no employment to areas with employment opportunities.
It promotes the sense of national hood and international community.
It promotes the transfer of technology and culture.
It enables the workers to move to those areas which are competent or specialized.
FACTORS WHICH LIMITS MOBILITY OF LABOUR
1. Lack of required education and training. Occupational mobility becomes difficult.
2. Age. The old people are less mobile.
3. Family Ties. The married people are less mobile people that is they do not prefer to stay away from their families.
4. Cost of movement. The cost of movement (transport) of a worker and her / his family may be high.
5. Housing problems. It may be difficult to occupy a residential house for the family.
6. Health difficulties. Workers with health problems such as diseases tend to be less mobile.
7. Political boundaries. It requires legal passports and certificates to enable one to migrate to another country and to be allocated to get employment which limits labour mobility.
Capital refers to man made resources which helps other factors of production such as land, labour in the production of goods and services.
FEATURES OF CAPITAL
Capital is man made resources used in production.
Some forms of capital are highly mobile such as sunk capital while other forms of capital are immobile such as floating capital.
Capital helps to increase the productivity of other factors of production. Example;- land with fertilizers more production and a fisher man with a fishing net catches more fish.
The supply of capital can be increased through savings, which is influenced by high interest rate. High interest rate brings about more saving which tend to bring high capital formation.
FORMS OF CAPITAL
Is a form of capital which is durable and does not change its form during the production process. Example;-buildings, machines, etc.
Is a form of capital which is durable and has only one specific use.eg railway locomotive or an rice factory (produces only rice). Fixed capital fall in this category if it could not be used for any other purpose.
Is a form of capital which not durable and changes its form at the end of the production process.e.g raw materials.
Is a form of capital which is not durable and has several uses. Examples are; – raw materials, fuel, and money.
CAPITAL FORMATION OR ACCUMULATION
Is the process of adding up stock of capital goods to the existing stock. Capital goods means the goods which are used for further production.
Capital formation depends or is influenced by saving which is affected by the level of income. That is high income levels leads to more savings and hence more capital formation.
The level of saving is influenced by the following factors;
The level of income.ie. The higher the income, the higher the level of saving.
The rate of interest.
The government policy political stability.
The willingness to save.i.e.saving habits.
Price. High price level reduces saving because large part of income is consumed.
Future expectations.Eg leaving an employment one will save more.
It refers to the process of organizing the other factors of production. An entrepreneur is a person who owns the business. It is said that if land, labour and capital are left alone, they will not produce. Therefore the entrepreneur has to organize them.
FUNCTION OF ENTREPRENEUR
Providing initial capital for starting the business.
Bear with the risk of loss and profit (uncertainty) bearing.
To employ new technology into the firm.
Employ other factors of production such as land,labour and capital and reward them accordingly.
Marketing the product i.e. finding whether the commodities could be demanded by the consumers or not.
Making all important decisions in the firm. Such as;- what to produce, how to produce i.e. method of production to be applied, for whom to produce and where to produce.
To look after the production i.e. supervises the whole process of production.
CHARACTERISTIC OF ENTREPRENEURSHIP
An entrepreneur does not work alone, he must employ other factors.
The supply of entrepreneurship skills is scarce and cannot be developed easily.
The reward of entrepreneurship depends on efficiency of other factors and it is known as profit.
In a small business, the entrepreneur and the organizer is the same person who is also the owner of the business.
CLASSIFICATION OF THE FACTORS OF PRODUCTION
The factors of production are traditional classified into land, labour, capital and entrepreneurship.
Distinction between the factors of production is possible.
It is very difficult to distinguish land from capital or labour from entrepreneurship.For example; The seeds and minerals are found in nature so they are land, but seeds and mineral are also raw materials hence they are capital.
Therefore the distribution between land and capital is just a matter of “time” in short seeds and raw materials are gifts of nature but in the long run they are capital.
Substitution between factors is possible .i.e. it is possible to substitute land for capital or substitute labour for capital. A farmer may increase the size of land for cultivation or on the existing land another one may improve seeds and use more fertilizers.
Also one can employ the labour or use machine; hence economists have classified the factors of production into specific and non- specific factors of production.
SPECIFIC FACTORS OF PRODUCTION
Are those factors of production which cannot be changed easily from one use to another use. Such as;-highly skilled teacher
2NON- SPECIFIC FACTORS OF PRODUCTION
Are those factors that can be easily changed from one use to another use. E.g. bare land, unskilled labour, raw materials such as diamond can be capital.
TECHNIQUES OR METHODS OF PRODUCTION
Is the method which is used to produce a commodity. These are techniques of production. It includes;-
Labor intensive technique.
Capital intensive technique.
Land intensive technique.
Is the method where by the big number of workers are used in production using simple tools eg where the labour are employed to firm a land using simple hoes is a labour intensive technique.
ADVANTAGES OF LABOUR INTENSIVE TECHNIQUE
It helps to reduce the problem of unemployment. More people will be employed.
It is less expensive (cheap).
The workers especially the unskilled ones may be lowly paid.eg. In the LDCS.
The maintain and train labour is also less expensive compared to maintain of capital machines.
It helps to distribute income among individual people and earn income through working.
It helps to rise government revenue through taxing the workers.
DISADVANTAGES OF LABOUR INTENSIVE TECHNIQUE
The products produced using labour intensive technique is of low quality.
Labor intensive technique leads to production of low output.
It may lead to some labour problems, like;-strikes or demand for higher wages.
Increased of use of labour intensive technique hinders technological development.
CAPITAL INTENSIVE TECHNIQUE
Is the technique where more of the machines are used in production and less labour is used.e.g Farming with a tractor or using computerized system of production.etc.
ADVANTAGES OF CAPITAL INTENSIVE TECHNIQUE
It leads to large scale production.
It improves the quality of the goods.
It helps to reduce labour problems.No demand for salary increase by the computers or robots.
It helps to promote technological advancement.
DISADVANTAGES OF CAPITAL INTENSIVE TECHNIQUE
It leads to unemployment of people.That is many people lose their employment as machines replaces labour.
It is a very expensive technique.
It is very costly.That is to maintain the capital in case of any employment.
Large scale production may lead into the problem of over production due to lack of a wide market.
LAND INTENSIVE TECHNIQUE
Is the method where more of land is used in production and less of capital eg to increase the form output one decides to expand the form size which using the less of fertilizer.
FACTORS WHICH DETERMINE THE CHOICE OF TECHNIQUE OF PRODUCTION
Price of factors.
That is, if the factors of production is sold at a lower price producers will use more units of that factor of production and the vice verse.
Efficiency of the factors.
Producers will choose a factor of production which is more efficient than the other factors. Example; – the use of capital creates more efficiency than labour.
Degree of substituting a factor of production. If a certain factor of production cannot be substituted with other factors of production, producers will have to use more units of that factor e.g. high specialized doctor cannot be substituted.
PRICING OF THE FACTORS OF PRODUCTION
Pricing of the factors of production refers to the system of making payments or rewarding the factors of production.
REWARDS FOR FACTORS OF PRODUCTION
The price for land is rent.
The price for labour is wages and salaries.
The price for capital is interest.
The price for entrepreneurship is profit.
Wages are the payments which are made for the productive services of a labour.
KINDS OF WAGES
Money wages refers to the wages paid and recorded interms of money. It includes monetary payment only.
Money wages are wages earnings that are measured or expressed interm of money or nominal or money wages refers to the actual sum of money earned by the workers.
Kind wages refers to the wages which are paid in the form of some goods e.g. a former pays in grams of crops to the labour, potter, carpenter etc for the services rendered by them
Real wages means the purchasing power of money wage interms of goods and services consumed by the wage earner plus other facilities provided by the employer free of cost e.g. free uniform for policemen, transport allowances etc.
FACTORS DETERMINING REAL WAGES
Money wages and purchasing power of money while competing real wages, we have to find out what quality of goods and services can be purchased with the money wages paid to the labour.
Extra income. If a labour can earn extra income from an association with a particular job, that should also be considered while counting real wages.
A teacher can earn extra income through tuition or writing a book, A doctor can earn extra income by giving consultancy to the patients at his house.
Facilities such as housing, medical, education, e.t.c given to the labour should also include in real wages.
Working hours.While computing real wages working hours with their distribution, leaves and vocation should be taken into consideration.
Nature of work. If the work is risky, dull or injurious to health.The real wages in that case will be considered low.
Working condition. Working conditions have large effect on real wages. Real wages are very much affected by behavior of the employer or environment of the working place provision for cold water and fans in the summer’s heater in the winter.
Permanency of the work.
Real wages will be more in the profession where work is regular and permanent in comparison to the jobs with temporary nature.
Time and cost of training.
Some workers require a long period of time and high cost for training e.g. engineering, medical and other case will be low because of time and cost of training.
Wages differs among different people in the same job and among different jobs. We find that there is a difference in the wages of workers working in different occupations. Wage differentials can be explained mainly on the following grounds;-
Agreeable of the job. Some jobs are more pleasant and agreeable than others. Supply of labour in pleasant job will be more than in unpleasant jobs hence wages may have to be raised to attract workers into less attractive jobs.
Regularity of the job. Some jobs provide regular employment while other give only irregular employment especially seasonal occupations such as sugar mill, ice factory, etc. hence the wages rate in the job having regular employment.
Risk and danger. Some jobs are more risky and dangerous than the others. For instance;-Air services, military mires are some such examples where risk and danger are great. Hence it must be compensated by giving more wages in such occupation.
Responsibility in the job. Wages sometimes differ on account of responsibility of the job eg there is more responsibility on the principal of college than the teachers that is why a college principle receives higher salary.
Working hours. Sometimes the hours of work are requiring very easily or very late attendance or shifts hence higher wages have to be paid in such occupation.
Cost and time of training. Jobs which require high quality training, wages will be higher in them.e.g; wages of doctors and engineers are always high.
Differences in ability. Labors who are more able and efficient will get higher wages.
Social prestige. Wages will also be high in the jobs having social prestige. Sometimes the wage rate is kept high merely to keep the high prestige of a particular job.
Non- competing groups.
There are different categories of labour which modern economics call non- competing groups in the market e.g.; plumbers cannot complete for the job of being a doctor or a butcher cannot be employed for the job of accountancy. Thus different wages are paid for different categories of labour.
Use of modern machines and techniques. Occupations having modern machines and uses high sophisticated techniques of production can provide higher wages.
RECARDIAN THEORY OF WAGE
The one different theory that explains how wages a rises from time to time for example substance theory of wages. Standard of living theory of wages finds theory marginal productivity theory and modern theory of wages and the bargaining theory of wages.
MARGINAL PRODUCTIVITY THEORY OF WAGE
The marginal productivity theory states that “Under perfect competition of every worker of the same skills and efficiency in a given category will receive wages equal to the marginal product of the labour.
The theory operates under the following assumptions;-
It assumes that labour is homogeneous.i.e they are the same in skills, efficiency, abilities, etc.
Factors of production i.e. labour can be substituted for each other perfectly.
The theory assumes that wage levels and labour productivity are independent. This is not necessary valid. Increased wages may be call for extra efforts from the labour force so that productivity increases.
It’s not always possible to separate the marginal contribution of each labour in the production.
There are other factors than marginal product which determine reward for labour in production.
2. SUBSISTENCE THEORY OF WAGES
This is so called “Iron law of wages”. It states that,” if wages rises above subsistence level increased in population is inevitable follows and this forces wages down to subsistence level”.
This theory was rejected due to the following;-
It is not realistic, because it is not necessary that the increase in wages must lead to the increase in population.
The theory does not explain the inequity of wages in different occupations and countries.
The theory attempts to explain mainly on the supply side with insufficient reference to the condition of demand.
Application of the theory was probably the theory that was formulated, since poor harvest in those days means that many people died for starvation. If may still be true of some more densely population where the standard of living is low.
3. THE MARKET THEORY OR MODERN THEORY OF WAGES
The modern theory of wages is also called demand and supply theory. According to this theory wages is determined by the interaction between demand and supply.
Wages are the price of labour like other prices are determined in a market.
-To understand the theory of wage determination, we have to understand the demand for and supply of labour affecting them.
DEMAND FOR LABOUR
The demand for labour in a factor market is a derived demand. It is derived from the anticipated goods and services in the production of which it assists. However the demand for labour is also affected by;-
Elasticity of demand for the commodity produced.
Technique of production.
Price of other factors of production.
Marginal productivity i.e. entrepreneurs demand for labour because of its productivity. It is because of its productivity that entrepreneurs are ready to pay them.
SUPPLY FOR LABOUR
The supply for labour can be defined in two ways;-
The total number of people available for employment.
The total numbers of hours that people are willing to work.
The supply of labour depends on the following factors;-
The size of population.
The proportion of the willingness and ability to work i.e. labour force.
The number of labour worked by each individual.
Wage rate i.e. the supply of labour increases with the rise in wage rate and decreases in wage rate.
NATURE OF THE SUPPLY CURVE FOR LABOUR
The supply of labour increases with the increase in wage rate. Therefore the supply curve for labour is upward sloping curve or it is downward sloping curve (which is sometimes known as regressive in nature).
That if wages increases the supply of labour increases. However it increases up to a certain point from there after it decreases until increase in wages forming what is so called ‘BACKWARD SLOPING CURVE” or “REGRESSIVE SLOPING CURVE”.
From the graph therefore an increase in wages from OWO leads to the increase in the number of working hours from ONO. But further increase in wages from OW1 leads to the decrease in the number of working hours from Ono to ON1.
Why the supply curve for labour is backward sloping or it is regressive in nature?
Reduction of number of labour/ workers willing and able to work. Sometimes it seems that when the wages of member of family especial men increase, it result the reduction of worker ( women’s ).
Work leisure rate or income substitution effect. Ie when wages increase workers income also increase. Worker may like to have more leisure in order to enjoy their ability ( income).
Meeting objectives / goals.
3. SUBSISTENCE THEORY OF WAGES
If wages rises above subsistence level on increase in population is inevitable from / follows and this wages should be paid to the level of subsistence (meeting basic needs ).
It is not realistic. It is not necessary when income increase and also population increases.
Does not explain the equality between higher earners and lower earners in a country.
The theory attempts to explain mainly only on the supply side with efficiency
The theory was probably true at the time that it was formulated since there was poor harvest in those days which means that many people died of starvation. It may still be true to some of more densely populated where the standard of living is low.
CAN TRADE UNIONS RAISE WAGES?
Trade unions can raise their wages if they follow this:-
If workers are paid below marginal productivity.
By increasing marginal productivity by other means. ie they pressurize an employer by demand for modern machines, capital etc.
By using demand for labour. Through make the change of technique interview in human labour.
Raised for particular type of labour in industry i.e education skills.
If wages take small portion in the cost of production. An employer can provide (rise the wage of a worker ) wage to a worker,if the wages take small portion in the cost of production.
COLLECTIVE BARGAINING AND TRADE UNION
Collective bargaining refers to the negotiations between a trade union and employer or an employer’s organization over the wages and work condition.
Is the continuous association of wage earners for the purpose of monetary and improve paying of the workers and condition of working.
Example; in Tanzania we have TFTU –Tanzania Federation Trade Union.
FUNCTIONS OF TRADE UNIONS
Bargaining on behalf of the workers for maintenance of better pay and good working condition i.e. provision of education, holiday recreations and
To safe guard jobs. One should actual be sure of not losing job.
To offer monetary benefits i.e. sickness and accident person.
To restrict the supply of labour so as to maintain their demand i.e. the higher the demand, the higher wage rate.
To keep all its members employed.
To participate in national and international social economic organizations. E.g. ILO.
FACTOR AFFECTING THE STRENGTH / POWER OF TRADE UNION
The size of its membership.
If the trade union has large size of members, its strength will be large, likewise if the trade union shows a small size of its member its strength will be less.
The extent of the effect it cause to the community or society to strike.
General economic conditions of the trade unions.
The nature of demand and supply of labour and product.
Proportion of the wage to the total cost of production.
RENT (THE REWARD TO LAND)
Is the reward to the use of services of land, according to Ricardo.
Is that portion of produce of the earth which is paid to the landlord for the use of original and indestructible power of the soil.
How does rent arise?
According to Ricardo opinion rent arise only on land not on other factors of production.
Because of the following peculiarities of land which are not found in other factors of production.
Land is free. It is a gift of nature hence it has no cost of production from societies’ point of view.
The supply of land is fixed and inelastic in the long run.
According to Ricardo “the continuous rise in population of the law of diminishing returns are the two principle reasons for the emergence of economic rent.
Thus According to Ricardo rent a rises because different plots of land have different fertility power.
Thus the difference in fertility power has been the reason for the emergence of economic rent.
What is economic rent?
Refers to the payment received by a factor over and above what is necessary to induce that factor to enter its present employment or to keep it there.
Refers to the minimum earning that must be paid to a unit of any factor to hold its present use. It is minimum payment that keeps a factor in the present occupation.
E.g. Economic rent = present earning – transfer earning.
Consider rent under extensive cultivation.
Grand of land
Total production in (000)
Therefore, According to Ricardian theory rent can be measured as
Rent = output of extra marginal land – output of the marginal land
This also can be illustrated by using the graph below
Main conclusions of the Ricardian theory.
Land is the only factor which posse’s original and indestructible power gifted by nature and those is the power which give rise to rent.
Rent has a differential surplus since it arises due to differences in fertility and situation.
To Ricardo rent was the result regardless of nature.
As the price of corn is equal to the cost of production over the marginal or no rent land does not enter price. In other words the price of corn really determines land rent rather than having land rent determine the price of corn. On this basis Ricardo concluded corn is high not because of rent is paid but rent is paid because corn is high,
CRITICISM OF THE RICARDIAN THEORY
He restricted rent to the land only while it is applicable to other factors of production. Rent is not the part of price of land. But according to modern economists rent does affect price.
He implied that there will be no unit in all land if were fertile. Since rent is not only restricted to the fertility and but also infertility land.
He ignored the possibility that there were alternative uses of the price of land .This basically based on natural productivity land.
Even infertile land can be made fertile through reclamation process.
MODERN THEORY OF RENT
According to the modern theory developed by this Joan Robinson and others rent can rise on any factor of production. i.e land,capital, labour and entrepreneurship.
According to the modern economist every factor has level element in other words. The supply of the factors of production is not perfectly elastic and hence they earn surplus income which is of the nature of rent.
According to Mrs. Joan Robinson, the essence of the concept of rent is conception of surplus earned by a particular part of factor of production over and the minimum necessary to include it to do its work.
According to prof. Lip say, Economic rent is an excess over transfer earnings that a unit of the factors actually earns.
In short Economic rent = factors actual earnings – transfer earnings
That is; Economic Rent = present earning – Transfer earning
DETERMINATION OF ECONOMIC RENT
According to economic to modern theory economic rent arise due to scarcity and specificity of the factors of production.
Suppose a mechanical engineers according in Kahama gold mining get $2500 as monthly pay. If he leaves Kahama Gold mining he can get $2000. In this situation $2500 is actually earning and $2000 is his transfer earnings that is the earning of the next best job.
This Economic rent = present earning – Transfer earning
= $us 2500 – $us 2000
In other word the rent of to any factors of production will depend on its elasticity of surplus as follows;-
If the factors is perfectly elastic, supply will earn no rent because both its actual earning and transfer earning are equal
Present earning = SENO
Transfer earning = SEON
2. Rent under perfect inelastic. When the factor is completely specific or has only one specific use, change in price has no effect on its supply i.e even at zero prices the supply of the factor will remain the same.
Thus this factor has no transfer earning. Therefore the whole actual earning is the economic rent.
This is illustrated under the diagram below
From the diagram
Transfer earning = o
Present earning = WELO
Rent = actual earning – transfer earning
WELO – 0
Actual earning = Rent
3. Rent under relatively elastic supply.
It suggested that normally the supply of factors tend to increase with the increase in the factor price.
Thus the supply of the factor remain upward sloping comes from left to the right.
If the supply curve slope upwards all units to the left for the one being considered have lower transfer earning. Thus the total transfer earning of the units is the area below the supply curve. And the total payment (present earning) is equal to the total area.
This illustrated diagram below
From the diagram we note that;
Rent = present earning – transfer earning
RENO – SENO = Res
Rent = RES
Thus the above analysis makes it clear that the more elastic the supply curve the less.
QUASI – RENT
The concept of quasi –rent was propounded and popularized by Prof. Marshall.
He used to explain the return of man- made produce goods the supply of which is fixed in the short period.
In a technical expression that indicates the relationship between output and the factor inputs used to produce such output.
In short production function can be written as;
Qx = f (K, L, E etc)
This can be simplified;
Qx = f ( k,l ) while l is variable and k is fixed.
TYPES OF PRODUCTION FUNCTION
Short run production function. Some factors are fixed while other are variable ie K (capital) is fixed labour is variable.
Qy = f(k,l)
It is subjected to the law of the diminishing returns.
Long run production function.
All the factors of production are variable. It is subjected to the law of return to scale.
FACTORS DETERMINING THE PRODUCTION FUNCTION
Quality of resources available.
State of technology.
Size of a firm.
Price of factors of production.
Political making a factor.
TOTAL PRODUCT, AVERAGE PRODUCT AND MARGINAL PRODUCT
TOTAL PRODUCT :- Is the level of output which can be produced by a given amount of input.
Total product = Labor x Average product
Where L is labour.
AVERAGE PRODUCT AP
Is the output per unit of variable factors
AP = TP/L
Where by TP=Total Product
Q =2L2– L find average product.
Divide L from the TP given.
Average product = 2L – 1
MARGINAL PRODUCT ( MP )
Is the addition to the total product that result to unit factor inputs.
Is a changes of total output as a result of unit change of a factor inputs.
Where by ΔTP=Change of total product
ΔL=Change of labour
Find marginal product of the following economics equation
The following table is demand from a production firm y.
THE GRAPH MP, TP, AP
THE GRAPH MP, TP, AP
G-Point of a Diminishing Returns.When quality labour employed are 3and marginal product rising up to and start to diminish.Total product increases from1 to 10. Average product increase until 5men are employed,then it deminish
The Law of Variable Proportions which is the new name of the famous Law of Diminishing Returns.
→According to Stigler” “As equal increments of one input are added, the inputs of other productive services being held constant, beyond a certain point, the resulting increments of produce will decrease i.e., the marginal product will diminish”.
→According to Paul Samulson “An increase in some inputs relative to other fixed inputs will in a given state of technology cause output to increase, but after a point, the extra output resulting from the same addition of extra inputs will become less”.
The law of variable proportions states that as the quantity of one factor is increased, keeping the other factors fixed, the marginal product of that factor will eventually decline. This means that upto the use of a certain amount of variable factor, marginal product of the factor may increase and after a certain stage it starts diminishing. When the variable factor becomes relatively abundant, the marginal product may become negative.
Law of Variable Proportions:
“in a given state of technology, when the units of variable factor of production (L) are increased within the units of other fixed factors, the marginal productivity increases at increasing rate up to a point, after this point. it will become less and less”
The assumptions of the law of variable proportion are given as below:
It is assumed that the technique of production should remain constant during production.
It operates in the short-run because in the long run, fixed inputs become variable.
Some inputs must be kept constant.
The various factors are not to be used in rigidly fixed proportions but the law is based upon the possibility of varying proportions. It is also called the law of proportionality.
It is assumed that all the units of variable factors of production are homogeneous in amount and quality.
It is assumed that labor is a single variable factor.
The law of variable proportion is explained with the help of the following schedule:
In the above schedule, units of variable factor (labor) are employed with other fixed factors of production. The marginal productivity of labor goes on increasing up to the 3rd worker. This is so because the proportion of workers to other fixed factors was at first insufficient.
After 3rd worker the marginal productivity goes on falling onwards till it drops down to zero at the 6th unit of labor. The 7th worker is only a cause of obstruction to the others and is responsible in making the marginal productivity negative.
The marginal productivity (MPL) and the average productivity (APL) equalize at 4the worker. Then the MPL falls more sharply
The number of workers are measured on X-axis while TPL, APL and MPL on Y-axis. The above diagram shows the three stages also obtained from the schedule.
At this stage MPL increases up to 3rd worker and its curve is higher than the average product, so that total product is increasing at increasing rate.
At this stage, MPL decreases up to 6th unit of labor where MPL curve intersects the X-axis. At 4the unit of labor MPL = APL after this, MPL curve is lower than the APL. TPL increases at decreasing rate.
At 6the unit of labor the MPL becomes negative, the APL continues falling but remains positive. After the 6th unit, TPL declines with the employment of more units of variable factor (L).
Relationship Among Total, Average and Marginal Product:
The relationship among total, average and marginal product of labor in the light of the law of variable proportion is explained as under:
The marginal productivity of labor increases, the TPL also increases at increasing rate. It is shown in the schedule up till 3rd unit of labor. The MPL curve has positive slope and TPL curve has rising tendency towards Y-axis.
When the MPL decreases onwards till it drops to zero, the TPL increases at decreasing rate as shown in the stage II and the TPL curve has positive slope but has rising tendency towards X-axis
When the MPL is equal to zero, the TPL is maximum as shown on the 6th unit of labor.
When the MPL becomes negative, the MPL curves falls below the X-axis, the TPL declines from its maximum position and its slope becomes negative as shown in the stage III in the above diagram.
When the MPL increases, The APL also increases but at slow rate. The MPL curve becomes above the APL curve. Both have positive slopes.
At some point, MPL = APL. At this point, MPL curve intersects the APL curve as shown at the 4th unit of labor in the above diagram.
After intersecting point, MPL falls sharply. The MPL curve becomes below the APL curve. Both curves have negative slope.
When MPL becomes negative, the APL never becomes negative because it is calculated from the TPL. So MPL curve is below the X-axis but APL curve is above the X-axis, having negative slope.
CAUSES FOR OPERATION OF THE LAW
Fixed of a factor.
Scarcity of a factor.
Existence of imperfect substitutes. There is no way capital can be substituted to labour.
Optimum combination of the inputs.
LIMITATIONS OF LAW OF VARIABLE PROPORTIONAL
Operates only in the short run.
It is restricted to land only yet in reality it can apply to other factors when they are fixed.
It is not applicable in case of virgin land because the land becomes productive for a long period.
Variable factors are not homogeneous, that is they differ in efficiency ability.
It does not consider the influence of other factors such as health of a worker.
Thus the operation of law of returns to scale is mainly caused by two major means,which are;-economics of scale and diseconomics of scale.
Very short run.
Refers to the period of time which is very short to make all factors variable i.e. that is all factor are fixed.
Refers to the period of time where at least one factor is fixed and the other is variable.
Refers to the period of time that is long enough to make all factors variable.
Very long run.
Refer to the period of time which is able to not only change factors of production but also the technology.
The law of return to scale of low production operates in long run while the law of Diminishing returns operates in the short run production function.
Consider the following table and then answer the question that follows;
From the table draw the curve to depict the law of variable proportion.
Identify the number of labour at
The number of labour at MP=AP from the graph is 6
Max = TP
The number of labour of maximum is 9
MP = 0
The point at that level MP = 0 is 9. Because the maximum is 9.
Given the following TP =2L2-20L
Find the unit of labour which will maximize output.
Calculate the TP, MP, and AP.
From TP = 2L2-20L
= 2 x 2L(2-1)-20L(1-1)
= 4L – 20
The about at maxim MP = 0
MP = TP
5 = L
The unit of labour which will maximize the output is 5
MP, TP, and AP
AP = TP/L
= 2L – 20
The average product can’t be -10 is +10
TP = 2(25) – 20(5)
= 50 – 100
The product can’t be negative then ignore negative and therefore TP = +50
= 2(25) – 20(5)
= 50 – 100
The product can’t be negative then ignore negative and therefore TP = +50
MP = âˆ†TP/âˆ†L
MP = 2L2-20L
= 4L – 20L
= 4L -20
Where L= 5
MP = 4L – 20
= 4(5) – 20
= 20 -20
The marginal product is 0
LAWS OF RETURNS TO SCALE
It states that;
An increase in input may lead to more than proportionate increase in output.
Decrease in inputs may lead to a proportionate decrease in output.
Law of increasing returns to scale. If inputs are doubled then the output increases more than the double inputs.
Law of decreasing returns to scale occurs if a production increase in inputs leads to less increase in outputs i.e If the inputs are doubled the number of output is less than the double inputs.
CAU“1““`SES OF THE INCREASING RETURNS TO SCALE TO OPERATE.
The reasons for the operation of increasing returns to scale are found in form of economies scale.
Labor economies of scale that is economics of specialization and division of labour are possible in large scale production.
Technical economies of scale.
Marketing economies of scale such as advertising through news papers, TV, magazines.
Managerial economies of scale such as specialization of management and division of labour management.
Economies related to transport and storage cost ie large scale firm normally their own transport eg large vehicles.
CAUSES OF THE DECREASING RETURNS TO SCALE TO OPERATE
( Dis economies of scale )
Marginal dis economies.
As a result of increasing managerial dis economies,the decreasing return to scale operates,
Exhaustible natural resources.
SCALE OF PRODUCTION
Refers to the size of the from and the technique employed in production. Divided into two
Large scale production.
Small scale production
The LRAC curve shows the lowest cost of producing different levels of output given the firms production function and factor prices.The LRAC curve is an envelope curve to the firms SRAC.
Economies of scale: Falling long run average cost from C1 to C2 as the scale of output increases.
Diseconomies of scale:Rising long run average cost as the scale of output increases.
CAUSES OF ECONOMIES OF SCALE
To improve production technique (applying up to date technology)
Efficiency utilization of resourses
Full improvement of resourses
Availability of reliable market
Effectively and economically useful of capital goods.
Internal economies of scale:are those factors which bring about the reduction in average cost as the scale of production of individual firm rises.
External economies of scale:are result from the simultanous growth or interaction of a number of firms in the same or related industries.These includes specialist companies of supplying and repering machinery.The expansion of an industry leads to the establishment of many firms specializing in a particular stage of production processes.
CAUSES OF DISECONOMIES OF SCALE
Weak market linefficiency
Leakage of resourses
Applying old techniques of production
Unemployment of resources
LARGE SCALE PRODUCTION
Refers to the scale of production in which large output is produced and the amount of inputs used is also large.
MERITS OF LARGE SCALE PRODUCTION
Ability to minimize the cost of production and maximize profit e.g buying inputs in large quality,employing advanced technology.
Variety of goods due to settled market.
Easy to raise capital from financial institutions like commercial banks.
Expansion of market through advertising researches.
There is ability to increase efficiency in production e.g advanced technology, skilled people,intensive capital.
Specialization and division of labour is applicable.
DEMERITS OF LARGE SCALE
It involves large cost of administration.
Very difficult to make decision. Due to large number of people
It needs large capital to start production to employ labour and machines.
Managers have less entrance on managing the scale.
Why do small scale firms continue to exist side by side with the large scale enterprise?
Some small scale firm supply inputs to the large scale firms. The large scale firm plays part as a market for small scale firm.
Small extent of the market. The output being produced by small scale firms is easily to be disposed then the output produced by the large scale firms.
Small scale firms have control with the customers.
Easy management in small scale firms due to small resources than in large scale firm which require complicated economies systems.
Simplicity in technique of production.
There some cost which small scale producers do not like advertising transport.
Decision making.It is quick because it involves one person( owner ).
Low operating and administrative system.
High commandment to owner of the firm.
DISADVANTAGES OF SMALL SCALE FIRM
Limited possibility of expansion because of small amount of capital.
Large average cost.
Can not produce variety of goods. It is risky in case of market decline.
Difficult to market the products, due to low advertisement.
Inefficient production because of instability of employing very skilled labour.
a. Choice of the appropriate formula and computations
This is a payment paid to labour for its efforts rendered in the production process
Types of Wages
Money or nominal wages
This refers to the amount of money received by a labourer for performing a certain work without considering the amount of goods and services worth it.
Is the wage that is measurable in the amount of goods and services worth it and therefore it considers the purchasing power.
This is the type of wage which is paid interms of physical goods. E.g. in rural areas labourers are at times paid interms of such as grains.
Determinants of Real wages
The price level
The purchasing power of money depends upon the price level. Therefore when the price increases the real wage decreases and the opposite is true.
This is an addition to what the labourer earns from other sources which finally results into high real wages.
Laborers receive extra facilities such as housing, medical, education etc. such benefit also increase the real wage of the worker.
When looking at the real wage. Working hours with their distribution leaves and vacations are very important. The less the working hours by provision of leave hours, the higher the real wage.
The nature of the work
If the work is risky, injurious e.t.c to the health of the labourers then the real wage in that case is to be considered low and the opposite is true.
Regularity of the work
Real wage will be more in those professions where work is regular and permanent as compared to the jobs of temporary nature.
Systems of Wage Payment
Pieces rate system: This is a system whereby a worker is paid according to the work done.e.g the quantity of output produced.
More output is produced as workers will aim at producing more to earn more.
With this system it is very easy to differentiate between a lazy and a hard working worker by comparing their output.
This system does not require close supervision as each worker intends to work harder.
It is easy for the employer and the employee to know the amount of payment.
Quicker workers can earn more than those who are slow and lazy
Workers may overwork themselves in order to earn more.
It is not suitable for kinds of work which cannot be measured quantity wise.
More careful workers who aim at producing high quality output may instead be paid less.
It may result into fall in quantity due to a rush to produce more.
It may result into accidents due to high speed among the workers in an effort to produce more.
Time rate system: This is a system of wage payment which is based on the hours of work by labourers which can be weekly, monthly etc.
Workers are assured of regular payments.
It is suitable for those types of works which cannot be measured quantitatively.
It is easy to calculate the wage payment in relation to the working time.
Workers will not rush their work which will result into high quality output.
With this system wage rates can easily be adjusted to reflect different skills required to do the job.
Output may be low because workers are assured of a regular payment
With this system it is difficult to differentiate between a hard worker and a lazy worker.
It requires close supervision to ensure that workers perform their duties.
With this system it’s not easy to reward extra payment to a hard worker because it is difficult to measure output produced by each worker.
The system encourages inefficiency because even the inefficient workers are paid at the end of the month.
Standard rate system: This is a system of wage payment where by all workers engage in similar works is paid the same.
Profit sharing system
It refers to a situation whereby labourers are paid different wages, despite the fact that they may be working in the same firm having the same education level etc.
Reasons for Wage Differential
Difference in the level of education.
Highly educated are paid more than the less educated since they have more skills, more knowledge etc.
Difference in the level of trust and responsibilities
Those who are in the position of more trust are paid more than those employees with low level of trust.
Difference in the level of experience
More experienced workers are paid more than less experienced workers as they are assumed to be more knowledgeable, experienced and more efficient compared to less experienced workers.
Difference in the riskiness of the job
Those workers which perform risky and dangerous jobs are paid more compared to other jobs. These dangerous occupations are such as miners. pilots etc.
Difference in Gender
In some situation males are paid more than female, because males use more energy and most of the works are done by males and not all of them are done by female.
Difference in the level of strength.
More energetic workers are paid more compared to less energetic workers. The more energetic a worker he/ she is can be able to perform more work and get more paid
At times wages differ among workers due to racial factors, where by the whites are paid more compared to the blacks.
Differences in the strength of Trade Unions.
Workers who belong to strong trade unions are normally paid more compared to those who belong to weaker trade unions.
Theories of Wage Determination
Subsistence theory of wages
This theory was presented by the physiography and was explained by a German economist Sallee. This theory may be known as The Iron Law of Wage
According to this theory, wages tend to settle at the level which is just sufficient to maintain the worker and his family at a minimum subsistence. If for some reason, wages are higher than this level, it is said that the workers would be encourage to marry, their number would increase by higher birth rate with the large supply of labour brings down the wage to the subsistence level.
If on the other hand, wages are below subsistence level marriages will be discouraged and ultimately labour supply will decrease, hence wages will rise and reach the subsistence level. This theory has been reflected because it is not realistic.
Criticisms of the theory.
The law is applicable to less developed countries where wages are on low subsistence level unlike in more developed country.
The theory only looks at increase in birth rates due to increase in wages neglecting other factors such as; early marriages.
The term minimum subsistence is vague, because there is nothing like a fixed minimum subsistence as it keeps on changing.
The theory is also unable to explain reasons for differences in wages.
It is not always true that increase in wages is always accompanied by increase in the population size
Wages Fund Theory
This theory is associated with the name of J.S. Mill. According to him, a wage fund is created and the wages are paid by the employer out of this fund. According to this theory, wages depends on two quantities:-
The wages fund set aside by the employer for the payment of wages and
The number of labourers seeking employment. The actual rate of wages can be found by dividing the fund by the number of workers.
According to this theory, wages cannot rise unless either the wage fund is increased or the number of working class people decreases.
Criticism of the theory
In real world there is nothing like a fixed wage fund as firms set wages according to the level of production.
The theory does not explain the method used in determining the wage fund.
The theory does not explain reasons for wage differentials among labourers.
Residual Claimant Theory.
This theory was advanced by the American economist John Walker.
According to him, wages are the residue left over after other agents of production have been paid. Rent, interest and profit, according to him are determined by definite laws. Out of the total production.When payments have been made to other factors, it is said that the whole of the remainder will go to workers.
This theory has also been rejected by most economists. It does not explain how trade unions are able to raise wages. Moreover, it is not the worker who is the residual claimant but the entrepreneur. The theory also ignores the influence of labour supply in wage determination.
Market theory of Wages.
According to this theory wages are determined by the interaction of demand & supply of the labour in the market and therefore the wage rate would be determined at the point of interaction of demand and supply curve for labour in the market.
Demand for labour is derived demand.Therefore when there is increase for demand of goods and services producers will demand more labour and the opposite is true.
Supply for labour refers to the number of labourers willing to work at the prevailing wage rate per period of time and it depends on factors such as population size, population composition etc.
From the above graph, Q_e W_e is the equilibrium wage rate.
Above that wage, demand for labour will be less than supply labour and hence surplus, labour but however that wage, demand for labour will exceed supply of labour and hence a shortage.
Marginal Productivity Theory
According to this theory a factor of production specifically labour should be paid according to its marginal productivity.
Marginal productivity is the additional output produced by an additional labour employed.Therefore a labour is paid according to his contribution (marginal product) to the firms total output. The higher the marginal productivity of the labourer, the higher the wage and the opposite is true.
If the employer pays a labourer more than the value of his marginal productivity it will instead result in to a loss.
Assumptions of the Theory.
The theory is based on the following assumptions:-
All units of labour are homogeneous.
The theory assumes that marginal productivity of any factor can be measured
It assumes perfect mobility of factors of production eg.Labor
The theory assumes operation of the law of diminishing returns.
The theory also assumes that wages are only determined by marginal productivity of labour.
Criticism of the Theory
In reality it is not true that all factors such as labour are homogeneous as it differs interms of strength, experience, skills etc.
Perfect mobility of factors of production eg. labour as at time limited by factors such as old age, fear to lose family ties.
The theory only looks at the demand side of labour neglecting the supply side of it
Increased wages can as well be determined by other factor besides marginal productivity such as level of experience, education and training.
In reality it is also difficult to measure marginal productivity of labour
It is also not true that the productivity of labour depends on the labourer himself but however depends on the efficiency of other factors.
Bargaining theory of Wages.
According to this theory wages are determined according to the bargaining strength of the labourers through their trade unions. Trade unions represent labourers to the management to discuss wage improvement and working conditions. Therefore the stronger the bargaining power, the higher the wages and the opposite is true.
Trade Union is an association of workers that aims at advocating for better payment and better working conditions.
It has been defined by Prof. Webb in the words “A Trade union is a continuous association of wage earners for the purpose of maintaining and improving the conditions of their employment.”
Method used by trade unions
Collective bargaining: This is when the trade union leadership represents a group of workers in negotiation with the management about interests of the workers and the general improvement in the working conditions.
Go slow tactics
Sabotage (creates a bad image of the company)
FUNCTIONS OF TRADE UNIONS.
To demand for increase in wages.
Improvement in working conditions.
Helps to fight job loss.
Helps to fight unfair dismissal.
Helps to protect against any kind of discrimination.
Trade unions help to advice the government in number of issues such as employment policies, wage determination etc
Trade unions help in improving the skills of its members through organizing seminar workshops etc.
Strength of the Trade Unions
Strength of the trade union depends on the extent at which a trade union is able to achieve its objective. Strength of the trade union will depend on the following factors.
Unity among members.
When there is unity among members, there is strength of the trade union because they tend to have a common stand.
The rise of membership
The bigger the membership the more strongly the trade union because they contribute more ideas and the voices is high.
Financial position of the trade union.
When the financial position of the trade union is high the more the stronger the trade union because it can open up more branches and can run up all the financial activities of the business.
The(impacts) level of inconvenience of trade union
The more the impact of the trade union activities,the stronger the trade union and the opposite in true
The labour laws of the Country.
If the labour laws are supporting and protecting the interest of the labourers then the trade union will be strong and the opposite is true
Trade union leadership.
If a trade union is led by committed and competitive leaders, he tends to be stronger as compared to one led by leaders who aim at fulfilling their own objectives.
Problems faced by Trade Unions in poor countries.
Lack of enough funds which tend to limit the operation of the union.
Government interferences in the activities of the trade union e.g. Setting restrictions on their operations.
Lack of enough co-operations among members.eg. Some do not pay membership subscription or fee.
Poor management and administrators who use trade union as a stepping stone as a base to achieve their own objectives
Tribal differences which tend to affect mobilization of members.
In many low developed countries, the government is the major employer and on many times resists to request from trade unions.
Factors that Determine Wages
The level of experience.
Level of education.
Government policy (minimum wage).
Level of responsibility.
The demand of the labour and supply as well.
Level of strength.
Level of productivity.
Costs of living.
Riskiness of the job given
Rent is a reward to the land lords for use of the land there it is the price of land.
In economics, rent is defined as a payment made to the land lord by the tenants for the use of their land.
In ordinary sense rent is defined as a periodical payment made for use of items such as house, a bicycle, and a car and so on.
Theories of Rent
There are two main theories of Rent
Ricardo theory or Ricardian theory.
Modern theory or demand and supply theory.
Ricardian Theory of Rent
This theory was put forward by David Ricardo and in his ideas he defined Rent as, “That portion of the produce of land which is paid to the land lord for the use of the original and indestructible process of the soil.” In other words Ricardo considered rent as a return to the landlords from the use of their land.
In his opinion Ricardo stated that rent is only applicable to land and not any other factor of production because land possesses unique features being a free gift of nature and having fixed supply. He also emphasized that land possesses some power which are free and indestructible and this is what referred to as the fertility power of soil, but however such fertility is not uniform to all portion of land, therefore some portions have high fertility and other low and hence basis of rent.
Ricardian theory has two elements
The first element is that rent arises due to the reasons that certain lands are more fertile as compared to other lands and in this way, surplus production occurs due to the difference in the fertility of land and it is called differential surplus or differential rent
The second element is that land is scarce and rent arises due to the security of land. According to Ricardo, the superior lands will pay scarcity rent at the same rate as the inferior lands but they will also pay a differential rent.
The Theory is based on the following assumptions:-
Land has a fixed supply.
Fertility differs among different portions of land.
He also assumed the law of diminishing returns to operate.
It is also assumed that land possesses original and indestructible power of the soil
Basing on all the above Ricardo concludes; that difference in rent among different portions of land depends on the superiority of the fertility and therefore more fertile land will fetch more rent than the less fertile.
Criticism of the Theory
In reality rent does not arise because of fertility but because land is scarce.
Rent is not only applicable to land but even to other items such as car, bicycle.etc
The law of diminishing return which was assumed to operate can be checked by modern methods of agriculture eg. use of fertilizers
It is also not true that there is such original and indestructible power of soil since fertilized soil tend to lose fertility after being used for a long period of time.
Land can as well be used for various uses besides cultivation. It can as well require to pay rent eg construction of commercial buildings.
Modern Theory of Rent
Under this theory rent is determined by its demand and supply.
Demand for land
Demand for land is derived demand by individuals and the economy as a whole. When there is more demand from products of land demand for land increase and the opposite is true.
Supply of land
On the other hand supply of land is fixed (perfectly inelastic) meaning that the supply of land can neither increase nor reduce when rent increases or decreases.
Basing on the above rent will be determined at the point of interaction of the demand and supply curve for land
From the above Ore is the equilibrium rent determined when demand and supply curve for land meet at point E.Therefore when demand for land increases rent will also increase and the opposite is true.
TRANSFER EARNINGS, ECONOMIC RENT AND QUASI RENT
This is the amount of money that any particular unit of a factor eg. labour could earn in its next best paid alternative use or employment.
Transfer Earnings means to the minimum amount that any unit of a factor eg. labour must earn in order to precept it from transferring to another alternative use. This means that any reduction in the actual earnings below the transfer earnings would cause the factor to transfer to the next best alternative use or employment.
Therefore transfer earnings are the minimum amount of money that must be paid to a unit factor in order to hold in its present use. E.g. if a labour is paid 70,000/= month in his current employment but would earn 60,000 in his next alternative employment then 60,000 is the transfer earnings. In order for the employer to retain his employee he should pay him a minimum of at least 60,000 or more.
This is the surplus earning to factors of production eg. labour over its transfer earnings.
Economic Rent is therefore the excess payment over and above the transfer earnings. Eg. if a labour currently earns 70,000/= at the current employment but could earn 60,000/= in the next best alternative employment then 10,000 is the economic rent.
Economic Rent = Actual earnings – Transfer earnings
Economic Rent = 70,000 – 60,000 = 10,000
This refers to short run earnings to those factors of production which are man made. E.g. machines, buildings etc whose supply is fixed in the short run.
Unlike land whose supply is fixed both in the short and in the long run factor such as machines, buildings and other there supply is inelastic in the short run but elastic in the long run
Because of their inelastic supply in the short run when demand increase, their income also increases and hence able to earn a surplus. The surplus earned is however temporary as their supply becomes elastic in the long run. When the supply increase in the long run and adjusted to demand their surplus earnings disappears. In summary quasi rent is the income earned by man made factors such as machines, building etc. whose supply is inelastic in the short run but elastic in the long run.
This is the price for the use of money capital borrowed. Therefore interest is the reward for capital owners from the capital land out.
Interest rate is the price on borrowed capital which is the percentage of the amount borrowed is normally charged annually.
Gross Interest means the total amount which a debtor pays to a creditor and the net interest is that part of the payment which is for use of capital only.
Reasons why interest is charged on capital
Capital increase productivity
Is the payment for risk involved in lending out
Payment for inconvenience involved when lending out
Cost of administering the credit eg. keeping records.
Reasons Why Interest Rate Differ Among Borrowers
The amount of loan
The bigger the amount borrowed, the higher the interest to be charged, higher risk involved and the opposite is true.
The repayment period.
For a shorter repayment period the less will be the interest rate as it is to a longer repayment period.
Demand & Supply of Capital
When demand capital is higher than its supply interest will be high. However when demand for capital is less than its supply interest will be low.
Credit worthiness of the borrower
If the borrower is more credit worth interest charged will be low the opposite is true.
Difference in distance between the lender and the borrower
When the distance between the lender and the borrower is big, interest high because of high administration cost and the opposite is true.
The purpose of the loan
High interest rates are normally charged for unproductive loan compared to productive loan, for example; investment loans.
The Inflationary Condition
During Inflation the interest rate is high due to the value of money is low and during the period of deflation, the interest rate is charged because the value of money is high.
Theories of Interest are of two kinds:-
Those theories which relate to the problem why interest is paid.
Those theories which relate to the problem how rate of interest is determined.
WHY INTEREST IS PAID?
The following theories explain why interest is paid:-
- Marginal Productivity Theory
- Waiting Theory
- Austrian Theory
- Liquidity Preference Theory
- Fisher’s Time Preference Theory
Marginal Productivity Theory
According to this theory, interest is paid due to the reasons that capital is productive with the help of capital; it is possible to increase the production of commodities to great extent. Capital is productive in the sense that labour assisted by capital produces more than without capital. E.g. fisherman can catch more fish with a net than without it.
But this theory does not explain the concept of interest properly because if people were willing to lend unlimited amount of money without interest, a business would expand up to a point where the falling price of the product would simply cover other charges in making their off. Interest which every entrepreneur must keep in view. This is due to the reason that interest is paid on capital because demand for capital is greater than supply capital it is scarcity rather than productivity which explains interest.
Waiting Theory or Abstinence Theory.
Another theory of interest is the abstinence theory. It was presented by Prof. Senior. According to him, saving involves a great sacrifice or abstinence, because saving is an act of abstaining from the consumption since to abstain is painful, it was necessary to reward people for this act. This reward was in the form of the interest paid to those who saved rather than consumed their income or a part of their income.
Marshall used the term waiting instead of abstinence.According to him saving implies waiting. When a person saves, he does not refrain from consumption forever, but he has to ward since most people do not like to wait an inducement is necessary to encourage this postponement of consumption and interest is this inducement.
This theory has a considerable element of truth in it but it does not clearly analyze the force acting on the side of demand for capital.
Austrian or Agro Theory
This theory is also called the Psychological theory of interest. It was first advanced by John Rae in 1834. But it was presented in the final shape by Prof. Bohm Bawerk of the Austrian School of Thought.
According to this theory interest arises because people prefer present goods to future goods. This is due to the reason that present wants are felt more seriously as compared to future wants and in this way, present satisfaction is attached greater importance than the future satisfaction.
Interest is the discount which must be paid in order to induce people to lend money or postpone present satisfaction to a future date.
Why do people prefer present satisfaction to future satisfaction?
Bohm Bawerk gave three reasons for this fact.
The future is uncertain.
Present wants are felt more seriously than the future wants.
Present goods possess a technical superiority over future goods.
Fisher’s Time Preference Theory.
This theory was put forward by Professor Irving Fisher. In his view he stated that interest rate is as a result of eagerness to spend on the present consumption rather than the future consumption. People always put a lower value on future goods rather than present goods. It is up on this that they are more eager to spend their income on present consumption other than future consumption. Basing on this if a person lends to another he has to forego his present consumption and this will require him being offered a reward which is called interest.
He also stated that the more the eagerness to spend on present consumption the higher will be the interest rate and the opposite is true.
Criticisms of the theory
The theory assumes no difference between present and future purchasing power which is wrong as in the real world the purchasing power of money goes on changing.
The supply of capital in a country does not only depend on the eagerness to spend but however it even depends on other factors such as number of financial institutions.
The theory is one sided whereby it mainly looks at the supply-side of capital ignoring the demand side of it.
Fisher’s theory is very general as it fails to show the influence of financial institutions on the rate of interest.
Liquidity Preference Theory
According to Keynes, interest is not a reward for waiting, nor is it a payment for time preference. The rate of interest is a reward for parting with liquidity. In other words, people have a demand to hold money in cash form. In order to induce people to part with liquidity, they must be paid a reward in the form of interest. The rate of interest depends upon the degree of liquidity preference. The greater the liquidity preference, the higher the rate of interest and vice versa. This theory sounds more realistic
HOW IS RATE OF INTEREST DETERMINED?
- Classical Theory
- Loanable Fund or New Classical Theory
- Keynesian or Liquidity Preference Theory
The classical theory of interest is also called the real theory of interest.
According to this theory, the rate of interest is the payment for assistance or waiting or time preference. The rate of interest I this theory is determined by the demand for capital and supply of savings.
Demand for capital.
The demand for capital goods comes from the firms which desire to invest. Capital goods are demanded because they can be used to produce consumer goods. If the demand for consumer goods is greater capital like other factors of production has marginal revenue productivity.
If capital goods are greater than the marginal revenue productivity will be lower and vice verse. Therefore, the marginal revenue productivity curve of capital slopes downwards towards the right.
Thus we conclude that demand for individual capital goods and for capital goods in general will increase as the rate of interest falls.
Supply of savings
According to this theory, the money which is to be used for purchasing capital goods is made available by those who save from their current incomes. Saving involves the element of waiting for future enjoyment of saving. But people prefer the present satisfaction of goods and services to the future enjoyment of them. There, if people are to be persuaded to save money and to lend it to the entrepreneur, they must be offered to some interest as reward. If reward for saving is higher, individual will be induced to save more and vice verso. The supply curve of capital slopes upwards toward the right.
The rate of interest is determined by the interaction of the force of demand for capital and the supply of savings. The rate of interest at which the demand for capital and supply of savings are in equilibrium will be determined in the market.
Criticism of the Theory.
According to the classical theory of interest, more investment can take place only by decreasing consumption but a decrease in demand for consumer goods is likely to decrease the incentive to produce capital goods and therefore it will affect investment adversely.
By assuming full employment, the classical theory has neglected the changes in the income level. According to Keynes, equality between savings and investments is brought about not by changes in rate of interest but by changes in the level of income.
Classical theory as pointed out by Keynes is indeterminate. Position of the savings schedule depends upon the income level. There will be different savings schedule for different levels of income.
Loanable Funds Theory
It may also be called Neo classical theory. According to this theory interest is the price paid for the use of loanable funds and also rate of interest is determined according to the forces of demand for and supply of loanable Funds. There are several sources of both supply and demand of loanable funds.
Supply of Loanable Funds.
It is derived from four basic sources namely
(b) dis hoarding
(c) bank credit
(d) Dis- investment
Saving by individuals contributes the most important source of loanable funds. At a higher rate of interest, saving will be greater and vice verse.
Dis hoarding: (DH)
It is another source of loanable funds individual may dis hoard money from the horded stock of previous period. At higher rate of interest, more will be dis hoarded and vice verse
Banking credit: (BM)
The banking system provides a third source of loanable funds. Banking by creating money can advance loans to the businessmen. The banks will lend more money at higher rates of interest than at lower ones.
Dis Investment: (DI)
Dis investment is the opposite of investment and takes place due to some reasons the existing stock of machine and other equipment is allowed to wear out without being replaced or when the inventories are drawn below the level of previous period. When this happens, the part of the revenue from the sale of product instead of going in to capital in to capital replacement flows in to the market for loanable funds.
DEMAND FOR LOANABLE FUNDS.
The demand for loanable funds comes mainly from three fields,
Investment (b) consumption (c) hoarding
Demand for loanable funds for investment purpose by business firms is the most important element of total demand for loanable funds.
The price of the loanable funds required to purchase the capital goods is oily the rate of interest. It will pay businessman to demand loanable funds up to the point at which the expected rate of return on the capital goods equal the rate of interest. Business on will fund it profitable to purchase large amounts of capital goods, when the rate of interest declines. Thus the demand for loanable funds curve for investment purposes slopes down wards to the right. This is represented by the curve I
The second big demand for loanable funds comes from individual who want to borrow for consumption purposes. Individual demand loanable funds when they wish to make purchases in excess of their current incomes and cash resources. Lower rate of interest will encourage some increase in consumer borrowing. Demand for loanable funds for consumption purpose is shown by the curve which also slopes downwards to the right.
The demand for loanable funds may come from those who want to hoard money. Hoarding signifies the people desire to hoard their saving as idle cash balance. Demand for hoarding is represented by curve of it. The demand for hoarding money also slopes downwards to the right
According to loanable funds theory, the rate of interest will be determined by the equilibrium between total demand for loanable funds and total supply of loanable funds as shown in the following diagram.
In the above diagram, LS is the total supply curve of loanable funds. It has been derived by the later summation of the saving curve (S), dis hoarding curve (DH), Bank total credit curve (BM) and dis investment (DI).
Total demand curve for loanable funds is LD which has been found out by the later summation of the curves, I, C and H which show respectively the demand for loanable funds for investment, consumption and hoarding purpose.
The curves LD and LS interest each other at Point E and in this way the equilibrium rate of interest is OR.
The theory has been criticized in the same way classical theory has been criticized. In fact there isn’t much difference in the classical and loanable funds theory. The difference is only in the meaning of savings.
Loanable funds theory like classical theory is indeterminate
It is also called the liquidity Preference Theory. It was presented by Keynes. According to him, “Interest is the reward for parting with liquidity for a specific period.”
According to him, interest is a monetary phenomenon in the sense that the rate of interest is determined by the demand for and supply of money. The rate at which interest will be paid depends on the strength of the preference for liquidity in relation to the total quantity of money available to satisfy desire for liquidity. Hence the greater the desire for liquidity, the higher the rate of interest and vice verse. Liquidity preference means the demand for money to hold it in cash form. Liquidity preference of a particular individual depends up on several consideration individual keep money in liquid form due to the following three motives;-
It relates to the demand for money or the need cash for the current transaction of individual and business exchanges. Individual holds cash in order to bridge the interval between the receipt of income and its expenditure. This is called the Income Motive.
The businessmen and the entrepreneur need money all the time in order to pay for raw materials and transport, to pay wages and salaries and to meet all other current expenses in curved. This is called the business motive for keeping money
Precautionary motive for holding money refers to the desire of the people to hold cash balances for unforeseen contingencies like;-sickness, accident and so on. The amount of money for this purpose depends on the nature of the individual and on the condition in which he lives.
Relates to the desire to hold one’s resources in liquid form in order to take advantage of the market movement regarding the future changes in the rate of interest or bond price.
According to Keynes supply of money is not affected by the rate of interest and it remains constant in the short period.
According to Keynes the rate of interest is determined at that point where demand for money is equal to supply of money or in other words where Liquidity curve and supply curve intersect each other
Criticism of the theory.
Keynes ignores saving or waiting as a means or source of invertible fund.
To part with liquidity without there being any sawing meaningless
The Keynesian theory only explains interest in the short run. It gives no due to the rates of interest in the long run.
The borrower’s intention is not so much to reward parting with liquidity so as to get a return on investment.
Liquidity preference is not the only factor government the rate of interest. There are several other factors which influence the rate of interest by affecting the demand for and supply of invertible funds.
Keynes makes the rate of interest independent of the demand for investment funds. Actually it’s not so independent.
Liquidity preference theory does not explain the existence of different rate of interest prevailing in the market at the same time. Owing to the perfect homogeneity of cash balance, the rates of interest have to be uniform.
Profit is the reward to the entrepreneur for his basic function such as bearing risks of the business.
Profit is the surplus of total revenue over expenses ie. â•¥ = TR – TC
Gross profit is the total amount which is received by the entrepreneur.
Net profit is that part of gross profit which is the reward for organizational services.
Characteristics of Profit
Profit is a residual reward
It is the left over after all other business expenses have been paid
Profit is not contractual like rent, wage and interest.
Profit is under trained unpredictable can be there or not
Profit can be negative but other rewards can never
Functions of profit
Profit is a source of capital through investment/entrepreneurship.
Is a source of revenue to the government through taxation.
It is an indicator of good performance of the company.
Profit encourages investment.
Profits are important to the entrepreneur when making decisions on resource a location.
Theories of profit
Rent theory of profit
This theory was presented by American economist Prof. Walker. According to this theory, profit determined just as rent is determined. According to Prof. Walker profit is the rent of ability just as there are different grades of land, there are different grades of entrepreneur. The superior entrepreneurs can earn more as compared to less efficient entrepreneur and profit arises due to the reasons that superior entrepreneurs have some surplus production over the cost of production. In this way profit is the reward for differential ability of the entrepreneur over the marginal entrepreneur or the non- profit entrepreneur. Profits are thus like rent and they do not enter into price.
Criticism of the Theory.
According to the modern economist, there may not be any marginal entrepreneur or non- profit entrepreneur because all entrepreneurs can earn something.
The theory does not explain the real nature of profit.
Wages Theory of Profit.
This theory was presented by Prof. Taussing and Devenport.
According to this theory, profits are determined just like wages because according to this theory organization is a superior kind of labour and the reward for the services should be determined according to the wages determination theory.
Criticism of the Theory
Profits are essentially a reward for taking risks but labourer takes no risks. His reward or wage is primarily for the labour performed by him.
Wages are paid in advance. Conversely entrepreneur has to take the responsibility of profit or loss.
The partner of limited firms receive profit but they do not undergo any physical exertion
Marginal Productivity Theory.
According to this theory profit are determined according to the marginal productivity of the entrepreneur. The marginal productivity is greater due to the reason that the supply of the entrepreneur is short as compared to their demand. As a result of this, profits are also high.
The marginal productivity theory does not help to explain fully how the profits are determined.
Dynamic Theory of Profit
This theory was presented by Prof. J.B Clark. According to this theory, profits occur due to the reasons that the circumstances are always changing. It is stated that in a static world where the size of the population, the amount of capital, the quantity and quality of human wants, the method of production, technical knowledge etc remain the same profit tend to disappear under the force of competition. Profits represents the difference between selling price and cost.
It is a surplus above cost and when there is perfect competition this surplus disappears because when the world is static and everything is known and knowable, there will be risk and no uncertainty and hence no profits. But according to J.B Clark, we are involving a dynamic world and some changes are constantly taking place. A clever entrepreneur forces these changes and by producing new things he can earn profit. It is only because the world is dynamic.
Risk Bearing Theory of Profit
This theory of profit is associated with the name Prof. Hawley.
According to this theory, profit is the reward for risk and responsibilities which are come by any entrepreneur. The greater the risk, the higher must be expected gain in order induce entrepreneurs to start the business.
According to carver, profit does not arise due to the reason that risk are taken by the entrepreneur by because the superior entrepreneur are able to reduce them.
Uncertainty Bearing Theory of Profit
This theory was presented Prof. Knight. According to this theory it is uncertainty bearing rather than the risk taking which is the special function of the entrepreneur and leads to profit. According to Knight risks are of two kinds:-
There are certain risks which can be unforeseen, eg. accidents like fire
There are certain risks which are not possible to foresee
Risks of the first kind are borne by the insurance companies.
As regards the risks of the second category, these are borne by the entrepreneur. Prof. Knight Calls them not risks but uncertainty. The term risk is applied to those dangers which can be known and foreseen. The entrepreneur gets remuneration for bearing uncertainty. The firm’s risk is applied to those dangers which can be known and foreseen. The entrepreneur gets remuneration for bearing uncertainties and nothing for the risk which have been foreseen.
Like other factors of production, uncertainty bearing has a supply price because no entrepreneur will be induced to face the uncertainty unless a certain return is expected.
Criticism of the theory.
i) Uncertainty bearing cannot be elevated to the status of a factor of production.
ii) Uncertainty bearing is not the sale function of the entrepreneur.
iii) Uncertainty is not the only factor that limits the supply of entrepreneur. Lack of funds, lack of knowledge and lack of opportunities are some of the factors that restrict the supply of entrepreneurs.
Types of Profits
Normal Profit or Zero Profit TR = TC.
This is a return which is just necessary to cover all its cost of production. Normal profits exist when TR = TC therefore it can be called zero profit.
Super normal Profit
These are profits which are above the normal profit. They exist when TR is more than TC, therefore it can as be called Abnormal profit.