Year: 2020

Economic Growth is a narrower concept than economic development. It is an increase in a country’s real level of national output which can be caused by an increase in the quality of resources (by education etc.), increase in the quantity of resources & improvements in technology or in another way an increase in the value of goods and services produced by every sector of the economy. Economic Growth can be measured by an increase in a country’s GDP (gross domestic product).

Economic development is a normative concept i.e. it applies in the context of people’s sense of morality (right and wrong, good and bad). The definition of economic development given by Michael Todaro is an increase in living standards, improvement in self-esteem needs and freedom from oppression as well as a greater choice. The most accurate method of measuring development is the Human Development Index which takes into account the literacy rates & life expectancy which affect productivity and could lead to Economic Growth. It also leads to the creation of more opportunities in the sectors of education, healthcare, employment and the conservation of the environment. It implies an increase in the per capita income of every citizen.

Economic Growth does not take into account the size of the informal economy. The informal economy is also known as the black economy which is unrecorded economic activity. Development alleviates people from low standards of living into proper employment with suitable shelter. Economic Growth does not take into account the depletion of natural resources which might lead to pollution, congestion & disease. Development however is concerned with sustainability which means meeting the needs of the present without compromising future needs. These environmental effects are becoming more of a problem for Governments now that the pressure has increased on them due to Global warming.

Economic growth is a necessary but not sufficient condition of economic development.

Harrod-Domar Theory:

Harrod-Domar theory is considered as the extension of Keynes’ short-term analysis of full employment and income theory. The Harrod-Domar growth model provides a long-term theory of output. The economists started paying their attention toward economic stability after the Great Depression of 1930s and economic ruin caused by World War II. Harrod and Domar have provided a model that focuses on the requirements necessary for steady economic growth. According to them, capital accumulation constitutes a major factor for the growth of an economy.

They also emphasized that capital accumulation not only generates income, but also increases the production capacity of the economy. For instance, if a construction plant is established, it would generate income for suppliers of different materials, such as cement, bricks, steel, and machinery with simultaneous increase in capital and production capacity of the economy.

The newly generated income from capital accumulation produces demand for goods and services. According to Harrod-Domar theory, the most necessary condition for the growth of an economy is that the demand created due to newly generated income should be sufficient enough, so that the output produced by the new investment (increase in capital) should be fully absorbed.

If the output is not fully absorbed, there would be excess or idle production capacity. This condition should be satisfied consecutively to maintain full employment level and achieve steady economic growth in the long term.

Following are the main assumptions of Harrod-Domar model:

(a) Constant Capital-Output Ratio:

Assumes that the relationship between capital and output always remains the same.

According to this assumption, the national output (which is equal to national income) is directly proportional to capital stock, which is expressed as follows:

Y = Kk, (k>0)

Where, Y = national output

K = total capital stock

k= output/capital ratio (constant)

As Harrod-Domar model has assumed that the output/capital ratio is constant, therefore, any type of increase in the national output would result in the k time increase in capital stock, which is as follows:

∆Y = k ∆ K

Therefore the increase in the growth of national output per unit time is equal to the increase in the growth of capital stock per unit time. In case the economy is in equilibrium and the capital stock is utilized completely, then the capital/output ratio (k) can be easily determined. After that, the extra capital required to produce the extra output can also be obtained. The capital stock and net investment (I) are equal to each other.

Therefore, the change in national output can be represented as follows:

∆Y = kI

(b) Constant Saving-Income Ratio:

Assumes that society saves a constant proportion of national income.

Therefore, saving is a function of income, and saving function can be written as follows:

S = sY, (s > 0)

Where, S = saving per unit time

s = constant propensity to save

Y = national income

At equilibrium, savings get equal to investment, which is as follows:

S = I = sY

On the basis of these assumptions, Harrod-Domar has determined the growth rate, which is as follows:

∆Y_t = kl_t

In such case, ∆Y_t can be calculated with the help of following formula:

∆Y_t = Y_t – Y_t-1

Or

Y_t – Y_t-1 = kI_t

Where, Y_t = income in time period t

Y_t-1 = income in lime period t -1

According to the assumption of Harrod-Domar model, at equilibrium in time period t:

I_t = S_t = sY_t

As I_t = sY_t, therefore, we can substitute sY_t in place of I_t while calculating the income in time period t, which is represented as follows:

Y_t – Y_t-1 = k*sY_t

The warranted growth rate can be calculated as follows:

Gw = Y_t – Y_t-1/Y_t = k. s

Or

Gw = ∆Y/Y_t = k. s

As the preceding equation of warranted growth rate shows that the growth rate is equivalent to the output/capital ratio (k) times the constant propensity to save. The growth rate, ∆Y/Y, is related to the equilibrium condition where I = S; therefore, the growth rate in such condition can also be regarded as equilibrium growth rate.

The equilibrium growth rate shows the capacity of utilizing capital stock. Warranted growth rate refers to the growth rate at which the amount of production is accurate neither too much nor too less.

One more growth rate given by Harrod-Domar model was target growth rate, which takes place due to increase in marginal propensity to save and investment or output/capital ratio. The increase in marginal propensity to save would result in the increase of saving, which further leads to an increase in investment.

Consequently, the income and production capacity of a nation also increase, which further increases the output of the nation. The increase in the production capacity in a particular period increases the income for coming years.

The increase in income leads to increase in saving and investment, and higher incomes in succeeding years. According to the principle of acceleration, the investment increases at a faster rate.

In aforementioned discussion, we have explained the Harrod-Domar model of economic growth with respect to capital accumulation. However, another important aspect that has been discussed in the model is the employment of labor.

The assumptions of the employment of labor aspect as per the Harrod-Domar model are as follows:

1. Considers that labor and capital are complementary to each other not substitutes
2. Regards capital/output ratio as constant

According to such assumptions, along with the capital/output ratio, the economic growth would occur when the potential labor force IS not completely utilized. This denotes that the potential labor supply restricts economic growth at full employment condition.

Therefore, economic growth would occur when the increase in labor exceeds the full employment condition. In addition, the actual growth rate becomes equal to warranted growth rate only when the warranted growth rate becomes equal to growth rate of labor force. In case the increase in the growth rate of labor is slow, then the growth can only be normalized with the help of labor-saving technology.

In such a condition, the growth in the long term is dependent on the growth rate of labor force (∆L/L) and labor-saving technology. Therefore, maximum growth rate in the long run would be equal to ∆L/L plus m, which is the rate of substitution of capital in place of labor.

This growth rate is termed as the natural growth rate (G_n) that can be calculated with the help of the following formula:

G_n = ∆L/L + m

The Harrod-Domar model provides more relevant theory of economic growth.

However, the model is not free from limitations. Some of the shortcomings of the model are as follows:

(c) Impractical Assumptions:

Refer to one of the major shortcomings of the model. The Harrod-Domar model involves assumptions that cannot be applied in practical situations. According to the Harrod-Domar Model, savings becomes equal to investment when warranted and actual growth rate are equal to each other.

This can be possible only under certain conditions, which are as follows:

1. Keeping marginal propensity to consume at constant
2. Assuming output/capital ratio at constant
3. Assuming that the technology for production is given
4. Keeping economy at equilibrium initially
5. Considering government expenditure and foreign trade negligible
6. Assuming that there are no adjustment gaps between demand and supply as well as investment and saving

However, these conditions cannot always be fulfilled; therefore, the warranted growth may not be equal to actual growth rate always. This makes the model unrealistic.

(d) Razor-Edge Model:

Refers to another name of the Harrod-Domar model. The economic factors that are used in the Harrod-Domar model are capital/output ratio, marginal propensity to consume, growth rate of labor force, and improvement in labor-saving technology.

These factors are derived independently from the model. Therefore, the equilibrium growth rate concept according to this model cannot be confirmed in long-run. Any deviation in these parameters can affect the equilibrium condition of an economy. Therefore, the model is sometimes referred as the razor-edge model.

Neo-Classical Theory:

The collective work of economists Tobin, Swan, Solow, Meade, Phelps and Johnson is termed as neo-classical theory of economic growth. The assumptions adopted by these theorists in the neo-classical theory are based on the views and norms given by neo- classical economists, such as Alfred Marshall, Wicksell, and Pigou.

Following are some of the assumptions of the neo-classical theory:

1. Assuming perfect competition in commodity as well as factor markets
2. Making factor payments equal to the marginal revenue productivity
3. Maintaining a variable ratio between capital and output
4. Assuming full employment condition

The assumptions of the neo-classical theory would be clearer by comparing them with the assumptions of the Harrod-Domar model, which is shown in Table1:

According to the neo-classical theory, the economic growth is determined with the help of certain factors, such as stock of capital, supply of labor, and technological development over time.

The production function for the neo-classical theory can be expressed as follows:

Y = F (K, L, T)

Where, Y = National output

K = Capital stock

L = Labor supply

T = Scale of technological development

According to the assumption of constant return to scale, increase in national output (∆Y) would be equal to the marginal productivity (MP) times AK and ∆L. Therefore,

∆Y = ∆K. MP_k + ∆L. MP_l

Where, MP_k = marginal physical product of capital

MP_l = marginal physical product of capital

When the equation of increase in national output is divided by Y, then we get the following equation:

∆Y/Y = ∆K (MP_k/Y) + ∆L (MP_l/Y)

The first term in the R.H.S is multiplied by K/K and second term by L/L; the resultant equation would be as follows:

∆Y/Y = ∆K/Y (K. MP_k/Y) + ∆L/Y (L.MP_l/Y)

The K. MP_k and L. MP represent the total stake of capital and labor in the national output, whereas K/Y* MP_k and L/Y* MP_l represent the relative stake of capital and labor in the national output. Therefore,

(K.MPk/Y) + (L.MP_l/Y) = 1

Let us assume that (K.MP_k/Y) = b, then

(L.MP_l/Y) = 1-b

Putting the value of (K.MP_k/Y) and (L.MP_l/Y) in the following equation, we get:

∆Y/Y = ∆K/Y (K.MP_k/Y) + ∆L/Y (L.MP_l/Y)

∆Y/Y = b ∆K/K + (1 – b) ∆T/T

In the preceding equation, the values of b and 1- b represents the elasticity of output with reference to the capital and labor respectively.

Therefore, according to the neo-classical theory, the economic growth rate is represented as follows:

Economic growth (at a given level of technology) = Elasticity of output with reference to the increase in capital stock + Elasticity of output with reference to the increase in labor

However, in case of technological change, the change in national output can be represented as follows:

∆Y/Y = b ∆K/K + (1 – b) ∆T/T

Therefore, in case of technological development, the economic growth rate can be represented as follows:

Economic growth (at a given level of technology) = Elasticity of output with reference to the increase in capital stock + Elasticity of output with reference to the increase in technological progress.

Some of the limitations of the neo-classical theory are as follows:

1. Regards technology as a constant factor, which is not true. This is due to the fact that a technology keeps advancing with time
2. Considers factor prices as the major factor for determining economic growth. However, the adjustments of factor prices can be interrupted with a change in liquidity.
3. Does not include the investment functions; therefore, the neo-classical theory has failed to describe the expectations of entrepreneurs and capital accumulation by them.
4. Considers capital assets as homogeneous, which is not real.

The workers are paid wages or salaries for the work done by them. Thus, the return to the workers should be according to their efforts and the pay standards prevailing in the industry.

There are several theories of wage determination propounded by different scientists and are based on varied assumptions.

Theories of Wage Determination

1. Subsistence Wage Theory

This theory was propounded by David Ricardo and called this theory as an “iron law wages.” According to this theory, the labor is paid the minimum amount of wage that is sufficient to subsist and perpetuate their race without either increase or decrease. It is based on the assumption that the law of diminishing returns applies to the industry, and the population tends to increase.

If the labor is paid below the subsistence level, they will die out of malnutrition, disease or hunger and therefore, the number of workers gets reduced. On the other hand, if the wage increases above the subsistence level, the number of workers will get attracted to procreate and thus, with the increase in labors the wage rate comes down. Thus, there is a subsistence level, which is maintained and is not either increased or decreased.

2. Wage Fund Theory

This theory was developed by Adam Smith, and is based on the assumption that the wage is paid out of the pre-determined wealth or fund, which lays surplus with the wealthy persons, as a result of savings. The amount of wage to be paid to the worker depends on the size of the fund. Larger the fund, more labor would be employed and given higher wages, whereas in the case of less funds, the wage would reduce to the subsistence level.

This theory was further expounded by J.S.Mill, and according to him the wage fund is fixed, and the wages can be determined on the basis of demand for and supply of labor. And thus, the fund size decides the demand for the labor. To have an increased wage, the number of labor is to be reduced, and the fund is to be enlarged.

3. Surplus Value Theory

This theory is given by Karl Marx,and according to him, like other articles, labor is also an article of commerce and could be purchased by paying a subsistence price.

The price of a product is determined by the amount of time; a labor devotes for its production. And the proportion of time spent by the labor on work is much less and, therefore, paid a minimum price and the surplus amount is utilized for the other expenses.

4. Residual Claimant Theory

Francis. A Walker propounded this theory, and according to him there four factors of production viz. Land, labor, capital and entrepreneurship.

The wage is the amount given in return for the amount of production and thus is paid after the payment of all other factors. Thus, the wage is considered to be a residual claimant, and is computed as:

Wage= Whole production- (Rent+ Interest+ Profit)

5. Marginal Productivity Theory

This theory is given byPhillips Henry Wicksteed and John Bates Clark, and it is based on the assumption that wage is determined on the basis of last worker’s contribution in the production i.e. the marginal production.

This theory assumes that wage depends on demand for and supply of labor. As far as, the marginal productivity is equal to the wages paid, a firm will continue employing more labor.

6. Bargaining Theory

John Davidson has given this theory, and according to him, the wages are determined on the basis of a bargaining capacity of workers or their unions and employers. If the trade union is stronger, then the wages will be high, and if the employer is powerful, the wages tend to be low.

7. Behavioral Theory

Several behavioral scientists (viz.March and Simon, Robert Dubin, Eliot Jacques,) have presented their research on the wage determination. According to them, there are various factors such as employer’s concern for the workers, the strength of unions, size and prestige of company, etc. that determines the amount of wage to be disbursed among the workers.

Thus, the firm can adopt either of the wage methods depending on the nature of a job and the worker’s contribution towards the accomplishment of a work.

According to modern economists, rent is considered as the payment made against the use of land by a tenant. They explained the concept of rent with respect to demand and supply of land.

The demand of land is not direct but derived demand. It is derived from the demand of products that are produced on the land.

In case, the demand of a product increases, then the demand of land also increases and vice-versa. This results in the increase or decrease of rent. For example, with increase in the population of a country, the demand for food increases. This results in the increase of requirement for land and its rent.

The demand of land depends on the marginal productivity of land, which is governed by the law of diminishing returns. Therefore, the demand curve would slope downwards. In such a case, it can be said that the rent of land can be obtained with the help of marginal productivity.

On the other hand, the supply of land is constant for the whole industry; however, an individual organization can increase its supply of land by purchasing more land. The supply of land is perfectly inelastic. This implies that the supply of land would remain the same even if the rent increases or decreases. Therefore, the supply price of land is zero.

For determining rent with the help of demand and supply of land, certain assumptions are made, which are as follows:

(i) Assumes that only one type of land and crop is used for cultivation. In such a case, there would only be one demand and supply curve.

(ii) Assumes that rent exists only in a perfectly competitive market.

Figure:1 shows how demand and supply forces of land interact to obtain rent of land:

In Figure-1, SS represents the supply curve of land that remains constant. Firstly, the demand curve of land was DD that intersects SS at point E. At point E, the rent is equal to OR (= SE). In case, the rent decreases to OR”, then the demand of land increases and rent come back to OR.

Similarly, if rent increases to OR’, then the demand of land declines and rent reaches OR again. D”D” is representing the no-rent condition when the cultivation of land occurs in a new country with plenty of good land. Therefore, OR is the rent at the equilibrium position where supply and demand of land becomes equal.

However, in case the land is of different types, then the demand and supply curve would be different for different lands. In case of an industry, the supply of land does not remain constant. The supply can be increased or decreased by purchasing or selling land or by paying more or less rent. Therefore, in case of a single industry the supply of land is elastic. The supply curve has an upward slope.

Figure: 2 shows the determination of rent in case of an industry:

In Figure-2, at demand DD the rent is OR and the quantity of land is OM. In case the demand reaches D’D’, the rent becomes OR’ with OM’ quantity of land. The land that was previously used for various purposes is now used for a specific industry. In case, the demand of land decline to D”D”, then the rent of land would be OR” and the quantity of land would be OM”. The modern theory of rent is based on the concept of transfer earnings.

Some of the modern economists have defined rent as follows:

According to Hibbdon, “Rent is the difference between the actual payment to a factor and its supply price or transfer earning.”

As per Boulding, “Economic rent may be defined as any payment to a factor of production which is in excess of the minimum amount necessary to keep the factor in its present occupation.

Factors of production can be defined as inputs used for producing goods or services with the aim to make economic profit.

In economics, there are four main factors of production, namely land, labor, capital, and enterprise. 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, labor, capital, and enterprise respectively. The theory of factor pricing deals with the price determination of different factors of production.

The determination of factor prices is always assumed to be similar to the determination of product prices. This is because in both the cases, the prices are determined with the help of demand and supply forces. Moreover, the demand for factors of production is similar to the demand for products.

However, there are two main differences on the supply side of factors of production and products. Firstly, in product market, the supply of a product is determined by its marginal cost of production. On the other hand, in factor market, it is not possible to determine the supply of factors on the basis of marginal cost.

For example, it is difficult to ascertain the exact cost of production for factors, such as land and capital. Secondly, the supply of factors of production cannot be readily adjusted as in the case of products. For instance, if the demand for a land increases, then it is not possible to increase its supply immediately.

Concept of Factor Pricing:

Factor pricing is associated with the prices that an entrepreneur pays to avail the services rendered by the factors of production. For example, an entrepreneur needs to pay wages to labor, rents for availing land, and interests for capital so that he/she can earn maximum profit. These factors of production directly affect the production process of an organization.

In context of an economy, these four factors of production when combined together produce a net aggregate of products, which is termed as national income. Therefore, it is important to determine the prices of these four factors of production. The theory of factor pricing deals with the determination of the share prices of four factors of production, namely land, labor, capital and enterprise.

In other words, the theory of factor pricing is concerned with the principles according to which the price of each factor of production is determined and distributed. Therefore, the theory of factor pricing is also known as theory of distribution. According to Chapman, the theory of distribution, “accounts for the sharing of the wealth produced by a community among the agents, or the owners of the agents, which have been active in its production.”

There are two aspects of each factor of production, which are as follows:

1. Price Aspect:

Refers to the aspect in which an organization pays a certain amount to avail the services of factors of production. For example, wages, rents, and interests constitute the price of factors of production.

1. Income Aspect:

Refers to another aspect in which a certain amount is received by a factor of production. For instance, rents received by a landlord and wages received by labor constitute the income generated from the factors of production.

Generally, it is assumed that factor pricing theory is similar to product pricing theory. However, there are certain differences between the two theories. Both the theories assume the determination of prices by the interaction of two market forces, namely demand and supply.

However, there are differences in the nature of demand and supply of factors of production with respect to that of products. The demand for factors of production is derived demand, while demand for products is direct demand. Moreover, the demand for the factors of production is joint demand.

This is because a product cannot be produced using a single factor of production. On the other hand, the supply of products is closely related with the cost of production, whereas there is no cost of production for factors. For example, there is no cost of production for land, labor, and capital. Therefore, the factor pricing is separated from product pricing.

Theories of Factor Pricing:

The theory of factor pricing is concerned with the principles according to which the price of each factor of production is determined and distributed. The distribution of factors of production can be of two types, namely personal and functional. Personal distribution is concerned with the distribution of income among different individuals.

It is associated with the amount of income generated not with the source of income. For example, an individual earns Rs. 20,000 per month; this income can be earned by him/her by wages, rents, or dividends. On the other hand, functional distribution is associated with the distribution of income among different factors of production as per their functions.

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.

Feature

1. Derived Demand:

It is observed that the demand for a factor, unlike the demand for a commodity, is a derived demand. It means that the demand for any factor of production depends on the existence of a demand for the goods that it helps to make. Thus the demand for computer program­mers or TV repairers is growing, as more and more electronic computers or TV sets are used. The demand for college teachers increases whenever the number of students in colleges increases.

2. Joint Demand:

The demand for a factor of production is essentially a case of joint demand. It means that as one particular factor cannot produce anything, almost all the factors are demanded jointly and at a time to produce a particular thing. But, the goods are not jointly demanded except in the case of some special goods like bread and butter or rubber-stamp and stamp-pad, etc.

3. Difficulties in Changing Factor Supply:

The supply of a factor has some peculiarities. The supply of most of the goods can, in general be increased or decreased according to their demand or prices. A rise in the price of a commodity would encourage the producers to produce and supply more of the same.

But any increase in factor price such as rent or wage does not bring about an increase in the supply of land at all or an immediate increase in the supply of labour even. Similarly, a fall in the price of a commodity generally brings about a fall in its supply, but this is not so in the case of land or labour or any other factor.

4. No Full Control over the Factor Supply:

It is also observed the owners of factors do not have full control over the conditions which determine factor supply. Thus the supply of money-capital depends in large measure on the country’s national income, law and order situation, banking system etc. The suppliers of capital or savers do not have any control over these’ conditions. But this characteristic is not normally found in the case of the supply of goods.

5. A Separate Theory for Each Factor:

In general no separate theory is needed for determining the prices of different types of goods; a single theory is enough for most of the goods (except for interrelated goods like joint products, etc.). But a separate theory is needed for each and every type of factor earnings, like rent, wages, interest and profits.

6. No Homogeneous Units of a Factor:

The different units of a product may be homogeneous, but the units of a factor are not generally so Besides the cost of production of a commodity can easily be determined, but the cost for a factor, land or labour, cannot be so determined.

Owing to the above reasons a separate theory is needed for determining factor prices, but the determination of factor prices becomes more complex than the determination of the prices of goods. This happens so, because in the former case the conditions (i.e., market situations) in both factor and product markets are to be considered at the same time, but in the latter case the prices of goods are determined in different market situations assuming factor-price constant.

The Modern theory of factor pricing provides a satisfactory explanation of the problem of distribution.

It is known as the demand and supply theory of distribution. According to the modem theory of factor pricing, the equilibrium factor prices can be explained by the forces of demand and supply.

Prices paid for productive services are like any other price and they are basically determined by demand and supply conditions. Incomes are received as payments for the services of factors of production. Wages are payments for the services rendered by labour.

Rents are payments for the services of land and interest is payment for the services of capital. In this way most incomes are remunerations or prices paid for services rendered by factors of production in the process of production. This theory is superior to the marginal productivity theory, because it takes into account both the forces of demand and supply in the determination of factor prices. Marshall held the view that no separate theory is required to explain factor prices. The principles which govern commodity pricing also govern factor-pricing. The following paragraphs touch upon the salient aspects of the theory.

“The theory of factor prices is just a special case of the theory of price. We first develop a theory of the demand for factors, then a theory of the supply of factors and finally combine them into a theory of determination of equilibrium price and quantities.” Lipsey and Stonier

Assumptions of Modern Theory of Distribution

1. Every producer tries to get maximum profit
2. Producers have perfect knowledge of the MRP
3. Active competition exists in the factor market
4. There is active competition among the different units of factors
5. The state does not intervene to equate the prices of the factor service

Demand for Factors of Production

The demand for factors of production is different from that of the demand for goods. The demand for goods is direct while the demand for factors of production is derived demand. The factors of production are demanded because they assist the process of production. Productivity of a factor refers to the contribution made by it in the process of production. If the demand for goods which the factor produces is more, its own demand will also be high and vice-versa. The elasticity of demand for industry with identical costs will be high.

It means that the total demand of a factor unit at OP price level is OM i.e. OX’ x 200. Further, at price level OP’, the demand is OM’ = (OX” X 200) and so on. Now, by taking all the possible combinations of factors price and the total demand for it we can draw the demand curve DD for the whole industry. In Figure, the factor price is determined by the quantity of the factor, possibility of substitutes, and elasticity of demand for final product. Thus, the demand for the factor is determined by its marginal revenue productivity.

The total demand for the factor in an industry, the demand for the factors by all the firms has to be added. It can be shown with the following fig. 1:

Factors Affecting Demand

The demand for factors is influenced by the following factors:

(i) The Elasticity of Demand for the Final Product

The demand for the services of a factor will be elastic if a slight fall in its price brings about a large responsiveness in its employment. Since the demand for the factor service is a derived demand, the elasticity of demand for the final product will determine the elasticity of demand for the factor service.

(ii) The Amount of Factor Required

The elasticity of demand for the factor service also depends upon the extent to which the factor service in question is required in the production of the commodity. If the factor service plays an insignificant role, then, demand for it would be inelastic i.e., demand for the factor service will not be affected by a change in the price.

(iii) Substitutability

Elasticity of demand for a factor service also depends upon the extent to which factor service in question can be substituted by other factors “The greater the ease with which factors of production can be substituted for each other, the more elastic is likely to be the demand for them.

Supply of Factors of Production

Like the demand for factors of production, supply of factors of production also differs from that of the goods. The supply of goods increases with the increase in price. But in the ease of factors of production, there exists no simple relation between supply and price. But for the sake of our convenience, we presuppose that there exists the positive relation between supply and price. It cannot be unrealistic because the higher prices attract the factors to work more.

Factors Affecting Supply

(i) Supply of Land

For an economy, supply of land is perfectly inelastic. Supply of land is free for an economy because it has no case of production. But for an industry, supply of land depends on opportunity cost. If opportunity cost of land increases in one industry as compared to another industry then more of it will be used in the former industry than the latter. Thus, for an industry supply curve will be upward sloping.

(ii) Supply of Labour

Supply of labour refers to the number of hours for which a labourer is willing to sell his services at a given price. There exists no definite relation between supply of labour and wage rate. Ordinarily, it is opined that up to a limit supply of labour increases with increase in wage. But after a given level, as the wage rate increases labour prefers leisure to work. In this situation, supply curve becomes backward sloping as seen in fig. 2.

In Fig. 2 SS is backward sloping supply curve of labour. It shows that up to OW wage rate supply of labourer is increasing but when wage rate rises from OW to OW] then supply of labour decreases from ON to ON₁,

(iii) Supply of Capital

Supply of capital depends on savings. Price of capital is called interest. According to classical economists with the increase in rate of interest, supply of savings will increase and vice-versa. Thus, supply curve of capital will slope upward.

(iv) Supply of Entrepreneur

There exists no definite relation between supply of entrepreneur and his price. Besides profits, supply of an entrepreneur depends on many non-economic factors.

In the words of J.B. Clark, “Under static conditions, every factor including entrepreneur would get a remuneration equal to marginal product.” As per Mark Blaug, “The marginal productivity theory contends that in equilibrium each productive agent will be rewarded in accordance with its marginal productivity.”

When an organization increases one unit of a factor of production (while keeping the other factors constant), the marginal productivity increases to a certain level of production. After reaching a certain level, the marginal productivity starts declining. This is because when an organization keeps on increasing the amount of a particular factor of production, the marginal cost also increases.

Types of Marginal Productivity

The theory of marginal productivity can be understood more clearly by gaining knowledge regarding the different types of marginal productivity.

The different types of marginal productivity are explained as follows:

(i) Marginal Physical Productivity

Refers to an increase in output occurred due to the increase in one unit of factor of production. According to M.J. Ulmer, “Marginal physical productivity may be defined as the addition to total production resulting from employment of one unit of a factor of production, all other things being constant.”

Example:- Suppose one labor is able to produce four quintals of wheat. If one more labor is hired, then the yield of wheat would reach to eight quintals. In such a case, the marginal physical productivity for the additional labor is four quintals of wheat (8-4=4).

The general formula for marginal physical productivity is as follows:

MPP_n = TPP_n -TPP_n-1

Where MPP_n = Marginal physical productivity for nth unit of labor

TPP_n = Total physical productivity of n units of labor

TPP_n-1 = Total physical productivity of n-1 units of labor

(ii) Marginal Revenue Productivity

Refers to the concept of marginal productivity with respect to change in total revenue. As per M.J. Ulmer, “Marginal revenue productivity may be defined as the addition to total revenue resulting from employment of one unit of a factor of production, all other things being constant.”

Let us understand the concept of marginal revenue productivity with the help of an example. Suppose one labor is able to produce wheat, which is worth of Rs. 50. If one more labor is hired, then the revenue generated from wheat would be Rs. 60. In such a case, the marginal revenue productivity for the second labor is Rs. 10 (60-50-10).

The formula for calculating marginal revenue productivity is as follows:

MRP = MPP * MR

Where MRP = Marginal Revenue Productivity

MR= Marginal Revenue

(iii) Value of Marginal Productivity

Refers to the value obtained by multiplying marginal physical productivity with the price of product produced. According to Ferguson, “The value of marginal product of a variable factor is equal to its marginal product multiplied by the market price of the commodity in question.”

The formula of value of marginal productivity is as follows:

VMP = MPP* AR

Where, VMP = Value of marginal productivity

MPP = Marginal physical productivity

AR = Market price of product

Let us understand the concept of value of marginal productivity with the help of an example. Suppose the market price of wheat is Rs. 10 per quintal and the marginal physical productivity for the additional labor is four quintals of wheat. In such a case, the value of marginal productivity for the additional labor would be Rs. 40 (4*10=40).

Assumptions of Marginal Productivity Theory:

The assumptions of marginal productivity theory are as follows:

(i) Perfect competition in product market

Refers to one of the main assumptions of marginal productivity theory. In marginal productivity theory, it is assumed that there is perfect competition in the product market. Thus, the change in output of an organization would not affect the market price of the product. In such a case, marginal revenue is equal to the average revenue of the product.

(ii) Perfect competition in factor market

Implies that organizations are required to purchase the factor of production at the prevailing market price only. In case of perfect competition, all the factors of production are perfectly mobile. In addition, the supply of factors of production is perfectly elastic.

(iii) Homogeneity of factors

Assumes that all the units of a factor of production are homogeneous in nature. Therefore, the units are perfect substitutes of each other.

(iv) Substitutability of factors

Assumes that various factors of production act as substitutes of each other. For example, capital act as the substitute of labor.

(v) Divisible factors

Assumes that various factors of production can be divided in small parts.

(vi) Maximum profit

Assumes that the main aim of every organization is to maximize their profit.

(vii) Full employment

Refers to one of the assumptions of marginal productivity theory. Under full employment condition, the supply of a factor of production is fixed in quantity.

(viii) Variable input coefficient

Assumes that an organization can use the factors of production in different quantities. In other words, the quantity of a factor can be changed, while keeping the other factors constant. For example, a land owner can employ two to three workers to plough a one hectare land.

(ix) Same state of technology

Assumes that the technology used in production is constant.

Limitations of Marginal Productivity Theory

Marginal productivity theory contributes a significant role in factor pricing.

In spite of its major contribution in factor pricing, the theory suffers from certain limitations, which are as follows:

(i) Unrealistic assumptions

Refer to one of the major limitations of marginal productivity theory. Marginal productivity theory stands true only under certain conditions, such as homogeneity of factors of production, perfect competition, and perfect mobility of factors of production.

(ii) Difficulty in measurement

Implies that the marginal productivity of a factor of production cannot be measured accurately. This is because while determining the marginal productivity of a factor, other factors are kept constant, which is not possible in the real scenario. For example, if the number of labor is increasing, then the other factors of production, such as tools, machinery, and raw material, needs to be increased for increasing the output.

Features of Perfect Competition

There are various market forms like perfect competition, monopoly, monopolistic competition, and oligopoly. Suppliers provide commodities based on the market demand, their cost and revenue functions. Each market structure leads to a different demand and revenue function. In this article, we will look at the features of perfect competition.

An essential aspect of perfect competition is the absence of any monopolistic element. These are the three essential features of perfect competition:

1. The number of buyers and sellers in the market is very large. These buyers and sellers compete among themselves. Due to the large number, no buyer or seller influences the demand or supply in the market.
2. The commodity sold or bought is homogeneous. In other words, goods produced by different firms are identical in nature.
3. Firms can enter or exit the market freely.

Additional Features of Perfect Competition

(i) Buyers and Sellers have a perfect knowledge of:

• The quantities of stock of goods in the market
• The conditions of the market
• Prices at which transactions of sale or purchase are happening.

(ii) There are facilities that help the movement of goods from one center to another.

(iii) Buyers have no preference between different sellers.

(iv) Also, buyers have no preference between different units of the commodity offered for sale.

(v) Sellers have no preference between different buyers.

(vi) At any given point in time, the goods are bought or sold at a uniform price. In other words, all firms must accept the price determined by the market forces to total demand and supply.

DETERMINATION OF PRICE UNDER PERFECT COMPETITION

Perfect competition is defined as a market situation where there are a large number of sellers of a homogeneous product. An individual firm supplies a very small portion of the total output and is not powerful enough to exert an influence on the market price.

A single buyer, however large, is not in a position to influence the market price. Market price in a perfectly competitive market is determined by the interaction of the forces of market demand and market supply. Market demand means the sum of the quantity demanded by individual buyers at different prices.

Similarly, market supply is the sum of quantity supplied by the individual firms in the industry. Each seller and buyer takes the price as determined. Therefore, in a perfectly competitive market, the main problem for a profit-maximizing firm is not to determine the price of its product but to adjust its output to the market price so that profit is maximized.

Price determination under perfect competition is analyzed under three different time periods:

(a) Market Period

(b) Short Run

(c) Long Run

(a) Market Period

In a market period, the time span is so short that no firm can increase its output. The total stock of the commodity in the market is limited. The market period may be an hour, a day or a few days or even a few weeks depending upon the nature of the product.

For example, in the case of perishable commodities like vegetables, fish, eggs, the period may be a day. Since the supply of perishable commodities is limited by the quantity available or stock in day that neither can be increased nor can be withdrawn for the next period, the whole of it must be sold away on the same day, whatever may be the price.

Fig. 1 shows that the supply curve of perishable commodities like fish is perfectly inelastic and assumes the form of a vertical straight line SS. Let us suppose that the demand curve for fish is given by dd. Demand curve and supply curve intersect each other at point R, determining the price OP. If the demand for fish increases suddenly, shifting the demand curve upwards to d’d’.

The equilibrium point shift from R to R” and the price rises to OP’. In this situation, price is determined solely by the demand condition that is an active agent.

Similarly, if the demand for a product is given, as shown in demand curve SS in figure 2. If the supply of the product decreases suddenly from SS to S’S’, the price increases from P to P’. In this case price is determined by supply, the supply being an active agent.

In this case supply curve shifts leftward causing increase in price of the reduced supply goods. Given the demand curve dd and supply curve SS, the price is determined at OP. Demand curve remaining the same, the decrease in supply shifts the supply curve to its left to S’S’. Consequently, the price rises from OP to OP’.

The supply curve of non-perishable but reproducible goods will not be a vertical straight line throughout its length. This is for certain goods can be withdrawn from the market if the price is too low as the seller would not sell any amount of the commodity in the present market period and would like to hold back the whole stock.

The price below which the seller declines to offer for any amount of his product is known as ‘reserve price’. Thus, the seller faces two extreme price-levels; at one he is ready to sell the whole stock and the other he refuses to sell any. The amount he offers for sale will vary with price.

The seller will be ready to supply more at a higher price rather than at a lower one will depend upon his anticipations of future price and intensity of his need for cash. The supply curve of a seller will, therefore, slope upwards to the right up to the price at which he is ready to sell the whole stock. Beyond this point, the supply curve will become a vertical straight line whatever the price.

(b) Pricing in the Short Run- Equilibrium of the Firm

Short period is the span of time so short that existing plants cannot be extended and new plants cannot be erected to meet increased demand. However, the time is adequate enough for producers to adjust to some extent their output to the increase in demand by overworking their fixed capacity plants. In the short run, therefore, supply curve is elastic.

Figure 3 shows the average and marginal cost curves of the firm together with its demand curve. Demand curve, in a perfectly competitive market, is also the average revenue curve and the marginal revenue curve of the firm. The marginal cost intersects the average cost at its minimum point. The U-shape of both the cost curves reflects the law of variable proportions operative in the short run during which the size of the plant remains fixed.

The firm is in equilibrium at the point B where the marginal cost curve intersects the marginal revenue curve from below:

The firm supplies OQ output. The QC is the average cost and the firm earns total profit equal to the area shown by ABCD. The firm maximizes its profit. Earlier to the point of equilibrium, the firm does not attain the maximum profit as each additional unit of output brings more revenue that its cost. Any level of output greater than OQ brings less marginal revenue than marginal cost.

For the equilibrium of a firm the two conditions must be fulfilled:

(a) The marginal cost must be equal to the marginal revenue. However, this condition is not sufficient, since it may be fulfilled and yet the firm may not be in equilibrium. Figure 4 shows that marginal cost is equal to marginal revenue at point e’, yet the firm is not in equilibrium as Oq output is greater than Oq’.

(b) The second and necessary condition for equilibrium requires that the marginal cost curve cuts the marginal revenue curve from below i.e. the marginal cost curve be rising at the point of intersection with the marginal revenue curve.

Thus, a perfectly competitive firm will adjust its output at the point where its marginal cost is equal to marginal revenue or price, and marginal cost curve cuts the marginal revenue curve from below.

The fact that a firm is in equilibrium does not imply that it necessarily earns supernormal profits. In the short-run equilibrium firms may earn supernormal profits, normal profits or may incur losses.

Whether the firm makes supernormal profits, normal profits or incurs losses depends on the level of the average cost at the short run equilibrium. If the average cost is below the average revenue, the firm earns supernormal profits. Figure 5 illustrates that the average cost QC is less than average revenue QB, and the firm earns profits equal to the area ABCD.

If the average cost is above the average revenue the firm makes a loss. Figure 6 shows that the Average cost QF is higher than QG average revenue and the firm is incurring loss equal to the shaded area EFGH. In this case the firm will continue to produce only if it is able to cover its variable costs.

Otherwise it will close down, since by discontinuing its operations the firm is better off; it minimizes its losses. The point at which the firm covers its variable costs is called ‘the closing-down point’. If the price falls below or average costs rise, the firm does not cover its variable costs and is better off if it closes down. Figure 7 explains shut- down point.

Equilibrium of the Industry

An industry is in equilibrium at that price at which the quantity demand is equal to the quantity supplied.

Figure 8 explains that DD is the industry demand and SS the industry supply. The point E at which industry demand and industry supply equalizes, the price OP is determined. OQ is the quantity demanded and quantity supplied. This, however, is a short run equilibrium where at the market-determined price some firms may be making supernormal profits, normal profits or making losses. In the long run the firms may not continue incurring losses. Loss making firms that cannot adjust their plant will close down.

Firms that are making supernormal profits will expand their capacity. Simultaneously new firms will be attracted into the industry. Free movement of firms in and outside the industry and readjustment of the existing firms in the industry will establish a long run equilibrium in which firms will just be earning normal profits and there will be no tendency of entry or exit from the industry.

(c) Pricing in the Long Run

The long run is a period of time long enough to permit changes in the variable as well as in the fixed factors. In the long run, accordingly, all factors are variable and non- fixed. Thus, in the long run, firms can change their output by increasing their fixed equipment. They can enlarge the old plants or replace them by new plants or add new plants.

Moreover, in the long run, new firms can also enter the industry. On the contrary, if the situation so demands, in the long run, firms can diminish their fixed equipments by allowing them to wear out without replacement and the existing firm can leave the industry.

Thus, the long run equilibrium will refer to a situation where free and full scope for adjustment has been allowed to economic forces. In the long run, it is the long run average and marginal cost curves, which are relevant for making output decisions. Further, in the long run, average variable cost is of no particular relevance. The average total cost is of determining importance, since in the long run all costs are variable and none fixed.

In the short run a firm under perfect competition is in equilibrium at that output at which marginal cost equals price or Marginal Revenue. This is equally valid in the long run. But, in the long run for a perfectly competition firm to be in equilibrium, besides marginal cost being equal to price, price must also be equal to average cost. If the price is greater than the average cost, the firms will be making supernormal profits.

Lured by these supernormal profits, new firms will enter the industry and these extra profits will be competed away. When the new firms enter the industry, the supply or output of the industry will increase and hence the price of the output will be forced down. The new firms will keep coming into the industry until the price is depressed down to average cost, and all firms are earning only normal profits.

On the other hand, if the price happens to be below the average cost, the firms will be incurring loses. Some of the existing firms will quit the industry. As a result, the output of the industry will decrease and the price will rise to equal the average cost so that the firms remaining in the industry are making normal profits. Hence, in the long run, firms need not be forced to produce at a loss since they can leave the industry, if they are having losses. Thus, for a perfectly competitive firm to be in equilibrium in the long run, price must equal marginal and average cost.

Now when average cost curve is falling, marginal cost curve is below it, and when average cost curve is rising, marginal cost curve must be above it. Hence, marginal cost can be equal to the average cost only at the point where average cost curve is neither falling nor rising, i.e. at the minimum point of average cost curve. Therefore, it is at the point of minimum average cost curve, and the two are equal there.

Thus, the conditions for long run equilibrium of perfectly competitive firm can be written as:

Price = Marginal Cost = Minimum Average Cost.

The conditions for the long run equilibrium of the firm under perfect competition can be easily understood from the Fig. 4.9, where LAC is the long run average cost curve and LMC in the long run marginal cost curve. The firm under perfect competition cannot be in long run equilibrium at price OP’, because though the price OP’ equals MC at G (i.e., at output OQ) but it is greater than the average cost at this output and, therefore, the firm will be earning supernormal profits.

Since all the firms are assumed to be identical, all would be earning supernormal profits. Hence, there will be attraction for the new firms to enter the industry. As a result, the price will be forced down to the level Op at which price, the firm is in equilibrium at F and is producing OQ” output.

At point F or equilibrium output OQ”, the price is equal to average cost, and hence the firm will be earning only normal profits. Therefore, at price OP, there will be no tendency for the outside firms to enter the industry. Hence, the firm will be in equilibrium at OP price and OQ output.

On the contrary, a firm under perfect competition cannot be in the long run equilibrium at price OP”. Though price OP” is equal to marginal cost at point E, or at output OQ” but price OP” is lower than the average cost at this point and thus the firm will be incurring losses.

Since all the firms in the industry are identical in respect of cost curves, all would be incurring losses. To avoid these losses, some of the firm will leave the industry. As a result, the price will rise to OP, where again all firms are making normal profits. When the price OP is reached, the firms would have no further tendency to quit.

Thus, to conclude that at price OP, the firm under perfect competition is in equilibrium in the long run when:

Price = MC = Minimum AC

Now, at price OP, besides all firms being in equilibrium at output OQ, the industry will also be in equilibrium, since there will be no tendency for new firms to enter or the existing firms to leave the industry, because all will be earning normal profits. Thus, at OP price, full equilibrium, i.e. equilibrium of all the individual firms and also of the industry, as a whole, is achieved in the long run under perfect competition.