Managerial Economics_English_M.COM_II.pdf

By: Dr. Gauri Dhingra
Assistant Professor
S.S Jain Subodh P.G(Autonomous)
College
1

National Income Concept
and Measurement
2

Meaning of National Income
•National income is the money value of
all the final goods and services
produced by a country during a period
of one year. National income consists
of a collection of different types of
goods and services.
3

NI is the Money measure of,
1.The net value of all products & services
2.Of an economy during a year
3.Counted without duplication
4.After having allowed for depreciation
5.Both in the public & private sectors
6.In consumption & capital goods sectors
7.Finally throwing in the net gains from
international transactions comprising of gains,
not merely from export, import, trade but also
from capital lent or invested abroad
4

Example
•If the value of a meter of cloth is Rs. 20
and the total cloth produced is 100
meters, then the money value of cloth is
Rs. 2000. In this way we can find out the
value of other goods and services and
the total value of all the goods and
services produced during one year.
5

Basic Concepts in National
income
•Gross Domestic Product (GDP)
•Net Domestic Product (NDP)
•Gross National Product (GNP)
•Net National Product (NNP)
6

Basic Concepts in National income
•Personal Income (PI)
•Disposable Personal Income (DPI)
•Real income
7

Circular Flow of Income
(Four Sector Economy)
Salaries
Remittances
for purchasesTaxes Taxes
Exports
Exports
Imports
Imports
Consumptio
n
Expenditure
Governmen
t (G)
Financial Market
Investment
(I)
Savings
(S)
Foreign
Nations
(X-M)
Factor
Payments
FirmsHouseholds
Factor Inputs
Goods
8

Gross Domestic Product
•Gross domestic product is the
money value of all final goods
and services produced in the
domestic territory of a country
during an accounting year.
9

Gross Domestic Product
•Domestic territory Means
a.Territory lying within the political frontiers,
including territorial waters of the country.
b.Ships and aircrafts operated by the
residents of the country between two or more
countries.
10

Gross Domestic Product at
Current price
•GDP can be estimated at current
prices and at constant prices. If the
domestic product is estimated on the
basis of the prevailing prices it is
called gross domestic product at
current prices.
11

Gross Domestic Product at Constant
price
•If GDP is measured on the basis of
some fixed price, that is price prevailing
at a point of time or in some base year it
is known as GDP at constant price or
real gross domestic product.
12

Net Domestic Product
•While calculating GDP no provision is
made for depreciation allowance (also
called capital consumption allowance). In
such a situation gross domestic product
will not reveal complete flow of goods
and services through various sectors.
13

Net Domestic Product
•A part of is therefore, set aside in the
form of depreciation allowance. When
depreciation allowance is subtracted
from gross domestic product we get net
domestic product.
NDP = GDP – Depreciation
14

Gross National Product
•Gross national product is defined as the sum of
the gross domestic product and net factor
incomes from abroad. Thus in order to
estimate the gross national product of India we
have to add net factor income from abroad -
income earned by non-resident in India to form
the gross domestic product of India.
GNP = GDP + NFIA.
15

Net National Product
•It can be derived by subtracting
depreciation allowance from GNP. It can
also be found out by adding the net
factor income from abroad to the net
domestic product.
NNP = GNP –
Depreciation OR
NNP = NDP + NFIA
16

NNP at factor cost or
National Income
•NNP at factor cost is the volume of
commodities and services turned
out during an accounting year,
counted without duplication. It can
also be defined as the net value
added at factor cost in an
economy during an accounting
year.
17

NNP at factor cost or National Income
•NNP at factor cost or national income is
defined as the sum of domestic factor
incomes and net factor income form
abroad. If NNP figure is available at market
price we will subtract indirect taxes and
add subsidies to the figure to get NNP at
factor cost or national income of the
economy.
18

NNP at factor cost or National
Income
•NNP at FC = National Income = FID +
NFIA
•FID factor income earned
domestic territory of a country.
•Net Factor Income from Abroad.
in the
19

Personal Income and Disposable
income
•Personal income and disposable income
are two concepts of national income very
commonly used in advanced countries.
Personal income may be defined as the
current income of
services. Personal income is not
persons or households from all
a
measure of production.
20

Some frequently used
terminologies
Personal Income and Disposable Income
•Personal Income: is the money income received by
households before they pay their personal taxes. PI=
NI-pre tax corporate profits-social security taxes+
transfer payments + Net interest (including dividend)
•Disposable personal income: is the income that
households can choose to consume or save after
subtracting income taxes from personal income.
Personal income- direct personal taxes
•Disposable personal income is the sum of
consumption and saving i.e. DPI=C+S
21

Disposable Income
•All personal income is not at the disposal to
be spent on consumption. Individuals have
to pay personal direct taxes to the
government. They are free to spend only
after the payment of taxes.
•DPI = Personal income – Personal Direct
taxes.
22

Disposable Personal Outlay
•The disposable personal income may be
spent fully or individuals may save. What
remains after saving is called the
personal outlay. Disposable income is
equal to consumption and savings.
•Disposable outlay = Disposable income
– Savings.
23

Real Income
•Since national income does not reveal the
real state of the economy, the concepts of
real income has been used. To find out the
real income of the economy, a base year is
selected and the price level of that year is
assumed to be 100.
•Real income= Money Income × 100
Price Index
24

Need for National Income Accounting
•Indicates Economic Growth:
–it indicates performance and the level of
economic growth in an economy. The data on
national income and per capita display the true
picture of the health of an economy. If both are
increasing continuously, it surely reflects an
increase in economic welfare, otherwise not.
•Helps in Policy Formulation:
–Statistical data on national income not only helps
in making economic analysis but also helps in
policy formulation. Moreover it not only helps in
formulating fiscal policy, monetary policy, foreign
trade policy but also helps in making
modifications and amendments wherever
necessary.
25

Need for National Income Accounting
•Helpful in Making Comparisons
–it helps us in comparing national income and per capita
income of our country with those of other countries. This
may lead us to make suitable changes in our plans and
approach to achieve rapid economic development of our
country.
•Helpful to Trade Unions
–National accounts throw light on distribution of factor
incomes which is very helpful to trade unions and other
labour organizations in making rational analysis of the
remuneration the labourers are getting.
•Distribution of income
–National income accounting describes distribution of
national income in terms of factors like interest, rent, profit &
wages. It also shows the relative significance of the factors
of production in
the
economy.
26

Need for National Income Accounting
•Helpful in economic planning
–National income accounting is helpful in
economic planning. The planning commission
comes to know about the resources available
for economic planning.
•Structural changes in the economy
–National income accounting is helpful in providing
knowledge of structural changes in the economy.
We are able to know that decrease or increase in
share of agriculture and industry in national
income.
•Facilitates forecasting
–National income accounting is helpful in
forecasting the effect of economic policies on
the level of production & employment.
27

GDP and WELFARE
•GDP is a measure of the economic
prosperity of a country compiled as output
or income. There is a strong correlation
between the development in GDP and
changes in several important social
factors, including tax payments and
unemployment and, to a lesser extent,
health and education. However, GDP is
regularly criticised for not presenting a fair
view of welfare. If GDP is a poor measure
of welfare, focusing one-sidedly on
increasing GDP may lead to misguided
political decisions
28

•The first criticism is that GDP is hopelessly flawed as
a measure of human welfare. For example, the
argument goes, it takes no account of pollution.
•GDPhasalwaysbeen ameasureofoutput,
not of welfare.Usingcurrentprices, it
measuresthevalueofgoodsandservices
producedfor finalconsumption, privateand
public,presentandfuture.
•ButGDPcan beconsideredacomponentof
welfare.
•Thesecondcriticism isthatGDPignores
distribution.Inarich countryliketheUS,some
say,thetypicalpersonorfamilyhasseenlittleor
nobenefitfrom growthsince the1970s.At the
same time, inequality has risen sharply.
•Thethirdcriticism isthataboveacertainlevel,a
highermaterialstandard of living doesnotmake people
happier.This viewconcludesthatweshould
29

Importance of GDP:
(i) Study of economic growth: The GDP has not only
a theoretic importance
importance. Harris is of
but also practical
the opinion
study of national income canbe split up
that the
into two
parts, one for the Ion term analysis and the other
GDP increasesova years,term study. If
that we areheadingtowards
for short
it shows
and if itis stagnant or is falling, it
that the economy is declining.
prosperity
indicates
The GDP(ii)
throws
Unequal distribution of wealth:
light on the earnings of various
of production and the total
the
output
If the outputisless and
distribution of wealth, the economist
of the
there is
can
factors
country.
unequal
suggestmeasures to increase output and to bridge
the income gap between the rich and the poor.
(iii) Problems of inflation and deflation : The GDP
statistics can a lot in
solving the problems of inflation in the country.
he
G
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o
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nomists
30

(iv) The share of government in economic progress: In a centrally controlled economy, all the
factors of production are awarded and are fully controlled by the state. In a mixed economy, the
state as well as the people in cooperation with each other can take part in the economic
advancement of the country, GDP shows the role which state is playing for the economic progress
of the people.
(v)Comparison with developed countries of the world: The GDP figures help us to
know the economic position of the people of the various countries. If the standard of
living of the people in one country is low, they can take measures to increase the
standard of living of the people.
(vi)Estimate of the purchasing power: The importance of the GDP can also be
judged from the fact that it throws light in the purchasing power of the people, their
power to save and the ability lo pay taxes to the government.
(vii)Guide to economic planning: The GDP figure is very helpful for the government
to frame short and long term economic policies according to the prevailing conditions
in the country.
(viii)Economy's structure: The GDP indicates the share of various sectors to the
economy. If in a particular sector, the share is less and it is desired to be raised, then
steps can be taken to increase it. GDP thus gives us a clear idea about the structure of
the economy.
(ix)Public Sector: GDP studies help us to know the relative roles of public and
private sector in the economy.
31

Difficulties and Problems in Measurement of National
Income
•Non monetized transactions: Exchange of goods and services
which have no monetary payments, like services rendered out of love,
courtesy or kindness are difficult to include in the computation of national
income.
•Unorganized sector: Contribution of unorganized sector are unrecorded. It
is very difficult to identify income of those who do not pay income tax.
•Multiple sources of earnings: Part time activity goes unrecognized and
such income is not included in national income.
•Categorization of goods and services: In many cases categorization of
goods and services as intermediate and final product is not very clear.
•Inadequate data: Lack of adequate and reliable data is a major hurdle to
the measurement of national income of underdeveloped countries.
32

Problems in National Income
Computation
•Unreported activities (underground
economy)
•Non market activities
•Economic bads-environmentnal damages
•Double counting
•Transfers
•Non-availability of data
•Non-monetized sector
•Mixed incomes: arises due to lack of
specialization
•Capital gains 33

Problems in National Income
Computation
•Unreported activities (underground economy): NI
does not record activities such as gambling,
prostitution, black marketing, drug dealing etc.
Because of this, NI underestimates the value of
output.
•Non market activities: Activities that take place within
household but do not come in the market are not
included in GDP. A house-wife’s contribution in cleaning,
washing, cooking etc. But if the home maid is hired for
this, his/her wages is included in GDP. In economies
where there are more activities of non-marketable
nature, accurate measurement of national income is
difficult.
34

Problems in National Income
Computation
•Economic bads-environmentnal damages: Ni
counts goods produced but ignores the bads.
No nation is making an account related to the
depletion of natural resources in terms of
mining minerals (oil, gas etc.), soil erosion, and
pollution of water and air. NI neither measures
the possible degradation of human capital as a
result of environmental pollution (ill health) nor
provides any account of resource depletion.
35

Problems in National Income
Computation
•Transfers: May lead to miscalculation of NI. For
example, social security payments like pension,
unemployment allowances, prize, gifts, charity
payments, awards, scholarships do not reflect the flow
of goods and services. In other words, these are not in
exchange of goods and services. But if these are not
considered properly, there will be overestimation of
NI. For example, if a retired person gets pension for
his past service and salary for the present job, a clear
distinction between his transfer income and income
that he earned in exchange of his services.
36

Problems in National Income
Computation
•Non-availability of data: Lack of data on various
economic activities has made the NIA a difficult
task in developing countries.
•Non-monetized sector: Imputation is done for owner
occupied housing, wages paid in kinds, services
provided free of cost and government services.
Exclusion of these activities understates the actual
economic activities. To include these, some type of
imputations are needed, which may lead to subjective
valuation.
•Mixed incomes: arises due to lack of specialization
37

Problems in National Income
Computation
•Capital gains: Sometimes there are capital
gains just because of the price rise. For
example, increase in the value of land and
building because of the inflation. Gains arising
from inflationary reasons should not be
included in NI since these are not against
productive services. However, any gain due to
improvements such as planting,
digging the well, leveling represent current
flow of goods and services and should be
included in NI.
38

Problems in National Income
Computation
•Double counting: Basic thrust in NIA to
follow value added approach is to avoid
double counting. But again it is difficult
to draw a clear line between final goods
and intermediate goods. The same
goods can be counted as intermediate
goods and final goods. Rice produced by
farmer is final good if consumed and is
intermediate if sold to the miller.
39

Methods of Measuring national
income
•Three alternative ways,
•Census method / production method/Value
Added Method
•Income method
•Expenditure method
40

Product Method
•Known as value added method
–Value added is the difference between
the value of goods as they leave a stage
of production and the cost of the goods
as they entered that stage.
–Value added is the increase in value
that a firm contributes to a product or
service.
–It is calculated by subtracting
intermediate goods from the value of
its sales.
–We use the value added method to avoid
the double counting.
41

Value added method
•STEPS
1.Classification of Productive Enterprises
▪(a) Primary Sector: It produces goods by exploiting
natural resources like land, water, forests, rivers, etc. It
includes all agricultural and allied activities like
fishing, forestry, mining and quarrying.
▪(b) Secondary Sector: It is also known as
manufacturing sector. It transforms one type of
commodity into another using men, machines and
materials. For example, manufacturing of fabric
from cotton and sugar from sugarcane.
▪(c) Tertiary Sector: It is also known as services sector
which provides services like banking, insurance,
transport, communication, trade and commerce, etc,
to primary and secondary sectors.
42

2. Calculation of Value Added
▪Value of Output ( - ) Value of
Intermediate Consumption
3.Calculation of Domestic Income
▪NDPFC
4.Calculation of National Income
▪NFIA
43

Stage of Production
Value of
intermediate
good
Value of SalesValue-added
Farmer - Palay 12,000 12,000
Rice Miller -Milled Rice 12,000 15,000 3,000
Retailers - Rice 15,000 20,000 5,000
GDP= Total Value
Added
20,000
Value Addition
44

•In product method we calculate the aggregate annual
value of goods and services produced in a year. It is also
known as the Value Added method. In this method GDP is
the sum of Gross Value Added by the entire production
units in the economy. The term that is used to denote the
net contribution made by a firm is called its value added.
•Simply it is the difference between value of output and
input/ raw material/ intermediate product at each stage of
production is called value added.
•the value added (value addition) of a firm = value of
production of the firm (-) value of intermediate goods
used by the firm.
45

•Gross Value Added = (gross)Value of Output –
(gross)Value of intermediate goods
•value of output =[ sales + change in stock] –intermediate
consumption
•If we include depreciation in value added, then the measure of
value added that we obtain Gross Value Added. If we deduct
the value of depreciation from Gross Value Added, we obtain
Net Value Added.
•Net Value Added (NVA or NDPFC ) = Value of output –
Intermediate consumption – Consumption of fixed capital –
Net indirect taxes
•Net Value Added at Market Price = Net Domestic
Product at Market Price = Gross Value Added at
Market Price – Depreciation
•Net Value Added at Factor Cost = Net Domestic
Product at Factor Cost = Net Domestic Product at
Market Price – Net Indirect Tax
46

Procedure
–Under this method, the economy is
divided into different industrial sectors
such as agriculture, fishing, mining,
construction, manufacturing, trade and
commerce, transport, communication
and other services (primary, secondary,
tertiary sectors)
–Then, the net value added at factor cost
(NVAFC) by each productive enterprise as
well as by each industry or sector is
estimated.
47

–in order to arrive at the net value
added at factor cost by an enterprise
we have to subtract the following
from the value of output of an
enterprise
•Intermediate consumption which is the value
of goods such as raw materials, fuels
purchased from other firms
•Consumption of fixed capital (depreciation)
•Net indirect taxes.
48

•Summing up the net values added at
factor cost (NVAFC) by all productive
enterprises of an industry or sector gives
us the net value added at factor cost of
each industry or sector.
•We then add up net values added at
factor cost by all industries or sectors
to get net domestic product at factor
cost (NDPFC).
•Lastly, to the net domestic product we add
the net factor income from abroad to get
net national product at factor cost (NNPFC)
which is also called national income.
49

NNP
FC (N.I) = GDP
MP (-) consumption of fixed capital
(Depreciation) (+) Net Factor Income from Abroad (-) Net
indirect Tax.
➢GVAMP = VOO(Value of output) in primary sector + VOO in
secondary sector + VOO in tertiary sector – cost of
intermediate consumption
➢NVAFC(NDPFC) = GVAMP – CFC(Depreciation) – NIT(Net
Indirect
Tax)
➢National income(NNPFC) = NDPFC + NFIA
50

Items included and excluded in National
Income Estimation by Value Added Method
Items Included Items Excluded
1. Service of free government
dispensary (it is a productive
service).
1. Receipt from sale of land (only
ownership has changed, no
addition
to national product has been
made).
2. Production done for
self- consumption.
2. Intermediate goods (as they
cause double counting).
3. Final goods produced
in an accounting year.
3. Sale of second hand goods (it
also leads to double counting).
4. Rent paid by the tenant (it is a
factor income).
4. Purchase of rented house by the
tenants (only ownership changes
like
those of financial transactions).
51

Precautions to be taken in Product Method
✓Imputed rent values of self-occupied houses should be included
in the value of output. Though these payments are not made to
others, their values can be easily estimated from prevailing
values in the market.
✓Sale and purchase of second-hand goods should not be included
in measuring value of output of a year because their values were
counted in the year of output of the year of their production. Of
course, commission or brokerage earned in their sale and
purchase has to be included because this is a new service
rendered in the current year.
52

✓Value of production for self-consumption are be counted while
measuring national income. In this method, the production for
self-consumption should be valued at the prevailing market
prices.
✓Value of services of housewives are not included because it is
not easy to find out correctly the value of their services.
✓Value of intermediate goods must not be counted while
measuring value added because this will amount to double
counting.
53

Suppose the GDP at market price of a country in a particular year was
Rs 1,100 crores. Net Factor Income from Abroad was Rs 100 crores.
The value of Indirect taxes – Subsidies was Rs 150 crores and National
Income was Rs 850 crores.
Calculate the aggregate value of depreciation.
Answer
As per question, GDPMP=1100 crores, NFIA =100 crores, NIT
=150 crores, NNPFC = 850 crores
∴ GDPFC= GDPMP- NIT
= 1100 – 150 = 950 crores.
GNPFC= GDPFC+ NFIA
= 950 + 100 = 1050 crores.
NNPFC = GNPFC + Depreciation
1050 = 850+ Depreciation
Depreciation = 1050 – 850 = 200 crores.
54

Calculate net value added at market price of a firm: -
FORMULA: -
Value of Output = Sale + change in stock
700 + 40=740
NVAat mp = Value of output - purchase of intermediate product - depreciation
740 - 400 - 80 = 260 thousands
Ans. 260/- thousand
55

Calculate net value added at market price of a firm
Value of output : - Sale + Change in stock ( 300+(-)10 = 290/-)
Gross Value added at mp = Value of output - Purchase of intermediate
product.
290 - 150 = 140/-
Net Value added at mp = Gross Value added at mp - . Depreciation
140 - 20 = 120
thousands ans.: - Rs. 120
thousands.
56

Georgi Mathew
Varughese 57

Georgi Mathew
Varughese
GVAFC ????
58

Georgi Mathew
Varughese
FIND NVAMP
59

Georgi Mathew
Varughese
FIND NVAFC
60

Georgi Mathew
Varughese
Calculate intermediate consumption
61

Calculate net value added at factor cost from the following data.
Items Rs. In crores
Purchase of materials30
Depreciation 12
Sales 200
Excise tax 20
Opening stock 15
Intermediate consumption48
Closing stock 10
62

GVAMP = Value of output – Intermediate
Consumption
=Sales + change in stock – Intermediate
Consumption
= 200+ (10 -15) – 48
= 200 - 5 - 48
= 200 - 53
= Rs.147 Crores
NVAMP = GVAMP –Depreciation
= Rs. 147 – 12
= Rs. 135 crores
NVAFC= NVAMP – Indirect tax
= 135 – 20
= Rs. 115 Crores
63

Georgi Mathew
Varughese
Income Method
By this method the total sum of the Factor payments
received during a given period is estimated to obtain
National Income. Depending on the way the income is
earned, it can be classified into following components;
➢Compensation to Employees
➢Operating Surplus ( rent, profit and interest)
➢Mixed Income of Self-employed
64

•The income approach:A method of computing GDP
that measures the income wages, rents, interest, and
profits received by all factors of production in producing
final goods.
•The income method measures national income from the
side of payments made to the primary factors of
production in the form of rent, wages ,interest and profit
for their productive services in an accounting year.
•Components of domestic income
–Compensation of employees (This is the reward or
compensation paid to employees for rendering productive
services. It includes wages and salaries, Employer’s
contribution to social security schemes, dearness
allowance, bonus, city allowance, house rent
allowance, leave travelling allowance etc.)
–Operating surplus:- It includes rent, profit and interest. Profit
includes corporate tax, dividend and undistributed profit.
–Mixed income of self employed:- Income of own account
workers like farmers, doctors, barbers etc, and
unincorporated enterprises like small shopkeepers, repair
shops retail traders etc, is known as mixed income.
65

Income
➢Personal Income
•NNP FC –
UNDISTRIBUTED
PROFITS – NET
INTEREST MADE BY
HPUSEHOLDS
– CORPORATATION
TAX + TRANSFER
PAYMENTS
•Personal income is
the income received
by households after
paying social
insurance taxes but
before paying
personal income
taxes.
➢Personal
Disposable
Income
•PI - Personal Taxes
•Disposable personal
income is what
people have readily
available to spend.
66

Georgi Mathew
Varughese 67

Items In cr.
Compensation of employees 800
Mixed income of self employed 900
Net factor income from abroad -50
Rent 350
Profit 600
Consumption of fixed capital 200
Net indirect taxes 250
Interest 450
Operating Surplus 1400
From the following data, calculate national income
68

GDPMP = Compensation of employees + mixed income
of self employed + operating surplus +
depreciation + net indirect taxes
=200+250+800+ 1400 (350+600+450)+900
=3550
GNPMP = GDPMP + NFIA
= 3550 +(-50)
= 3500
NNPMP= GNPMP – Dep.
= 3500- 200
= 3300NNPF
C
= NNPMP- NIT
=3300- 250
=Rs. 3050
crores
69

Georgi Mathew
Varughese
Calculate NNPFC and Private Income
70

Georgi Mathew
Varughese
From the following data, calculate national income
71

Georgi Mathew
Varughese
Calculate
national
income
72

Georgi Mathew
Varughese
Find personal
disposable income
73

Expenditure Method
In this method the total sum of expenditure on the purchase of
final goods and services produced during an accounting year
within an economy is estimated to obtain the value of
domestic income.
Final Expenditure is the expenditure on the purchase of final
goods and services during an accounting year. It is broadly
classified into 4 categories;
➢Private final consumption expenditure
➢Government final consumption expenditure
➢Investment expenditure or gross domestic capital formation
➢Net exports (exports – imports)
74

Georgi Mathew
Varughese
The expenditure approach: A method of computing
GDP that measures the amount spent on all final goods
during a given period.
Expenditure categories:
Personal consumption expenditures (C)—household
spending on consumer goods.
Gross private domestic investment (I)—spending by
firms and households on new capital: plant, equipment,
inventory, and new residential structures.
Government consumption and gross investment (G)
Net exports (EX – IM)—net spending by the rest of the
world, or exports (EX) minus imports (IM)
The expenditure approach calculates GDP by adding
together these four components of spending. In
equation form:
GDP = C + I + G + ( X − M)
75

76

77

Items Rs. In crores
Compensation of employees 1,200
Net factor income from - 20
Net indirect taxes 120
Profit 800
Private final consumption expenditure 2,000
Net domestic capital formation 770
Consumption of fixed capital 130
Rent 400
Interest 620
Mixed income of self employed 700
Net export -30
Govt. final consumption expenditure 1100
Operating surplus 1820
Employer’s contribution to s
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e
m
se
e
300
78

GDPMP = Depreciation + private final consumption
expenditure + net domestic capital formation + net exports +
Govt. final consumption expenditure.
= 130 + 2,000 + 770 + (- 30) + 1,100
= 3,970 crore
GNPM
P
NNPM
P
= GDPMP + NFIA
=3,970 + (-20)
=3,950 crore
= GNPMP –
Depreciation
= 3,950 – 130
= 3,820 croreNNPFC = NNPMP –
NIT
= 3,820 – 120
= Rs.3,700
crore
79

Calculate NNPMP
80

Georgi Mathew
Varughese
Calculate Net Domestic Product at FC and Net National Disposable Income
81

Georgi Mathew
Varughese
Find NNPFC
82

Difficulties in Measuring National Income in India
•Non-monetized Sector
•Lack of distinct differentiation in economic
activities
•Conceptual problems
•Black money
•Inter-regional differences
•Non-availability of data about certain incomes
•Mass Illiteracy
•Difficulty in obtaining data about income
•Difficulties of sampling technique
•Misc. difficulties
83

Green GDP
•National income or output adjusted
for the depletion of natural
resources and degradation of
environment.
•Eg. National Income is 100000 and
the cost of pollution is 30000 then
the Green GDP is 100000 –
30000 = 70000
84

National Disposable Income (NDI)
•National disposable income = National income +
Net indirect taxes + Net current transfers from rest
of the world
•Net Disposable Income Is the Income which is at
the disposal of the nation as a whole for spending
or disposal.
•National disposable income is the maximum
available income (earned and transfer incomes)
from all sources that a nation can spend on
consumption and saving without disposing off its
assets to finance its expenditure.
85

•National Disposable Income = NNPMP + other current
transfers from the rest of the world, where current
transfers from the rest of the world include items such as
gifts, aids etc.
•Net Disposable Income (NDI) can be net and gross.
Gross NDI includes depreciation whereas Net NDI is
exclusive of depreciation. Net National Disposable
Income is the sum of NNP at MP and net current
transfers from rest of the world.
•As against it Gross National Disposable Income is the
sum of Gross National Product at MP (GNP at MP)
and net current transfers from rest of the world. The
difference between the two is consumption of fixed
capital at national level (i.e., national depreciation).
Symbolically:
•Gross NDI = GNP at MP + Net current transfers from rest
of the world
•Net NDI = NNP at MP + Net current transfers from rest of
the
world = Gross NDI – Depreciation
86

Private Income
•Factor income from net domestic
product accruing to the private
sector + national debt interest + net
factor income from abroad +
current transfers from government
+ other net transfers from the rest
of the world
87

Georgi Mathew
Varughese
Questions
1.Calculation of national income , explain 3
methods
2.GDP and welfare how these are related
3.Explain circular flow of income
Write any 2 of this (3 marks
each)
88

4. Calculate Nominal, Real GDP and GDP deflator from the table. (3 mark)
Year Price of
rice
Qty of
rice
Price of wheatQty of wheat
20101 100 2 50
20112 150 3 100
20123 200 4 150
* Use 2010 as base year
Nominal GDP
2010 – (1*100) + (2*50) = 200
2011 – (2*150) + (3*100) = 600
2012 – (3*200) + (4*150) = 1200
Real GDP
2010 – (1*100) + (2*50) = 200
2011 – (1*150) + (2*100) = 350
2012 – (1*200) + (2*150) = 500
GDP deflator
2010 – (200/ 200) * 100 = 100
2011 – (600/ 350) * 100 = 171
2012 – (1200
Ge
/
or
5
g
0
i
M
0)
at
*
he
1
w
00
Va
=
ru
2
gh
4
e
0
se
89

5. Calculate personal income (2 mark)
Personal Income = Personal Disposable Income + Personal
Taxes + Miscellaneous Receipts of Government
Administrative Departments
= 200 + 30 + 50 = Rs. 28
G
0
eo
c
rg
r
i
o
M
r
a
e
thew Varughese
90

Georgi Mathew
Varughese
6. From the following data, calculate Personal Income
and
Personal Disposable Income. (Values are in crore) (4
mark)
(a)Net Domestic Product at factor cost 8,000
(b)Net Factor Income from abroad 200
(c)Undisbursed Profit 1,000
(d)Corporate Tax 500
(e)Interest Received by Households 1,500
(f)Interest Paid by Households 1,200
(g)Transfer Income 300
(h)Personal Tax 500
NNPFC = NDPFC + NFIA = 8000 + 200 = 8200
PI = NNPFC – undistributed profits – corporate tax – net
interest paid by households + transfer payments
= 8200 – 1000 – 500 – (-300) + 300 = 7300
91

Georgi Mathew
Varughese
7. Calculate Gross National Disposable Income and
personal income from the following data (5 mark)
92

Georgi Mathew
Varughese 93

Georgi Mathew
Varughese
8. Net National Product at Factor Cost and Gross National
Disposable Income from the following data (6 mark)
94

Georgi Mathew
Varughese
•Income Accruing to Private Sector = Personal Disposable
Income + Personal Tax + Retained Earnings of Private
Corporate Sector + Corporation Tax – National Debt
Interest – Current Transfer Payments by Government –
Net Current Transfers from Rest of the World + Net Factor
Income to Abroad
= 1000 + 90 +10 + 30 – 20-40-(-10)+(-10) = Rs.
1070 crore
•NDPFC = Income Accruing to Private Sector+ Saving of
Non- departmental Enterprises + Income from Property
and Entrepreneurship Accruing to the Government
Administrative Departments
= 1070 + 50 + 70 = Rs. 1190 crore
•NNPFC = NDPFC - NFIA = 1190 - (-10) = 1200 cr
•Gross National Disposable Income = NNPFC + NIT + net
current
transfers from the rest of the world + Depreciation
= 1200 + 80 + (10) + 60 = 1330ct
95

Calculate NNP at market price and Private Income from the data
GDP = C + I + G + X – M = 100 + 30 + 20 + (-10) = 140
GNP = GDP + NFIA = 140 + (-5) = 135
NNPMP = GNPMP – Depreciation = GNPMP - DFI = 135 – 25 = 110
(domestic factor income = gross NDI – net NDI = 170 – 145 =
25)
Private income = PDI + Personal Tax + corporation tax + savings of private
corporate sector= 70+20+15+5 =
110
Georgi Mathew
Varughese 96

Chapter- Rent
97

RICARDIAN
THEORY OF RENT
98

DEFINITION
Classical Definition
Carver: Rent is the price paid for the use of land.
David Ricardo: Rent is that portion of the produce of the
earth which is paid to the land lord for the use of original
and indestructible powers of the soil.
Anatol Murad: Rent is that portion of the landlords income
which is attributable to his ownership of land
99

DEFINITION
Modern Definition
Boulding: Economic rent may be defined as payment
made to a factor of production in excess of the minimum
amount necessary to keep the factor in its present
occupation.
In modern economic usage, rent is represented as the
difference between the total return to a factor of production
(land, labour, or capital) and its supply price—that is, the
minimum amount necessary to attain its services.
100

TYPES OF RENT
1. ECONOMIC RENT : Economic rent may be defined as
payment made to a factor of production in excess of the
minimum amount necessary to keep the factor in its present
occupation.
2. GROSS RENT: It is the rent which is paid for the services of
land and capital invested on it. It includes the following: (a)
Payment for the use of land (b) Interest on capital invested
on it (c) Wages for the services of land lord for supervising
the investment in land.
3. CONTRACTUAL RENT: It is the payment made to the land
lord by tenants on the basis of some contract which may be
verbal or written. It may be more or less than the economic
rent.
101

TYPES OF RENT
4. SCRACITY RENT: It applies to all the factors of production
whose supply is less elastic. Scarcity rent arises due to the
scarcity of factors of production.
5. DIFFERENTIAL OR SITUATION RENT: It refers to the rent
arises due to the difference in the fertility of land. This type
of rent arises under extensive cultivation. The surplus
enjoyed by more fertile land over and above the less fertile
land is known as differential rent.
6. QUASI RENT: According to Marshall quasi rent is the surplus
earned by man made factors of production whose supply is
inelastic or fixed in the short run but elastic in the long run.
102

Various economists have proposed different
theories for the origin of rent. Prominent among the
theories of rent are:
(a)Ricardian Theory of Rent
(b)Modern Theory of Rent
103

❑The Ricardian theory of rent follows from the views of
classical writers about the operation of law of diminishing
returns in agriculture. Classical authors, West, Torrents,
Malthus and Ricardo, each of them independently
formulated the theory of differential rent.
❑The classical theory of rent in the form presented and
elaborated by David Ricardo has become more popular,
though the ideas of all of them concerning the land rent
are fundamentally same.
104

➢David Ricardo, a British economist, defined rent as, the
portion of the produce of the earth which is paid to
the landlord for the use of the original and
indestructible powers of the soil.
➢Ricardian rent is also known as pure rent.
➢The true economic rent is only a payment for the use of
land. It excludes interest on landlord’s investment.
105

➢The supply of land is fixed and the existing
quantity of land gifted by nature cannot be
increased or decreased.
➢Another assumption is that original powers such as fertility
of land are gifted by God and are not due to human efforts
of any type.
➢Land is a non-perishable factor of production. The
powers/qualities of land cannot be destroyed and the
fertility of land never diminishes.
➢Land has only one use i.e. Cultivation. There are no
alternative uses of land.
106

➢Different lands have different fertility levels.
➢Utilization of land for cultivation is done based on the
order of fertility of land. Most fertile land is cultivated first
before using the next grade land.
➢Law of diminishing returns or increasing costs
operates in agriculture.
➢Assumption of perfect competition is also made.
➢Ricardo assumed the existence of margin land which is a
'no rent land'. It could be understood as the grade of land
after which no land is used.
107

➢The quantity of land is limited, and so is
its productiveness, and it is not uniform in quality.
➢If the superior land will not support the population,
recourse must be made to inferior lands and the
produce is, thus, raised at different costs.
➢The differential advantage of the superior land
over the inferior gives rise to Economic Rent.
➢The amount of rent is determined by the degree of the
differences in productivities of land.
108

According to Ricardo, rent can be determined under two
situations:
a)Extensive Cultivation: It refers to the system of
cultivation wherein more land is used to increase
production.
b)Intensive Cultivation: It refers to the system of
cultivation where large amounts of labour and
capital are used in same piece of land for
increasing production
109

According to Ricardo:
❑All the units of land are not of the same grade. They
differ in fertility and location.
❑The application of the same amount of labor, capital
and other cooperating resources give rise to difference
in productivity.
❑This difference in productivity or the surplus which
arises on the superior units of land over the inferior
units is an economic rent".
110

➢Let us assume that there are four types of land,
classified based on its fertility, viz., A, B, C and D in
descending order of their fertility.
➢A grade of land will be cultivated first. With particular
amount of labour and capital, let us assume that it yield
60 quintal of corn per acre
➢Now when A grade of land exhausted then B grade of land
will be cultivated. Now With same amount of labour and
capital, let us assume that it yield 50 quintal of corn per
acre.
➢Now as user of A grade land enjoy surplus of 60-50 =
10 quintals of corn. Hence they must pay rent equal
to 10 quintals per hectare on this land. 111

Grades of Land Yield per Acre RENT
A 60 60 - 20 = 40
B 50 50 – 20 = 30
C 35 35 – 20 =15
D 20 20 – 20 = 00
➢Same way when B grade of land is exhausted then C
grade of land will be cultivated and now it will be
marginal land and differential rent would occur to A
grade and B grade land.
➢This can be seen from table given below:
112

Grades of
Land
Yield per
Acre
RENT
A 60 60-20=40
B 50 50-20=30
C 35 35-20=15
D 20 20-20=00
A
Grade of Land
Yield in Quintals Per Hectare
30
20
10
40
50
60
B C D
Rent on A Grade Land =60-20= 40
Rent on B Grade Land =50-20= 30
113

Grades
of Land
Yield in
Quintals
per Acre
RENT
A 60 60-20=40
B 50 50-20=30
C
D
35 35-20=15
20 20-20=00
A
Grade of Land
Yield in Quintals Per Hectare
20
10
30
40
50
60
B C D
114

O
P
D
S
E
Output
MC
AC
F
O
D Grade
A Grade
O
MC
AC
F
P
Q
R
S
MC
AC
G
O
B Grade
115

➢The surplus or economic rent also arises to the land
cultivated intensively. This occurs due to the operation of
the famous law of diminishing returns.
➢When the land is cultivated intensively, the application of
additional doses of labor and capital brings in less and less
of yield. The dose whose cost just equates the value of
marginal return is regarded marginal or no rent dose. The
rent arises on all the infra-marginal doses.
116

Combination of
Labour and Capital
Yield per Acre RENT
A 60 60-20=40
B 50 50-20=30
C 35 35-20=15
D 20 20-20=00
For example, the application of A unit of labor and capital to a
plot of land yields 60 quintals of wheat, the B dose gives 50
quintals of wheat and with C it drops down to 35 quintals and
for D 20 quintals only. The rent when measured from the D or
marginal dose is 40 quintal (60 - 20 = 40) on A dose and 30 on
B dose, 15 on C dose and the D dose is a no rent dose.
117

A
Grade of Land
Yield in Quintals Per Hectare
1020 30 405060
B
C
D
Rent o
A =60
n combination
-20= 40
118

❖No Original and Indestructible Power
❖Wrong Assumption of 'No Rent Land'
❖Rent Enters Into Price
❖Wrong Assumption of Perfect Competition
❖All Lands are Equally Fertile
❖Historically Wrong
❖Neglect of Scarcity Principle
❖Rent is not only for land
❖Difficulty in Measurement of Productivity only
due to Original Fertility
119

MODERN THEORY OF
RENT
120

DEFINITION
Boulding: Economic rent may be defined as
payment made to a factor of production in excess of
the minimum amount necessary to keep the factor
in its present occupation.
In modern economic usage, rent is represented as
the difference between the total return to a factor of
production (land, labour, or capital) and its supply
price—that is, the minimum amount necessary to
attain its services.
121

❖The modern economists like Pareto, Mrs. Joan
Robinson, Boulding, Stigler, Shepherd, opined
the Ricardian theory of rent is too closely
related to land.
❖Boulding and Joan Robinson emphasized that
whenever the supply of factor units to an
industry or economy is not perfectly elastic, a
part of the earnings of a factor will consist of
surplus or economic rent, since the full price
they get are not necessary to make all the
factor units available.
122

❑According to the modern theory of rent, the
rent of a factor, from the point of view of any
industry, is the difference between its actual
earnings and transfer earnings.
Rent = Present Earnings - Transfer Earnings.
❑Transfer earning refers to the amount of
money, which a factor of production could earn
in its next best-paid use (opportunity cost).
123

124

Whole
produce is
rent D`
D
Here Present Earnings =
ORxOS = ORES
Transfer Earnings = Zero
Rent = Present Earnings
- Transfer Earnings.
Thus Rent = ORES
E
S`
R
O S
Hectare of Land
Price
125

Now if demand increases from DD’ to D
0D
0
Then Rent increases
from ORES to OPFS
F
D
0
S`
E
D
0
D`
D
R
O S
P
126

Rent = Present Earnings
- Transfer Earnings.
Here:
Present Earnings = OSEM
Transfer Earning = OSEM
Rent = OSEM-OSEM
= ZERO
E
S`S
O M
Hectare of Land
Price
D`
D
127

Then Present Earnings
increases from OSEM to OSFN
Transfer Earning also
increases to OSFN
Rent = ZERO
D
0
F
D
0
Now if demand increases from DD’ to D
0D
0
N
E
S`S
O M
Hectare of Land
Price
D`
D
128

A
th unit of Factor has a supply price equal to AQ.
In other words, AQ must be paid to the A
th unit of
land in order to keep it in the wheat industry.
A
th unit of land
obtains price (AH
= OP) while its
transfer earnings
are only AQ.
Therefore, A
th unit
of land earns QH
as economic rent
(QH = AH-AQ)
F
R
B C D
I J K
S
T
E
L
U
S
S
O
Price
M
D
D
H
A
Q
129

FEATURES OF
MODERN THEORY OF RENT
❑Rent can be a part of the income of all
factors of production. Entire income of land
is called rent because its supply is perfectly
inelastic. But in this case of other factors,
only a part of their income is of the nature of
rent.
❑Rent can be a part of the income of all
factors of production. Entire income of land
is called rent because its supply is perfectly
inelastic. But in this case of other factors,
only a part of their income is of the nature of
rent .
130

FEATURES OF
MODERN THEORY OF RENT
❑Amount of rent depends upon the difference
between actual earning and transfer earning.
❑Rent arises when the supply of the factor is
either perfectly inelastic or less elastic . On the
other hand no rent arise when the supply of the
factor is perfectly elastic.
131

AMPLIFICATION OF RICARDIAN THEORY
According to the Ricardian theory, rent is that portion
of the produce of the earth which is paid to the
landlord for the use of the original and indestructible
powers of the soil. Rent therefore is peculiar to
land alone. It is not available to other factors of
production. But according to modern theory, rent is
also earned by other factors, such as labour, capital
entrepreneur etc, reason being that rent arises when
a factor becomes either specific or its supply
less than perfectly elastic.
MODERN THEORY IS A MODIFIED AND
AMPLIFIED FORM OF RICARDIAN THEORY
132

MODIFICATION OF RICARDIAN THEORY
Modern theory of Rent has made the following
modification:
❑Measurement of Rent: According to Ricardian Theory, rent
is the difference between the produce of marginal land and that of intra
marginal lands. This concept is based on the assumption that there does exist
a land that earns no rent, but in reality there does not exist any land.
Consequently, rent in Ricardian sense cannot be measured. According to
modern theory, rent is measured from the difference between actual earning
and transfer earning.
MODERN THEORY IS A MODIFIED AND
AMPLIFIED FORM OF RICARDIAN THEORY
133

❑Cause of Emergence of Rent : The logic given by
the modern theory regarding the cause of
emergence of rent is more realistic. According to
Ricardo, scarcity of land gives rise to rent. Because
of scarcity of land, people have either to use of
inferior land or put more and more units of labour
and capital on the same piece of land. There is
difference in amount of produce of inferior and
superior land. Due to difference, superior land
enjoys some surplus over inferior land.
MODIFICATION OF RICARDIAN THEORY
134

❑Rent and Price : Modern theory is a modified form
of Ricardian theory, in respect of relation between rent
and price. According to Ricardo, rent does not enter
into price. But according to modern economists it is
not wholly true. They hold that from the point of view
of an economy, rent does not enter into price.
MODIFICATION OF RICARDIAN THEORY
135

RENT AND PRICE
There are two views of economists in respect
of rent and price : (i) Ricardian view (ii)
Modern view
Ricardian View
Ricardo is of view that the rent does not enter
in price. It is price that influences rent and
not rent that influences price. Ricardo’s view
is based on the assumption that (i) supply of
land is limited for the society (ii) land has no
cost of production and (iii) land has only one
use.
Marginal land is no rent land. It does not yield any rent. However price of agricultural
produce is determined by the cost of production of the produce raised on marginal land.
136

Modern View
Modern view of rent is more comprehensive
and logical. According to this theory, it is
wrong on the part of Ricardo to assert that
rent never enters into price .
Modern economists view the relationship
between rent and price from three different
angles:
From point of view of Economy
From the point of view of industry
From the point of view of firm
RENT AND PRICE
137

Modern View
From point of view of Economy
From the point of view of the entire economy,
land is a free gift of nature. Total supply of land
is perfectly inelastic, so there is no need of
paying any minimum supply price for its use.
In other words, from the point of view of
economy transfer earning of land is zero.
Accordingly, entire earning of land is a surplus
or rent.
RENT AND PRICE
138

Rent and Price: Modern View
From the point of view of industry
Land can have alternative uses for an industry. In
order to make use of land, the industry will have to
pay a minimum price equivalent to its transfer
earning.
If more price than the transfer earning is required
to be paid for the land for a given industry, then the
amount by which the price is more than transfer
earning will be called its rent.
Thus from the point of view of industry, transfer earning
of the land is included in the cost and so influences the
price; but the income, over and above the transfer
earning, called rent, is not included in cost and
accordingly does not influences the price.
139

From the point of view of firm/individual
producer
Price that an individual producer pays for
the land, is very much a part and parcel of
his expense and so is included in the
average cost of production of the
commodity. As such from the point of view
of an individual producer, rent influences
price, that is, rent enters price of the
product
Rent and Price: Modern View
140

RELATION BETWEEN RENT AND PRICE
AREA RELATION
From the point of
view of an
economy
Entire income of land will be
called rent, but rent will not
enter price
From the point
of view of an
industry
(a)Minimum price or transfer
earning of land will enter in
price
(b)Earning of land which is
above the transfer earning is
called rent and does not enter
in price
From the point
of view of a
Firm
Rent enters price ; i.e.,
influences the price
141

❑According to Ricardian, rent is peculiar to land
only. But the modern economists hold that
rent can be a part of the income of each factor
of production .
DIFFERENCE BETWEEN RICARDIAN
AND MODERN THEORY OF RENT
❑ According to Ricardian Theory, rent is the
reward for the original and indestructible
powers of the soil. Modern theory of rent
attributes it to the difference between actual
earning and transfer earning.
142

❑According to Ricardo, rent does not enter
into price. Rent is not price determining, it
is price determined. But according to
modern theory of rent, relation between rent
and price is not so simple, from the point of
view of an economy , rent does not enter in
price , but from the point of view of a firm it
does not enter into price
DIFFERENCE BETWEEN RICARDIAN
AND MODERN THEORY OF RENT
143

PROFIT
Profit is a financial benefit that is realized when the amount of revenue
gained from a business activity exceeds the expenses, costs, and taxes
needed to sustain the activity.
Profit simply means a positive gain generated from business operations or
investment after subtracting all expenses or costs.
Profit differs from the return in three respects namely:
¥ Profit is a residual income, while return is total revenue.
¥ Profits may be negative, where as returns, such as wages and interest
are always positive.
¥ Profits have greater fluctuations than returns.
According to modern economists, profits are the rewards of purely
entrepreneurial functions. According to Thomas S.E., “pure profit is a
payment made exclusively for bearing risk. The essential function of the
entrepreneur is considered to be something which only he can perform.
This something cannot be the task of management, for managers can be
hires, nor can it be any other function which the entrepreneur can delegate.
Hence, it is contended that the entrepreneur receives a profit as a reward
for assuming final responsibility that cannot be shifted on the shoulders of
anyone else.”
144

1. Accounting Profit:
Refers to the total earnings of an organization. It is a return that is calculated as a difference between revenue and costs,
including both manufacturing and overhead expenses. The costs are generally explicit costs, which refer to cash payments
made by the organization to outsiders for its goods and services. In other words, explicit costs can be defined as payments
incurred by an organization in return for labor, material, plant, advertisements, and machinery.
The accounting profit is calculated as:
Accounting profit= TR-(W+R+I+M) = TR-Explicit Costs
TR = TOTAL REVENUE
W = WAGES AND SALARIES
R = RENT
I = INTEREST
M = COST OF MATERIALS
While calculating the profits, only the explicit costs or book costs, i.e. the cost recorded in books of account is considered.
The accounting profit is used for determining the taxable income of an organization and assessing its financial stability. Let
us take an example:
Suppose that the total revenue earned by an organization is Rs. 2, 50,000. Its explicit costs are equal to Rs. 10,000. The
accounting profit equals = Rs. 2, 50,000– 10,000 = Rs. 2, 40,000. It is to be noted that the accounting profit is also called
“gross profit”. When depreciation and government taxes are deducted from the gross profit, we get the net profit.
Types of profit:
145

2. Economic Profit:
The economic profit differs from the accounting profit in the sense; it takes into
account the implicit or imputed cost while calculating the profit of a firm. The implicit
cost is called an “opportunity cost”. The opportunity cost is the income forgone that
could be made from the use of the second best alternative. Such as, is if entrepreneur
uses his capital in his own business, he foregoes the dividend which would have been
earned by purchasing the shares of another company. The examples of implicit cost are
rents on own land, salary of proprietor, and interest on entrepreneurs own investment.
The economic profit is also called as a pure profit. The pure profit makes the
provisions for depreciation, insurable risks, and necessary minimum payments to the
share holder so that they do not withdraw from the capital .Thus, pure profit is the
residual lest after all the contractual costs Viz. Transfer cost of management,
depreciation, insurable risks, payments to shareholders, have been met.
The economic profit is calculated as:
Economic profit = Total revenue-(Explicit costs+ implicit costs)
Pure profit = Accounting profit – (opportunity cost+ unauthorized payments, e.g.
bribes)
Economic profit is not always positive; it can also be negative, which is called
“economic loss”. Economic profit indicates that resources of a business are efficiently
utilized, whereas economic loss indicates business resources can be better employed
elsewhere.
146

1) The Dynamic Theory:
Prof. J.B. Clark propounded the dynamic theory of profit in the year 1900. To him profit is the difference
between the price and the cost of production of the commodity. Profit is the result of progressive change in
an organized society. The progressive change is possible only in a dynamic state. According to Clark the
whole economic society is divided into organized and unorganized society. The organized society is further
divided into static and dynamic state. But profit is the result of dynamic change. In a dynamic state, “five
generic changes are going on, everyone of which reacts on the structure of society.” they are:
1. Population is increasing.
2. Capital is increasing.
3. Methods of production are improving.
4. The forms of industrial establishment are changing, the less efficient shops, etc. Are passing from the
field, and the most efficient are surviving.
5. The wants of consumers are multiplying.
In a static state, the competition tends to eliminate these five kinds of changes so that each factor receives
what it produces. Thus profit is the result exclusively of these above mentioned five dynamic changes.
According to the Clark, “ two general results must follow: first, values, wages and Interest will defer from
the static standards ; secondly, the static standards themselves will always be changing.” The typical change
is an invention. An invention enables the entrepreneur to produce more and reduce costs. A divergence
between the selling price and the costs of production leads to the emergence of profit. But such profit is
temporary, because competition leads to the adoption of this invention by the other entrepreneurs in the
industry. Production increases and prices fall. On the other hand, competition for the services of factors tends
to raise their wage and interest rate. Thus, according to Clark, the profit is an elusive amount which can be
grasped, but cannot be held by an entrepreneur as it slips through the fingers and bestows itself to all the
society members. Clark’s dynamic theory of profit should not be misinterpreted as, the profits in the dynamic
economy remain for a short period of time and then disappears forever. But, however, generic changes take
place frequently, and the manager or entrepreneur through his foresight must capitalize on it and continue to
make a profit in excess of the normal profit.
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Criticism:
Clark’s dynamic theory of profit has been severely criticized mainly by Prof.
Knight on the following counts.
● It is wrong to say that there is no profit in static state because every
entrepreneur is paid profit irrespective of the state of an economy.
● This theory does not fully appreciate the nature of the entrepreneurial
function. If there are no profits in a static state, it means there is no
entrepreneur. But without an entrepreneur it is not possible to imagine how
different factors of production would be employed.
● Mere change in an economy would not give rise to profits if those changes
are predictable. It is only the unpredictable, provision can be made for such
changes and the expenditure can be included in the cost of production.
● This theory assumes the existence of perfect competition and static state. But
they are far from reality.
● This theory states that profit arises because of dynamic changes. But Knight
says that it is only unforeseen changes that give rise to profit.
● This theory associates profit for imitating progressive changes in the
economy. But in reality profit is paid to entrepreneur for other important
functions like risk taking and uncertainty bearing.
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1) Schumpeter’s Innovation Theory of Profit:
Definition: The Innovation Theory of Profit was proposed by Joseph. A. Schumpeter, who believed that
an entrepreneur can earn economic profits by introducing successful innovations.
According to Schumpeter, innovation refers to any new policy that an entrepreneur undertakes to
reduce the overall cost of production or increase the demand for his products.
Thus, innovation can be classified into two categories;
● The first category includes all those activities which reduce the overall cost of production such
as the introduction of a new method or technique of production, the introduction of new
machinery, innovative methods of organizing the industry, etc.
● The second category of innovation includes all such activities which increase the demand for a
product. Such as the introduction of a new commodity or new quality goods, the emergence or
opening of a new market, finding new sources of raw material, a new variety or a design of the
product, etc.
An entrepreneur can earn larger profits for a longer duration if the law allows him to patent his
innovation. Such as a design of a product is patented to discourage others to imitate it. Over the time,
the supply of factors remaining the same, the factor prices tend to rise as a result of which the cost of
production also increases. On the other hand, with the firms adopting innovations the supply of goods
and services increases and their prices fall. Thus, on one hand the output per unit cost increases while
on the other hand the per unit revenue decreases.
There is a point of time when the difference between the costs and receipts gets disappears. Thus, the
profit in excess of the normal profit disappears. This innovation process continues and also the profits
continue to appear or disappear.
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Criticism:
1. Shareholders Earn profit: according to Schumpeter, risk taking is the function of the capitalist
and not the entrepreneur. But in his later book
“capitalism, socialism and democracy”, he points out that the rapid economic development of
the 19
th
century in capitalist economies was partly due to many innovations made by
entrepreneurs who happened to be risk takers. It is the shareholders of modern corporations who
undertake risks and thus earn profit.
2. Profit the reward for uncertainty: profit is not regarded as the reward of uncertainty which is not
a correct view because every innovation is associated with uncertainty. If the innovation takes
place without the element of uncertainty, the reward for innovation is not profit but simply
wages of management.
3. Incomplete explanation: innovation is not the only function of the entrepreneur for which he
earns profit. Profit accrues to the entrepreneur because of his organizational ability, when he is
able to reduce business costs. Thus Schumpeter’s theory is an incomplete explanation of the
emergence of profit.
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3) The Risk theory:
This theory is associated with American economist Hawley. According to him profit is the reward for
risk-taking in business. Risk-taking is supposed to be the most important function of an entrepreneur.
Every production that is undertaken in anticipation of demand involves risk.
For bearing such risk, profit is paid to entrepreneur. No entrepreneur will be willing to undertake risks
if he gets only the normal return. Therefore the reward for risk-taking must be higher than the actual
value of the risk. If the entrepreneur does not receive the reward, he will not be prepared to undertake
the risk. Thus higher the risk greater is the possibility of profit.
But all persons are incapable of undertaking risks, so risks act as a deterrent to the supply of
entrepreneurs. Those who remain in the business are able to earn an excess of payment above the
actuarial value of the risk and thus Earns profit.
Criticism:
● Meaning of risk unclear: Hawley does not clarify the meaning of the risk. According to knight,
risks are of two types, insurable and non-insurable. Risks proper refer to insurable risks. Such
risk taking cannot give rise to profit because the entrepreneur’s covers risk by the payment of
premium.
● Profit due to entrepreneurial ability: risk taking is not the only entrepreneurial function which
leads to the emergence of profit. Profit is also due to the organizational and coordinating ability
of the entrepreneurs.
● Profit the reward do avoiding risks: according to Carver, those entrepreneurs who are able to
avoid risks earn profit. Hence, profit arises not because risks are undertaken but because they are
avoided by able entrepreneurs.
● Incomplete theory: there is little empirical evidence to prove that entrepreneurs earn more in
risky enterprises. In a way, all enterprises are risky for an element of uncertainty is present in
them. And every entrepreneur aims at making large profit. Thus Hawley’s risk theory is also an
incomplete theory of profit. 151

3) The Uncertainty Bearing:
Frank's H. Knight treated profit as residual return to uncertainty bearing, not to risk bearing. Obviously,
knight made a distinction between risk and uncertainty. He decided risk into calculable and non-
calculable risk. Calculable risk is those whose probability of occurrence can be statistically estimated
on the basis of available data. For ex. Risk due to fire, theft, accident, etc. Are calculable and such risk
are insurable. There remains, however, an area of risk in which probability of risk occurrence cannot be
calculated. For instance, there may be a certain element of cost which may not be accurately calculable
and the strategies of the competitor may not be precisely assessable.
It is in the area of uncertainty that decision making become a crucial function of entrepreneur. If his
decision are proved right by the subsequent function of interpreter makes profit and vice versa. Profit
arises from the decision taking ang implemented under the condition of uncertainty.
Criticisms:
● This theory concentrates only on innovation, which is only one of the many functions of the
entrepreneur and not the only factor.
● This theory does not consider profit as the reward for risk-taking. According to Schumpeter it is
the capitalist not the entrepreneur who undertakes risk.
● This theory has ignored the importance of uncertainty bearing which is one of the factors that
determines profit.
● This theory attributes profit only to innovation ignoring other functions of
entrepreneur.Uncertainty bearing cannot be looked upon as a separate factor of production like
land, labour or capital. It is a psychological concept which forms part of the real cost of
production.
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5) Marginal Productivity:
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.
After reaching a certain point, the marginal cost exceeds marginal revenue, thus the marginal
productivity declines. On the other hand, if the marginal revenue is greater than marginal cost, the
organization opts for employing an additional unit of factor of production.
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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.”
Let us understand the concept of marginal physical productivity with the help of an 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).
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).
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Criticism:
● This theory is not a satisfactory theory of profit because it is very difficult to calculate the
marginal productivity of entrepreneurship.
● Like land, labour, or capital the marginal revenue productivity of entrepreneurship is a
meaningless concept in the case of a firm because unlike other factors, there can be only one
entrepreneur in a firm.
● This theory is based on the homogeneity of entrepreneur, in an industry. Entrepreneurs differ in
efficiency. It is therefore, not possible to have one marginal revenue productivity curve for all
entrepreneurs. This theory thus fails to determine profit accurately.
● This theory fails to explain why entrepreneurs sometimes earn windfall or chance gains and even
monopoly profits.
● It is one-sided theory which takes into account only the demand for entrepreneurs and neglects
supply of entrepreneurs.
● It is a static theory according to which all entrepreneurs earn only normal profits in the long-
run. In the real world entrepreneurs earn more than normal profit due to its dynamic nature.
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6) Shackle’s Theory:
Prof. G.L.S. Shackle has extended Knight’s theory of profit by introducing expectations under
conditions of uncertainty. According to Shackle, expectations are of two types: general and particular.
General expectations relate to variables general to the economy as a whole.
They are associated with future macro-variables such as the general price level, GNP. Balance of
payments, etc. On the other hand, particular expectations relate to variables particular to a firm or
industry. They are associated with such micro-variables as the future reaction of a particular
marketing strategy adopted by a firm, the future pricing policy of a competitive firm, etc.
The decisions of the business community are generally based on general expectations. If it regards
them favorable, investments are made. But there is ‘subjective certainty’ in the case of general
expectations. Their time horizon is about 12 months.
As the general expectations have subjective certainty and their time horizon is also of reasonable
duration, the business community is able to anticipate price and income increases correctly for the
economy as a whole, and by adopting appropriate inventory policies, it earns windfall profit.
But in the case of particular expectations, there is “subjective uncertainty” and the time horizon is also
quite long ranging between 100 to 150 months. Under particular expectations, a firm or an industry
may earn either innovative profit or monopoly profit depending upon its policies and competitors.
Under perfect competition, the number of buyers and sellers of a similar product is very large
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A firm which innovates in introducing new techniques of production or new products or new techniques of
management earns innovator’s profit. On the other hand, when there is monopolistic competition and the product is
differentiated, it is the marketing policy that leads to profit. As there is subjective uncertainty and the time horizon
is quite long, it is
the taking of correct decisions by a firm about marketing, advertising, etc. of its products in relation to the products
of its competitors that lead to monopoly profit. Thus profit whether monopoly or innovative arises under subjective
uncertainty depending upon correct decision-making by a firm.
Who takes such decisions in a firm and what is the basis? According to Shackle, decision-making under uncertainty
is done by the entrepreneur of a firm. The routine types of decisions which often require “weighing the evidence”
are made by the respective heads of departments in the firm.
So far as the basis of decision-making is concerned, Shackle adopts a psychological approach. According to him,
the entrepreneur formulates hypotheses about the future consequences of his decision. He imagines a neutral point
to the right of which he places those hypotheses that are pleasing and to the left of it, those that are displeasing.
All pleasing or displeasing consequences that are close to the neutral point appear “very plausible” and have a low
degree of “potential surprise”. But more pleasing and more displeasing hypotheses that are moving away from the
neutral point on both directions have a growing degree of potential surprise.
To take one hypothesis, it is a combination of its plausibility and its relative pleasantness and unpleasantness. When
the entrepreneur moves towards the right
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of the neutral point, the hypothesis grows in pleasantness faster than it grows in implausibility. But after a
point, the increasing pleasantness offsets the increasing implausibility of the hypothesis. Ultimately, there is
“peak” hypothesis on the pleasant side.
On the other hand, when the entrepreneur moves towards the left of the neutral point, the hypothesis grows
in pleasantness faster than it grows in plausibility. But after a certain point, the increasing unpleasantness
offsets the increasing plausibility of the hypothesis.
Ultimately, there will also be a peak hypothesis on the unpleasant side. Shackle calls the pleasant side peak
the “focus gain” and unpleasant side peak the “focus loss”. If the focus gain exceeds the focus loss, the
entrepreneur will make a positive decision.
He will make investments and earn profit. On the contrary, if the focus loss exceeds the focus gain, the
entrepreneur will make a negative decision and refrain from making investments because his particular
expectations are likely to be unfavorable. Thus in Shackle’s theory, the entrepreneurial decision-making is
neither irrational nor whimsical. Rather, it is based on his intuitive perception.
158

Criticism:
Prof. Shackle has formulated a psychological theory of profit which is highly abstract. But it
contains within it the elements of Knight’s uncertainty theory of profit, Schumpeter’s
innovations theory of profit and monopoly theory of profit.
However, it is essentially a decision theory which is based on the psychology of the entrepreneur. As
pointed out by Prof. Kier stead, “Professor Shackle himself uses the device of introspection effectively,
but introspection can allow him to discover how he makes a decision; it cannot tell with any certainty
how an entrepreneur or a Board of Directors makes a decision.”
159

7) Rent Theory of Profit:
This theory was first propounded by the American Economist Walker. It is based on the ideas of Senior and J.S.
Mill. According to Mill, “the extra gains which any producer obtains through superior talents for business or
superior business arrangements are very much of a kind similar to rent. Walker says that “Profits are of the same
genus as rent”. His theory of profits states that profit is the rent of superior entrepreneur over marginal of less
efficient entrepreneur.
According to these economists, there was a good deal of similarity between rent and profit. Rent was the reward
for the use of land while a profit was the reward for the ability of the entrepreneur. Just as land differs from one
another in fertility, entrepreneurs differ from one another in ability. Rent of superior land is determined by the
difference in productivity of the marginal and super marginal land; similarly the profits of the marginal and
super marginal entrepreneurs.In short it is the intra-marginal lands that earn a surplus over marginal lands. So
also intra marginal entrepreneurs earn a surplus over marginal entrepreneur. Just as there is the marginal land,
there is the marginal entrepreneur. The marginal land yields no rent; so also marginal entrepreneur is a no profit
entrepreneur.
The marginal entrepreneur sells his produce at cost price and gets no profit. He secures only the wages of
management not profit. Thus profit does not enter into cost of production. Like rent, profit also does not enter
into price. Profit is thus a surplus.
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Criticism:
● This theory is unrealistic: Walker’s view of Profit as a surplus like rent is unrealistic and it cannot be
accepted as true approach of Profit
● It is not a true surplus as Marshall has said: In this connection Marshall has said that land can earn
positive or zero rent. But in the case of firm’s entrepreneurs may have negative profits or losses.
● Profits only in a dynamic state: Rent can emerge in both static and dynamic conditions whereas profits we
can find only in a dynamic state.
● Profit is not gift of ability: Profit does not arise always due to the superior ability of the entrepreneur. It
may arise due to monopoly, innovation, risk, uncertainty etc.
● This theory overlooks the important function of the entrepreneur as a risk-bearer: From the profits of
entrepreneur we must deduct the losses sustained by some others, who have been driven to bankruptcy.
When this is done, there may be no surplus element in Profit and the analogy to rent vanishes. Moreover, it
fails to explain the Profit of the ordinary shareholder of a joint-stock company.
● This theory fails to explain the main causes of the size of Profits:The differential gain arises because of
the scarcity of superior units, either of land or of entrepreneurs. But the real thing is the explanation of the
causes of the scarcity of the superior units. In the case of the rent of land, the point is not of great importance
because the limitation is due to nature. Here the rent theory can throw no light on the fundamental questions.
● Profits do not enter into price this cannot be said here: The reward for risk-bearing must enter into long-
period cost of production. In the short-period, Profits may not enter into price. But in the long-run, supply of
entrepreneurs not being fixed by nature, normal Profits must form a part of cost of production.
161

8) Wage Theory of Profit:
This theory was propounded by Taussig, the American economist. According to this theory, profit is also a type of
wage which is given to the entrepreneur for the services rendered by him. In the words of Taussig, “profit is the
wage of the entrepreneur which accrues to him on account of his ability”.
Just as a labourer receives wages for his services, the entrepreneur works hard gets profit for the part played by him
in the production. The only difference is that while labourer renders physical services, entrepreneur puts in mental
work. Thus an entrepreneur is not different from a doctor, lawyer, teacher, etc., who do mental work. Profit is thus a
form of wage.
Criticism:
● Element of risk and uncertainty: The entrepreneur’s work is full of risk and uncertainty and profit is given
to face this risk. But the workers receive wages simply for his labour. Risk and uncertainty part do not
incorporate anywhere in his activities. For labourer risk is of losing the job which is an extreme step.
● Profit is flexible, it may vary: Profits may rise or fall. It depends upon the business conditions and situations.
But wage may remain stable and cannot fluctuate more in the short- period.
● This theory is silent over the payment to shareholders: The shareholders of any organisation or company
do not perform any function but they receive the share of profits in the form of dividend for undertaking risk
of money invested. This theory fails to explain this contention as to why they are paid.
● Entrepreneurs windfall or chance profits: The entrepreneur may receive windfall or chance profits but a
worker cannot have opportunity to get wages of chance or windfalls.
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Dr. Waqar Ahmad, Allenhouse Business School
Wages
12/17/2016
163

Dr. Waqar Ahmad, Allenhouse Business School
Wages are remuneration paid to labor in
return for the services rendered.
Benham has defined the term wages in a
restricted sense.
According to him, a wage may be defined as
a sum of money paid under contract by an
employer to a worker in exchange for service
rendered.
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Dr. Waqar Ahmad, Allenhouse Business School
Various System of Wages Payments:
The remuneration of labor is paid in various manners and
under various names. It can be classified as follows:
(1) Classification According to the Class of Workers
Engaged:
(i)Salary
(ii)Pay
(iii)Wage
(iv)Fee
(2) Classification According to the Manner of Payment:
(i) Time Wages: (ii) Piece Wages:
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Dr. Waqar Ahmad, Allenhouse Business School
Payments of Wages on the Basis of Form/Kinds of Wages:
On the basis of form, wages are of two kinds, nominal wage and real
wage.
(1)Nominal wages:
"By 'nominal wage' is meant the total amount of money earned by a
person during a certain period".
For instance, you employ a servant and pay him $2600 per month for
the services he renders to you. The amount which is paid in terms of
money only is named as nominal wages.
(2)Real Wages:
"Real wages refer to the total amount of satisfaction which a worker
receives in the form of necessities, comforts and luxuries in return for
the services".
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Dr. Waqar Ahmad, Allenhouse Business School
Factors on which Real Wages Depends:
There are following factors that influence the real wages:
(i)Purchasing Power of Money
(ii)Opportunity of Extra Earning
(iii)Nature of Work
(iv)Future Prospects
(v)Hours of Work
(vi)Tenure of Services
(vii)Form of Payment
(viii)Expenses of Trainings
(ix)Social Status.
167

Dr. Waqar Ahmad, Allenhouse Business School
How are Wages Determined/Theories of Wages
Determination:
There are various theories of wages which lave been put
forward by different economists from time to time but none of
them is free from criticism. The most important theories of
wages determination are:
(1)Subsistence Theory of Wages.
(2)Wage Fund Theory.
(3)Residual Claimant Theory.
(4)Marginal Productivity Theory.
(5)Modern Theory of Supply and Demand.
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Dr. Waqar Ahmad, Allenhouse Business School
Subsistence Theory of Wages:
The subsistence theory of wages owes its origin to Physiocratic School of France.
The theory is also named as Iron or Brazen Law of Wages. According to this theory:
"The wage in the long run tends to be equal to the minimum level of subsistence. By
'minimum level of subsistence is meant the amount which is just sufficient to meet
the bare necessities of life of the worker and his family".
Criticism on Subsistence Theory of Wages:
This theory has beep criticized on the following grounds:
(i)It is incorrect to say that when the money income of a person increases above the
subsistence level, he marries early and the birth rate increases.
(ii)The theory fails to explain the wage differences in different employments.
(iii)The third criticism levied on the subsistence wages is that it entirety ignore the demand
side of the labor and emphasizes only the supply side for the determination of the wages.
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Dr. Waqar Ahmad, Allenhouse Business School
2) Wage Fund Theory:
The theory of wage fund first introduced in Economics by Adam Smith and later on it was developed by J.S. Mill. The theory
briefly explains that:
"Wages depend upon the proportion between population and capital, or rather between the number of laboring classes who work
for hire and the aggregate of what may be called the wage fund which consists of that part of circulating capital which is
expanded in the direct hire of labor".
Formula for Wage Fund Theory:
Wage Rate = Wage Fund
Total Number of Workers
If it is desired that the average rate should increase, it can be achieved in two ways. Firstly, by increasing the floating capital and
secondly by reducing the number of workers.
Criticism on Wage Fund Theory:
The theory has been subjected to a great deal of criticism by Longe, Thornton and Jevon on the following grounds:
(i)There is no special fund which is particularly meant for the payment of wages to the workers. The wages are paid out of the
national dividend which is a flow and not fixed like that of fund.
(ii)The theory is inadequate to explain the wage differences in different occupations.
(iii)The theory gives undue importance to the supply side. It makes wrong assumption that the demand for labor remains
constant.
(iv)The theory assumes that labor is homogeneous but in fact it is heterogeneous.
(v)The level of wages do not necessarily depend upon remuneratory capital. In newly developed countries, the capital available
is generally less than the established countries but there the wages are relatively higher because of the greater productivity of
each worker.
170

Dr. Waqar Ahmad, Allenhouse Business School
Residual Claimant Theory:
Residual claimant theory is associated with the name of American economist Walker. According to Walker:
"Wages equal to Whole product minus rent interest and profit".
Jevon has stated the theory of residual claimant in the following words:
"The wages of a working man are ultimately coincident with what he produces, after
the deduction of rent, taxes and the interest on capital".
In short, the theory states that labor receives what remains after payment of rent, interest, profit and taxes out of the national
dividend.
Criticism on Residual Claimant Theory:
The theory has been criticized by Longe and Thornton on the following points:
(i)The theory ignores the influence of supply side in the determination of wages.
(ii)If fails to explain as to how the trade unions raise the wages of the workers.
(iii)It is also point out that the residual claimant is the entrepreneur and not the labor. The labor gets his share during the process
of production of a commodity.
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Dr. Waqar Ahmad, Allenhouse Business School
Marginal Productivity Theory of Wages Under Perfect Competition:
Some of the modern economics explain the determination of wages by means of
marginal productivity analysis.
According to this theory:
"Wages in perfect competition tend to be equal to the marginal
net product of a labor. By marginal net product of a labor is
meant net addition or net subtraction made to the value of the
total produce of a firm when one unit is added or withdrawn
from it".
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The marginal productivity theory of wage states that the price of
labour, i.e., wage rate, is determined according to the marginal product
of labour. This was stated by the neoclassical economists, especially J.
B. Clark, in the late 1890s.
The term marginal product of labour is interpreted here in three ways:
marginal physical product of labour (symbolized by MPPL), value of the
marginal product of labour (symbolized by VMPL) and marginal
revenue product of labour (symbolized by MRPL).
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When marginal product of labour is expressed in money terms we
obtain VMPL. MRPL is the change in total revenue following a change
in the employment of labour. Marginal productivity theory of wage
states that wage of labour equals VMPL (= MRPL). Employer will
employ labour up to the point until market wage equals labour’s value
of the marginal product (VMP) and marginal revenue product (MRP).
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Assumptions of Marginal Productivity Theory of Wage:
The important assumptions of this theory are:
i. Perfect competition prevails in products market and in labour market.
Perfect competition in product market implies that products are
homogeneous and the price of the goods is given for all firms in the
market. Perfect competition in labour market also implies that labour as
well as firms behave as ‘wage-takers’; no one can influence the wage
rate.
Consequently, labour supply curve, SL, becomes perfectly elastic. Since
wage rate does not change, labour supply curve incidentally, becomes the
average cost curve of labour (ACL) and it coincides with the marginal cost
curve of labour (MCL).
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ii. Law of variable proportions operates.
iii. The firm aims at profit-maximization.
iv. All labourers are homogeneous and are divisible.
v. Labour is mobile and is substitutable to capital and other inputs.
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Wage rate will be determined by the interaction of demand and supply
curves of labour in the market. Labour demand curve is explained by the
VMPL curve. Since perfect competition exists in the product market,
VMPL curve coincides with the MRPL curve. VMPL = MRPL curve is the
firm’s demand curve for labour.
This curve slopes downward because of diminishing marginal returns. In
Figure, VMPL = MRPL = DL represents the firm’s demand curve for labour.
177

178

Further, as perfect competition exists in the labour market, the labour
supply, SL = ACL = MCL, curve has been drawn perfectly elastic.
In Figure, E is the equilibrium point since at this point labour demand
equals labour supply. The equilibrium wage rate thus determined is OW.
Corresponding to this wage rate, equilibrium level of employment is OL.
Note that for OL amount of labour, VMPL = MRPL is LE, which equals
wage rate OW. At this going wage rate (i.e., OW) the employer will be
maximizing profit by employing OL units of labour. However, less (more)
labour will be employed if market wage rate rises above (falls below) OW.
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CRITICISM OF THE THEORY
i. In the real world, perfect competition does not exist—both in the
product market and in the labour market. Imperfect competition is
found in all the markets. This theory, therefore, has limited applicability
in the real world. If it is applied to the imperfectly competitive market,
the workers will be subject to exploitation.
ii. Labour can never be homogeneous— some may be skilled and some
may be unskilled. Wage rate of a worker is greatly influenced by the
quality of labour. A higher wage rate is enjoyed by the skilled labour
compared to the unskilled labour. This simple logic has been totally
ignored by the authors of this theory.
iii. Perfect mobility of labour is another unrealistic assumption.
Mobility of labour may be restricted due to socio-political reasons.
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iv. The marginal productivity theory of wage ignores the supply side of labour
and concentrates only on the demand for labour. It is said that labour is
demanded because labour is productive. But why labour is supplied cannot be
answered in terms of this theory.This is because of the fact that, at a given wage
rate, any amount of labour is supplied. But we know that higher the wage rate,
higher is the supply of labour. This positive wage-labour supply relationship has
been ignored by the makers of this theory.
v. Full employment of resources is another unrealistic assumption.
vi. This theory, in fact, is not a wage theory but a theory of employment. Wage
rate is predetermined. At the given wage rate OW, how many units of labour are
supplied can be known from this theory. In this sense, it is a theory of
employment and not a theory of wages.
vii. Finally, this theory ignores the usefulness of trade union in wage
determination. Trade union, through its collective bargaining power, also
influences wage rate in favour of the members of the organization.
181

Modern Theory of Wages:
Modern theory of wages regards wages as a price of labour and all other prices
determined by the usual supply and demand analysis. According to this
approach, wages are determined by the interaction of market forces of demand
and supply.
Demand for Labour:
The demand for labour comes from the entrepreneurs as it is used for the
production of goods and services. Thus, the demand for labour depends upon
the productivity of labour i.e., the higher the productivity of labour, the greater
will be the demand for it from employers. Thus, demand for labour depends
upon the marginal productivity of labour; since the marginal productivity of
labour will slope downwards after a stage, the demand curve of labour will also
slope downward.
182

Factors Affecting the Demand for Labour:
1. Technological Changes:
Technological changes influence the marginal productivity of labour. Therefore,
these changes also influence the demand for labour.
2. Derived Demand:
Demand for labour is a derived demand. It means that demand for labour
depends upon the demand for goods and services which it produces. If at any
given time the demand for a particular commodity produced by the labour is
high, it is natural that the demand for labour shall also be high. Hence, the
greater is the consumer demand for the product, the higher will be the demand
for the labour to produce that commodity.
183

3. Proportion of Labour:
The demand for labour also depends upon the proportion in which labour is
mixed with other factors of production. When a small amount of labour is
engaged in the production of a product, the demand for that type of labour is
inelastic. For instance, the demand for labour for operating automatic machines
or latest machines in large scale factories is inelastic.
4. Cost of other Factors:
The demand for labour depends upon the cost of other factors of production
which can be used as substitute for labour. If substitute factors are costly, the
entrepreneur will naturally substitute labour in place of costly factor.
In such a case the demand for labour will be high. If the prices of substitute
factors which can be used in place of labour have declined, the substitute factor
will be used in place of labour. Hence, the demand for labour will decline.
184

This can be shown with the help of Figure
In Figure number of labourers has been measured on OX-axis and the wage rate
on Y-axis. DD is the industry’s demand curve. It slopes downward from left to
right indicating that when wages are low, demand for labourers increases and
when the wage rate tends to increase, demand for labour decreases.
185

Supply of Labour:
Supply of labour in an economy depends upon both economic as well as non-
economic factors. Economic factors influencing the supply of labour comprises
of existing employment, desire to increase monetary income, bargaining power
of the labourers, size of population, income distribution etc. while the non-
economic factors consist of family affection, social conditions, domestic
environment etc.
Psychological factors also affect the supply of labour. It is only due to the
psychological factors that a worker decides how much time he should devote to
work and how much to leisure. Moreover, the supply of labour also depends on
the elasticity.
186

The supply of labour for a firm is perfectly elastic, so, the firm at current wages
can employ as many workers as it wishes. On the contrary the nature of supply
of labour for an industry is not infinitely elastic. Thus, it cannot employ more
and more labourers at the current wage rate. The industry can do so by
attracting labourers from other industries by offering them higher wages.
Following diagram clears this point more vividly.
187

Factors Affecting Supply:
1. Size of Population:
The size of population is determined by the difference in birth
rate and the death rate. The proportion of total population
which is called working population depends upon occupational
distribution, level of technical advancement, conservation and
mobility of labour.
2. Efficiency of Labour:
The supply of labour does not merely depend upon the size of
population. It also depends upon the efficiency of labour.
Efficiency depends upon several factors like hours of working,
service and working conditions, wage rates, economic
incentives and other conditions that have a bearing upon the
working ability of labour.
188

3. Mobility of Labour:
The supply of labour also depends upon the mobility of labour. If the labour is
less mobile either because the means of transport are not developed or there is
conservatism among the labourers, or because there are climatic, language or
traditional hindrances, then it follows that supply of labour shall be highly
limited.
189

190
References:
https://www.slideshare.net/luxminy/ricardian-theory-of-
rent-46384548
https://www.slideshare.net/georgimathew/national-income-
accounting-114271749
https://www.slideshare.net/luxminy/modern-theory-of-rent-46385001
http://www.microeconomicsnotes.com/economic-theories/theory-of-
wages/theory-of-wages-top-6-theories-with-criticisms/15744
http://www.economicsdiscussion.net/theories-of-wages/top-6-
theories-of-wages-with-diagram/12634
http://www.economicsdiscussion.net/wages/top-3-theories-of-wages-
with-diagram/7446
https://www.slideshare.net/BikashKumar78/theory-of-profit
https://www.academia.edu/18571389/Theories_of_Profit

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