Factor Pricing: Rent, Wages, Interest and Profit (Basic Theories) Questions

Question 1

Define factor pricing.

Accepted Answer

Factor pricing refers to determination of rewards paid to factors of production—rent, wages, interest and profit.

Question 2

What is rent?

Accepted Answer

Rent is the reward paid for the use of land and other natural resources.

Question 3

What are wages?

Accepted Answer

Wages are the reward paid for the services of labour.

Question 4

Define interest.

Accepted Answer

Interest is the reward paid for the use of capital or loanable funds.

Question 5

What is profit?

Accepted Answer

Profit is the reward for entrepreneurship and uncertainty-bearing and is the surplus remaining after paying costs.

Question 6

State any one motive of liquidity preference.

Accepted Answer

Speculative motive is one motive of liquidity preference; people hold money due to expectations about future interest rates.

Question 7

Explain Ricardian theory of rent (basic).

Accepted Answer

Ricardo explained rent as **differential surplus** arising due to differences in fertility and location of land. Since land is scarce and non-uniform, superior lands produce more than inferior lands with same input. The least fertile land in cultivation (marginal land) earns **zero rent**, and rent on superior land equals excess produce over marginal land.

Question 8

Explain marginal productivity theory of wages.

Accepted Answer

Marginal productivity theory states wages are determined by the marginal productivity (marginal revenue product) of labour. A profit-maximising firm employs labour up to the point where **MRP of labour equals wage rate (MRP = W)**. Demand for labour is derived from demand for the product, so when product demand rises, labour demand and wages tend to rise.

Question 9

Explain Keynes liquidity preference theory of interest.

Accepted Answer

Keynes explained interest as the reward for parting with liquidity. Interest rate is determined by **demand for money (liquidity preference)** and **supply of money**. People demand money for **transactions**, **precautionary** and **speculative** motives. With a given money supply, higher liquidity preference raises interest rate and lower liquidity preference reduces it.

Question 10

Differentiate between gross interest and net interest.

Accepted Answer

**Net (pure) interest** is payment purely for use of capital. **Gross interest** includes net interest plus other components such as payment for risk, inconvenience, management and administrative expenses. Therefore gross interest is generally higher than net interest.

Question 11

Explain Knight’s uncertainty theory of profit.

Accepted Answer

Knight stated that profit is the reward for bearing **uncertainty**. He distinguished **risk**, which is measurable and insurable, from **uncertainty**, which is unmeasurable and cannot be insured. Entrepreneurs earn profit because they take decisions under uncertain conditions and bear the consequences of unexpected changes in demand, prices and technology.

Question 12

Write a short note on derived demand of factors.

Accepted Answer

Demand for factors of production is called **derived demand** because it depends on demand for the final goods they help produce. When demand for a product increases, firms produce more and demand more labour, capital and land. Therefore factor prices and employment are closely linked to product market conditions.

Question 13

Explain factor pricing and discuss Ricardian theory of rent.

Accepted Answer

Factor pricing refers to determination of rewards paid to factors of production—rent for land, wages for labour, interest for capital and profit for entrepreneurship. These factor prices are determined by the demand and supply of factors in factor markets. Demand for factors is derived from demand for the goods and services produced by them.

**Ricardian theory of rent:** David Ricardo explained rent as a **differential surplus** arising due to the scarcity and non-uniformity of land. Lands differ in fertility and location advantages. When population grows and demand for food increases, cultivation extends from superior land to inferior land. The least fertile land in cultivation is called **marginal land** and it yields no surplus over cost; therefore it earns **zero rent**.

Superior lands produce more output with the same inputs compared to marginal land. The difference between output of superior land and marginal land is the rent. Thus rent is not a cost of production but a surplus arising from differential advantages. Rent increases when demand for agricultural produce increases and cultivation extends to less fertile lands.

Hence, Ricardian rent is determined by differences in productivity and the existence of marginal land with zero rent.

Question 14

Explain marginal productivity theory of wages and Keynes liquidity preference theory of interest.

Accepted Answer

**Marginal productivity theory of wages:** This theory states that wages are determined by the marginal productivity of labour. A firm employs labour up to the point where the marginal revenue product of labour (MRP) equals wage rate (W). If MRP exceeds W, hiring more labour increases profit; if MRP is less than W, employing labour reduces profit. Hence equilibrium wage tends to equal the value contributed by the marginal worker. Demand for labour is derived from demand for the product.

**Keynes liquidity preference theory of interest:** Keynes explained interest as a monetary phenomenon and the reward for parting with liquidity. Interest rate is determined by the interaction of **demand for money (liquidity preference)** and **supply of money**. People demand money for (i) transactions motive, (ii) precautionary motive and (iii) speculative motive. The speculative demand depends on expectations about future interest rates. Given a fixed money supply, higher liquidity preference increases interest rate, while lower liquidity preference reduces it.

Thus, wages depend on marginal productivity of labour, and interest depends on money demand and money supply under Keynes’ theory.

Question 15

Explain profit and discuss Knight’s uncertainty theory of profit. Differentiate risk and uncertainty.

Accepted Answer

Profit is the reward for entrepreneurship and is the surplus remaining after paying all costs of production. In economic sense, normal profit is the minimum required to keep the entrepreneur in business, while supernormal profit is profit above normal profit.

**Knight’s uncertainty theory of profit:** Frank H. Knight argued that profit arises due to uncertainty. He distinguished between risk and uncertainty. **Risk** is measurable and insurable, such as fire or theft, where probabilities can be estimated. **Uncertainty** is unmeasurable and cannot be insured, such as unpredictable changes in consumer tastes, technology, competition, government policy and business cycles.

Entrepreneurs take decisions in uncertain conditions and bear the consequences of wrong forecasting. Because uncertainty cannot be insured, the entrepreneur is rewarded with profit for bearing such uncertainty and for taking responsibility for business decisions.

**Difference between risk and uncertainty:** Risk is measurable and can be insured; uncertainty is not measurable and cannot be insured. Therefore, profit is mainly associated with uncertainty-bearing rather than ordinary insurable risks.

Factor Pricing: Rent, Wages, Interest and Profit (Basic Theories)

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