Micro-Economics-II (ECB-201) B.

A (IIIrd Semester)

Unit-II
FACTOR PRICING
Structure
2.0 Introduction
2.1 Unit Objectives
2.2 Marginal Productivity Theory of Distribution
2.3 Ricardian Theories of Rent
2.4 Quasi-Rent
2.5 Competitive Labour Markets Wage Determination under Perfect
Competition
2.6 Competitive Labour Markets Wage Determination under Imperfect
Competition
2.7 Wages and Collective Bargaining
2.8 Theories of Profit
2.8.1 Risk and Uncertainty Theory
2.8.2 Schumpeterian Theory of Profit
2.9 Summary
2.10 Answer to Check Your Progress
2.11 Questions and Exercises

2.0 Introduction
In economics, there are four main factors of production, namely land, labour, capital,
and entrepreneur. The price that an entrepreneur pays for availing the services of these factors
is called factor pricing.
An entrepreneur pays rent, wages, interest, and profit for availing the services of land,
labour, capital, and entrepreneur respectively. The theory of factor pricing deals with the
price determination of different factors of production.
2.1 Unit Objectives
The theory of factor pricing deals with the prices paid for factor services (land, labour,
capital, entrepreneur) and received by the sellers of factor services. It deals with wage rate,

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interest rate specific rent and profit. In short theory of factor pricing studies how rent of land,
wages of labour interest on capital and profit of entrepreneur is determined.
In this unit the theory of factor pricing deals with determination of prices of services
of different factors of production, whereas theory of value deals with the determination of
prices of goods produced. In both the theories prices are determined by the intersection of
demand and supply curves. Therefore a question arises that why a separate study of factor
pricing? This is because of the fact that the nature of demand and supply of factors and that of
commodities. The difference in nature of demand and supply are as follows:
2.2 Marginal Productivity Theory of Distribution
The oldest and most significant theory of factor pricing is the marginal productivity
theory. It is also known as Micro Theory of Factor Pricing.
It was propounded by the German economist T.H. Von Thunen. But later on many
economists like Karl Mcnger, Walras, Wickstcad, Edgeworth and Clark etc. contributed for
the development of this theory.
The marginal productivity theory of distribution, as developed by J. B. Clark, at the
end of the 19th century, provides a general explanation of how the price (of the earnings) of a
factor of production is determined.
According to this theory, remuneration of cache factor of production tends to be equal
to its marginal productivity.
Marginal productivity is the addition that the use of one extra unit of the factor makes
to the total production. So long as the marginal cost of a factor is less than the marginal
productivity, the entrepreneur will go on employing more and more units of the factors. He
will stop giving further employment as soon as the marginal productivity of the factor is
equal to the marginal cost of the factors.
Definitions:
“The distribution of income of society is controlled by a natural law, if it worked
without friction, would give to every agent of production the amount of wealth which that
agent creates.” -J.B. Clark
“The marginal productivity theory contends that in equilibrium each productive agent
will be rewarded in accordance with its marginal productivity.” -Mark Blaug
“The marginal productivity theory of income distribution states that in the long run
under perfect competition, factors of production would tend to receive a real rate of return
which was exactly equal to their marginal productivity.” -Liebhafasky

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Assumptions of the Theory:

The main assumptions of the theory are as under:
1. Perfect Competition:
The marginal productivity theory rests upon the fundamental assumption of perfect
competition. This is because it cannot take into account unequal bargaining power between
the buyers and the sellers.
2. Homogeneous Factors:
This theory assumes that units of a factor of production are homogeneous. This
implies that different units of factor of production have the same efficiency. Thus, the
productivity of all workers offering the particular type of labour is the same.
3. Rational Behaviour:
The theory assumes that every producer desires to reap maximum profits. This is
because the organizer is a rational person and he so combines the different factors of
production in such a way that marginal productivity from a unit of money is the same in the
case of every factor of production.
4. Perfect Substitutability:
The theory is also based upon the assumption of perfect substitution not only between
the different units of the same factor but also between the different units of various factors of
production.
5. Perfect Mobility:
The theory assumes that both labour and capital are perfectly mobile between
industries and localities. In the absence of this assumption the factor rewards could never
tend to be equal as between different regions or employments.
6. Interchangeability:
It implies that all units of a factor are equally efficient and interchangeable. This is
because different units of a factor of production are homogeneous, since they are of the same
efficiency, they can be employed inter-changeable, and e.g., whether we employ the fourth
man or the fifth man, his productivity shall be the same.
7. Perfect Adaptability:
The theory takes for granted that various factors of production are perfectly adaptable
as between different occupations.
8. Knowledge about Marginal Productivity:
Both producers and owners of factors of production have means of knowing the value
of factor’s marginal product.

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9. Full Employment:
It is assumed that various factors of production are fully employed with the exception
of those who seek a wage above the value of their marginal product.
10. Law of Variable Proportions:
The law of variable proportions is applicable in the economy.
11. The Amount of Factors of Production should be Capable of being Varied:
It is assumed that the quantity of factors of production can be varied i.e. their units
can either be increased or decreased. Then the remuneration of a factor becomes equal to its
marginal productivity.
12. The Law of Diminishing Marginal Returns:
It means that as units of a factor of production are increased the marginal productivity
goes on diminishing.
13. Long-Run Analysis:
Marginal productivity theory of distribution seeks to explain determination of a
factor’s remuneration only in the long period.
Some Key Concepts:
The theory is also based on key certain concepts.
These are the following:
1. Marginal Physical Product (MPP):
The first is marginal physical product of a factor. The marginal physical product
(MPP) of a factor, say, of labour, is the increase in the total product of the firm as additional
workers are employed by it.
2. Value of the Marginal Product (VMP):
The second concept is value of marginal product. If we multiply the MPP of a factor
by the price of the product, we would get the value of the marginal product (VMP) of that
factor.
3. Marginal Revenue Product (MRP):
The third concept is marginal revenue product (MRP). Under perfect competition, the
VMP of the factor is equal to its marginal revenue product (MRP), which is the addition to
the total revenue when more and more units of a factor are added to the fixed amount of other
factors, or MRP = MPP x MR under perfect competition. It is simply MPP multiplied by
constant price, as P = MR. [VMP of a factor = MPP of the factor x price of the product per
unit, and MRP of a factor=MPP of the factor x MR under perfect competition. So under
perfect competition VMP of a factor = MRP of that factor.]

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Explanation of the Theory:

The marginal productivity theory states that under perfect competition, price of each
factor of production will be equal to its marginal productivity. The price of the factor is
determined by the industry. The firm will employ that number of a given factor at which
price is equal to its marginal productivity. Thus, for industry, it is a theory of factor pricing
while for a firm it is a factor demand theory.
Analysis of Marginal Productivity Theory from the Point of View of an Industry:
Under the conditions of perfect competition, price of each factor of production is
determined by the equality of demand and supply. As the theory assumes that there exists full
employment in the economy, therefore, supply of the factor is assumed to be constant. So,
factor price is determined by its demand which itself is determined by the marginal
productivity. Thus, under such conditions, it becomes essential to throw light on the demand
curve or marginal productivity curve of an industry.
As the industry consists of a group of many firms, accordingly, its demand curve can
be drawn with the demand curves of all the firms in the industry. Moreover, marginal revenue
productivity of a factor constitutes its demand curve. It is only due to this reason that a firm’s
demand or labour depends on its marginal revenue productivity. A firm will employ that
number of labourers at which their marginal revenue productivity is equal to the prevailing
wage rate.
Fig 2.2 shows that at wage rate OP1, the demand for labour is ON1 and marginal
revenue productivity curve is MRP1. If wage rate falls to OP, firms will increase production
by demanding more labour. In such a situation the price of the commodity will fall and
marginal revenue productivity curve will also shift to MRP2.
Figure 2.1: Analysis of Marginal Productivity Theory

At OP wages, the demand for labour will increase to ON. DD1 is the firm’s demand
curve for labour. The summation of demand of all the firms shows demand curve of an

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industry. Since the number of firms is not constant under perfectly competitive market, it is
not possible to estimate the summation of demand curves of all firms. However, one thing is
certain that is the demand curve of industry also slopes downward from left to right. The
point where demand for and supply of a factor are equal will determine the factor price for
the industry. This theory assumes the supply of a factor to be fixed.
Figure 2.2: Wage Rate, Demand for Labour & MRP Curve

Figure 2.3: Demand and Supply of a Factor at Equal State

Thus factor price is determined by the demand for factor i.e. factor price will be equal
to the marginal revenue productivity. It has been shown by Fig. 2.3. In the Fig. 2.3, number
of labour has been taken on OX axis whereas wages and MRP have been taken on OY axis.
DD1 is the industry’s demand curve for labour. This is also the Marginal Revenue
Productivity curve.
Factor Price (OW) = Marginal Revenue Productivity MRP.
Thus under perfect competition, factor price is determined by the industry and firm
demands units of a factor at this price.
Analysis of Marginal Productivity Theory from the Point of View of Firm:
Under perfect competition, number of firms is very large. No single firm can
influence the market price of a factor of production. Every firm acts as a price taker and not a
price maker. Therefore, it has to accept the prevailing price. No employer would like to pay

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more than what others are paying. In other words, a firm will employ that number of a factor
at which its price is equal to the value of marginal productivity. Therefore, from the point of
view of a firm, the theory indicates how many units of a factor it should demand.
It is due to this reason that it is also called Theory of Factor Demand. Other things
remaining the same, as more and more labourers are employed by a firm, its marginal
physical productivity goes or- diminishing. As price under perfect competition remains
constant, so when marginal physical productivity of labour goes on diminishing, marginal
revenue productivity will also go on diminishing. Therefore, in order to get the equilibrium
position, a firm will employ labourers up to a point where their respective marginal revenue
productivity is equal to their wage rate.
Table 2.1: Factor Demand by the Firm

Table 2.1 indicates that wage rate of labour is Rs. 55 per labourers. Price of the
product produced by the labourer is Rs. 5 per unit. Now, when a firm employs one labourer,
his marginal physical productivity is 20 units. By multiplying the MPP with price of the
product we get marginal revenue productivity. Here, it is Rs. 100 for the first labour. The
marginal revenue productivity of second labourer is Rs. 85 and of third labourer it is Rs. 70.
The marginal revenue productivity of fourth labourer is Rs. 55 which is equal to wage rate.
The firm will earn maximum profits if it employs up to the fourth labourer. If the firm
employs fifth labourer, it will have to suffer losses of Rs. 15. Therefore, to get maximum
profits, a firm will employ a factor upto a point where MRP is equal to price.
Figure 2.4: Constant Wage Rate under Perfect Competition

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In Fig. 2.4 number of labourers has been measured on OX-axis and wage rate on Y-
axis. MRP is marginal revenue productivity curve and WW is the wage rate prevailing in the
market. Since, under perfect competition wage rate will remain constant that is why WW
wage line is parallel to OX-axis.
MRP curve is sloping down-ward. It cuts WW at point E which is the equilibrium
wage rate of Rs. 55. At point E, firm will demand only four labourers. Thus, from the above,
we can conclude that a factor is demanded up to the limit where its marginal productivity is
equal to prevailing price.
Figure 2.5: Average Wages & Average Net Revenue Productivity at Equal State

Under perfect competition, in long period in the equilibrium position, not only the
marginal wages of a firm are equal to marginal revenue productivity, even the average wages
of the firm are equal to average net revenue productivity as has been shown in Fig. 2.5. The
fig. 2.5 shows that at point ‘E’ marginal wages of labour are equal to marginal revenue
productivity and the firm employs OM number of workers. At this point, even the average net
revenue productivity is equal to average wages. Thus firm earns only normal profit. If wage
line shifts from NN to N[N] then the demand for labour increases from OM to OM1.
Determination of Factor Pricing under Imperfect Competition:
Marginal productivity theory applies to the condition of perfect competition. But in
real life we face imperfect competition. Therefore, economists like Robinson, Chamberlin
have analysed factor pricing under imperfect competition. There are various firms under
imperfect competition. But here we shall analyze only Monopsony. Under monopsony, there
is perfect competition in product market. Consequently MRP is equal to VMP. There is
imperfect competition in factor market.
It indicates that there is only one buyer of the factors. Therefore, monopsony refers to
a situation of market where only a single firm provides employment to the factors. If the firm
demands more factors, factor price will go up and vice-versa. However, the determination of
factor price under monopsony can be explained with the help of Fig. 2.6.

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Figure 2.6: Determination of Factor Price under Monopsony

In Fig. 2.6 number of labourers has been shown on X-axis and wages on Y-axis. MW
is marginal wage curve and ARP is the average wage curve. MRP is the marginal revenue
productivity curve and AW is the average revenue productivity curve.
In the fig. 2.6 a monopsony will employ that number of labourers at which their
marginal wage is equal to MRP. In the fig. 2.6 firm is in equilibrium at point E. Here, firm
will employ ON labourers and they will be paid wages equal to NF. In this way, ON
labourers will get less wages than their MRP i.e. EN. Monopsony firm will have EF profit per
labourer which arises due to exploitation of labourers. Total profit SFWW’ is due to
exploitation of labour.
2.3 Ricardian Theories of Rent
David Ricardo, an English classical economist, first developed a theory in 1817 to
explain the origin and nature of economic rent.
Ricardo used the economic and rent to analyse a particular question. In the
Napoleonic wars (18.05-1815) there were large rise in corn and land prices.
Did the rise in land prices force up the price of corn, or did the high price of corn
increase the demand for land and so push up land prices. Ricardo defined rent as, “that
portion of the produce of the earth which is paid to the landlord for the use of the original and
indestructible powers of the soil.” In his theory, rent is nothing but the producer’s surplus or
differential gain, and it is found in land only.
Assumptions of the Theory:
The Ricardian theory of rent is based on the following assumptions:
1. Rent of land arises due to the differences in the fertility or situation of the different plots
of land. It arises owing to the original and indestructible powers of the soil.
2. Ricardo assumes the operation of the law of diminishing marginal returns in the case of
cultivation of land. As the different plots of land differ in fertility, the produce from the

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inferior plots of land diminishes though the total cost of production in each plot of land is
the same.
3. Ricardo looks at the supply of land from the standpoint of the society as a whole.
4. In the Ricardian theory it is assumed that land, being a gift of nature, has no supply price
and no cost of production. So rent is not a part of cost, and being so it does not and cannot
enter into cost and price. This means that from society’s point of view the entire return
from land is a surplus earning.
Reasons for Existence of Rent:
According to Ricardo rent arises for two main reasons:
(1) Scarcity of land as a factor and
(2) Differences in the fertility of the soil.
Scarcity Rent:
Ricardo assumed that land had only one use—to grow corn. This meant that its supply
was fixed, as shown in Figure 2.7. Hence the price of land was totally determined by the
demand for land. In other words, all the price of a factor of production in perfectly inelastic
supply is economic rent—it has no transfer earnings.
Thus, it was the high price of corn which caused an increase in the demand for land
and a rise in its price, rather than the price of land pushing up the price of corn. However, this
analysis depends on the assumption that land has only one use. In the real world a particular
piece of land can be put to many different uses. This means its supply for any one use is
elastic, so that it has transfer earnings.
Figure 2.7: Earnings of a Factor in Fixed Supply

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Differential Rent:
According to Ricardo, rent of land arises because the different plots of land have
different degree of productive power; some lands are more fertile than others. So there are
different grades of land. The difference between the produce of the superior lands and that of
the inferior lands is rent—what is called differential rent. Let us illustrate the Ricardian
concept of differential rent.
Differential Rent on account of differences in the fertility of soil:
Ricardo assumes that the different grades of lands are cultivated gradually in
descending order—the first grade land being cultivated at first, then the second grade, after
that the third grade and so on. With the increase in population and with the consequent
increase in the demand for agricultural produce, inferior grades of lands are cultivated,
creating a surplus or rent for the superior grades. This is illustrated in Table 2.2.
Table 2.2: Calculation of Differential Rent

Table 2.2 shows the position of 3 different plots of land of equal size. The total cost is
the same for each plot of land. Let us assume that the order of cultivation reaches the third
stage when all the three plots of land of different grades are cultivated and the market price
has come to the level of Rs. 5 per kg of wheat.
The first grade land, being the most fertile, produces 40 kg, the second grade 70 kg
and the third grade land, being less fertile, only 20 kg. So, the first grade land earns a surplus
or rent of Rs. 100, the second grade a rent of Rs. 50 and the third one earns no surplus. The
first two plots are called the intra-marginal and the third one is the marginal (or no-rent) land.
This simple example shows how the differences in the fertility of the different plots of land
create rent for the superior plots of lands.
The concept of differential rent arising due to differences in the fertility of different
plots of land is illustrated in Fig. 2.8.

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Figure 2.8: Different Rent

Here, AD, DG and GJ are three separate plots of land of the same size, but of
difference in fertility. The total produce of AD is ABCD, that of DG is DEFG and that of GJ
is GHIJ. The first and second plots of land generate a surplus shows by the shaded area,
which represents the rent of the first two plots of land. Since the third plot GJ has no surplus
it is marginal land or no-rent land. Grade 4 (below-marginal) land will not be cultivated,
because rent is negative (Rs. 25 in this example).
Rent and Price:
From the Ricardian theory we can show the relation between rent (of land) and price
(of wheat). Since the market price of wheat is determined by costs of the marginal producer
and since, for this marginal producer, rents are zero, Ricardo concluded that economic rent is
not a determinant of market price. Rather, price of wheat is determined solely by the market
demand for wheat and the availability of fertile land.
Deductions from the Theory:
If rent depends on price and on the superiority of rent producing land over marginal
land, we can deduce the following:
1. Improved methods of farming:
Improved methods of cultivation may lead to a fall in rent (demand remaining
unchanged). It is because increased output on the superior grades of land will make the
cultivation of inferior grades of land unnecessary.
2. Population growth:
Population growth is likely to lead to a rise in rent, since the increased demand for
land will bring poor quality land into cultivation, thus lowering the output of marginal land.
Thus, if the price of food increases, the rent of existing land will increase.

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3. Improved transport facilities:

Improved transport facilities are likely to lead to a fall in rent. It is because the output
of less fertile land of foreign countries may be able to compete more closely with the home
produce. So there will be no need to cultivate inferior home areas. As a result the output of
the marginal land rises and rent falls.
Thus, it is difficult to say whether or not rent increases with economic progress.
However, rent is likely to fall with economic progress if population growth is unable to fully
neutralise the effects of technological progress and improvement in transport facilities.
Criticisms of the Theory:
Ricardian theory has been criticised on the following grounds:
1. Ricardo considers land as fixed in supply. Of course, land is fixed in an absolute sense.
But land has alternative uses. So the supply of land to a particular use is not fixed
(inelastic). For example, the supply of wheat land is not absolutely fixed at any given
time.
2. Ricardo’s order of cultivation of lands is also not realistic. If the price of wheat falls the
marginal land need not necessarily go out of cultivation first. Superior grades of land
might cease to be cultivated if a fall in the price of its output causes such land being
demanded for other purposes (e.g., for constructing houses).
3. The productivity of land does not depend entirely on fertility. It also depends on such
factors as position, investment and effective use of capital.
4. Critics have pointed out that land does not possess any original and indestructible
powers, as the fertility of land gradually diminishes, unless fertilisers are applied
regularly.
5. Ricardo’s assumption of no-rent land is unrealistic as, in reality; every plot of land earns
some rent, although the amount may be small.
6. Ricardo restricted rent to land only, but modern economists have shown that rent arises
in return to any factor of production, the supply of which is inelastic.
7. According to Ricardo, rent does not enter into price (cost) but from the point of view of
an individual farm rent forms a part of cost and price.
Conclusion:
In spite of the various short-comings of the Ricardian theory, it cannot be discarded—
as Stonier and Hague remarked — “The concept of transfer earnings helps to bring the simple
Ricardian theory of rent into closer relation with reality.”

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2.4 Quasi-Rent
The concept of quasi-rent was given by Alfred Marshall. He defined quasi rent as
surplus earnings generated by the factors of production, except land.
The earnings from machines and instruments are termed as quasi-rent.
The quasi-rent refers to the income produced when the demand for products increases
suddenly.
It is used for a short-period of time. In economic rent, the supply of factor is fixed,
such as land. However, in quasi-rent the supply of factor is temporary and can be increased or
decreased after some time, such as machine.
For example, there is a sudden increase in the demand of houses, but the supply of
houses does not increase with that speed because of the limited building material.
The sudden increase in the return from selling of houses is termed as quasi-rent. Quasi-rent is
regarded as the surplus that is temporary in nature. When the building material would be
available, then the surplus amount would automatically be eradicated. Similarly, same type of
surplus arises in case of other goods, such as ships, machines, and automobiles.
In long-run, the earnings from durable goods are equal to the current interest rate.
However, they can provide surplus earnings for temporary period, which are termed as quasi-
rent. In short-run, equipment is used for only one purpose and not for other purposes. This
implies that the transfer earning for such equipment is zero in the short run.
Therefore, the total earnings generated from the short run equipment are termed as
quasi-rent. The supply of equipment is fixed in the short-run and cannot be increased with the
increase in demand. However, in long-run, the supply of equipment can be increased that
would result in the extinction of surplus earnings.
Quasi rent can also be expressed in terms of revenue, which is as follows:
Quasi-rent = Total revenue – total variable cost
In the long run, all the costs are considered as variable cost. In long-run, the
equilibrium can be attained when total revenue is equal to total costs. In such a case, there is
no quasi-rent.

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Figure 2.9: Quasi-Rent

In Figure-2.9, SS represents the inelastic supply curve. The demand (DD) and supply
(SS) curve intersects at point E. At point E, the price is equal to OP and quantity of
equipment is OS. In the short run, the increased demand (D’D’) reaches to the price level of
OP’ with the constant supply of OS.
As the number of equipment is constant in short-run, therefore, the transfer earnings
are zero and quasi-rent is equal to total earnings from the equipment. However, in long-run,
the supply of equipment (PL) is perfectly elastic. Therefore, any number of equipment can be
supplied at OP. Now, the supply reaches to OM and prices fall to E”M. The quasi- rent would
disappear because the price gets equal to the transfer earning (OP).
2.5 Competitive Labour Markets Wage Determination under Perfect
Competition
The analysis of wage determination under conditions of perfect competition is exactly
the same as given there. In the case of wage determination, it should be remembered that
average factor cost (AFC) becomes average wage (AW) and marginal factor cost becomes
marginal wage (MW).
When there prevails perfect competition in the labour market, wage rate is determined
by the equilibrium between the demand for and supply of labour. Demand for labour is
governed by marginal revenue product of labour (MRP).
Wage rate determined by demand for and supply of labour is equal to the marginal
revenue product of labour. Thus, under perfect competition in labour market, a firm will
employ the amount of labour at which wage rate = MRP of labour.
As regards the supply of labour, it may be pointed out that supply of labour to the
whole economy depends upon the size of population, the number of workers available for
work out of a given population, the number of hours worked, the intensity of work, the skills
of workers and their willingness to work.

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The size of population depends upon a great variety of social, cultural, religious and
economic factors among which wage rate the size of population rises or falls with a rise or
fall respectively in the wage rate, and from this they had deduced a law called “Iron Law of
Wages”. But the history has shown that rise in the wage rate may have just the opposite effect
on the size of population from what the subsistence theory of wages conceives.
Moreover, the historical experiences have revealed that the size of population is
dependent upon the great variety of social, cultural, religious and economic factors among
which wage rate plays only a minor determining role. However, the willingness to work may
be influenced greatly by the changes in the wage rate.
On the one hand, as wages rise, some persons will do not work at lower wages may
now be willing to supply their labour. But, on the other hand, as wages rise, some persons
may be willing to work fewer hours and others like women may withdraw themselves from
labour force, since the wages of their husbands have increased.
Thus there are two conflicting responses to the rise in wages and therefore the exact
nature of supply curve of labour is difficult to ascertain. It is, however, generally held that the
total supply curve of labour rises up to a certain wage level and after that it slopes backward.
This is shown in Fig. 2.10. As wage rate rises up to OW, the total quantity supplied of labour
rises, but beyond OW, the quantity supplied of labour decreases as the wage rate is increased.
Figure 2.10: Beyond a Certain Wage Rate, Supply Curve of Labour is Backward Sloping

But so far as supply of labour to a particular industry is concerned it slopes

upward. As the wages in an industry are increased labourers from other industries will
shift to this industry. The elasticity of the supply curve of labour to an industry will
also depend upon the transfer earnings of labourers.

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Similar is the case of supply of workers to a particular occupation. If wages in one

occupation go up, some persons from other similar occupations would be attracted to it and
thus the supply of labour to that occupation will increase.
Thus because of occupational shifts, the supply curve of labour to a particular
occupation is elastic and rises upwards. The long-run supply curve of labour is more elastic
than the short-run supply curve since, in the long-run, besides the occupa-tional shift in the
labour force, new entrants in the labour market (who are now children) can also adopt the
occupation by getting training for it in the very first instance.
Figure 2.11: Determination of Wages

How the wage rate is determined by demand for and supply of labour is shown in
Figure 2.11 where DD represents the demand curve for labour and SS represents its supply
curve. The two curves intersect at point E. This means that at wage rate OW, quantity
demanded of labour is equal to quantity supplied of it.
Thus, given the demand for and supply of labour wage rate OW is deter-mined and at
this wage rate labour market is cleared. All those who are willing to work at the wage rate
OW get employment. This implies that there is no involuntary unemployment and full
employment of labour prevails.
It is important to note that there will be no equilibrium at any wage rate higher or
lower than OW. For example, at a higher wage OW c supply of labour exceeds quantity
demanded of it and as a result involuntary unemployment equal to UT emerges. Given the
competition among labourers, this unemployment would push down the wage rate to OW.
On the other hand, at a lower wage rate OWC the demand for labour exceeds the
amount of labour which people are willing to supply. In view of the excess demand for
labour, the wage rate will go up to OW where the demand for labour equals the amount
supplied of it. Thus wage rate OW will finally settle in the labour market.

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Though wage rate is determined by demand for and supply of labour, it is equal to the
value of marginal product of labour. This is so because in order to maximise its profits, a firm
will equalise the wage rate with the value of the marginal product (VMP) of labour.
If the firm stops short of this equality, the value of the marginal prod-uct (VMP) will
be greater than the wage rate which would imply that there was still scope for earning more
profits by increasing the em-ployment of labour. On the other hand, if the firm goes beyond
and employs more labour than the equality point, the value of the marginal product of labour
will become smaller than the wage rate.
As a result, the firm will incur losses on workers employed beyond the equality point
and it will therefore be to the advantage of the firm to reduce the employment of labour. Thus
in order to maximise profits and be in equilibrium the firm working under conditions of
perfect competition in the factor and product markets will employ so much labour that the
wage rate is equal to the value of marginal product (or marginal revenue product) of labour.
It will be seen from Fig. 2.11 that the firm working in perfect competition in the labour
market will take the wage rate OW as given and equates it with value of marginal product
(VMP) and employs OM labour. To sum up, the wage rate is determined by demand for and
supply of labour, but is equal to the value of marginal product (or marginal revenue product)
of labour.
It is worth mentioning that when the firms are in equilibrium by equating value of
marginal product of labour to the wage rate, they may be making profits or losses in the short
run. Consider Figure 2.12 which depicts the equilibrium position of the firm in the short run.
It will be seen from Fig. 2.12 that at the wage rate OW, the firm is in equilibrium when it is
employing OM amount of labour. It will be further seen that the firm is making super-normal
profits since in equilibrium employment OM, average revenue product of labour (ARP)
which is equal to RM is greater than the wage rate OW (=ME).
Figure 2.12: Equilibrium of the Firm with Super-Normal Profits

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This can happen in the short run, but not in the long run. When firms are earning
super-normal profits in the short run more entrepreneurs will enter the market in the long run
to purchase labour to produce the products made by it.
Entry of more entrepreneurs to the labour market will compete away the super-normal
profits. As a result, the demand for labour will rise and the demand curve for labour will shift
outward to the right, which will raise the wage rate and will eliminate the profits.
It should be carefully noted that a firm will not employ labour if wage rate exceeds average
product of labour. Unlike machines labour is a variable factor and if its employment is not
sufficient to recover its wages, it will be laid off even in the short run.
Figure 2.13: A Firm will not Employ Labour at Wage Rate OW

Consider Fig. 2.13 at wage rate OW1, a firm will be incurring losses if it employs ON1
amount of labour at which wage rate OW1 = VMP = MRP. Therefore, at wage rate OW1, the
firm will not employ labour.
To sum up, in the long run, the equilibrium between demand for and sup-ply of labour
is established at the level where the wage rate of labour is equal to both the VMP (MRP) and
ARP of labour and thus the firms earn only nor-mal profits. The long-run equilibrium
position of the firm working under perfect competition is depicted in Fig. 2.14 where it will
be seen that the firm is in equilibrium at ON level of employment (i.e., at point T) at which
wage rate is not only equal to value of marginal prod-uct but also average revenue product of
labour.
Given the ARP and v MP curves, if the wage rate is lower than OW (= N.T.), the
number of firms employing labour will change causing changes in demand for labour. As a
result of this, the wage rate will ultimately settle at the level OW or NT.

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Figure 2.14: Long-Run Equilibrium of the Firm

Changes in Equilibrium Wage Rate:

We have explained above how through interaction of demand for and supply of labour
determines the market wage rate. Now, if any of the factors causes a shift either in demand
curve or in supply curve of labour, the equilibrium will be disturbed causing a change in the
wage rate. Both demand for and supply of labour can shift.
Shift in Demand Curve for Labour:
Demand for labour increases if its productivity increases, say through technological
improvement. This will cause a rightward shift in the demand curve for labour and as shall be
seen from Fig. 2.15 this will bring about a rise in the wage rate.
Similarly, if the demand for a product, say of a textile cloth, increases, the demand for
textile workers being a derived demand will also go up. This too will cause an upward shift in
the demand for textile workers causing a rise in their wage rate.
Further, if the price of a textile cloth rises, it will increase the value of marginal
product, (VMP = Price x MPP) of textile workers. With this higher value of marginal
product, it will become profitable for the producer to hire more workers. As a result, demand
for textile workers will increase causing a rise in their wage rate.
Conversely, if the demand for a product decreases or its price falls, it will induce a
reduction in the demand for labour. Given the supply curve, decrease in demand for labour
will bring about reduction in wage rate.

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Figure 2.15: Effect of Increase in Labour Demand on the Wage Rate

Shift in Labour Supply Curve:

If the factors determining labour supply undergo a change, the supply curve of labour
will shift causing a change in the equilibrium wage rate. The supply of labour to a given
occupation or industry will decrease if the wages in alternative occupations or industries go
up.
In this case at every wage rate less labour will be offered to a given occupation or
industry. This will cause a shift in the supply curve of labour to the left and, given the
demand curve for labour, result in rise in the wage rate. This is shown in Figure 2.16.
Figure 2.16: Effect of Decrease in Labour Supply on Wage Rate

Similarly, if workers valuation of their leisure time changes, the supply curve of
labour will shift. If most workers start attaching a higher value to their leisure time spent with
their families, the less labour will be supplied to an occupation or industry. This will cause a

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shift in the labour supply curve to the left resulting in higher wage rate as is illustrated in Fig.
2.16.
Conversely, if for any reason, the wage rate in alternative occupation fall or workers’
preferences for leisure declines, supply of labour to a given occupation or industry will
increase at every wage rate. This will cause a shift in the supply curve of labour to the right
and result in-fall in the wage rate.
2.6 Competitive Labour Markets Wage Determination under Imperfect
Competition
Economists, such as Joan Robinson and Pigou, have contributed a lot in determining
wages in imperfect competition.
There can be various forms of an imperfect market, including monopolistic
competitive market, oligopoly, and monopoly.
Here, we will focus our discussion of wage determination in context of monopsony.
In case of monopsony, there is only one buyer of a factor of production, which is labour in
this case. This single buyer has no competitor in the market.
Therefore, the position of the buyer is very strong as compared to labour. Monopsony
can also take place when a single employer employs a huge labour force for a particular job
type. In this case, the employer would have a control on setting the wages for that particular
job.
Figure-2.17: Determination of Wage Rate under Imperfect Competition

In Figure-2.17, AW (average wage curve) is representing the supply curve of labour,

while MRP represents the demand curve of labour. AW is showing an upward slope. This
implies that employer needs to pay higher wages if he/she wants to hire more labour. MW
represents the marginal wage curve.
MW intersects MRP at point E, which is the equilibrium point. At point E, MW gets
equal to MRP when the number of labour is equal to ON with the wage rate of OW (=NH).

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The wage rate OW is lower than the MRP wage rate that is NE. Therefore, the labour is
getting wage rate lower by EH from the actual MRP rate that they deserve.
EH represents the level of wage rate at which labour is exploited in monopsony
condition. It is also termed as monopsonistic exploitation. Therefore, in case of monopsony,
the wage rate and number of employees is low as compared to perfect competition. In case of
perfect competition, the equilibrium point would be at C. At point C, wage rate would be OW
(=NC) and number of labour is ON that is higher as compared to the case of monopsony.
2.7 Wages and Collective Bargaining
Meaning:
Collective bargaining is a process of negotiating between management and workers
represented by their representatives for determining mutually agreed terms and conditions of
work which protect the interest of both workers and the management. According to Dale
Yoder’, “Collective bargaining is essentially a process in which employees act as a group in
seeking to shape conditions and relation­ships in their employment”.
Michael J. Jucious has defined collective bargaining as “a process by which
employers, on the one hand, and representatives of employees, on the other, attempt to arrive
at agreements covering the conditions under which employees will contribute and be
compensated for their services”.
Thus, collective bargaining can simplify be defined as an agreement collectively
arrived at by the representatives of the employees and the employers. By collective
bargaining we mean the ‘good faith bargaining’. It means that proposals are matched with
counter proposals and that both parties make every reasonable effort to arrive at an
agreement’ It does not mean either party is compelled to agree to a proposal. Nor does it
require that either party make any specific concessions.
Why is it called collective bargaining? It is called “collective” because both the
employer and the employee act collectively and not individually in arriving at an agreement.
It is known as ‘bargaining’ because the process of reaching an agreement involves proposals
and counter proposals, offers and counter offers.
Objectives:
The basic objective of collective bargaining is to arrive at an agreement between the
management and the employees determining mutually beneficial terms and conditions of
employment.

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This major objective of collective bargaining can be divided into the following sub-
objectives:
1. To foster and maintain cordial and harmonious relations between the
employer/management and the employees.
2. To protect the interests of both the employer and the employees.
3. To keep the outside, i.e., the government interventions at bay.
4. To promote industrial democracy.
Importance:
The need for and importance of collective bargaining is felt due to the advantages it
offers to an organisation.
The chief ones are as follows:
1. Collective bargaining develops better understanding between the employer and the
employees:
It provides a platform to the management and the employees to be at par on
negotiation table. As such, while the management gains a better and deep insight into the
problems and the aspirations of die employees, on the one hand, die employees do also
become better informed about the organisational problems and limitations, on the other. This,
in turn, develops better understanding between the two parties.
2. It promotes industrial democracy:
Both the employer and the employees who best know their problems, participate in
the negotiation process. Such participation breeds the democratic process in the organisation.
3. It benefits the both-employer and employees:
The negotiation arrived at is acceptable to both parties—the employer and the employees.
4. It is adjustable to the changing conditions:
A dynamic environment leads to changes in employment conditions. This requires
changes in organisational processes to match with the changed conditions. Among other
alternatives available, collective bargaining is found as a better approach to bring changes
more amicably.
5. It facilitates the speedy implementation of decisions arrived at collective negotiation:
The direct participation of both parties—the employer and the employees—in
collective decision making process provides an in-built mechanism for speedy
implementation of decisions arrived at collective bargaining.

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2.8 Theories of Profit

This theory was first propounded by the American Economist Walker. It is based on
the ideas of Senior and J.S. Mill. According to Mill, “the extra gains which any producer
obtains through superior talents for business or superior business arrangements are very much
of a kind similar to rent. Walker says that “Profits are of the same genus as rent”. His theory
of profits states that profit is the rent of superior entrepreneur over marginal of less efficient
entrepreneur.
According to these economists, there was a good deal of similarity between rent and
profit. Rent was the reward for the use of land while a profit was the reward for the ability of
the entrepreneur. Just as land differs from one another in fertility, entrepreneurs differ from
one another in ability. Rent of superior land is determined by the difference in productivity of
the marginal and super marginal land; similarly the profits of the marginal and super marginal
entrepreneurs.
In short it is the intra-marginal lands that earn a surplus over marginal lands. So also
intra marginal entrepreneurs earn a surplus over marginal entrepreneur. Just as there is the
marginal land, there is the marginal entrepreneur. The marginal land yields no rent; so also
marginal entrepreneur is a no profit entrepreneur.
The marginal entrepreneur sells his produce at cost price and gets no profit. He
secures only the wages of management not profit. Thus profit does not enter into cost of
production. Like rent, profit also does not enter into price. Profit is thus a surplus.
Profit is necessarily a residual sum. Land, labour, and capital are frequently used under
contracts whereby they receive a predetermined return. Wet profit is a sum over and above
the ordinary costs of business, including such contractual outlays.
Nobody contracts to pay the entrepreneur the residual sum which constitutes net
profit. Business profits are, therefore, specially contingent upon successful management risk.
Business is faced with a number of uncertainties—technical uncertainties (those relating to
the future period of the produce and the volume of sales).
The entrepreneur receives a reward for combining the factors of production to meet
the economic needs of a world faced with uncertainties. He takes a risk which others are
unwilling to bear, and if he successfully manages the risk, he receives profits. This means that
a businessman, in order to earn profits, has to do two things:
(1) Select the risks which he wishes to bear; and
(2) Manage them successfully.

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The selection of risk is made at almost every step of a businessmen’s career. His most
important problem is the selection of business in which he wishes to engage himself. But
even thereafter many risks arise. Some of them he may have to bear even though he would
rather not; others he may transfer to people more willing to bear them (or unable to escape
them); still others he may shift by insurance.
The greater the risk and uncertainty in business, the greater the opportunities for large
profits. That all entrepreneurs do not make profits is too frequently overlooked. Some
businessmen, of course, make high profits, and usually these cases are the ones that receive
greatest public attention; but many businessmen make no profits, and a great many more
incur substantial losses.
Since risks and, therefore, profits (and losses) appear because of changes and
uncertainties in a dynamic society, profits vary from year to year. In fact, all instances of
economic uncertainties can be treated as cases of choice between smaller rewards more
confidently and a larger one less confidently anticipated.
2.8.1 Risk and Uncertainty Theory
An important theory associates profit with risk and uncertainty. According to F.H.
Knight, profit is a reward for uncertainty bearing. Even before Knight, F.B. Hawley and A.C.
Pigou had pointed out that entrepreneurs earn profits because they have to bear the risks of
production.
But Knight has greatly developed the theory of profits based on uncertainty. He has
distinguished between risk and uncertainty on the one hand and predictable and unpredictable
changes on the other. According to him, dynamic changes give rise to profits only if changes
and their consequences are of unpredictable character. Only those changes whose occurrence
cannot be known before hand give rise to profits.
Profits, Unpredictable Changes and Uncertainly:
As we have noted above, if there were no changes or if the changes were foreseen and
predictable, there would have been no uncertainty about the future and therefore no profits.
Profits arise because of the uncertainty of future.
If the future conditions could be completely foreknown in the present, then
competition would certainly adjust things to the ideal state where all prices would equal costs
and profits would not emerge. Thus it is our ignorance about the future and uncertainty of it
that give rise to profits.

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In other words, it is the divergence of actual conditions from those which have been
expected and on the basis of which business contracts have been made that give rise to
uncertainty and profits. Prof. A.K Dass Gupta rightly maintains, “Uncertainty is thus a
permanent feature of economic system. It is one of the limitations of human ingenuity that it
cannot unearth the contents of the future.
Trained instructs of businessmen coupled with statistical information may go a long
way, but in so far as the course of nature (both physical and human) is anything but
rhythmical, the future would always remain more or less of mystery.” He further writes, “so
long as entrepreneurs start operations with imperfect knowledge about the state of the market
and so long as the anticipated marginal product of the hired factors deviates from their actual
product, so long a surplus would persist.”
We thus see that entrepreneurs have to undertake the work of production under
conditions of uncertainty. In advance they have to make estimates of the future conditions
regarding demand for the product and other factors which affect price and costs. In view of
their estimates and anticipations, they make contract with the suppliers of factors of
production in advance at fixed rates of remuneration.
They realise the value of the output produced by the hired factors after it has been
produced and sold in the market. But a good deal of time is spent in the process of producing
and selling the product. It follows, therefore, that a good time gap elapses between the
contracts made by the entrepreneur with the factors of production at fixed rates and the
realisation of sale proceeds from the output made by them.
As mentioned before, these contracts are based upon anticipations about the future
conditions. But between the times of contracts and sale of the output many changes may take
place which may upset anticipations for good or for worse and thereby give rise to the profits,
positive and negative.
Now, if the conditions prevailing at the time of sale of output could be known or
predicted when the entrepreneurs enter into contractual relationships with the factors of
production about their rates of remuneration, there would have been no uncertainty and,
therefore, no profits.
Thus uncertainty, that is, ignorance about the future conditions of demand and supply,
is the cause of profits. It should be noted that positive profits accrue to those entrepreneurs
who make correct estimate of the future or whose anticipations prove to be correct. Those
whose anticipations prove to be incorrect will have to suffer losses.

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We thus see that profit is a residual and non-contractual income which accrues to the
entrepreneurs because of the fact of uncertainty. The entrepreneur is unhired factor; he hires
others for work of production. It is, therefore, entrepreneur who bears uncertainty and earns
profits as a reward for that. J.F. Weston who has been a prominent exponent and supporter of
uncertainty theory of profit explains the emergence of profits in the following way: “Under
uncertainly total product may not be equal to total costs (explicit and implicit) because plans
are not fulfilled.
How this occurs is briefly indicated. Two classes of owners of productive services are
distinguished.
First, those with rates of compensation fixed in advance of the determination of the
results of operations are called hired factors and receive contractual returns.
Second, those with rates of compensation dependent upon the results of operation are
referred to as unhired factors who receive non-contractual or residual returns. Whatever the
basis upon which contractual relationships have been entered, actual results will not have
been accurately foreseen because of uncertainty. Hence whatever the basis upon which
contractual commitments have been made events actually do not turn out that way. This is the
significance of economic profit. It is not possible to plan in advance exactly what total
product or total costs will be.”
What Causes Uncertainty?
Now, the question is what changes cause uncertainty. There are two types of changes
which take place and are responsible for conditions of uncertainty. First type of changes
refers to innovations (for example, introduction of a new product or a new cheaper method of
production etc.) which are introduced by the entrepreneurs themselves.
These innovations not only create uncertainty for the rivals or competitors who are
affected by them but they also involve uncertainty for the entrepreneur who introduces them
because one cannot be certain whether a particular innovation will be definitely successful.
The second types of changes which cause uncer-tainty are those which are external to the
firms and industries.
These changes are:
(1) Changes in tastes and fashions of the people,
(2) Changes in Government policies and laws especially taxation,
(3) Wage and labour policies and laws,
(4) Movements of prices as a result of inflation and depres-sion,
(5) Changes in income of the people,

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(6) Changes in production technology etc. All these changes cause uncertainty and bring
profits, positive or negative, into existence.
Insurable and Non-Insurable Risks:
We have seen above that entrepreneurs work under conditions of uncertainty and that
they bear uncertainty and earn profits as a reward for that. Here a distinction drawn by F.H.
Knight between insurable and non-insurable risk is worth mentioning. Because of the
changes that are continuously occurring in the economy entrepreneur has to face many risks.
But all risks do not cause uncertainty and give rise to profits.
It is only non-insurable risks that involve uncertainty and the entrepreneur earns
profits for bearing these non-insurable risks. Now, the question arises as to what kind of risks
are insurable and what non-insurable. The entrepreneur faces risks like fire, theft, accident
etc. which may cause him huge losses.
But these risks of fire, theft, accident etc. can be insured against on the payment of a
fixed premium. Insurance premium is included in the cost of production. Thus no uncertainty
arises due to insurable risks as far as individual entrepreneurs are concerned and therefore
they cannot give rise to profits.
Now, only those risks can be insured the probability of whose occurrence can be
calculated. Thus an insurance company knows by its calculation on the basis of past statistics
that how much percentage of the factories will catch fire in a year.
On the basis of this information, it will fix the rate of premium and is able to insure
the factories against the risk. But there are risks which cannot be insured and therefore they
have to be borne by the entrepreneurs. These non-insurable risks relate to the outcomes of the
price-output decisions taken by the entrepreneurs.
Whether it will pay him to increase output, reduce output and what will be the
outcome in terms of profits or losses as a result of his particular output decision. Again,
whether it will pay him to lower price or to raise it and when he takes a particular price
decision whether he would make profits or losses.
Similarly, he has to face risks as a result of his decisions regarding mode of
advertisement and outlay to be made on it, product variation etc. For taking all these
decisions he has to guess about demand and cost condi-tions and always there is risk of
suffering losses as a result of decisions.
No insurance company can insure the entrepreneurs against commercial losses which
may emerge out of decisions regarding price, output, and product variation and also against

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the losses which may fall upon the entrepreneurs due to the structural, cyclical and other
exogenous changes which take place in the economy.
It is, therefore, clear that it is non-insurable risks that involve uncertainty and give rise
to profits. To quote Knight, “It is ‘uncertainty’ distinguished from insurable risk that
effectively gives rise to the entrepreneurial form of organisation and to the much condemned
‘profit’ as an income form.”
Conclusion:
All the theories of profits explained above have some element of truth. No single
theory can adequately explain the existence of profits in all cases. Thus, economic profits can
arise as a result of disequilibrium caused by dynamic changes in the economy and frictions in
the instantaneous adjustment to the new conditions.
They can arise due to the existence of monopoly in the product and factor markets,
due to the introduction of innovations by the entrepreneurs, due to higher risk and correctly
estimating the uncertain future and due to higher managerial efficiency and skills. B.S.
Keirstead rightly writes, “Profits may come to exist as a result of monopoly or monopsony as
a reward for innovation, as a reward for the correct estimate of uncertain factors either
particular to the industry or general to the whole economy”.
2.8.2 Schumpeterian Theory of Profit
This theory was propounded by Schumpeter. This theory is more or less similar to
that of Clark’s theory. Instead of five changes mentioned by Clark, Schumpeter explains the
change caused by innovations in the production process. According to this theory profit is the
reward for innovations. He uses the term innovation in a sense wider than that of the changes
mentioned by Clark.
Innovation refers to all those changes, in the production process with an objective of
reducing the cost of commodity so as to create gap between the existing price of the
commodity and its new cost. Innovation may take any shape like introduction of a new
technique or a new plant, a change in the internal structure or organizational set up of the firm
or change in the quality of raw material, a new form of energy, better method of
salesmanship, etc.
It has been held by Joseph Schumpeter that the main function of the entrepreneur is to
introduce innovations in the economy and profits are reward for his performing this function.
Now, what is innovation? Innovation, as used by Schumpeter, has a very wide connotation.
Any new measure or policy adopted by an entrepreneur to reduce his cost of production or to

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increase the demand for his product is an innovation. Thus innovations can be divided into
two categories.
First types of innovations are those which reduce cost of production, or in other
words, which change the production functions. In this first type of innovations are included
the introduction of a new machinery, new and cheaper technique or process of production,
utilisation of a new source of raw material, a new and better method of organising the firm,
etc.
Second types of innovations are those which increase the demand for the product, or
in other words, which change the demand or utility function. In this category are included the
introduction of a new product, a new variety or design of the product, a new and superior
method of advertisement, discovery of new markets etc.
If an innovation proves successful, that is, if it achieves its aim of either reducing the
cost of production or enhancing the demand for a product, it will give rise to profit. Profits
emerge because due to successful innovations either cost falls below the prevailing price of
the product or the entrepreneur is able to sell more and at a better price than before.
Schumpeter makes a distinction between invention and innovation. Innovation is brought
about mainly for reducing the cost of production and it is cost reducing agent. Profit is the
reward for this strategic role, Innovations are not possible by all entrepreneurs. Only
exceptional entrepreneurs can innovate. They are capable of tapping new resources, technical
knowledge and reduce the cost of production. Thus the main motive for introducing
innovation is the desire to earn profit. Profit is therefore the cause of innovation.
Profits are of temporary nature. The pioneer who innovates earns abnormal profit for
a short period. Soon other entrepreneurs, “swarm in clusters”, compete for profit in the same
manner. The pioneer will make another innovation. In a dynamic world innovation in one
field may induce other innovations in related fields.
The emergence of motor car industry may in turn stimulate new investments in the
construction of highways, rubber, tyres and petroleum products. Profits are thus causes and
effects of innovation. The interest of profit leads entrepreneur to innovate and innovation
leads to profit. Thus profit has a tendency to appear, disappear and reappear.
Profits are caused by innovation and disappear by imitation. Innovational profit is
thus, never permanent, in the opinion of Schumpeter. Therefore it is different from other
incomes, such as rent, wages and interest. These are regular and permanent incomes arising
under all circumstances. Profit on the other hand is a temporary surplus resulting from
innovation.

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Prof. Schumpeter also explained his views on the functions of the entrepreneur. The
entrepreneur organizes the business and combines the various factors of production. But this
is not his real function and this will not yield him profit. The real function of the entrepreneur
is to introduce innovations in business. It is innovations which yield him profit.
It should be noted that profits accrue not to him who conceives innovation, nor to him
who finances it but to him who introduces it. Further, whenever any new innovation is to be
introduced, it always calls for a new combination of factors or reallocation of resources.
It is here worth mentioning that profits caused by a particular innovation are only
temporary and tend to be competed away as others imitate and also adopt that. An innovation
ceases to be new or novel, when others also come to know of it and adopt it.
When an entrepreneur introduces a new innovation, he is first in a monopoly position,
for the new innovation is confined to him only. He therefore makes large profits. When after
some time others also adopt it in order to get a share, profits will disappear. If the law allows
and the entrepreneur is able to get his new innovation e.g., new product patented, then he will
continue to earn profits.
But in a competitive economy and without patent laws, the existing competitors or the
new firms will soon adopt any successful innovation and profits would be eliminated. But in
a competitive and progressive economy the entrepreneurs always continue to introduce new
innovations and thus profits continue emerging out of them.
Thus Prof. Stigler writes, “Unless one can construct a permanent monopoly, such
profits as are realised by successful innovations are essentially transitional and will be
eliminated by the attempts of other firms to share them. But these profits may exist for a
considerable time because of the ignorance of other firms of their existence or because of the
time required for the entry of new firms. More important, the successful innovator can
continuously seek new disequilibrium profits since the horizon of conceivable innovations is
unlimited.”
We have seen above that innovations are important source of profits. Obtaining
profits is a necessary incentive for the entrepreneurs to conceive and introduce innovations
which help the economic development of the country. Since innovations, if successful, yield
profits and profits is also the motive to introduce innovations, profits are both the cause and
effect of innovations.
Criticisms:
1. This theory concentrates only on innovation, which is only one of the many functions of
the entrepreneur and not the only factor.

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2. This theory does not consider profit as the reward for risk-taking. According to
Schumpeter it is the capitalist not the entrepreneur who undertakes risk.
3. This theory has ignored the importance of uncertainty bearing which is one of the
factors that determines profit.
4. This theory attributes profit only to innovation ignoring other functions of entrepreneur.
5. Monopoly profits are permanent in nature while Schumpeter says that innovate profits
occur temporarily.
6. This theory has presented a very narrow view of the function of the entrepreneur. He
not only introduces innovation but he is equally responsible for proper organisation of
the business. As such profit is not merely due to innovation. It is also due to
organizational work performed by the entrepreneur. As it is well known, every
entrepreneur does not innovate and yet he must earn profit if he is to stay in business.
7. It is an incomplete theory because it has failed to explain all the factors that influence
profit.
2.9 Summary
The theory of factor pricing is concerned with the principles according to which the
price of each factor of production is determined and distributed. It is concerned with the
source of income, such as wages, rents, interests, and profits. In regard of distribution of
factors of production, there are two theories, namely marginal productivity theory and
modern theory of factor pricing. This unit gives a detailed information regarding this topics
2.10 Answer to Check Your Progress
Marginal Productivity Theory: It contends that in equilibrium each productive agent will
be rewarded in accordance with its marginal productivity
Marginal Physical Product (MPP): The first is marginal physical product of a factor. The
marginal physical product (MPP) of a factor, say, of labour, is the increase in the total
product of the firm as additional workers are employed by it.
Value of the Marginal Product (VMP): The second concept is value of marginal product. If
we multiply the MPP of a factor by the price of the product, we would get the value of the
marginal product (VMP) of that factor.
Reasons for Existence of Rent: According to Ricardo rent arises for two main reasons:
(1) Scarcity of land as a factor and
(2) Differences in the fertility of the soil.

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Quasi Rent: It can be defined as surplus earnings generated by the factors of production,
except land.
2.11 Questions and Exercises
1. Critically examine marginal productivity theory of distribution
…………………………………………………………………………………………………
2. Discuss the Marshalls theory of quasi-rent theory
…………………………………………………………………………………………………
3. Explain how the wage of a competitive labour markets is determination under perfect
competition
…………………………………………………………………………………………………
4. What is profit? Risk and Uncertainty is an important factor that leads to profit. Elaborate.
…………………………………………………………………………………………………
5. Critically examine the Schumpeterian Theory of Profit.
…………………………………………………………………………………………………

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