CHAP TER

6 Distribution
Analysis

“Distribution accounts for the sharing of wealth produced by a

community among the agents or owners of the factors which have been
active in its production”
–Chapman

LEARNING OBJECTIVES

1 To acquire knowledge about distribution of income among the factors of

production.

2 To enable the students to understand the theories of rent, wages, interest and
profit.

6.1 6.2
Introduction Meaning of Distribution

The factors of production viz., Land, Distribution means division of income

Labour, Capital and Entrepreneur or among the four factors of production in
Organization are involved in production. terms of rent to landlords, wage to labourer,
The theory of functional distribution interest to capital and profit to entrepreneurs.
deals with how the relative prices of these
factors of production are determined. The
theory of factor prices is popularly known
as the theory of distribution. Interesting
aspect here is in the fact that large number
of ideas has emerged and various factors
have been identified the economists,
contributing to the development of
Economics Science.

Distribution Analysis 121

6.3 also known as “General
Theory of Distribution”
Kinds of Distribution of or “National Dividend
Income Theory of Distribution”.

Assumptions
Personal Distribution
This theory is based on the following
Personal Distribution is the distribution assumptions:
of national income among the individuals.
1. All the factors of production are
homogenous.
2. Factors of production can be
substituted for each other.
3. There is perfect competition both in
the factor market and product market.
4. There is perfect mobility of factors
of production.
5. There is full employment of factors.
6. This theory is applicable only in the
long-run.
7. The entrepreneurs aim at profit
Functional Distribution
maximization.
Functional Distribution means the 8. There is no government intervention
distribution of income among the four in fixing the price of a factor.
factors of production namely land, labour,
9. There is no technological change.
capital and organisation for their services
in production process. Explanation of the Theory
According to the Marginal Productivity
6.4 Theory of Distribution, the price or the
reward for any factor of production is
Marginal Productivity
equal to the marginal productivity of that
Theory of Distribution
factor. In short, each factor is rewarded
according to its marginal productivity.
Introduction
Marginal Productivity Theory of Marginal Product
distribution was developed by Clark, The Marginal product of a factor of
Wickseed and Walras. This theory production means the addition made
explains how the prices of various factors to the total product by employment of
of production are determined. This an additional unit of that factor. The
theory explains how rent, wages, interest Marginal Product may be expressed as
and profit are determined. This theory is MPP, VMP and MRP.
Distribution Analysis 122
1. Marginal Physical Product (MPP) the point, the marginal revenue product
The Marginal Physical Product of a is less than the price of the factor. Hence,
factor is the increment in the total employer will suffer loss when he uses more
product obtained by the employment of the factor. Therefore, the conclusion is
of an additional unit of that factor. that the employer will so adjust the price of
the factor of production so as to equalize
2. Value of Marginal Product (VMP)
the marginal revenue product of that factor.
The Value of Marginal Product is
obtained by multiplying the Marginal In short, the Marginal Productivity
Physical Product of the factor by the Theory of Distribution states that
price of product. a) The price of a factor of production
Symbolically depends upon its productivity.
b) The price of a factor is determined by
VMP = MPP x Price and will be equal to marginal revenue
product of that factor.
3. Marginal Revenue Product (MRP)
c) Under certain conditions, the price of a
The Marginal Revenue Product of a
factor will be equal to both the average
factor is the increment in the total
and marginal products of that factor.
revenue which is obtained by the
employment of an additional unit of
The Marginal Productivity Theory
that factor.
of Distribution can be represented
MRP = MPP x MR diagrammatically as follows:

Statement of the Theory Marginal Productivity under

An employer employs a factor of Perfect Competition
production because it is productive. So,
the price he wants to pay for the factor Y
Factor Price and Revenue

Q
depends upon its productivity. The greater P
MFC = AFC
the productivity of a factor, the higher
will be its reward. If the price of a factor
Product

ARP
of production is less than its marginal
revenue product, the employer will use MRP
more of this factor, because his profit will
be increased.
O N X
When more of a factor is employed, Factor Units
its marginal revenue product diminishes. Diagram 6.1
But the employer will gain by using
additional units of the factor until the
marginal revenue product of the factor The diagram 6.1 refers to the factor pricing
is equal to its price. The employer’s profit under perfect competition in the factor
will be maximum at this point. Beyond market. X axis represents factor units
Distribution Analysis 123
and Y axis represents the factor price and In diagram 6.2 the factor pricing under
revenue product. MRP is the Marginal imperfect competition is represented. AFC
Revenue Product Curve and ARP is the is Average Factor Cost curve. It represents
Average Revenue Product curve. AFC is the price paid to the factors. It increases
the Average Factor Cost curve and MFC as the number of factors demanded by the
is the Marginal Factor Cost curve. AFC is employer increases. As AFC rises, MFC
horizontal under perfect competition and lies above AFC. It represents the marginal
MFC coincides with it. cost paid to the factors. At the point Q,
When there is perfect competition in MFC = MRP, where the employer attains
the factor market, the firm is in equilibrium his maximum profit and so he stops
(i.e., earning maximum profits) only when employment of the factors at the point.
MFC = MRP. Hence, in the diagram, the firm But the average cost paid is NRSO and the
reaches equilibrium at point Q by employing average revenue obtained is NQ or OP.
ON units of factors and paying OP price (NQ) Total revenue obtained is NQPO. Therefore,
where MFC = MRP. At the point Q, MRP = exploitation per unit of factor is RQ. But the
ARP. The price paid to the factor (NQ) is also total number of factors is ON. Thus, the total
equal to marginal revenue product (NQ) exploitation of factor by the employer is RQ
and average revenue product (NQ). This X SR = “PQRS” (shaded area). Thus, under
means that there is no exploitation of factors imperfect competition, factor is exploited at
under perfect competition. Beyond the point the equilibrium position.
Q, no employer will employ factors, because
Criticisms
after that point, the price paid to the factor
is more than marginal revenue product and This theory is subject to a few criticisms
average revenue product. 1. In reality, the factors of production
are not homogenous.
Marginal Productivity Theory 2. In practice, factors cannot be
under Imperfect Competition substituted for each other.
3. This theory is applicable only in the
long–run. It cannot be applied in the
Y MFC short-run.

Q
6.5
Factor Price and Revenue

AFC
P
Rent
Product

S
R ARP 6.5.1 Meaning
MRP Rent is the price or reward given for the
O N
use of land or house or a machine to
X
Factor Units the owner. But, in Economics, “Rent” or
Diagram 6.2 “Economic Rent” refers to that part of

Distribution Analysis 124

payment made by a tenant to his landlords 1. Land differs in fertility.
for the use of land only. 2. The law of diminishing returns
operates in agriculture.
3. Rent depends upon fertility and
location of land.
4. Theory assumes perfect competition.
5. It is based on the assumption of long
period.
6. There is existence of marginal land
or no-rent land.
7. Land has certain “original and
indestructible powers”.
8. Land is used for cultivation only.
9. Most fertile lands are cultivated first.

Statement of the Theory with

Illustration
Assume that some people go to a newly
discovered island and settle down there.
6.5.2 Ricardian Theory of There are three grades of land, namely
Rent A, B and C in that island. ‘A’ being most
fertile, ‘B’ less fertile and ‘C’ the least
The Classical Theory of fertile. They will first cultivate all the most
Rent is called “Ricardian fertile land (A grade) available. Since the
Theory of Rent”. David land is abundant and idle, there is no need
Ricardo explained the to pay rent as long as such best lands are
theory of rent thus: freely available. Given a certain amount of
labour and capital, the yield per acre on ‘A’
Assumptions grade land is 40 bags of paddy.
Ricardian theory of rent assumes the Suppose another group of people
following: goes and settles down in the same island
after some time. Hence the demand for
“Rent is that portion of the produce agricultural produce will increase. The
of the earth which is paid to the most fertile lands [A grade] alone cannot
landlord for the use of the original produce all the food grains that are needed
and indestructible powers of the on account of the operation of the law of
soil”. diminishing returns. So the less fertile
lands [B grade] will have to be brought
David Ricardo
under cultivation in order to meet the

Distribution Analysis 125

growing population. For the same amount
labour and capital employed in ‘A’ grade Y
land, the yield per acre on ‘B’ grade land 40

Yield Per Acre (in Bags)

Economic Rent
is 30 bags of paddy. The surplus of 10 30
bags [40-30] per acre appears on ‘A’ grade No Rent
20
land. This is “Economic Rent” of ‘A’ grade Land
land. 10

Suppose yet another group of

0 A B C X
people goes and settles down in the same
Various Grades of Land
island. So the least fertile land (C grade)
will have to be brought under cultivation. Diagram 6.3
For the same amount of labour and capital,
the yield per acre on ‘C’ grade land is 20
bags of paddy. This surplus of ‘A’ grade
land is now raised to 20 bags [40-20], and
Diagrammatic Explanation
it is the “Economic Rent” of ‘A’ grade land.
The surplus of ‘B’ grade land is 10 bags In diagram 6.3, X axis represents various
[30-20]. This is the economic rent of ‘B’ grades of land and Y axis represents
grade land. yield per acre (in bags). OA, AB and BC
are the ‘A’ grade, ‘B’ grade and ‘C’ grade
In the above illustration in ‘C’
lands respectively. The application of
grade land, cost of production is just equal
equal amount of labour and capital on
to the price of its produce and therefore
each of them gives a yield represented
does not yield any rent (20 - 20). Hence,
by the rectangles standing just above the
‘C’ grade land is called “no-rent land or
respective bases. The ‘C’ grade land is the
marginal land”. Therefore, No-Rent Land
“no–rent land” ‘A’ and ‘B’ grade lands are
or Marginal Land is the land in which cost
“intra –marginal lands”. The economic
of production is just equal to the price of
rent yielded by ‘A’ and ‘B’ grade lands is
its produce. The land which yields rent is
equal to the shaded area of their respective
called “intra –marginal land”. Therefore, rent
rectangles.
indicates the differential advantage of the
superior land over the marginal land.
Criticisms

Table 6.1 Ricardian Theory Following are the limitations of Ricardian

of Rent theory of rent.
1. The order of cultivation from
Grades Production Surplus (i.e.,
most fertile to least fertile lands is
of Lands (in bags) Rent in bags)
historically wrong.
A 40 40-20=20
2. This theory assumes that, rent does
B 30 30-20= 10
not enter into price. But in reality,
C 20 20-20= 0 rent enters into price.

Distribution Analysis 126

6.5.3 Quasi-Rent “Quasi-Rent is the income derived
from machines and other appliances
made by man”.

-Alfred Marshall

6.5.4 The Modern Theory

of Rent / Demand &
Supply Theory of Rent
Marshall introduced the concept of Quasi The classical economists’ thought that
rent. Factors other than land say plant land as a factor of production was different
and machinery are fixed in supply during from other factors of production. But
short period. They earn surplus income modern economists thought that all
when demand rises. It is purely temporary the factors of production are alike and
as it disappears in long run due to increase there is no basic difference between
in supply. The quasi-rent is a surplus that them. Hence, a special theory was rent,
a producer receives in the short period developed by Ricardo is not necessary.
over variable costs from the sale of output. Therefore, economists like Joan
Robinson and Boulding have contributed
Distinction between “Rent” their ideas for the determination of rent,
and “Quasi-Rent” which is known as the “Modern Theory
of Rent”.
Sl. No. Rent Quasi-Rent
1. Rent accrues Quasi-Rent
to land accrues to “The essence of the conception of
manmade rent is the conception of surplus
appliances. earned by a particular part of a factor
2. The supply of The supply of production over and above the
land is fixed of manmade minimum earnings that is necessary
forever. appliances is to induce it to do work”
fixed for a short - Joan Robinson
period only.
3. It enters into It does not Rent is the difference between the actual
price enter into price. earnings of a factor of production and its
transfer earning.

QR= Total Revenue – Total Rent = Actual earning –

Variable Cost Transfer earning.

Distribution Analysis 127

The minimum payment that has to be 2. Real Wages
made to a particular factor of production Real wages are the wages paid in
to retain it in its present use is known as terms of goods and services. Hence,
transfer earnings. real wages are the purchasing power
of money wages.
6.6 3. Piece Wages
Wages Wages that are paid on the basis of
quantum of work done.
4. Time Wages
Wages that are paid on the basis of
the amount of time that the worker
works.

6.7
Theories of Wages

Wages are a payment for the services of 6.7.1 Subsistence Theory of

labour, whether intellectual or physical. Wages
Wage may be paid daily, weekly, fortnightly, Subsistence theory is one of the oldest
monthly or yearly and partly at the end of theories of wages. It was first explained by
the year in the form of bonus. Physiocrats, a group of French economists
and restated by Ricardo.

6.6.1. Meaning According to this theory, wage

must be equal to the subsistence level of
Wage is the price paid to the labourer for the labourer and his family. Subsistence
the services rendered . means the minimum amount of food,
clothing and shelter which workers and
“A sum of money paid under contract their family require for existence.
by an employer to a worker for the If workers are paid higher wages
services rendered”. than the subsistence level, the workers
-Benham would be better off and they will have large
families. Hence, the population would
increase. When the population increases,
6.6.2 Kinds of Wages the supply of labourer would increase and
therefore, wages will come down.
Wages are divided into four types:
On the other hand, if wages are lower
1. Nominal Wages or Money Wages. than the subsistence level, there would be
Nominal wages are referred to the a reduction in population and thereby the
wages paid in terms of money. supply of labour falls and wages increase
Distribution Analysis 128
to the subsistence level. So this theory is
6.7.3 Wage Fund Theory of
closely associated with Malthusian Theory of
Wages
Population. This theory holds that the wages
of workers would not be above or below the This theory was first
subsistence level of the labourer and his family. propounded by Adam
Smith. But the credit
Criticisms goes to [Link] who
1. Role of trade unions in collective perfected this theory
bargainings was not found. According to Mill
2. It does not explain the differences in “every employer will keep
wages in different occupations. a given amount of capital
for payment to the workers”. It is a known as
3. The assumption that population would
“Wage Fund”. It is fixed and constant. Wages
increase with a rise in wage rate is not
depend directly upon the fund and inversely
correct. Poor families (and countries)
with number of labourers employed. The
have more Children than rich families
average wage of a worker can be calculated
(countries). Wage rate alone does
by using the formula.
not-determine birth-rate Actually,
as increases, people can afford to
downsize their family size for adopting Total Wage
costly family planning procedures; Fund
Average wage per worker =
while poor people cannot do so. Number of
Workers
6.7.2 Standard of Living
Theory of Wages
If the number of workers increases, the
The Standard of Living Theory of Wages wage per worker would fall and vice
developed by Torrance is an improved versa.
and refined version of the Subsistence
Theory of Wage. According to this theory, Criticisms
wage is equal to the standard of living of
1. It does not explain the difference in
the workers. If standard of living is high,
wages in different occupations.
wages will be high and vice versa.
2. It ignores the role of trade unions.
Standard of living wage means the
amount necessary to maintain the labourer in 3. Actually the capitalists will take away
the standard of life to which he is accustomed. a large sum before making payment of
wages.
Criticism
1. According to this theory, the standard 6.7.4 Residual Claimant
of living determines wages. But in actual Theory of Wage
practice, wages determine the standard This theory was propounded by the
of living. American economist [Link] in 1875,
Distribution Analysis 129
in his book Political Economy. According
Capital
to this theory, wage is the residual portion All man - made things that help
after paying the remuneration of all the produce goods.
other three factors, namely, land, capital
and organization. Money is invested to buy things
such as building, machiney...

Criticisms
The reward for capital investment
1. This theory does not explain the role is interest.
of trade unions can secure higher
wage for workers.
2. Demand side of labour in the
determination of wages needs to be 6.8.1 Meaning
considered.
Interest is the reward paid by the borrower
to the lender for the use of capital.
6.7.5 Marginal Productivity
Theory of Wage
“Interest is the price paid for the use
The application of general theory of of capital in any market”
distribution to wage fixation is the -ALFRED MARSHALL
marginal productivity theory of wages.
According to the theory wages are
determined by the marginal productivity
of labour and equal to it at the point of 6.8.2 Kinds of Interest
equilibrium. Gross Interest
Under perfect competition wage is Gross interest is the total interest amount
paid equal to marginal product of labour received by creditors from debtors.
(wage = MPL) But in real world where
Gross Interest = (Net Interest) + (reward
there is imperfect competition, there is
for inconvenience) + (insurance against
exploitation of labour and wage is less
risk of non-repayment) + (payment for
than MPL.
service of debt management)

6.8 Net Interest

Interest Net Interest is only a part of the gross
interest. It is the payment for use of capital
Generally speaking, interest is a payment only. A good example for net interest
made by a borrower to the lender for the is the interest payable for Government
money borrowed. Securities.

Distribution Analysis 130

 Criticism
6.9 Theories of Interest 1. According to this theory, saving involves
suffering. But savings may not always
involve suffering to some rich people.
Rich people have money for which they
do not get interest. Hoarding of money
is to quench the thirst for liquidity.

6.9.2 Agio Theory of Interest/

The Psychological
Theory of Interest/Time
Preference Theory
This theory was propounded by John Rae
6.9.1 Abstinence Theory or in 1834. But credit goes to Bohm Bawerk an
Waiting Theory Austrian School economist who has given
final shape to the theory. The American
This theory was propounded by [Link].
economist Irving Fisher modified and gave
To him, interest is the reward for abstaining
a new theory viz Time Preference theory.
from the immediate consumption of wealth.
According to Senior, capital is the result of According to this theory, people
saving. But saving involves “abstinence” prefer present goods rather than future
or “sacrifice”. It is possible to save only if goods. Because the present goods are more
one abstains from present consumption. certain than future goods, just “as a bird in
Such abstinence from present consumption the hand is worth two in the bush”. Ther
involves some suffering. Hence, it is are many countries where no one knows
necessary to reward the saver (capitalist) what will happen next [Link] crisis of
to compensate for the sacrifice he has 1996 and American crisis of 2007-08 were
to undergo by abstaining from present not predicted even for economists, including
consumption. Therefore, interest is the Nobel Laureats. So, when people save they
reward or compensation paid to the saver have to postpone their present enjoyment or
(capitalist) for his “abstinence” or “sacrifice”. satisfaction. If one postpones one’s present
satisfaction, one has to be paid an “Agio”
Marshall accepted the Abstinence
or “Premium”. This premium is “interest”.
Theory of interest. But he used the word
People prefer present consumption than
‘waiting’ instead of “abstinence”. Saving
future consumption due to the risk increasing
implies waiting. According to him, interest
and uncertainties of the present world.
is the reward for waiting. Saving involves
waiting. But people do not like to wait. So,
in order to make them wait and in turn to 6.9.3 Loanable Funds Theory/
save, we have to pay them some reward. The Neo Classical Theory
Therefore, interest is the reward paid to the The Loanable Funds Theory, also known
saver (capitalist) for his “waiting”. as the “Neo–Classical Theory”, was
Distribution Analysis 131
developed by Swedish economists like 1. Savings planned by individuals
Wicksell, Bertil Ohlin, Viner, Gunnar are called “ex-ante savings”. E.g.
Myrdal and others. LIC premium, EMI payment etc.
According to this theory, interest is 2. The unplanned savings are called,
the price paid for the use of loanable funds. “ex-post savings”. Savings is left
The rate of interest is determined by the out after spending are ex post
equilibrium between demand for and supply saving.
of loanable funds in the credit market. 2. Bank Credit (BC)
The bank credit is another source of
Demand for Loanable Funds
loanable funds. Commercial banks
The demand for loanable funds depends create credit and supply loanable
upon the following: funds to the investors.
1. Demand for Investment (I) 3. Dishoarding (DH)
The most important factor responsible Dishoarding means bringing out
for the loanable funds is the demand the hoarded money into use and
for investment. Bulk of the demand thus it constitutes a source of supply
for loanable funds comes from of loanable funds. In India,after
business firms which borrow money 1991,Public sector undertakings
for purchasing capital goods. are being sold to private people to
2. Demand for Consumption (C) mobilize more [Link] is also
called disinvestment.
The demand for loanable funds comes
from individuals who borrow money 4. Disinvestment(DI)
for consumption purposes also. Disinvestment is the opposite of
3. Demand for Hoarding (H) investment. In other words disinvestment
means not providing sufficient funds for
The next demand for loanable funds
depreciation of equipment. It gives rise
comes from hoarders. Demand for
to the supply of loanable funds.
hoarding money arises because of
people’s preference for liquidity, idle All the four sources of supply of
cash balances and so on. The demand loanable funds vary directly with the
for C, I and H varies inversely with interest rate.
interest rate.

Supply of Loanable Funds Classical theory of Interest

The supply of loanable funds depends The equilibrium interest rate,

upon the following four sources: according to classical theory, is
determined by the intersection of
1. Savings (S)
demand and supply curves, Demand
Loanable funds come from savings. for money refers to investment. Supply
According to this theory, savings of money refers to savings S=I.
may be of two types, namely,
Distribution Analysis 132
Equilibrium funds; this is obtained by the summation of
the demand for investment curve I, demand
The rate of interest is determined by the
curve for consumption demand or dissaving
equilibrium between the total demand for
curve and curve for demand for hoarding
and the total supply of loanable funds.
curve H. The LD and LS curves, intersect
each other at the point “E” the equilibrium
Supply of and Demand for point. At this point, OR rate of interest and
Loanable Funds OM is the amount of loanable funds.
Supply of = Savings +
loanable funds Bank Credit + Criticisms
Dishoarding +
Disinvestment 1. Many factors have been included
= S + BC + DH + DI in this [Link] ther are many
more [Link] such factors are
Demand for = Investment + 1)Asymmetric Information and 2)
loanable funds Consumption +
Moral [Link] practice larger
Hoarding
firms, due to their political powers,
=I+C+H are able to get huge bank credit at
lower interest [Link] due to NPAs,
Y (Non-Performing Assets)small firms
and depositors lose their interest
DH DI S BM
income. The loanable funds theory is
Rate of Interest

LS “indeterminate”’ unless the income

R’ E’
level is already known. (This can be
E
studied in 12th standard Economics)
R
2. It is very difficult to combine real
I
H DS factors like savings and investment
LD
with monetary factors like bank
0 M’ M X credit and liquidity preference.
Demand for Loanable Funds and
Supply of Loanable Funds
Diagram 6.4 6.9.4 Keynes’ Liquidity
Preference Theory of
In Diagram 6.4, X axis represents the Interest or The Monetary
demand for and supply of loanable funds Theory of Interest
and Y axis represents the rate of interest. The Keynes propounded the
LS curve represents the total supply curve Liquidity Preference
of loanable funds. This is obtained by the Theory of Interest in
summation of the Saving Curve (S), Bank his famous book, “The
credit curve (BC), Dishoarding curve (DH) General Theory of
and Disinvestment curve (DI). The LD curve Employment, Interest
represents the total demand for loanable and Money” in 1936. J.M. Keynes

Distribution Analysis 133

According to Keynes, interest is purely a The amount saved under this motive
monetary phenomenon because the rate depends on the level of income. Mt
of interest is calculated in terms of money. and Y are positively associated. (Say
To him, “interest is the reward for parting Mt = 0.125Y; that means if income
with liquidity for a specified period of is ₹ 1000, demand for transaction
time”. motive is ₹ 125)

Meaning of Liquidity Mt = f (y)

Preference
2. The Precautionary Motive
Liquidity preference means the preference
The precautionary motive relates to
of the people to hold wealth in the form
the desire of the people to hold cash
of liquid cash rather than in other non-
to meet unexpected or unforeseen
liquid assets like bonds, securities, bills of
expenditures such as sickness,
exchange, land, building, gold etc.
accidents, fire and theft. The amount
saved for this motive also depends
“Liquidity Preference is the preference on the level of income. (Say Mp =
to have an amount of cash rather than 0.125Y; it means if income is ₹ 1000,
of claims against others”. demand for Mp is ₹ 125)
- Meyer
Mp = f (y)

Motives of Demand for Money 3. The Speculative Motive

According to Keynes, there are three The speculative motive relates to the
desire of the people to hold cash in
order to take advantage of market
movements regarding the future
changes in the price of bonds and
securities in the capital market.
The amount saved for this motive
depends on the rate of interest. Ms
= f (i). There is inverse relation
between liquidity preference and
rate of interest (Say Ms = 450-100i).

motives for liquidity preference. They are: Determination of Rate of

1. The Transaction Motive Interest
The transaction motive relates to the According to Keynes, the rate of interest
desire of the people to hold cash for is determined by the demand for money
the current transactions (or day–to- and the supply of money. The demand
day expenses). for money is liquidity preference. In fact,
Distribution Analysis 134
liquidity preference for speculative motive Y
M3 M2 M4
determines rate of interest. The supply of L
money is determined by the policies of
L3 E3
the Government and the Central Bank

Rate of Interest
of a country. The total supply of money
consists of coins, currency notes and bank
deposits (Say M = 200). L2 E2

E4
L4
P
Equilibrium between Demand
and Supply of Money
0 M3 M2 M4 X
The equilibrium between liquidity preference Demand for Money and
and demand for money determine the Supply of Money
rate of interest. In short-run, the supply of Diagram 6.6
money is assumed to be constant (₹ 200).
LP is the liquidity preference Curve =0.125Y+0.125Y+(450-100i). Total
(demand curve). M2 M2 shows the supply supply of money=₹ 200. Mt and Mp are
curve of money to satisfy speculative influenced by Y. Hence for the sake of
motive. Both curves intersect at the point easy understanding, Ms alone can be
E, which is the equilibrium point. Hence, considered Demand for money=supply
the rate of interest is 2.5. If liquidity of money at equilibrium point:450-
preference increases from LP to L1P1 the 100i=200;450-200=100i;250=100i;
supply of money remains constant, the i=250/100=[Link] is equilibrium interest
rate of interest would increase from OI In reality, interest rate is also influenced
to OI1. Numerical examples given above by national income and commodity sector
can also be used for better understanding. [Link], they are not included
Total demand for money=Mt+Mp+Ms here for making the understanding easier.
Suppose LP remains constant. If the supply
Y
M2 of money is OM2, the interest is OI2 and if the
L1 supply of money is reduced from OM2 to OM3,
L the interest would increase from OI2 to OI3. If the
Rate of Interest

supply of money is increased from OM2 to OM4,

E1 the interest would decrease from OI2 to OI4.
I1

E
I P1 Criticisms
P
1. This theory does not explain the
existence of different interest rates
0 M2 X prevailing in the market at the same
Demand for Money and time.
Supply of Money
2. It explains interest rate only in the
Diagram 6.5
short-run.
Distribution Analysis 135
6.10 Here cost implies explicit costs only
(Normally economic cost, social cost and
3UR¿W
environmental cost are not considered
by the Accountants in India).
The entrepreneur coordinates all the other
b. Net Profit or Pure Profit or Economic
three factors (land, labour and capital) of
profit or True profit
production. Entrepreneur is rewarded for
his srvices in the form of profit. Net or pure or economic or true profit
is the residual left with entrepreneur
after deducting from Gross profit the
6.10.1 0HDQLQJRI3UR¿W
remuneration for the self-owned factors of
Profit is a return to the entrepreneur for the production, which are called implicit cost.
use of his entrepreneurial ability. It is the
net income of the organizer. In other words, Net Profit = Gross Profit-
profit is the amount left with the entrepreneur Implicit costs
after he has payments made for all the other c. Normal Profit
factors (land, labour and capital) used by
It refers to the minimum expected
him in the production process. However,
return to stay in business.
there are other versions also.
d. Super Normal Profit
Super normal profits are over and
6.10.2 .LQGVRI3UR¿W
above the normal profit.
I. Monopoly Profit: Profit earned by
the firm because of its monopoly Super Normal = Actual profit-
control. Profit Normal profit
II. Windfall Profit: Some times, profit
arises due to changes in price level. 6.11
Profit is due to unforeseen factors.
7KHRULHVRI3UR¿W
III. Profit as functional reward: Just
like rent, wage and interest, profit is
earned by the entrepreneur for his
entrepreneurial function.

6.10.3. &RQFHSWVRI3UR¿W
a. Gross Profit
Gross Profit is the surplus which accrues
to a firm when it subtracts its Total
Expenditure from its Total Revenue.

Gross Profit = Total Revenue-

Total cost

Distribution Analysis 136

 Schumpeter, an entrepreneur is not only
6.11.1 Dynamic Theory of
an undertaker of a business, but also an
3UR¿W
innovator in the process of production. To
This theory was him, profit is the reward for “innovation”.
propounded by the Innovation means invention put into
American economist commercial practice.
[Link] in 1900. To him,
According to Schumpeter, an
profit is the difference
innovation may consist of the following:
between price and cost
of production of the 1. Introduction of a new product.
commodity. Hence, profit 2. Introduction of a new method of
is the reward for dynamic production.
changes in society. Further he points out 3. Opening up of a new market.
that, profit cannot arise in a static society.
4. Discovery of new raw materials
Static society is one where everything is
5. Reorganization of an industry / firm.
stationary or stagnant and there is no change
at all. Therefore, there is no role for an
entrepreneur in a static society. The price of When any one of these innovations is
the commodities in a static society would be introduced by an entrepreneur, it leads to
equal to their cost of production. So, there reduction in the cost of production and thereby
would be no profit for the entrepreneur. brings profit to an entrepreneur. To obtain
The entrepreneur only gets wages for profit continuously, the innovator needs to
management and interest on his capital. innovate continuously. The real innovators do
so. Imitative entrepreneurs cannot innovate.
At present several changes are
taking place in a dynamic society. Changes
are permanent. According to Clark, the 6.11.3 Risk Bearing Theory of
following five main changes are taking 3UR¿W
place in a dynamic society.
Risk bearing theory of profit was
1. Population is increasing propounded by the American economist
2. Volume of Capital is increasing. [Link] in 1907. According to him,
3. Methods of production are improving. profit is the reward for “risk taking”
in business. Risk taking is an essential
4. Forms of industrial organization are
function of the entrepreneur and is the
changing.
basis of profit. It is a well known fact that
5. The wants of consumer are multiplying. every business involves some risks.
Since the entrepreneur undertakes
the risks, he receives profits. If the
6.11.2 Innovation Theory of entrepreneur does not receive the reward,
3UR¿W he will not be prepared to undertake the
Innovation theory of profit was risks. Thus, higher the risks, the greater
propounded by Joesph. [Link]. To are the profit.
Distribution Analysis 137
 Every entrepreneur produces incalculable or not measurable or non-
goods in anticipation of demand. If his insurable).
anticipation of demand is correct, then According to Knight, profit does
there will be profit and if it is incorrect, not arise on account of risk taking,
there will be loss. It is the profit that because the entrepreneur can guard
induces the entrepreneurs to undertake himself against a risk by taking a suitable
such risks. insurance policy. But uncertain events
cannot be guarded against in that way.
When an entrepreneur takes himself the
6.11.4 Uncertainty Bearing
burden of facing an uncertain event, he
7KHRU\RI3UR¿W
secures remuneration. That remuneration
Uncertainty theory was propounded is “profit”.
by the American economist Frank
[Link]. To him, profit is the reward for
“uncertainty bearing”. He distinguishes
between “insurable” and “non-insurable” 6.12
risks. Conclusion

Insurable Risks In this chapter, the determination of

Certain risks are measurable or calculable. how the prices of various factors of
Some of the examples of these risks production (namely land, labour, capital,
are the risk of fire, theft and natural and organization) has been discussed. In
disasters. Hence, they are insurable. Such short, all the theories are related to factor
risks are compensated by the Insurance pricing of factors of production of factors
Companies. of production. However,it needs to be
understood that no theory can completely
comprehend every [Link] reality will
Non-Insurable Risks
always be more complicated than what
There are some risks which are the theories could predict or perceive.
immeasurable or incalculable. The Theories are only guide lines,they cannot
probability of their occurrence cannot predict with 100% [Link],the
be anticipated because of the presence scientific studies attempt to enhance the
of uncertainty in them. Some of the degree of perfection.
examples of these risks are competition,
market condition, technology change and
GLOSSARY
public policy. No Insurance Company can
undertake these risks. Hence, they are non- 1. Distribution – Distribution of
insurable. The term “risks” covers the first wealth among agents or the owners
type of events (measurables - insurable) of the factors of production.
and the term “uncertainty” covers the 2. Rent – Rent is reward for the use of
second type of events (unforeseeable or land.

Distribution Analysis 138

3. Wages – Wages are the reward for labour. 8. Money wage – Money wage is the
4. Interest – Interest is the price paid remuneration received by a labourer
for the use of capital. in terms of money.
5. Profit – Profit is the reward for 9. Real wage – Real wage is the
organisation or entrepreneurship. purchasing power of the money
wages in terms of goods and
6. Quasi-Rent – Quasi-Rent is the
services.
surplus earned by man-made
appliances and instruments of 10. Loanable fund – Loanable fund is
production in the short-period. that part of capital meant for loan.
7. Transfer earnings – Transfer earnings 11. Innovation – Invention put into
refer to minimum payment payable to commercial practice.
a factor to retain it in its present use.

MODEL QUESTIONS

PART – A

1. In Economics, distribution of income 3. Rent is the reward for the use of

is among the a. capital
a. factors of production b. labour
b. individual c. land
c. firms d. organization
d. traders
4. The concept of ‘Quasi-Rent’ is
2. Theory of distribution is popularly associated with
known as, a. Ricardo
a. Theory of product-pricing b. Keynes
b. Theory of factor-pricing c. Walker
c. Theory of wages d. Marshall
d. Theory of Interest

Distribution Analysis 139

 5. The Classical Theory of Rent was c. interest
propounded by d. profit
a. Ricardo
11. Keynesian Theory of interest is
b. Keynes popularly known as
c. Marshall a. Abstinence Theory
d. Walker b. Liquidity Preference Theory
6. ‘Original and indestructible powers of c. Loanable Funds Theory
the soil’ is the term used by
d. Agio Theory
a. [Link]
12. According to the Loanable Funds
b. Walker Theory, supply of loanable funds is
c. Clark equal to
d. Ricardo a. S + BC + DH + DI
b. I + DS + DH + BM
7. The reward for labour is
c. S + DS + BM + DI
a. rent
d. S + BM + DH + DS
b. wage
c. profit 13. The concept of meeting unexpected
expenditure according to Keynes is
d. interest
a. Transaction motive
8. Money wages are also known as
b. Precautionary motive
a. real wages
c. Speculative motive
b. nominal wages
d. Personal motive
c. original wages
14. The distribution of income or wealth
d. transfer wages
of a country among the individuals are
9. Residual Claimant Theory is a. functional distribution
propounded by b. personal distribution
a. Keynes c. goods distribution
b. Walker d. services distribution
c. Hawley
15. Profit is the reward for
d. Knight
a. land
10. The reward given for the use of capital b. organization
a. rent c. capital
b. wage d. labour

Distribution Analysis 140

16. Innovation Theory of profit was given by c. Walker
a. Hawley d. [Link]
b. Schumpeter 19. Abstinence Theory of Interest was
c. Keynes propounded by
d. Knight a. Alfred Marshall
17. Quasi-rent arises in b. N.W Senior

a. Man-made appliances c. Bohm-Bawerk

b. Homemade items d. Knut Wicksell

c. Imported items 20. Loanable Funds Theory of Interest is

d. None of these called as
a. Classical Theory
18. “Wages as a sum of money are paid under
contract by an employer to a worker for b. Modern Theory
services rendered” –Who said this? c. Traditional Theory
a. Benham d. Neo-Classical Theory
b. Marshall

Part- A Answers

1 2 3 4 5 6 7 8 9 10
a b c d a d b b b c
11 12 13 14 15 16 17 18 19 20
b a b b b b a a b d

PART – B Answer the following questions in one or two

sentences.

21. What is meant by distribution? 25. What do you mean by interest?

22. Mention the types of distribution. 26. What is profit?
23. Define ‘Rent’. 27. State the meaning of liquidity
preference.
24. Distinguish between real and money
wages.

Part C Answer the Following Questions in a Paragraph

28. What are the motives of demand for 29. List out the kinds of wages.
money?
30. Distinguish between rent and quasi-rent.

Distribution Analysis 141

31. Briefly explain the Subsistence Theory 33. Describe briefly the Innovation
of Wages. Theory of Profit.

32. State the Dynamic Theory of Profit. 34. Write a note on Risk-bearing Theory
of Profit.

PART – D Answer the Following Questions in One Page

35. Explain the Marginal Productivity 37. Elucidate the Loanable Funds Theory
Theory of Distribution. of Interest.

36. Illustrate the Ricardian Theory of 38. Explain the Keynesian Theory of
Rent. Interest.

ACTIVITY
Visit any manufacturing unit (factory) and collect information
about factors of production (land, labour, capital and organisation)
and compare their remunerations.
Students may be asked to meet the stakeholders in the
factory.
„ Entrepreneur.
„ Manager or Managing Director.
„ Employees.

References

1. Dewett, K.M. and Navalur, M.H. (2016), “Modern Economic Theory”, S. Chand
and Company Pvt. Ltd., New Delhi.
2. Jhingan, M.L. ( ), Micro Economic Theory,
3. Ahuja, H.L. (2016), “Principle of Microeconomics”, [Link] and Company Pvt.
Ltd., New Delhi.
4. Karl, E. Case, Raw C. Fair and Sharon Oster (2014), “Principle of Economics”,
Pearson, Darling Kindersley (India), Pvt. Ltd., New Delhi, Douglas C.
5. Alfred W. Stonier and Hague (2008), “A Text Book of Economic Theory”,
Pearson, Dorling Kindersley (India), Pvt Ltd., New Delhi.

Distribution Analysis 142