Have you ever wondered how the income earned by landowners, laborers, capitalists, and entrepreneurs is determined? Unit 5 of Microeconomics focuses on how various factors of production—land, labor, capital, and entrepreneurship—are rewarded in the form of rent, wages, interest, and profit.
This unit helps BBA students understand the logic behind factor pricing and the major theories that explain income distribution.
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What is Factor Pricing?
Factor pricing refers to the determination of the price (i.e., income or reward) paid to the factors of production:
Land → Rent
Labor → Wages
Capital → Interest
Entrepreneurship → Profit
It plays a crucial role in income distribution and resource allocation in any economy.
Marginal Productivity Theory of Distribution
This theory states that each factor of production is paid according to its marginal productivity—that is, the additional output created by employing one more unit of that factor.
For example, if hiring one more worker increases output by 5 units, and each unit sells for ₹10, the worker’s wage should be ₹50.
Assumptions:
Perfect competition in factor and product markets
Diminishing returns to factors
Rational behavior by firms
Rent – Ricardian and Modern Theories
Ricardian Theory of Rent:
David Ricardo defined rent as the payment made for the use of land, which arises due to its natural scarcity and differences in fertility.
Rent is surplus earned by superior land over the marginal (no-rent) land.
It does not affect price, but is determined by price.
Modern Theory of Rent:
The modern view extends rent to any factor whose supply is less than perfectly elastic.
Rent arises when supply is fixed or limited in the short run.
It applies to labor, capital, and other resources—not just land.
Wages – Real vs Money Wages and Theories
Money Wages:
The nominal wage paid in terms of currency (₹/month).
Real Wages:
The purchasing power of wages; it considers the effect of inflation and cost of living.
Theories of Wages:
Subsistence Theory (Ricardo): Wages tend to settle at the level just enough to sustain workers.
Wage Fund Theory: Wages depend on a fund set aside for paying labor.
Marginal Productivity Theory: Wage equals the marginal product of labor.
Modern Theories: Include bargaining power, efficiency wage theory, and institutional factors.
Interest – Classical and Keynesian Theories
Classical Theory of Interest:
Interest is the reward for saving.
Determined by the supply of savings and the demand for investment.
Higher interest rates encourage saving but discourage investment.
Keynesian Theory of Interest:
Interest is the reward for parting with liquidity.
Determined by liquidity preference (desire to hold money) and money supply.
Interest rate balances the demand and supply of money.
Profit – Risk and Uncertainty Theories
Profit is the reward for entrepreneurship, and its sources have been explained in various theories:
Risk Theory (Hawley):
Profit is the reward for taking risks in business.
Greater the risk, higher the expected profit.
Uncertainty Theory (Knight):
Distinguishes between measurable risks and unmeasurable uncertainty.
Profit arises due to uncertainty that cannot be insured or predicted.