Chapter 15

Input Pricing
 Lecture Plan
• Objectives
• Introduction
• Wage
– Demand and Supply of Labour
– Marginal Productivity Theory
– Other Theories of Wages
• Interest
– Time Preference Theory
– Loanable Funds Theory
– Liquidity Preference Theory
• Rent
– Ricardian Theory of Rent
– Modern Theory of Rent
• Profit
– Theories of Profit
• Summary
 Chapter Objectives

• To introduce different factors of production

and their pricing.
• To explain the nuances of determination of
wage and backward bending supply curve
of labour.
• To understand determination of rent and
interest.
• To illustrate the different theories of profit.
 Introduction
• A firm is a buyer of factor inputs and needs them in
various quantities,
• Returns (or rewards) to inputs are:
• Wages (and salaries) to labour
• Interest to capital
• Rent to land
• Profit to entrepreneurship
• Input pricing determines the amounts of different factors
to be employed in any production process.
• It has similarity with commodity pricing
• Like goods, factor prices are determined in the factor markets,
at the equilibrium determined by their demand and supply.
 Wage
• A sum of money paid under contract by an employer to a
worker for services rendered.
– Remuneration to a person who works for someone else
• The most commonly accepted measuring unit is time.
– Paid on the basis of hours, days, months, or even a year.
• Characteristics
• Labour and services (productivity) are inseparable.
• Labour (man hour) is perishable, it cannot be stored.
• Its demand depends upon the goods it can produce, i.e. it
has derived demand.
• Higher the skills acquired, more is the bargaining power of a
worker.
• Normally wage refers to payment to unskilled labour,
while salary is payment to skilled labour.
 Demand and Supply of Labour
S1 Demand for labour
• Depends on:
Wages
• price,
• types of goods that
are in demand,
P
w* • required skill sets to
produce the goods in
demand.
Supply of labour
S • Governed by:
O • the prevailing wage
Hours of Labour rate in the market
• Labour supply curve S1S slopes upwards • preference of labour
till wage rate w*. for leisure
• If wage increases beyond w*, the curve • Supply curve of labour is
bends backwards; backward bending.
– beyond w*, workers would not go for
more work, but would prefer more
hours of leisure.
 Marginal Productivity Theory

• Demand for labour is determined by the value of output of an

additional worker.
• Rests on the assumptions of a perfectly competitive market and profit
maximization.
• A firm will employ workers till marginal revenue product (MRPL) is
equal to the market wage rate.
• MRPL is equal to the marginal product of labour (MPL) times the
marginal revenue of the output generated (MRQ).

• Value of marginal product of labour (VMPL) in a competitive market is:

• Hence:
 Other Theories of Wages
Bargaining Theory of Wages
• Based on negotiations between employers and unions.
• Labour and employer, have conflicting objectives.
– Each wants the maximum share of firm’s profits and each side
is aware of the costs and risks of a strike.
• Equilibrium is achieved like one in a game theory problem.

Efficiency Wage Hypothesis

• Employers find it more beneficial to pay their workers wages
that are higher than their marginal revenue product.
– Richer workers are healthier or more productive, or better
motivated, or keener to avoid unemployment.
• It helps to explain why market price system may not work in
the labour market.
 Interest
• Price which the borrower of capital has to pay to the
lender of capital.
• Gross interest is the payment made to the creditor for
using its funds.
• Includes net interest and other elements like
payment for risk, reward for inconvenience and
reward for management of the available funds.
• Net interest is the payment made for using the services
of only the capital borrowed.
• Savings is a source of capital
• The owner of savings earns interest as a return for
partying away from savings temporarily.
 Time Preference Theory
• Time preference: Amount by which consumers value
immediate consumption in preference to deferred
consumption.
• Interest is the compensation paid for deferring present
consumption
• Factors affecting time preference of consumers:
• Higher preference to present consumption than
future consumption
• Uncertainty attached to future; higher the uncertainty
greater the preference for present
• Consumers’ orientation towards age, pleasure and
future planning
• Higher the preference for present expenditure higher is
the rate of interest.
 Loanable Funds Theory
Demand for loanable funds
• By firms for investment, by households for consumption and saving,
and by governments to finance their expenditure.
• Higher the rate of interest, the less would be the funds borrowed.
• Demand curve is downward sloping
Supply of loanable funds
• By central banking system, by households by offering past
accumulated saving and idle cash balances, disinvestment of capital
invested in machines and equipments.
• Higher the rate of interest, the more is the supply of loanable funds.
• Demand curve is downward sloping
Equilibrium
• Intersection of demand and supply curves determines the rate of
interest.
 Liquidity Preference Theory
Keynes: Interest is a purely monetary phenomenon and is the reward
of parting with liquidity for a specified period of time.
Demand for money in liquid form depends upon:
Transaction Motive
• To meet daily expenses
• Not affected by the rate of interest
Precautionary Motive
• To meet unforeseen events like accident and illness, or increase in
price of inputs.
• Not affected by the rate of interest
Speculative Motive
• Individuals may opt between holding idle money and investing in
expectation of capital gain
• Depends on expectation about the rate of interest and yield from
bonds
Supply of money is constant in the short run.
 Liquidity Preference Theory
Rate of interest is determined by demand and supply in a
competitive situation, at the intersection of demand and supply
curves of money.
L1
L M
Inte L Inte M
Inte L2
rest rest rest

r r1
2
E
r r
L1
1 r2 L
L O O
L2
O Quantity of M Quantity of money
M M1 Quantity of M
money money
Demand
2 for Money Supply for Money Equilibrium Rate of
Interest

With an increase in liquidity preference, the demand curve for money

shifts to the right (supply being constant); the rate of interest
increases.
 Rent

• Price paid for the use of land

• Income earned by landowners from the users of lands (also called as
contract rent)
• Determined by the level of its demand since land is fixed in supply.
• Signifies a surplus, i.e. the amount a factor of production earns over
and above the minimum amount it needs to remain engaged in its
present occupation.
• Economic rent is the surplus that is earned by the owner of a factor,
after paying all other expenses, including payment for own services.
• Occurs only when the factor of production has less than perfectly
elastic demand.
• Among all the factors, land has the least elastic supply, and the total
supply of land is fixed and perfectly inelastic to humanity.
• Thus return for any use of land is called a rent
 Ricardian Theory of Rent
• David Ricardo attributed rent as the payment made for using the
“original and indestructible powers of the soil”.
– It is the surplus left after making payments to all other factors of
production like labour and capital.
• Land is divided on the basis of fertility, assuming that the total supply
of land is fixed.
• Rent is reward of land with higher fertility being less in supply.

MCB
MCA
Price,
MCC
Revenue,
ACB ACC
Cost
ACA

BA BB BC
P AR=MR=P
RB
EB
RA
EA

O
QA Quantity QB Quantity QC Quantity

Highly fertile land Less fertile land Least fertile land

 Modern Theory of Rent

• Rent is earned by any factor of production

• Has two broad components:
– Transfer earnings: The minimum amount that must be paid
in the form of return to a factor, to ensure that it stays in its
present use.
– Economic rent: The amount a factor input earns over and
above its transfer earnings.
• Quasi rent: Rent earned by a factor that has perfectly
inelastic supply in the short run, but elastic supply in the
long run.
– A temporary phenomenon.
– Accrues to factors of production other than land, the
supply of which can be increased in the long run.
 Profit
• Normal profit: Opportunity cost of entrepreneurs
• Supernormal profit: Profit which actually is seen on the balance
sheet of the firm.
• Subnormal profit: Loss or negative profit.
• Accounting vs. Economic Profits
• Accounting profit is the excess of revenue over explicit costs of
production.
• Economic profit includes implicit costs (like wage of the
entrepreneur had he/she worked in another company) as well.
• Gross and Net Profit
• Gross Profit= Net Sales Revenue-Cost of goods sold
• Net profit = Gross profit- Indirect expenses +Indirect receipts
 Theories of Profit
Innovation Theory
• Schumpeter proposed profit as the reward earned by innovative firms.
• These firms identify new market opportunities and are the first to enter
a competitive industry with an innovative product (or idea).
• Profit is earned by an innovator till new firms are attracted towards the
competitive industry and they start imitating the innovator.
Uncertainty Bearing Theory
• Knight: Profit is the return or reward to taking risk amidst uninsurable
uncertainty.
• The entrepreneur works under the condition of uncertainty which
cannot be insured and profit is the reward for bearing such
uncertainty.
• Rate of profit will be determined by the entrepreneur’s capacity to bear
uncertainty.
• Profit has to be substantially higher than definite return on capital
(interest).
 Summary
• The firm is the buyer of factor inputs supplied by households.
• Returns (or rewards) to labour are termed as wages (and salaries), to capital
as interest, to land as rent and to entrepreneurship as profit.
• Wages are payment for services rendered to some one else as per certain
terms and conditions, measured against time.
• Demand for labour depends upon its price, types of goods that are in demand,
required skill sets which determine the quality of labour, etc.
• Supply of labour is governed by the prevailing wage rate in the market and
preference of labour for leisure.
• In a perfectly competitive market, the optimal level of labour used will be
determined by the equality of the marginal cost of labour with the marginal
revenue derived from the last unit of labour employed.
• Rent is commonly the income earned by landowners from the users of land.
• In economics, “rent” signifies a surplus, i.e. the amount a factor of production
earns over and above the minimum amount it needs to remain engaged in its
present occupation.
• According to Ricardo, rent is the reward for indestructible qualities of land.
• As per the modern theory of rent, economic rent is the amount an input earns
over and above its transfer earnings.
• Surplus earned by factor inputs other than land is referred to as quasi rent.
 Summary
• Interest is the price which the borrower of capital has to pay to the lender of
capital.
• As per time preference theory, interest is the compensation for deferring
present consumption. According to loanable funds theory, rate of interest
depends on the demand for and supply of loanable funds.
• Motive for holding money to bridge the time gap between receipts and
payment is transactions motive. Demand for money to meet unforeseen
events is precautionary demand; speculative demand for money is for
speculative purposes, and depends inversely on expectation about the rate of
interest of bonds.
• Rate of interest is determined by demand and supply in a competitive
situation, at the intersection of demand and supply curves of money.
• Profit is the return to the entrepreneur.
• Accounting profit is the excess of revenue over explicit costs of production; in
economics, opportunity cost is taken into consideration while ascertaining
profits.
• Gross profit is the difference between direct cost of production and revenue
from sales of product; net profit is calculated by deducting indirect cost from
gross profit and adding any indirect revenue during the course of business.
• Schumpeter proposed profit as the reward earned by innovative firms.
• Knight considered profit as the return or reward to taking risks amidst
uncertainties.