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Business Economics

Unit 1

Perfect Competition

Meaning Market Status

When Every producer and consumer is free to sell or buy and the contact between them is such that the prices come to equality, quickly and easily.

Perfect competition is a market structure featured by a large number of buyers and sellers of an identical products.

Competition is considered a healthy sign in consumption, production , distribution and also in the exchange.

The consumer have freedom of choice and subject

Definitions

According to Boulding—”A Perfect Competition

market may be defined as a large number of buyers

and sellers all engaged in the purchase and sale of

identically similar commodities, who are in close

contact with one another and who buy and sell

freely among themselves.”

“A market is said to be perfect when all

the potential buyers and sellers are

promptly aware of the prices at which

the transaction take place. Under such

conditions the price of the commodity

will tend to be equal everywhere.”

“A Perfect Competition market is that type

of market in which the number of buyers

and sellers is very large, all are engaged in

buying and selling a homogeneous

product without any artificial restrictions

and possessing perfect knowledge of the

market at a time.”

Characteristics of perfect competition 1. Large Number of Buyers and Sellers:

The first condition is that the number of

buyers and sellers must be so large that

none of them individually is in a position

to influence the price and output of the

industry as a whole. In the market the

position of a purchaser or a seller is just

like a drop of water in an ocean.

2. Homogeneity of the Product:

Each firm should produce and sell a

homogeneous product so that no buyer

has any preference for the product of any

individual seller over others. If goods will

be homogeneous then price will also be

uniform everywhere.

3. Free Entry and Exit of Firms:

The firm should be free to enter or leave

the firm. If there is hope of profit the firm

will enter in business and if there is

profitability of loss, the firm will leave the

business.

4. Perfect Knowledge of the Market:

Buyers and sellers must possess complete

knowledge about the prices at which goods

are being bought and sold and of the prices

at which others are prepared to buy and

sell. This will help in having uniformity in

prices.

5. Same Price for Commodity 6. Heterogeneity of factors:

Characteristics of perfect competition 7. Perfect Mobility of the Factors of

Production and Goods: There should be

perfect mobility of goods and factors

between industries. Goods should be free

to move to those places where they can

fetch the highest price.

8. Absence of Price Control & Govt.

Intervention: There should be complete

openness in buying and selling of goods.

Here prices are liable to change freely in

response to demand and supply

conditions.

9. Perfect Competition among Buyers and

Sellers: In this purchasers and sellers have

got complete freedom for bargaining, no

restrictions in charging more or demanding

less, competition feeling must be present

there.

10. Absence of Transport Cost:

There must be absence of transport cost.

In having less or negligible transport cost

will help complete market in maintaining

uniformity in price.

11. Independent Relationship between Buyers and Sellers:

There should not be any attachment between sellers and purchasers in the

market. Here, the seller should not show prick and choose method in

accepting the price of the commodity. If we will see from the close we will find

that in real life “Perfect Competition is a pure myth.”

Equilibrium of Firm (Long Run)

Y

X

TR

TC

R

P

Q

M O M1

T

C

&

T

R

OUTPUT

•TR-TC = Profit

•Profit is maximum at ‘PQ’

•Profit goes on increasing till the

point ‘P’

•From the point ‘P’ profit starts

declining

•Firms equilibrium is at the point ‘R’

•After equilibrium, firm becomes in

loss

Equilibrium of Firm (Long Run)

Short Run Equilibrium

Price & Output Determination

Y

X

D=AR=MR

MC

AC

0

P

Q

P

R

I

C

E

OUT PUT

Super Normal Profit

E

• 0Q is the maximum

profitable output

•Beyond this point,

production is not profitable

because cost becomes more

than price

•As price is equal in this

market, AR and MR are

same.

•At quantity 0Q price is 0P

and AC is 0P0, firm earns

super normal profit

P0




profitable output




than price



same.


and AC is 0P1, firm faces

loss.

Y

X

D=AR=MR

MC AC

0

P

Q

P

R

I

C

E

OUT PUT

LOSS

E P1



Y

X

D=AR=MR

MC

AC

0

P

Q

P

R

I

C

E

OUT PUT

Normal Profit


profitable output




than price



same.


and AC is also 0P, firm earns

normal profit because AC

includes normal profit

Price Fixation

Buyers

Sellers

25 50 75 100

25 50 75 100

Range of Mutual

Benefit

P

r

i

c

e

Demand & Supply

Y

X C M N P O

T

S

D

P

A

B

Q

Super Normal Profit

Normal Profit

Loss

Business Economics

Unit 2

Monopoly

Monopoly is a Greek word which means single seller

Monos - Single

Polus - Seller

Market Status

Complete control over the supply by producer or seller

It does not mean the absence of competition

Commodity has no near or remote substitute (Motor car & Bicycle)

Hence other producers may not be able to compete

Definition

“Monopoly means the control of a

producer or group of producers over the

supply of a commodity, which has no

near or remote substitute and that these

is always a threat of entry by the small

sellers and the interference by the

government.”

Definition

“A market structure characterized by a

single seller, selling a unique product in

the market. In a monopoly market, the

seller faces no competition, as he is the

sole seller of goods with no close

substitute. He enjoys the power of

setting the price for his goods.”

Features or Characteristics of Monopoly

Single producer or seller

Absence of competition

No close substitute

Zero cross elasticity of demand

Control over the supply by producer

No distinction between firm and industry

Pure monopoly is found in developing economies not in

developed economies

Features or Characteristics of Monopoly

Downward sloping demand curve

Monopolist is a price maker

Seller can either decide price or quantities to be sold

Monopolist can prevent entry of new firms in the long

run

Restriction on entry and exit

Price discrimination

Price Discrimination

Under Price Competition AR = MR, where-as under

Monopoly MR < AR.

Under perfect competition price is determined by the

interaction of total demand and supply. This price is

acceptable to all the firms in the industry.

Under Monopoly, to sell every additional unit of the

commodity price will have to be lower.


In the words of Dooley, “Discriminatory

monopoly means charging different rates from

different customers for the same good or service.”

According to J.S. Bains, “Price discrimination refers

strictly to the practice by a seller to charging

different prices from different buyers for the same

good.”

Types of Price Discrimination

I. Personal

Refers to price discrimination when different prices are charged from different

individuals. The different prices are charged according to the level of income of

consumers as well as their willingness to purchase a product. For example, a doctor

charges different fees from poor and rich patients.

II. Geographical

Refers to price discrimination when the monopolist charges different prices at different

places for the same product. This type of discrimination is also called dumping.

III. On the basis of use

Occurs when different prices are charged according to the use of a product. For

instance, an electricity supply board charges lower rates for domestic consumption of

electricity and higher rates for commercial consumption.

Degrees of Price Discrimination


I) First-degree Price Discrimination: Refers to a price

discrimination in which a monopolist charges the maximum

price that each buyer is willing to pay. This is also known as

perfect price discrimination as it involves maximum exploitation

of consumers. In this, consumers fail to enjoy any consumer

surplus. First degree is practiced by lawyers and doctors.

II) Second-degree Price Discrimination:

Refers to a price discrimination in which buyers are divided into

different groups and different prices are charged from these

groups depending upon what they are willing to pay. Railways

and airlines practice this type of price discrimination.


III) Third-degree Price Discrimination: Refers to a price

discrimination in which the monopolist divides the entire

market into submarkets and different prices are charged in

each submarket. Therefore, third-degree price discrimination is

also termed as market segmentation.

Necessary conditions for price discrimination


Monopoly situation

Separate markets

Understandable product differentiation

Buyer’s illusion (watching movie)

Prevention of re-exchange of commodities

Non-transferability characteristics of commodity

Necessary conditions for price discrimination


Let go attitude of buyers

Legal sanction (Electricity for domestic and industrial purpose)

Ignorance of the consumers

Creating artificial difference (for Rich and Poor)

Geographical distance (Domestic and Foreign Buyers)

Monopoly Vs Perfect competition

1. Output and Price:

Under perfect competition price is equal to

marginal cost at the equilibrium output. While

under monopoly, the price is greater than

average cost. 2. Equilibrium:

Under perfect competition equilibrium is

possible only when MR = MC and MC cuts the

MR curve from below. But under simple

monopoly, equilibrium can be realized whether

marginal cost is rising, constant or falling. 3. Entry:

Under perfect competition, there exist no

restrictions on the entry or exit of firms into

the industry. Under simple monopoly, there

are strong barriers on the entry and exit of

firms. 4. Discrimination:

Under simple monopoly, a monopolist can

charge different prices from the different

groups of buyers. But, in the perfectly

competitive market, it is absent by definition.


5. Profits:

The difference between price and marginal

cost under monopoly results in super-normal

profits to the monopolist. Under perfect

competition, a firm in the long run enjoys only

normal profits. 6. Supply Curve of Firm:

Under perfect competition, supply curve can be known. It

is so because all firms can sell desired quantity at the

prevailing price. Moreover, there is no price

discrimination. Under monopoly, supply curve cannot be

known. MC curve is not the supply curve of the

monopolist.

7. Slope of Demand Curve:

Under perfect competition, demand curve is perfectly elastic. It is

due to the existence of large number of firms. Price of the

product is determined by the industry and each firm has to accept

that price. On the other hand, under monopoly, average revenue

curve slopes downward. AR and MR curves are separate from

each other. Price is determined by the monopolist.


8. Goals of Firms:

Under perfect competition and monopoly the

firm aims at to maximize its profits. The firm

which aims at to maximize its profits is known

as rational firm.

9. Comparison of Price:

Monopoly price is higher than perfect

competition price. In long period, under

perfect competition, price is equal to average

cost.

10. Comparison of Output:

Perfect competition output is higher than

monopoly price.

Business Economics

Unit: 3

Monopolistic Competition

Meaning

• E.H. Chamberlin’s work was entitled “The Theory of

Monopolistic Competition” and Mrs. Robinson’s “The

Economics of Imperfect Competition”.

• Both economists challenged the concept of perfect

competition and monopoly as unrealistic and attempted to

present a new theory which is more realistic of the two new

approaches, the view of Chamberlin’s theory of monopolistic

competition received wide acclamation. Critics also regarded

Chamberlin’s contribution as novel and superior to that of

Mrs. Robinson’s. In fact the real credit goes to Chamberlin for

setting a new and realistic trend in the economics value.

Meaning

• Monopolistic competition is a form of imperfect market

• In this market situation, both elements of monopoly and competition are present

• In this market there are many sellers of a differentiated products

• In this market products are close substitutes but not perfect substitutes.

• Monopolistic Competition refers to the market situation in which

there is a keen competition, but neither perfect nor pure, among a

group of a large number of small producers or suppliers having some degree of monopoly because of the differentiation of their

products. Thus, we can say that monopolistic competition (or

imperfect competition) is a mixture of competition and a certain degree of monopoly, on the basis of a correct appraisal of the

market situation.

Definitions

1. Monopolistic Competition refers to competition among a large number of sellers producing close but not perfect substitutes for each other.

2. According to Prof. Lerner – “The condition of imperfect competition arises when a seller has to face the falling demand curve.”

3. According to Prof. J. K. Mehta – “It has been more fully realised that every case of exchange is a case of what may be called partial monopoly and partial monopoly is looked at from the other said a case of imperfect competition. There is a blending of both competition element and monopoly element in each situation.”

4. According to Prof. Leftwich – “Monopolistic Competition (or imperfect competition) is that condition of industrial market in which a particular commodity of one seller creates an idea of difference from that of the other sellers in the minds of the consumers.”

Characteristics of Monopolistic Competition

• Less Number of Buyers and Sellers: In this market neither buyers nor sellers are too many as

under perfect competition nor there is only one seller as under monopoly.

• Product Differentiation: Although the commodities produced by different producers can

serve as perfect substitutes to those produced by others, yet they are different in colour,

form, packing, design, name etc. So there is product differentiation in the market.

• Lack of Knowledge on the Part of Consumers: Neither consumers nor sellers have full

knowledge of market conditions, so there is international difference in the price of goods

from those of others.

• High Transportation Cost: Price discrimination Even though similar goods are there because

of different transport costs are bought and sold at different prices.

• Advertisement: Advertisement plays an important role because buyers are influenced to

prefer by advertisement, which plays upon their mind and makes them the product of one

firm to those of another.

Characteristics of Monopolistic Competition

• Ignorance of the Buyers: There are some people who think that high priced goods will be

better and of higher quality. So, they avoid buying low priced goods.

• Freedom on entry and exit

• Downward sloping demand curve

• Difference between firm and industry

• The seller is price maker as well as price taker

• Less mobility of factors of production

• Non-price competition

• Imaginary difference is created

Equilibrium of Firm

Difference Between Monopolistic competition and Perfect Competition

Business Economics

Unit: 4

Oligopoly

Meaning • Oligopoly refers to a market situation or a type of market in which a few firms

control the supply of a commodity. The competing firms are few in number but

each one is large enough so as to be able to control the total industry output.

However, increase of its output or sales will reduce the sales of rival firms by a

noticeable amount.

• This is surely the case if three to six or even ten firms control an industry’s output,

with each controlling enough to exert influence on price. Oligopoly is the most

prevalent form of market organisation in the manufacturing sector at modern

times and arises due to various reasons such as, economies of scale, patents and

trademarks, control over the sources of raw materials, government’s sanction,

need of a large capital, and so on. The chief characteristic of oligopoly is the

interdependence among the rival sellers.

Definition

• “Oligopoly is that situation in which a firm bases its markets policy in part on the expected behaviour of a few close rivals.” – J. Stigier

• “An oligopoly is a market of only a few sellers, offering either homogeneous or differentiated products. There are so few sellers that

they recognize their mutual dependence.” – PC. Dooley

• “Oligopoly is a market structure characterized by a small number of firms and a great deal of interdependence.” –Mansfield

Forms of Oligopoly

• Pure Oligopoly: Here, the oligopolists sell practically homogeneous

products. This type is found in steel, copper, cement petrol and a few

other industries.

• Differential Oligopoly: In such a case a few firms sell similar but not

identical products under the same conditions. It is found in automobiles,

tyre, electrical appliances, cigarettes, baby food and a few other

industries.

Characteristics of Oligopoly

• Interdependence: If a small number of sizeable firms constitute an industry

and one of these firms starts advertising campaign on a big scale or designs a

new model of the product which immediately captures the market, it will

surely provoke countermoves on the part of rival firms in the industry.

• Advertising: Advertising is a powerful instrument in the hands of an

oligopolist. A firm under oligopoly can start an aggressive advertising

campaign with the intention of capturing a large part of the market.

• Group Behaviour: There can be two firms in the group, or three or five or even

fifteen, but not a few hundred. Whatever the number, it is quite small so that

each firm knows that its actions will have some effect on other firms in the

group.

• Competition: Since under oligopoly, there are a few sellers, a move by one

seller immediately affects the rivals. So each seller is always on the alert and

keeps a close watch over the moves of its rivals in order to have a counter-

move.

Characteristics of Oligopoly

• Barriers to Entry of Firms: As there is keen competition in an oligopolistic industry,

there are no barriers to entry into or exit from it. However, in the long-run, there are

some types of barriers to entry which tend to restrain new firms from entering the

industry.

• Lack of Uniformity: Firms differ considerably in size. Some may be small, others very

large.

• Existence of Price Rigidity: In oligopoly situation, each firm has to stick to its price. If

any firm tries to reduce its price, the rival firms will retaliate by a higher reduction in

their prices. This will lead to a situation of price war which benefits none.

• No Unique Pattern of Pricing Behaviour: Each firm wants to remain independent and

to get the maximum possible profit. Towards this end, they act and react on the price-

output movements of one another which are a continuous element of uncertainty.

• Indeterminate Demand Curve: The interdependence of the oligopolists, however,

makes it impossible to draw a demand curve for such sellers except for the situations

where the form of interdependence is well defined. In real business operations, the

demand curve remains indeterminate.

Price Determination under oligopoly

• ‘Tight’ oligopoly situation in which two or three firms dominate the

entire market and the ‘loose’ oligopoly situation where six or seven firms

occupy the maximum share of the market. Other firms share the

balance. It includes both differentiation and standardization. It

encompasses the cases in which firms are acting in collusion and in

which they are acting independently. Therefore, the existence of various

forms of oligopoly prevents the development of a general theory of price

and output. The element of mutual interdependence in oligopolistic

market further complicates the determination of price and output.

Price Determination under oligopoly

1. Price Determination in Non-Collusive Oligopoly: In this case, each firm

follows an independent price and output policy on the basis of its judgment

about the reactions of his rivals. If the firms are producing homogeneous

products, price war may occur. Each firm has to fix the price at the

competitive level. On the contrary, in case of differentiated oligopoly, due to

product differentiation, each firm has some monopoly control over the

market and therefore charge near monopoly price.

2. Equilibrium under Collusion: The modern economists are of the view that

independent price determination cannot exist for long in oligopoly. It leads

to uncertainty and insecurity and to overcome them there is a tendency

among oligopolists to act collectively by tacit collusion. In addition, the

firms can gain the economics of production. All the firms in oligopoly tend

to enlarge their size and lower their costs of production per unit and

capture maximum share of the market.

Collusive oligopoly is a situation in which firms in a particular industry

decide to join together as a single unit for the purpose of maximising their

joint profits and to negotiate among themselves so as to share the market.

Business Economics

Unit 5

Theories of Distribution

Rent

• Concept: the term, rent is applied to the periodic payments

made regularly for the hire of a particular asset. For example,

the payments made by a tenant to the owner of a house, or

factory or land on weekly, monthly, or yearly basis is a rent in

the popular sense.

• Modern Concept of Rent: "Economic rent may be defined an

any payment to a unit of production which Is in excess of the

minimum amount necessary to keep that factor In its present

occupation".

Rent

• Definitions

Prof. Marshal defined rent as, “The income derived from the

ownership of land and other free gifts of nature.”

Prof. Ricardo defined rent as, “the payment by a tenant

farmer to the landlord for the use of the land.”

Modern View: Rent is a payment to any factor of production,

over and above its transfer earning.”

Recardian Theory of Rent

The theory of economic rent was first propounded by the

English Classical Economist David Ricardo (1773 -1823). David Ricardo in his book. "Principles of Political Economy and

Taxation", 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 power of the soil.”

Ricardo in his theory of rent has emphasized that rent is a

reward for the services of land which is fixed in supply.

Secondly, it arises due to original qualities of land which are indestructible". (The original indestructible powers of the soil

include natural soil, fertility, mineral deposits, climatic conditions etc.

https://economicsconcepts.com/definition_and_meaning_of_rent.htm


Assumptions:

1) Land has no alternative use

2) Transfer price of land is zero

3) Rent depends on fertility and location of the land

4) No landlord is a farmer and no farmer is a landlord

5) Land differs in fertility

6) Law of diminishing returns works here

7) Land possesses certain original and indestructible power

8) Assumption of perfect competition

9) Theory assumes order of cultivation

10) Rent does not enter into the price of the product

11) Existence of marginal or no rent land

12) Tendencies of diminishing returns and increasing population


Rent Under Extensive Cultivation

According to Ricardo, all the units of land are not of the same grade.

They differ in fertility and location. The application of the same amount of

labor, capital and other cooperating resources give rise to difference in

productivity. This difference in productivity or the surplus which arises on the

superior units of land over the inferior units is an economic rent".

Grades of

Land

Cost of

Cultivation

Production of

Wheat (in Qntls)

Value of output (Rs.

1000 per Qntl)

Rent

‘A’ (2 Acres) Rs. 20000 30 Rs. 30000 Rs.

10000

‘B’ (2 Acres) Rs. 20000 25 Rs. 25000 Rs. 5000

‘C’ (2 Acres) Rs. 20000 20 Rs. 20000 Rs. 000


Rent Under Extensive Cultivation

Graphical Illustration

Re

nt &

Co

st

Plots of Land

30000

20000

10000

A C B

Differential Surplus

No Rent Land

Cost


Rent Under Intensive Cultivation

Unit of Labour

and Capital

Cost of

Cultivation

Production of

Wheat (in Qntls)

Value of output (Rs.

1000 per Qntl)

Rent

‘I’ (2 Acres) Rs. 20000 30 Rs. 30000 Rs.

10000

‘II’ (2 Acres) Rs. 20000 25 Rs. 25000 Rs. 5000

‘III’ (2 Acres) Rs. 20000 20 Rs. 20000 Rs. 000


Rent Under Intensive Cultivation

Graphical Illustration

Re

nt &

Co

st

No of Attempts

30000

20000

10000

I III II

Super Marginal Doses

Marginal Dose

Cost

Criticism on Ricardian Theory of Rent

i) No Original and Indestructible Power: Ricardo is of the opinion that rent is paid due to the original and indestructible powers of the soil. It is pointed out that there are no powers of the soil which are indestructible. As we go on cultivating a piece of land time and again, its fertility gradually diminishes. To this criticism, it is replied that there are properties of the soil, such as climate situation, sunshine, humidity, soil composition, etc., which are infect original and indestructible.

ii) Wrong Assumption of 'No Rent Land': Ricardo assumes the existence of no-rent land. A land which just meets the cost of cultivation. The modern economists are of the opinion that if a plot of land can be put to several uses, then it does yield rent.

iii) Rent Enters Into Price: According to Ricardo, rent does not enter into price. The modern economists are of the opinion that it does eater into price.

iv) Wrong Assumption of Perfect Competition: Ricardo is of the opinion that perfect competition prevails between the landlord and the tenant, but in the actual world, it is imperfect competition which is the order of the day.

Criticism on Ricardian Theory of Rent

v) All Lands are Equally Fertile: Ricardo assumes that rent arises due to difference in the fertility of the soil. But the modern economists assert that if all lands are equally fertile, even then the rent will arise. The rent can arise: (a) if the produce is not sufficient to meet the requirements of the people, and (b) due the operation of the law of diminishing returns.

vi) Historically Wrong: Carey and Roscher have criticized the orders of cultivation assumed by Ricardo. They are of the opinion that it is not necessary that A grade land will be cultivated first, even if it lies far away from the city. To this it is replied by Walker that when Ricardo uses the words 'best land' he means by it the land which is superior both in fertility and in situation.

vii) Neglect of Scarcity Principle: It is pointed out by the modem economists that the concept of rent can be easily explained with the help of the scarcity principle and so there is no need to have a separate theory of rent.

viii) The order of cultivation is wrong

ix) Law of diminishing returns can be postponed

x) Applicable in the long run only

Wage

Meaning & Definition

• In economics, the price paid to labour for its contribution to the process of production

is called wages.

• Labour is an important factor of production. If there is no labour to work, all other factors, be it land or capital, will remain idle.

• Thus, Karl Marx termed labour as the “creator of all value”.

“A wage may be defined as the sum of money paid under contract by an employer to worker for services rendered.” -Benham.

“Wages is the payment to labour for its assistance to production.” -A.H. Hansen.

'Wage rate is the price paid for the use of labour.” -Mc Connell.

“Wage is a price paid by the employer to the worker on account of labour performed.” T. R. Turner

Concepts of Wages

A. Money Wages or Nominal Wages: The total amount of money received

by the labourer in the process of production is called the money wages or nominal wages.

B. Real Wages: Real wages mean translation of money wages into real terms or in terms of commodities and services that money can buy. They refer to the advantages of worker’s occupation, i.e. the amount of the necessaries, comforts and luxuries of life which the worker can command in return for his services.

An example will make the things clear. Suppose ‘A’ receives Rs. 500 p.m. as money wages during the year. Suppose also that midway through the year the prices of commodities and services, that the worker buys, go up, on the average, by 50%.

It means that though the money wages remain the same, the real wages (consumption basket in terms of commodities and services) are reduced by 50%. Real wages also include extra supplementary benefits along with the money wages.

Types of Wages

1. Piece Wages: Piece wages are the wages paid according to the work done by

the worker. To calculate the piece wages, the number of units produced by the worker are taken into consideration.

2. Time Wages: If the labourer is paid for his services according to time, it is called as time wages. For example, if the labour is paid Rs. 35 per day, it will be termed as time wage.

3. Cash Wages: Cash wages refer to the wages paid to the labour in terms of money. The salary paid to a worker is an instance of cash wages.

4. Wages in Kind: When the labourer is paid in terms of goods rather than cash, is called the wage in kind. These types of wages are popular in rural areas.

5. Contract Wages: Under this type, the wages are fixed in the beginning for complete work. For instance, if a contractor is told that he will be paid Rs. 25,000 for the construction of building, it will be termed as contract wages.

Marginal Productivity Theory of wages

• The marginal productivity theory of wage states that the price

of labour, i.e., wage rate, is determined according to the marginal product of labour. This was stated by the neoclassical

economists, especially J. B. Clark, in the late 1890s.

• The term marginal product of labour is interpreted here in

three ways: marginal physical product of labour, value of the marginal product of labour and marginal revenue product of

labour.

• According to this theory, “the wages of a labour should be

equal to his marginal productivity.”


• In the short run wages may be more or less than marginal

productivity, but in the long run the wages must be equal to

the value of the marginal productivity.

• As consumer demands commodity on account of its utility, in

the same way labour is demanded on account of his

productivity.

• And as consumer will not pay more than products utility, in

the same way wages will not be paid more than labour’s

productivity.


Assumptions

i. Perfect competition prevails in products and labour market.

ii. Law of variable proportions operates.

iii. The firm aims at profit-maximization.

iv. All labourers are homogeneous and are divisible.

v. Labour is mobile and is substitutable to capital and other

inputs.

vi. Resources are fully employed.


Limitations of Marginal Productivity Theory of Wage

i. In the real world, perfect competition does not exist.

ii. Perfect mobility of labour is another unrealistic assumption. Mobility of labour may be restricted due to socio-political reasons.

iii. The marginal productivity theory of wage ignores the supply side of labour and concentrates only on the demand for labour.

iv. Full employment of resources is another unrealistic assumption.

v. Finally, this theory ignores the usefulness of trade union in wage determination.

vi. This Theory, in fact, is not a wage theory but a theory of employment. Wage rate is predetermined.

vii. Labour can never be homogeneous, some may be skilled and some may be unskilled.

viii. The demand for labour does not depend on marginal productivity but it depends upon savings of the capitalists.

Interest

Meaning & Definitions

• Interest is a premium which is paid on capital that is borrowed.

• In simple words, interest means the reward for the use of capital. It

is also called the income of the owner of capital for lending it.

• In other words, it is the price paid by the borrower of money to its lender.

“Interest is the price paid for the use of capital in any market.”

–Marshall

“Interest is a reward for parting with liquidity for a specified period.”

-J.M. Keynes

“Interest is a payment made by the borrower of capital, by virtue of its productivity, a reward for the abstinence.”

– Knut Wicksell

Concept of Interest

Gross Interest: Gross interest refers to the entire payments made by the borrower to the lender on a certain amount of loan received for a period of time. It includes not only the payment for the use of money capital but also for risks, inconvenience and management.

Net Interest: Net interest is the payment purely made for the use of money. Net interest rate is determined by the forces of demand and supply of funds or money. It generally relates to public and is comparatively low to gross interest.

Gross Interest includes

1) Net Interest

2) Insurance against risk

3) Wages for management

4) Reward for inconvenience

Loanable funds theory of interest

• The neo-classical theory of interest or loanable funds theory of

interest owes its origin to the Swedish economist Knut Wicksell.

• According to this theory, rate of interest is determined by the

demand for and supply of loanable funds. In this regard this theory is more realistic and broader than the classical theory of interest.

• Classical economists says that money is merely a medium of

exchange, that is why does not have any effect on the real economic variables which determine the rate of interest.

• But neo-classical economists argue that interest is the price for the use of money which affects the economic variables and the factors

responsible for demand & supply of loanable funds.


Demand for Loanable Funds

• The demand for the loanable funds is inversely related to the rate of interest, so the demand slopes downward from left to right.

• According to this theory demand for loanable funds arises for the following three purposes;

1. Investment (I): Investment refers to the expenditure for the purchase of making of new capital goods including inventories. The price of obtaining such funds for the purpose of these investments depends on the rate of interest.

2. Hoarding (H): The demand for loanable funds is also made up by those people who want to hoard it as idle cash balances to satisfy their desire for liquidity.

3. Consumption Demand (CD): This demand comes from the people at that time when they want to spend beyond their current income.


Supply for Loanable Funds

• The supply of loanable funds is derived from the basic four sources as savings, dishoarding, disinvestment and bank credit.

1. Savings (S): Savings constitute the most important source of the supply of loanable funds.

2. Dishoarding (DH): Dishoarding is another important source of the supply of loanable funds. Generally, individuals may dishoard money from the past hoardings at a higher rate of interest.

3. Disinvestment (DI): Disinvestment will be high when the present interest rate provides better returns in comparison to present earnings.

4. Bank Money (BM): The banks advance loans to the businessmen through the process of credit creation.


Determination of Rate of Interest

According to loanable funds

theory, equilibrium rate of interest is that

which brings equality between the

demand for and supply of loanable funds.

In other words, equilibrium interest rate is

determined at a point where the demand

for loanable funds curve intersects the

supply curve of loanable funds

The daigram shows that the

equilibrium rate of interest is EM; at this

rate, the demand for loanable funds is

equal to the supply of loanable funds i.e.

OM.


Criticism

1. Full Employment: Keynes opined that loanable funds theory is based on the unrealistic assumption of full employment

2. Indeterminate: This theory assumes that savings and income both are independent. But savings depend on income.

3. Impracticable: This theory assumes savings, hoarding, investment etc. to be related to interest rate. But in actual practice investment is not only affected by interest rate but also by the marginal efficiency of capital whose affect has been ignored.

4. Unsatisfactory Integration of Real and Monetary Factors:

5. Constancy of National Income: Loanable funds theory rests on the assumption that the level of national income remains unchanged. In reality, due to the change in investment, income level also changes accordingly.

6. In modern times the rate of interest is mainly an administered price which is determined by the monetary authority of the country.

7. This theory is indeterminate unless the income level is already known.

Profit

Meaning

The term profit has distinct meaning for different people, such as businessmen,

accountants, policymakers, workers and economists.

Profit simply means a positive gain generated from business operations or investment

after subtracting all expenses or costs.

In economic terms profit is defined as a reward received by an entrepreneur by

combining all the factors of production to serve the need of individuals in the

economy faced with uncertainties.

Entrepreneur performs important functions in production and he is rewarded for his

services in the form of profit.

Profit

Definitions

“For bearing the risks or uncertainties associated with production, an entrepreneur gets profit as reward.” – Hawley

“Profit is earned by the entrepreneur for bearing uncertainties related with the production and sales.” – Prof. Knight

“Profit is a dynamic surplus.” – Clerk

“Profit is reward to entrepreneur for his role as a innovator.” – Joseph

Schumpeter

Gross Profit: wages, rent & other manufacturing expenses.

Net Profit: Salary, interest A& office expenses.

Uncertainty bearing theory of profit

• This theory was propounded by an American economist Prof. Frank H. Knight. This theory, starts on the foundation of Hawley’s risk bearing theory. Knight agrees with Hawley that profit is a reward for risk-taking. There are two types

of risks viz. foreseeable risk and unforeseeable risk. According to Knight unforeseeable risk is called uncertainty bearing.

• Knight, regards profit as the reward for bearing non-insurable risks and uncertainties. He distinguishes between insurable and non-insurable risks.

• Non-insurable risk is called uncertainty bearing and he regards profit as the

reward of bearing non-insurable risks and uncertainties. So there is direct relationship between profit and uncertainty bearing. The greater the uncertainty, the higher the level of profit.

• Insurable risks: Fire, Theft, Flood, Death by accident etc.

• Non-Insurable Risks: Competition, Technology, Risk of govt. intervention, Cyclical risk, Risk of demand etc.

Uncertainty bearing theory of profit

Criticism 1. According to this theory, profit is the reward for uncertainty bearing. But critics point

out that sometimes an entrepreneur earns no profit in spite of uncertainty bearing.

2. Uncertainty bearing is one of the determinants of profit and it is not the only

determinant. Profit is also a reward for many other activities performed by

entrepreneur like initiating, coordinating and bargaining, etc.

3. It is not possible to measure uncertainty in quantitative terms as depicted in this

theory.

4. In modern business corporations ownership is separate from control. Decision-making

is done by the salaried managers who control and organise the corporation.

Ownership rests with the shareholders who ultimately bear uncertainties of business.

Knight does not separate ownership and control and this theory becomes unrealistic.

5. Uncertainty bearing cannot be looked upon as a separate factor of production like

land, labour or capital. It is a psychological concept which forms part of the real cost of

production.

6. Monopoly firms earn much larger profits than competitive firms and they are not due

to the presence of uncertainty. This theory throws no light on monopoly profit.

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