Year: 2020

The level of prosperity and quality of living standards in an economy. Economic welfare can be measured through a variety of factors such as GDP and other indicators which reflect welfare of the population (such as literacy, number of doctors, levels of pollution e.t.c)

Economic welfare is a general concept which doesn’t lend to easy definition. Basically, it refers to how well people are doing. Economic welfare is usually measured in terms of real income/real GDP. An increase in real output and real incomes suggests people are better off and therefore there is an increase in economic welfare.

However, economic welfare will be concerned with more than just levels of income. For example, people’s living standards are also influenced by factors such as levels of health care, and environmental factors, such as congestion and pollution. These quality of life factors are important in determining economic welfare.

Factors influencing economic welfare

1. Real income: influencing potential consumption
2. Employment prospects: unemployment significant cost
3. Job satisfaction: satisfaction at work as important as income and wage
4. Housing: High income but unaffordable housing diminishes economic welfare. Good, cheap housing essential to economic welfare
5. Education: opportunities to study through lifetime, influence welfare
6. Life expectancy and quality of life: access to healthcare, also are lifestyles healthy, e.g. levels of obesity/smoking rates
7. Happiness levels: normative judgements on whether people are happy.
8. Environment: economic growth can cause increased pollution, which damages health and living standards.
9. Leisure time: high wages due to working very long hours diminishes economic welfare. Leisure has economic value.

Economic Welfare and Utility

Economics is concerned with ideas of utility. Utility represents the satisfaction/happiness of a consumer. For example, if you are willing to pay £10 for a CD, then presumably you get a utility of at least £10 worth from the good.

Welfare Economics

This is a branch of economics devoted to determining the optimal allocation of resources in society. It is concerned with allocative efficiency and social efficiency.

Measure of economic welfare (MEW)

This was developed in 1972 as an alternative to GDP. It was developed by William Nordhaus and James Tobin. (Nordhaus, WD and Tobin, J (1972) Is Growth Obsolete?

It adjusts the measure of total national output, to include only items that help improve economic well-being.

In addition to GNP the MEW includes:

• The value of leisure time enjoyed by citizens.
• Value of unpaid work
• Economic output in the underground economy (not measured by official GDP statistics)

The MEW also excludes factors which reduce economic welfare, such as

• Environmental damage

It is also known as net economic welfare (NEW) (Samuelson and Nordhaus, 1992).

Index of Human Development Index HDI

A related concept is that of Human development index (HDI)

This is a measure which seeks to look at the available choices that people have. It is a composite indicator comprised of 3 basic factors affecting living standards – income, life expectancy and education. The three components are:

1. Real GDI per Capita, adjusted for the local cost of living (PPP)
2. Life expectancy
3. Education – levels of literacy

The highest human development is given a value of 1. Low levels of Human development are given a value close to 0.

Well-being index

This is a measure of economic well-being and life satisfaction, created by the ONS. It looks at health, relationships, education and skills, what we do, where we live, our finances and the environment. It includes positive data but also includes surveys and questionnaires – it also uses quite a new methodology and is experimental in terms of economic data.

According to classicists, there will always be full employment in a free enterprise capitalist economy because of the operation of Say’s Law and wage-price flexibility. This classical theory came under severe attack during the Great Depression years of 1930s at the hands of J. M. Keynes.

He rejected the notion of full employment and instead suggested full employment as a special case and not a general case. Full employment is a temporary phenomenon, an astrological coincidence! He claimed his theory to be ‘general’, i.e., applicable at any point of time. That is why he christened his epoch-making book: The General Theory of Employment, Interest and Money (1936). Thus, Keynes’ theory is “general”.

In this book, he not only criticized the classical macroeconomics, but also presented a ‘new’ theory of income and employment. He is often described by economists as a revolutionary one in the sense that it was Keynes who salvaged the capitalist economy from destruction in the 1930s. Critics, however, label him as a ‘conservative revolutionary’.

Keynes’ theory of employment is a demand-deficient theory.

This means that Keynes visualized employment/unemploy­ment from the demand side of the model. His theory is thus known as demand-oriented approach. According to Keynes, the volume of employment in a country depends on the level of effective demand of the people for goods and services. Unemployment is attributed to the deficiency of effective demand.

It is to be kept in mind that Keynes’ theory is a short run theory when population, labour force, technology, etc., do not change. Once Keynes remarked that since “in the long run we are all dead”, it is of no use to present a long run theory. In view of this, one can argue that the volume of employment depends on the level of national income/output.

Higher (lower) the level of national output, higher (lower) is the volume of employment. Thus, Keynesian theory of employment determination is also the theory of income determination. In this section, we intend to determine the level of employment in terms of the principle of ‘effective demand’.

(a) Meaning of Effective Demand:

Keynes’ theory of employment is based on the principle of effective demand. In other words, level of employment in a capitalist economy depends on the level of effective demand. Thus, unemployment is attributed to the deficiency of effective demand and to cure it requires the increasing of the level of effective demand.

By ‘effective’ demand, Keynes meant the total demand for goods and services in an economy at various levels of employment. Total demand for goods and services by the people is the sum total of all demand meant for consumption and investment. In other words, the sum of consumption expenditures and investment expenditures constitute effective demand in a two-sector economy.

In order to meet such demand, people are employed to produce all kinds of goods, both consumption goods and investment goods. However, to complete our discussion on effective demand we need another component of effective demand—the component of government expenditure. Thus, effective demand may be defined as the total of all expenditures, i.e.,

C + I + G

Where, C, I and G stand for consumption, investment, and government expenditures.

Here we ignore government expenditure as a component of effective demand. According to Keynes, the level of employment is determined by effective demand which, in turn, is determined by aggregate demand function or aggregate demand price and aggregate supply function or aggregate supply price.

In Keynes’ words:

“The value of D (Aggregate Demand) at the point of Aggregate Demand function, where it is intersected by the Aggregate Supply function, will be called the effective demand.”

1. Aggregate Supply (AS):

Employers hire and purchase various inputs and raw materials to produce goods. Thus, production involves cost. If sales revenue from the sale of output produced exceed cost of production at a given level of employment and output, the entrepreneur would be induced to employ more labour and other inputs to produce more.

At any given level of employment of labour, aggregate supply price is the total amount of money that all entrepreneurs in an economy expect to receive from the sale of output produced by given number of labourers employed. For each particular level of employment, there is an aggregate supply price.

Here, by ‘price’ we mean the amount of money received from the sale of output, i.e., sales proceeds. Thus, aggregate supply prices refer to the proceeds from the sale of output at each level of employment and there are different aggregate supply prices for different levels of employment. If this information is expressed in a tabular form, we obtain “aggregate supply price schedule” or aggregate supply function.

The aggregate supply function is a schedule of the minimum amounts of proceeds required to induce varying quantities of employment. Simply, it shows various aggregate supply prices at different levels of employment. Plotting this information graphically, we obtain aggregate supply curve.

According to Keynes, aggregate supply function is an increasing function of the level of employment. Aggregate supply (AS) curve slopes upward from left to the right because volume of employment increases with the increase in sale proceeds.

But there is a limit to increase output level. This is called full employment level of output beyond which output cannot be increased. It is because of full employment that AS curve becomes vertical or perfectly inelastic. This means that the level of employment cannot exceed full employment (N_f) even by increasing aggregate supply price. This is shown in Fig. 10.4.

2. Aggregate Demand (AD):

Aggregate demand or aggregate demand price is the amount of money or price which all entrepreneurs expect to receive from the sale of output produced by a given number of men employed. Or it refers to the expected revenue from the sale of output at a particular level of employment.

Each level of employment is associated with a particular aggregate supply price and there are different aggregate demand prices for different levels of employment. Like the aggregate supply schedule, aggregate demand schedule shows the aggregate demand price for each possible level of employment.

Plotting the aggregate demand schedule we obtain aggregate demand curve as there is a positive relation between the level of employment and aggregate demand price i.e., expected sales receipts. This is shown in Fig. 10.4. It rises from left to right.

(b) Equilibrium Level of Employment —the Point of Effective Demand:

We have studied separately aggregate demand and aggregate supply as the two determinants of effective demand. Now we will describe how equilibrium level of employment is determined in an economy by using the concept of effective demand.

The level of employment in an economy is determined at that point where the aggregate supply price equals the aggregate demand price. In other words, the intersection of the aggregate supply function with the aggregate demand function determines the volume of income and employment in an economy.

It is thus clear that so long as expected sales receipts of the entrepreneur (i.e., aggregate demand schedule) exceed costs (i.e., aggregate supply schedule), the level of employment should be increasing and the process will continue until expected receipts equal costs or aggregate demand curve intersects aggregate supply curve.

Note that the AS curve starts from the origin. If aggregate receipts (i.e., GNP) are zero, entrepreneurs would not hire workers. Likewise, AD curve also starts from the origin. The equilibrium level of employment is determined by the intersection of the AS and AD curves.

This is the point of effective demand—point E in Fig. 10.4. Corresponding to this point, ON_e workers are employed. At the ON₁ level of employment, expected receipts exceed necessary costs by the amount RC. Entrepreneurs will now go on hiring more labour till ON_e level of employment is reached.

At this level of employment, entrepreneurs’ expectations of profits are maximized. Employment beyond ON_e is unprofitable because costs exceed revenue. Thus, actual employment (ON_e) falls short of full employment (ON_f). Keynesian system shows two kinds of equilibria—actual employment equilibrium determined by AD and AS curves and underemployment equilibrium.

Keynes made little emphasis to the aggregate supply function since its determinants (such as technology, supply or availability of raw materials, etc.,) do not change in the short run. Keynes was examining the possibility of unemployment in a capitalistic economy against the backdrop of the Great Depression of 1930s.

After diagnosing the problem, Keynes recommended policy prescription so as to create more employment in the economy. Indeed, for curing unemployment problem, he did not subscribe to the classical ideas— the supply-oriented policies.

Keynes attached great importance to demand-stimulating policies to cure unemployment. In other words, Keynes paid emphasis on the aggregate demand function. That is why Keynes’ theory is known as a ‘theory of aggregate demand’.

Fig. 10.4 shows the situation of equilibrium at less than full employment level. Actual equilibrium, ON_e, is short of fill employment equilibrium, ON_e. Thus, the distance ON_f – ON_e measures unemployment. This is called involuntary unemployment— a situation at which people are willing to work but do not find jobs. This unemploy­ment, according to Keynes, is due to deficiency of aggregate demand.

This unemployment can be removed by stimulating aggregate demand. Aggregate demand is the sum total of consumption and investment demand or expenditures in the economy. By raising consumption expen­diture, level of employment can be raised. But there is a limit to consumption expenditure. So what is needed is the raising of (private) investment demand.

Anyway, increase in consumption demand and investment demand will raise the level of employment in the economy. The point of effective demand has been changed in Fig. 10.4 because of the shifting of AD curve from AD to AD₁. New effective demand is now given by E₁. Corresponding to this point, equilibrium level of employment is ON_f—the level of full employment.

Thus, in Keynes’ theory, unemployment is due to the deficiency of effective demand. Only by stimulating effective demand can a higher level of employment be achieved. However, Keynes goes on arguing that equilibrium level of employment will not necessarily be at full employment.

A capitalist economy will always experience underemployment equilibrium—an equili­brium situation less than full employment. Full employment, according to Keynes, can never be achieved. In Keynes’ scheme of things, both consumption and investment cannot be raised enough to employ more work force.

Therefore, he recommends government to come forward and take appropriate action to cure unemployment problem. This means that aggregate demand is now the sum total of all consumption, investment and government expenditures.

It is because of the multiplier effect of both private investment expenditure and government expenditure that there will be larger income, output and employment.

But, equilibrium in the economy will be established at less than full employment situation because of:

(i) Wage rigidity

(ii) Interest inelasticity of investment

(iii) Liquidity trap

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.