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

Wages

w*

Hours of Labour

Labour supply curve S1S slopes upwards till wage rate w*. If wage increases beyond w*, the curve bends backwards; beyond w*, workers would not go for more work, but would prefer more hours of leisure.

Demand for labour Depends on: price, types of goods that are in demand, required skill sets to produce the goods in demand. Supply of labour Governed by: the prevailing wage rate in the market preference of labour for leisure Supply curve of labour is backward bending.

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 firms 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 of money. In the short run supply of money is constant.
Demand
L1 M

Interest

L L2

for money is determined by liquidity preference of people. With an increase (decrease) in liquidity preference, the demand curve for money shifts to the right (left). The rate of interest increases (decreases), supply being constant.

r1 r r2 O

E1 E E2 L2 L L1

M Quantity of money

Equilibrium Rate of Interest

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. Some land is more fertile than other. Cultivation begins on highly fertile land; as demand increases less fertile land is brought into cultivation; thus highly fertile land earns rent. The process continues. Rent is reward of land with higher fertility being less in supply.

Ricardian Theory of Rent

Supply of land is given Demand is perfectly elastic, hence AR=MR=P Equilibrium quantity of land is where MR=MC Rent occurs when AR >AC
Equilibrium quantity= OQB OR>OCB
MCA ACA BA BB CB EA MCB ACB R=CC EB BC

Equilibrium quantity = OQA OR>OCA

Price, Revenue, Cost R CA

Equilibrium quantity= OQC OR=OCC

MCC ACC

Rent

Rent

AR=MR=P

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 entrepreneurs 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.