UNIT 4

COST
CONTENTS
• Elements of Cost
• Factors of Production
• Theory of Rent
• Theory of Interest
• Theories of Profit
Elements of Cost
NEED OF COST ANALYSIS
• A cost function expresses the relationship
between the cost of production and levels
of output.
• The basic objective is to maximize profits
and minimize cost of production
• Cost is used in different context in different
discipline
 COST CONCEPTS
• A cost function expresses the relationship between the cost of
production and levels of output. The various cost concepts
are:-

• Social and private costs:

▫ Social cost of producing a commodity refers to the
opportunities of producing other commodities foregone,
given the scarce resources.

▫ In simple terms, it is the cost of alternative good sacrificed

by a community in producing a certain amount of one good.

▫ Private costs, on the other hand, include the costs incurred

by an individual firm to obtain the resources used for the
production of commodity.

▫ The reduction in private cost of a product would result in

the reduction in of social cost, due to the emergence of a
 Contd..
Explicit and Implicit costs:

• Production of a commodity generally requires different kinds

of labour and capital in many forms. Modern economists call
the direct production expenses as the explicit costs of
production.

• It includes the expenses incurred by a producer on buying the

productive services owned by others. Whereas, implicit costs
include the evaluation of a producer’s efforts and sacrifices
incurred in production process.

• In other words, it refers to the reward a producer would like

to pay self for self-owned and self-employed resources.

• They include a normal return on own investment, and the

opportunity cost (alternative earnings) of own labour.
Contd..
• Sunk costs:
▫ They are the costs which cannot be recovered, and
therefore, are not included in the decision making
process.

▫ They include the costs of highly specialized resources or

inputs, which once installed, cannot be put to any
alternative use. For e.g., a big plant or machine installed
by a firm which has become obsolete or inoperative due
to non-availability of some parts, then the money spent
on it is known as a sunk cost.

▫ It is sunk because neither can the firm uses it, nor sell it,
or put it to any alternative use.

▫ Hence, sunk costs have no relevance in decision making.

 Contd..
Short run & long run cost :
• The short run is defined as a period in which the
supply of at least one element of the inputs cannot be
changed. To illustrate, certain inputs like machinery,
buildings, etc., cannot be changed by the firm
whenever it so desires. It takes time to replace, add
or dismantle them.

• Short-run costs are the costs that can vary with the
degree of utilisation of plant and other fixed factors.
In other words, these costs relate to the variation in
output, given plant capacity.

• Short-run costs are, therefore, of two types: Fixed

costs and variable costs.
Contd..
Incremental cost
• When business changes its nature or
activities then , Incremental cost are
incurred by the firms.

• Cost due to Change in total cost due to

change in level of business activity

• Example : new machinery is purchased , thus

it increases the total cost of production ,
called incremental costs.
Contd..
Replacement cost :
• Old machine is replaced with new machine
the cost incurred is called “Replacement
cost” or “substitution cost ”

Historical cost :
• Based on purchase price of a machinery
initially

• Based on a point of view of a accountant

(records at original cost rather than market
cost )
Elements of Cost

i. Material:

• Helps in producing or manufacturing goods. Material

implies a substance from which a product is made For
example, an organization requires materials, such as
bricks and cement for constructing a building.
Contd..
Material is divided into two categories, which are as follows:

a. Direct Material:

Refers to a material that is directly related to a specific product, job, or process.

Direct material becomes an integral part of the finished product. Some of the
examples of direct material are as follows:
1. Timber is raw material for making furniture
2. Sugarcane for making sugar.
3. Textile for garment industry
4. Gold for making jewellery
5. Cans for tinned food and drink

b. Indirect Material:

Refers to a material that is not directly related to a particular product or activity.

Such materials cannot be easily identified with the product. The examples of
indirect material are as follows:
1. Oils for lubricating machines
2. Printing and stationary items for publishing books
3. Nails for making furniture
4. Threads for manufacturing garments
Contd..
ii. Labor:
• Acts as an important part of production. An organization
requires labor to convert raw materials into finished goods.
Labor cost is the main element of cost.
• Labor can be of two types, which are discussed as follows:
a. Direct Labor:
• Refers to labor that takes an active part in manufacturing a
product. This type of labor is also known as process labor,
productive labor, or operating labor. The costs related to direct
labor are called direct labor costs. These costs vary directly
with the change in the level of output, thus it is referred as a
variable expense.
b. Indirect Labor:
• Refers to labor that is not directly related to the manufacturing
of a product. The indirect labor cost may or may not vary with
the change in the volume of output. This type of labor is used in
the factory, office, and selling and distribution department.
Contd..
iii. Expenses:
• Refer to costs that are incurred in the production of finished
goods other than material costs and labor costs.

• Expenses are further divided into two parts:

a. Direct Expenses:
• Imply the expenses that are directly or easily allocated to a
particular cost center or cost units. These expenses are called
chargeable expenses. Some of the direct expenses of an
organization include acquiring machinery for special processes,
fees paid to architects and consultants, and costs of patents and
royalties.

b. Indirect Expenses:
• Refer to expenses that cannot be allocated to specific cost center
or cost units. For example, rent, depreciation, insurance, and
taxes of building.
Total Cost
• Total cost (TC) of a firm is the sum-total of all
the explicit and implicit expenditures incurred
for producing a given level of output.
• It represents the money value of the total
resources required for production of goods and
services.
• For example, a shoe-maker’s total cost will
include the amount she/ he spends on leather,
thread, rent for his/her workshop, interest on
borrowed capital, wages and salaries of
employees, etc., and the amount she/he charges
for his/her services and funds invested in the
business.
Total Variable Cost
• Variable costs are those costs which are
incurred on the Employment of variable
factors of production whose amt. can be
altered in the short run.
• Thus, the total variable cost change with
changes in output in short run, i.e. they
increase or decrease when the output rises
or falls.
• TC = TFC + TVC
 Average Cost
Average cost (AC) is the cost per unit of output. That is, average
cost equals the total cost divided by the number of units
produced (N). If TC = Rs. 500 and N = 50 then AC = Rs. 10.
Average fixed cost:-
• Average fixed cost is the total fixed cost divided by the no. of
units of output produced. Therefore, AFC=TFC / Q
• Avg. fixed cost curve slops downward throughout its length but it
doesn't touch the x axis.
• As output increases, the total fixed cost spreads over more &
more units & therefore avg. fixed cost becomes less & less.
Average variable cost:-
• Average variable cost is the total variable cost divided by the no.
of units of output produced. Therefore,
• AVC= TVC / Q
• The average variable cost is variable cost per unit of output .
Average total cost:-
• The average total cost or what is called simply average cost is the
total cost divided by the number of unit of output produced.
 Marginal Cost
• Marginal cost (MC) is the extra cost of
producing one additional unit. At a given level of
output, one examines the additional costs being
incurred in producing one extra unit and this
yields the marginal cost.
• For example, if TC of producing 100 units is Rs.
10,000 and the TC of producing 101 units is Rs.
10,050, then MC at N = 101 equals Rs.50.
• Marginal cost refers to the change in total cost
associated with a one-unit change in output. This
cost concept is significant to short-term decisions
about profit maximizing rates of output.
• Marginal cost (MC) = change in Total cost/
Change in volume of output
Cost Analysis
• The diagram shows that both total variable
cost (TVC) and total cost (TC) curves are
increasing functions of the level of output.
• TVC initially increases at a decreasing rate
and then at an increasing rate. However, the
total fixed cost curve remains constant at all
output levels.
• The shape of total cost curve (TC) reflects that
at each level of output, total cost exceeds the
variable cost.
• The vertical distance between TC and TVC
represents total fixed cost. Initially, the
distance between TC and TVC is relatively
high when the proportion of fixed to total cost
is high.
• But, as the level of output increases, fixed
cost constitutes a small fraction of total cost
and hence the TC converges towards TVC.
• This is because, with the rise in the level of
Cost Analysis
• Marginal cost (MC) is the change in total
cost due to an additional unit of output
produced, i.e., MC = C / Q. Since total fixed
cost remains fixed at all levels of output,
the MC reflects the change in TVC only.
• The slope of TVC represents the marginal
cost, i.e., C/ Q = MC. The MC significantly
influences the behaviour of a rational profit
maximizing firm.
• It falls faster than the fall in AVC, becomes
constant and cuts the AC and AVC at
minimum and rises faster than the AVC.
• This is because it reflects the immediate
changes in per unit cost in response to the
increased in the level of output.
• This is the consequence of the law of
variable proportions, the AC has its
minimum to the right of AVC, because it
Long Run Cost
• Long-run is defined as the period in which all factors of
production are variable.

• While, in the short-run some costs are fixed and others vary
(variable costs), in the long-run all the costs are variable.

• Hence, the long run cost reflects the returns to scale. When a
manager decides to increase all the factors of production, it is
known as a change in the scale of a firm’s operation.

• In response to the change in the scale, the firm may experience

increasing, constant and/or diminishing returns to scale.

• These changes in returns may be expressed in terms of cost

conditions as decreasing costs, and constant costs and/or
increasing costs. This is shown by diagram – 13.
Contd..
• At the initial short-run average cost SAC1, the
firm produces OQ1 units of output at per unit
cost OC1.
• When the manager plans to increase output to
OQ2 units, the average cost would be OC3 on
the rising part of the SAC1 cost curve if the
same plant is used.
• On the other hand, if an additional plant is
installed, the cost would fall to OC2 (OC2 <
OC1). Thus, the installation of a new plant
decreases the cost per unit of output.
• The diagram shows that average cost will
successively fall till the installation of the
Contd..
• This level is known as the optimum level of output, at
which the long run average cost (LAC) is minimum
and the LMC cuts it from below. Here, the long run
equilibrium condition of LAC = LMC and LMC
cutting LAC from below have been reached.
• If output increases beyond OQ3, the LAC would rise
for every additional plants installed. No rational
manager would install new plant beyond it, as they
wish to make at least normal profits in the long run.
• The long run average cost curve (LAC) is also known
as envelope curve as it envelopes several average
cost curves corresponding to different plant size.
• Further, it is also known as a planning curve, as it
guides the manager in planning the future expansion
of plant and output.
Factors of Production
Production Function - This relationship may
be expressed as follows:-X = f (A, L, K, M, T)
• X = output of commodity X,
• A = land employed in the production of X,
• L = labor employed,
• K = capital employed,
• M = management employed,
• T = technology used,
 Law of Variable Proportions: (Short Run Analysis of
Production):

Definition:
• “The input output relationships when certain inputs are kept
fixed and others inputs are made variable, it is called as law of
variable proportion”.

• The Law of Variable Proportions which is the new name of the

famous law of Diminishing Returns has been defined by
Stigler in the following words:

• "As equal increments of one input are added, the inputs of

other productive services being held constant, beyond a certain
point, the resulting increments of produce will decrease i.e., the
marginal product will diminish".
 Assumptions
The law of variable proportions also called the law of
diminishing returns holds good under the following
assumptions:

• Short run. The law assumes short run situation. The

time is too short for a firm to change the quantity of
fixed factors. All the, resources apart from this one
variable, are held unchanged in quantity and quality.

• Constant technology. The law assumes that the

technique of production remains unchanged during
production.

• Homogeneous factors. Each factor unit in assumed

Schedule:

Fixed Input Variable Total Average Marginal Product Product

Produce MP
Three Stages of the Law:

There are three phases or stages

of production, as determined by
the law of variable proportions:
• Increasing returns.
• Diminishing returns.
• Negative returns.
Diagram/Graph:
These stages can be explained
with the help of graph below:
• Stage of Increasing Returns.
The first stage of the law of
variable proportions is generally
called the stage of increasing
returns. In this stage as a
variable resource (labor) is
added to fixed inputs of other
resources, the total product
increases up to a point at an
increasing rate.
Three Stages of the Law:

• The total product from the

origin to the point K on the
slope of the total product curve
increases at an increasing rate. K
• From point K onward, during
the stage II, the total product no
doubt goes on rising but its
slope is declining.
• This means that from point K
onward, the total product
increases at a diminishing rate.
• In the first stage, marginal
product curve of a variable
factor rises in a part and then
falls.
• The average product curve rises
throughout .and remains below
the MP curve.
 Causes
Three Stages of the Law:

• The phase of increasing returns

starts when the quantity of a
fixed factor is abundant relative
to the quantity of the variable
factor. As more and more units
of the variable factor are added
to the constant quantity of the
fixed factor, it is more
intensively and effectively used.
This causes the production to
increase at a rapid rate.
• Another reason of increasing
returns is that the fixed factor
initially taken is indivisible. As
more units of the variable factor
are employed to work on it,
output increases greatly due to
fuller and effective utilization of
 • This is the most important stage
Stage of Diminishing Return

in the production function. In

stage 2, the total production
continues to increase at a
diminishing rate until it reaches
its maximum point (H) where
the 2nd stage ends.
• In this stage both the marginal
product (MP) and average
product of the variable factor
are diminishing but are positive.
 Causes
Stage of Diminishing Return

• The 2nd phase of the law occurs

when the fixed factor becomes
inadequate relative to the
quantity of the variable factor.
As more and more units of a
variable factor are employed,
the marginal and average
product decline.
• Another reason of diminishing
returns in the production
function is that the fixed
indivisible factor is being
worked too hard.
• It is being used in non-optimal
Proportion with the variable
factor, Mrs. J. Robinson still
goes deeper and says that the
diminishing returns occur
 • In the 3rd stage, the total
Stage of Negative Return

production declines. The TP,

curve slopes downward (From
point H onward). The MP curve
falls to zero at point M and then
is negative. It goes below the X
axis with the increase in the use
of variable factor (labor).
•
 Causes of Negative Returns:
Stage of Negative Return

• The 3rd phases of the law starts

when the number of a variable,
factor becomes, too excessive
relative, to the fixed factors, A
producer cannot operate in this
stage because total production
declines with the employment of
additional labor.
• A rational producer will always
seek to produce in stage 2 where
MP and AP of the variable factor
are diminishing. At which
particular point, the producer will
decide to produce depends upon
the price of the factor he has to
pay. The producer will employ the
variable factor (say labor) up to
the point where the marginal
product of the labor equals the
Importance
The law of variable proportions has vast general applicability. Briefly:

• It is helpful in understanding clearly the process of production. It

explains the input output relations. We can find out by-how much the
total product will increase as a result of an increase in the inputs.

• The law tells us that the tendency of diminishing returns is found in

all sectors of the economy which may be agriculture or industry.

• The law tells us that any increase in the units of variable factor will
lead to increase in the total product at a diminishing rate. The
elasticity of the substitution of the variable factor for the fixed factor
is not infinite.

• From the law of variable proportions, it may not be understood that

there is no hope for raising the standard of living of mankind. The
fact, however, is that we can suspend the operation of diminishing
returns by continually improving the technique of production
Law of Returns to Scale:
Definition and Explanation:
• The laws of returns are often confused with the law of returns to
scale. The law of returns operates in the short period. It explains the
production behavior of the firm with one factor variable while other
factors are kept constant. Whereas the law of returns to scale operates
in the long period. It explains the production behavior of the firm with
all variable factors.
• There is no fixed factor of production in the long run. The law of
returns to scale describes the relationship between variable inputs and
output when all the inputs or factors are increased in the same
proportion. The law of returns to scale analysis the effects of scale on
the level of output. Here we find out in what proportions the output
changes when there is proportionate change in the quantities of all
inputs. The answer to this question helps a firm to determine its scale
or size in the long run.
• It has been observed that when there is a proportionate change in the
amounts of inputs, the behavior of output varies. The output may
increase by a great proportion, by in the same proportion or in a
smaller proportion to its inputs. This behavior of output with the
increase in scale of operation is termed as increasing returns to scale,
 Causes
• If the output of a firm
(1) Increasing Returns to Scale:

increases more than in

proportion to an equal
percentage increase in all
inputs, the production is said
to exhibit increasing returns
to scale.
• For example, if the amount
of inputs are doubled and the
output increases by more
than double, it is said to be
an increasing returns to
scale. When there is an
increase in the scale of
production, it leads to lower
average cost per unit
 • When all inputs are increased
(2) Constant Returns to Scale:

by a certain percentage, the

output increases by the same
percentage, the production
function is said to exhibit
constant returns to scale.
• For example, if a firm
doubles inputs, it doubles
output. In case, it triples
output. The constant scale of
production has no effect on
average cost per unit
produced.
 • The term 'diminishing' returns to
(3) Diminishing Returns to Scale:

scale refers to scale where output

increases in a smaller proportion
than the increase in all inputs.
• For example, if a firm increases
inputs by 100% but the output
decreases by less than 100%, the
firm is said to exhibit decreasing
returns to scale. In case of
decreasing returns to scale, the
firm faces diseconomies of scale.
The firm's scale of production
leads to higher average cost per
unit produced.
• The figure 11.6 shows that when a firm
uses one unit of labor and one unit of
capital, point a, it produces 1 unit of
quantity as is shown on the q = 1
isoquant. When the firm doubles its
outputs by using 2 units of labor and 2
units of capital, it produces more than
double from q = 1 to q = 3.
• So the production function has increasing
returns to scale in this range. Another
output from quantity 3 to quantity 6. At
the last doubling point c to point d, the
production function has decreasing
returns to scale. The doubling of output
from 4 units of input causes output to
increase from 6 to 8 units increases of
two units only.
Theory of Rent
• Unlike variable factor, the marginal productivity theory of
distribution fails to determine price of factor whose supply
is fixed (e.g. land) or quasi fixed (e.g. capital equipments)
as there is zero marginal product of fixed factor.
• There exists separate body of theory, i.e. theory of rent
which helps explain the pricing of these fixed factors.
• According to classical theory, rent is the price paid for the
use of land. However, in modern theory, the concept of
rent is not confined to land. It can be applied to any factor
whose supply is inelastic in the short run.
• There are three different concepts of rent: land rent,
economic rent and quasi-rent.
Theory of Rent
• The land rent is paid by the tenant to the landlord for hiring
land and the landlord obtains this price because of the fact
that the supply of land is scarce.
• The concept of economic rent is widely applicable, in the
sense that it is the price paid to any factor on top of what is
required to retain the factor in its current employment.
• In other words, economic rent is a payment to a factor in
excess of its opportunity cost.
• The quasi-rent is the earnings of fixed capital equipments.
The capital equipments are quasi-fixed factors in the sense
that the supply of these factors are fixed only in short run,
while their supply varies in the long run.
The Classical theory of land rent (by David Ricardo)
• David Ricardo, an English classical economist, first
developed a theory in 1817 to explain the origin and
nature of economic rent.
▫ Firstly, it is payment to the landlord just for the use of
land. It differs from contractual rent which accounts for the
return on capital invested by the landlord. The portion of
the landlord's earnings which is spent for the improvement
of land is considered as rent.
▫ Secondly, rent is generated due to the scarcity of land. That
is, for an economy the area of land is fixed. In other words,
the supply of land is completely inelastic.
▫ Two more concepts of rent appears in this theory is
scarcity rent and differential rent.
The Classical theory of land rent (Assumptions)
1. Rent of land arises due to the differences in the fertility or
situation of the different plots of land. It arises owing to the original
and indestructible powers of the soil.
2. Ricardo assumes the operation of the law of diminishing
marginal returns in the case of cultivation of land. As the different
plots of land differ in fertility, the produce from the inferior plots of
land diminishes though the total cost of production in each plot of
land is the same.
3. Ricardo looks at the supply of land from the standpoint of the
society as a whole.
4. In the Ricardian theory it is assumed that land, being a gift of
nature, has no supply price and no cost of production. So rent is not
a part of cost, and being so it does not and cannot enter into cost
and price. This means that from society’s point of view the entire
return from land is a surplus earning.
Scarcity Rent
Ricardo assumed that land had only one use—to grow
corn. This meant that its supply was fixed, as shown
in Figure 13.1.
Hence the price of land was totally determined by the
demand for land.
In other words, all the price of a factor of production
in perfectly inelastic supply is economic rent—it has
no transfer earnings.
Thus, it was the high price of corn which caused an
increase in the demand for land and a rise in its price,
rather than the price of land pushing up the price of
corn.
However, this analysis depends on the assumption that
land has only one use. In the real world a particular
piece of land can be put to many different uses.
This means its supply for any one use is elastic, so
that it has transfer earnings.
Differential Rent
The difference between the produce of the
superior lands and that of the inferior lands
is rent—what is called differential rent. Let
us illustrate the Ricardian concept of
differential rent.

Ricardo assumes that the different grades of

lands are cultivated gradually in descending
order—the first grade land being cultivated
at first, then the second grade, after that the
third grade and so on. With the increase in
population and with the consequent
increase in the demand for agricultural
produce, inferior grades of lands are
cultivated, creating a surplus or rent for the
superior grades.
 Differential Rent
• Table 13.1 shows the position of 3 different plots of
land of equal size. The total cost is the same for each
plot of land. Let us assume that the order of
cultivation reaches the third stage when all the three
plots of land of different grades are cultivated and
the market price has come to the level of Rs. 5 per
kg of wheat.

• The first grade land, being the most fertile, produces

40 kg, the second grade 30 kg and the third grade
land, being less fertile, only 20 kg. So, the first grade
land earns a surplus or rent of Rs. 100, the second
grade a rent of Rs. 50 and the third one earns no
surplus. The first two plots are called the intra-
marginal and the third one is the marginal (or no-
rent) land.
• This simple example shows how the differences in
the fertility of the different plots of land create rent
 Differential Rent
• Here, AD, DG and GJ are three
separate plots of land of the same size,
but of difference in fertility. The total
produce of AD is ABCD, that of DG
is DEFG and that of GJ is GHIJ.
• The first and second plots of land
generate a surplus shows by the
shaded area, which represents the rent
of the first two plots of land.
• Since the third plot GJ has no surplus
it is marginal land or no-rent land.
• Grade 4 (below-marginal) land will
not be cultivated, because rent is
negative (Rs. 25 in this example).
Deductions from the Theory:
• 1. Improved methods of farming: Improved methods of cultivation
may lead to a fall in rent (demand remaining unchanged). It is
because increased output on the superior grades of land will make
the cultivation of inferior grades of land unnecessary.
• 2. Population growth: Population growth is likely to lead to a rise
in rent, since the increased demand for land will bring poor quality
land into cultivation, thus lowering the output of marginal land.
Thus, if the price of food increases, the rent of existing land will
increase.
• 3. Improved transport facilities: Improved transport facilities are
likely to lead to a fall in rent. It is because the output of less fertile
land of foreign countries may be able to com­pete more closely
with the home produce. So there will be no need to cultivate
inferior home areas. As a result the output of the mar­ginal land
Criticisms of the Theory:
1. Ricardo considers land as fixed in supply.
2. Ricardo’s order of cultivation of lands is also not realistic.
3. The productivity of land does not depend entirely on fertility. It also
depends on such factors as position, investment and effective use of capital.
4. Critics have pointed out that land does not possess any original and
indestructible powers, as the fertility of land gradually dimi­nishes, unless
fertilisers are applied regularly.
5. Ricardo’s assumption of no-rent land is unrealistic as, in reality; every
plot of land earns some rent, although the amount may be small.
6. Ricardo restricted rent to land only, but modern economists have shown
that rent arises in return to any factor of production, the supply of which is
inelastic.
7. According to Ricardo, rent does not enter into price (cost) but from the
point of view of an individual farm rent forms a part of cost and price.
MODERN THEORY OF RENT
Modern theory of rent is an amplified and modified
version of Ricardian theory of Rent.
It was first of all discussed by J.S. Mill and after that
developed by economists like Jevons, Pareto,
Marshall, Joan Robinson etc.
According to modern theory, economic rent is a
surplus which is not peculiar to land alone. It can be a
part of income of labour, capital, entrepreneur.
According to modern version rent is a surplus which
arises due to difference between actual earning and
MODERN THEORY OF RENT
The fact, however, is that other factors of production i.e., labor, capital
and entrepreneurship may also be earning economic rent.
The essential factors of rent are the relative scarcity of the products
that land can yield.
The transfer earnings of a factor of production is the minimum
payment required for preventing that factor for transferring it to some
other use.
It is called the factor supply price in its present occupation. For
example, a worker earns Rs.6000/- per month in a factory. In the next
best employment, he can get Rs.5000/- only per month.
The surplus or excess of Rs1000/- which a worker is earning over and
above the minimum payment necessary for inducting him to work in
the present occupation is the economic rent.
TRANSFER EARNING
When we transfer one factor from one use to another, we
have to sacrifice the income earned by it from its earlier
use. Sacrifice of earning is called transfer earning.
Basically, the concept of transfer earning in economics is
introduced by Prof. Benham.
According to him, “The amount of money which any
particular unit could earn in its best paid alternative use is
sometimes called its transfer earnings.”
A similar idea was developed by Pigou. Different
economists consider transfer earnings as that amount of
money which any particular unit could come in its best paid
alternative use.
FEATURES OF MODERN RENT THEORY
Rent is a type of income produced through a difference of
actual earnings and transfer earning. Rent comes from
income of all the production factors.
Rent is increased due to the scarcity of land in the particular
area
Fundamentally speaking, rent is paid because the produce of
the land is scarce in relation to its demand, rent will arise
even if all the land in a country is exactly alike.
The demand also increases due to labor and overall
economic conditions.
Rent arises when the supply of the factor is inelastic or
DETERMINING RENT- MODERN THEORY DEMAND AND SUPPLY
ANALYSIS:

(A) Demand For a Factor: The demand for a factor

is a derived demand. Land The higher the produce,
the greater is the demand for land.
A firm will pay rent equal to the marginal revenue
productivity of land. The demand curve of a factor
is, negatively sloped
B)Supply of a factor. The supply of land to a
particular use (say industry) is quite elastic. The
supply of a factor (to an industry) is, therefore,
greater is the demand for land. A firm will pay rent
equal to the marginal revenue productivity of land.
The demand curve of a factor is, negatively sloped
an industry) is, therefore, rent elastic.
The supply curve of a factor (industry) slopes
upward to the right.
QUASI RENT
There is an element of rent present in some men’s wages, i.e.,
the extra income earned by some natural ability. For example,
an artist or musician with special gifts will be able to ask a very
high price for his services.
The theory of rent cannot be applied to interest as the two differ
in many ways.
Land is limited, capital is not; rent tends to rise, interest tends to
fall. Some economists give the term ‘Quasi-rent’ to any gains
which is due to a special advantage and which, therefore, is
similar to rent.
They give the term Quasi-rent to profits as they are a surplus
due to the exceptional business power of the owner of the
QUASI RENT
This gain, which is due to circumstances rather than to
ability, is a quasi-rent. By its nature it is usually
temporary.
However, some of the payments made under the name of
rent include an element of interest, e.g., the rent of a
farm includes a payment for the use of the farm-house
and buildings, which are really interesting because the
buildings are capital, not land.
Also, fertilizers and manures sunk in the soil increase the
yield, i.e., the extra return from the land is rent, although
it could be regarded as profit from the outlay, or interest.
Theory of Interest
• Interest, in finance and economics, is payment from
a borrower or deposit taking financial institution to
a lender or depositor of an amount above
repayment of the principal sum (that is, the amount
borrowed), at a particular rate.
• The rate of interest is equal to the interest amount
paid or received over a particular period divided by
the principal sum borrowed or lent (usually
expressed as a percentage).
• Compound interest means that interest is earned on
prior interest in addition to the principal. Due to
compounding, the total amount of debt grows
exponentially, and its mathematical study led to the
discovery of the number
CLASSICAL THEORY
• According to this theory rate of interest is
determined by the intersection of demand
and supply of savings. It is called the real
theory of interest in the sense that it explains
the determination of interest by analyzing the
real factors like savings and investment.
• Therefore, classical economists maintained
that interest is a price paid for the supply of
savings.
DEMAND FOR SAVING
• Demand for savings comes
from those who want to
invest in business activities.
• Demand for investment is
derived demand.
• Any factor of production is
demanded for its
productivity.
• The demand for the factor is
high when there are higher
expectations from it.
• Since, all the factors are not
equally productive, so,
capital demand will be high
for more productive uses first
and then gradually with the
increase in its supply, will
shift to less productive uses.
DEMAND FOR SAVING
• Demand for capital can be
raised to a point where marginal
productivity of capital becomes
equal to the interest paid on it.
• Thus, if the marginal
productivity of capital is more
than the interest paid, then it is
beneficial to borrow money and
vice-versa.
• Equilibrium will prevail at a
point where marginal
productivity of capital equals
the rate of interest.
• This shows that there exists an
inverse relationship between
demand for capital and the
interest rate.
• This fact can be made clear with
the help of the following table 1
and diagram 1:
DEMAND FOR SAVING
• The Fig. 1 depicts that
there exists an inverse
relationship between
the investment and the
rate of interest.
• It indicates that more
capital is demanded at
a low interest rate and
vice versa.
Supply of Savings
• Supply of capital is the result of
savings. It comes from those who
have an excess of income over
consumption.
• To a large extent, willingness to
save is affected by the rate of
interest. On a higher rate of
interest people save more to earn
the benefits of a high rate of
interest. On the other hand, at the
low rate of interest, people save
less.
• Thus, we may say that there is a
direct relationship between the
supply of savings and the rate of
interest. The following table and
diagram justifies this fact in a
more vivid way.
Supply of Savings
• In Fig. 2 savings have been
represented on X-axis and
interest rate on Y Axis.
• SS is the supply curve which
moves upward from left to
right.
• It shows that supply of savings
is interest elastic. Higher the
interest rate, more will be
saved and vice-versa.
• This signifies that there is a
direct relationship between
savings and the rate of
interest.
Equilibrium Rate of Interest
• According to classical theory,
equilibrium interest rate is
restored at a point where
demand for and supply of
capital are equal i.e
• The table 3 reveals that
equilibrium rate of interest
will be determined at a point
where demand for and supply
of capital are equal.
• As is clear from the table that
equilibrium interest rate 8%
is determined because at this
level demand for and the
supply of capital are equal
i.e. Rs. 700 crores.
Equilibrium Rate of Interest
• Equilibrium is restored at point E which
determines rate of interest as 8% and
demand and supply of capital as Rs. 700
crores.
• Now, if the rate of interest increases to 10%
supply of savings exceeds the demand for
capital i.e. supply is more than demand.
• This will lead to a fall in interest rate to the
level of 8%.
• On the other hand, when the interest rate
falls to 6%, demand for savings exceeds the
supply of savings which will push up the rate
of interest to restore an equilibrium rate i.e.
8%.
• Therefore, rate of interest is in equilibrium
only at a point where the demand for capital
equals the supply of capital.
Criticism
• Indeterminate Theory: Keynes has maintained that the classical
theory is indeterminate in the sense that it fails to determine the
interest rate. In this theory, interest is determined by the equality of
demand and supply. But the position of savings varies with the
income level. Thus, unless we know the income, interest rate cannot
be determined.
• Fixed Level of Income: Classical theory assumes that the level of
income remains constant. But in actual practice income changes
with a small change in investment. Thus, it is not correct to assume
a fixed level of income.
• Long Run: Classical theory determines the interest rate through the
interaction of demand and supply of capital in the long run. Keynes
pointed out that in the long run we all are dead. Therefore, there was
an urgent need of a theory which determines rate of interest in the
short-run.
Criticism
• Full Employment: This theory assumes that there is full
employment of resources in the economy. But, in reality,
unemployment or less than full employment is a general
situation. Full employment is only an abnormal case…
Thus, this theory does not apply to the present world.
• Savings and Investment: Classical economists assume that
savings and investment are interring dependent. But
actually investment changes, income also changes which
leads to a change in savings. Thus, both are interdependent
on each other.
• Ignores Monetary Factors Classical theory takes into
consideration only the real factors for determining the rate
of interest and ignores the monetary factors.
KEYNES’S LIQUIDITY PREFERENCE
THEORY
• According to Keynes, Interest is purely a monetary
phenomenon. It is the reward of not hoarding but the reward
for parting with liquidity for the specified period.
• It is the ‘Price’ which equilibrates the desire to hold wealth
in the form of cash with the available quantity of cash.
• Here Liquidity Preference Theory is determined by the
supply of and demand for money. Supply of money comes
from banks and the government. On the other hand, demand
for money is the preference for liquidity.
• Hence, when somebody lends money he has to sacrifice this
liquidity. A reward which is offered to make him prepared
for parting with liquidity is called Interest.
• Therefore, in the eyes of Keynes—”Interest is the reward for
Liquidity Preference or Demand for Money:
• People prefer to keep their resources “Liquid”. It is because of
this reason that among various forms of assets money is the
most liquid form.
• The desire for liquidity arises because of three motives:
• (i) The transaction motive - The income motive is meant “to
bridge the interval between the receipt of income and its
disbursement”, and similarly, the business motive as “the
interval between the time of incurring business costs and that of
the receipt of the sale proceeds.”
• (ii) The precautionary motive - The precautionary motive relates
to “the desire to provide for contingencies requiring sudden
expenditures and for unforeseen opportunities of advantageous
purchases
• (iii) The speculative motive - securing profit from knowing
Supply for Money:
• The supply of money refers to the total quantity of money
in the country for all purposes at any time.
• Though the supply of money is a function of the rate of
Interest to a degree, yet it is considered to be fixed by the
monetary authorities, that is, the supply curve of money is
taken as perfectly inelastic.
• The supply of money is not affected by the Interest rate,
hence, the supply of money remains constant in the short
period.
Determination of Interest Rate:
• OR is the equilibrium rate of
interest. The theory further states
that any change in the liquidity
preferences function (LP) or change
in money supply or changes in both
respectively cause changes in the
rate of interest. Thus as shown in
figure below, it given the money
supply the liquidity preference
curve (LP) shifts from LP1 to LP2
implying thereby an increase in
demand for money, the equilibrium
rate of interest also rises from to R
Determination of Interest Rate:

• Similarly, assuming a given liquidity preference function

(LP) as in fig. (b) when the money supply increases from
M1 to the rate of interest falls from R1 to R2.
Criticism
• This theory is indeterminate, inadequate and misleading -
In the Keynesian version, the liquidity preference function will shift up or down with
changes in the level of income. Particularly the liquidity preference for transactions and out
of precautionary motive.
• It is one sided theory
• Role of saving has been ignored
• The theory has completely failed to explain depressionary
situation:
• This theory is vague and confusing
• This theory ignores productivity of capital
• It focuses attention on short-run ignores the long-period:
Theory of Profit
• This is the amount of factor earnings enjoyed by the
entrepreneur class. In the standard literature of micro
economics the concept of profit maximization is widely
used to determine equilibrium price and demand for
factor inputs as well as outputs. Several theories were
developed to examine the origin and nature of profit.
• Risk Bearing Theory
• Uncertainty Bearing Theory
• Rent Theory of Profit
• Innovation Theory
• Theory of Monopoly Power
• Marginal Productivity Theory of Profit
• Dynamic Theory of Profit
• Labour Exploitation Theory
Risk Bearing Theory
• The risk bearing theory of profit is
established by Hawley. It suggests that an
entrepreneur's profit depends on his risk
taking behavior.
• The higher the risk undertaken, the more
will be the profit earned. However, it should
be noted that the amount of profit actually
depends on how efficiently risk is managed
by the entrepreneur, not the amount of risk
borne by him.
• Therefore, entrepreneurs have to undertake
these risks and claim profit as a reward for
bearing these risks.
Uncertainty Bearing Theory
• Prof. Knight suggests that profit is the reward for
bearing uncertainty. In the theory of production, the
assumption of certainty is somewhat unrealistic as with
the progress of the economy, entrepreneurs have to face
uncertainty in the sphere of production.
• However, if production takes place for commercial
purposes, that is price and output depend on the
interaction between buyers and sellers, then uncertainty
arises in the decisions of entrepreneurs. This uncertainty
generates profit.
• According to knights there is a difference between risk
and uncertainty. Many situations may arise during the
process of production which can be anticipated or whose
probability of occurrence can be statistically estimated.
These situations are known as insurable risks. The loss
from insurable risks can be avoided by paying some fixed
Uncertainty Bearing Theory
• However, some events which cannot be predicted or
whose probability of occurrence cannot be easily
estimated, are known as uninsurable risks. No insurance
company is ready to provide insurance coverage against
these kind of risks. Thus these uninsurable risks can
generate uncertainty in the process of production.
• Like other factors there exists a supply price of
uncertainty. This supply price is known as profit. In the
production process since entrepreneurs supply the
uncertainty factor, they enjoy profit.
• It should be noted that in Knight’s theory in the midst of
uncertainty, if producers’ anticipations regarding output
and price decisions are found correct, then they enjoy
profits otherwise they incur losses.
Rent Theory of Profit
• The rent theory of profit developed by Walker suggests
that profit earned by the entrepreneur is considered as a
reward for his efficiency and ability. The entire earning
of the entrepreneur is not pure profit.
• Marginal entrepreneur is that entrepreneur who can only
manage the cost of production. Thus marginal
entrepreneur operates at the break-even point where price
equals average cost.
• The greater the efficiency of the entrepreneur as
compared to the marginal entrepreneur the higher will be
the rent obtained by the entrepreneur.
Innovation Theory
• The innovation theory of profit is developed by
Schumpeter. The creation of new products or new
processes of production is called invention, while
innovation is the commercial utilization of invention.
Thus the innovator derives profit by commercially
utilizing the newly invented products.
• An entrepreneur is said to be an innovator when he
brings a new product for commercial purpose and can
earn supernormal profit. However, this super normal
profit can be obtained only in the short run.
Theory of Monopoly Power
• The theory of monopoly power states that profit arises
due to lack of competition in the market. In a perfectly
competitive market because of free entry and free exit, a
firm will earn only normal profit.
• In this imperfectly competitive situation a firm with
superior position in all respects enjoys market power or
monopoly power in deciding prices and outputs.
• Thus, this superior firm obtains higher profit than the
other weak firms. The greater the monopoly power
enjoyed by an entrepreneur, the higher will be the profit
obtained by him.
Marginal Productivity Theory of Profit
• Marginal productivity theory suggests that any factor
input is paid according to their marginal revenue
productivity.
• By virtue of the same logic it can be said that the profit
of the entrepreneur should be the marginal revenue
productivity of the marginal entrepreneur.
• According to Marshall, marginal productivity of the
entrepreneur can be determined by the difference
between the level of output produced by the entrepreneur
and the level of output without the entrepreneur.
• This implies that entrepreneurs, who are efficient, can
survive and inefficient entrepreneurs are forced to exit
from the market in the long run.
Dynamic Theory of Profit
• The dynamic theory of profit developed by J. B. Clark
suggests that profit is generated in a society which is
dynamic in nature.
• The dynamic nature of a society means that the
population, size of capital, level of output, taste and
preferences of people of that society are changing. All
these changes cause the gap between price and unit cost.
Profit arises when price exceeds unit cost.
• Entrepreneurs claim profit as a reward for undertaking
these risks or uncertainties in the dynamic society.
Labour Exploitation Theory
• Labour exploitation theory was developed by Karl Marx. This
theory suggests that profit is the result of exploitation of labour.
• The additional value of output over the value of payments to
the factors of production should be accrued to the labourer.
This additional value known as surplus value is the origin of
profit. This surplus value is appropriated by entrepreneurs
instead of laborers.
• For example, suppose that a labourer puts 10 hour work efforts
and generates 100 units value of output. But he is paid only 40
units value of output which is equivalent to 4 hours units of
labour. Thus the labourer creates a surplus value of 60 units.
• The owner of the firm will pocket this surplus value or profit as
a return for his capital invested.
Labour Exploitation Theory
• The Marxian theory of profit also suggests that the stock of
capital in an economy increases through the reinvestment of the
profit earned by the capitalist.
• Increase in capital stock will lead to increase in productivity of
labour. The wage should be increased with the increase in
productivity of labour, but actually wage do not rise. The
entrepreneur’s profit will only rise.
• Even if the wage rate tends to increase over time, the
entrepreneur will employ labor saving technology. The resulting
effect is that demand for labor decreases and the wage rate
remains the same.
• Since the laborer is denied from receiving the surplus value
generated due to the rise in productivity of labor, according to
Marx laborer is said to be exploited. Profit is, therefore, the
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