Unit V - Lecture notes 5th PDF

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UNIT VTHEORIES OF DISTRIBUTIONSyllabus: Marginal Productivity theory of Distribution. Ricardian Theory of Rent Wages – Nominal and Real wages, Minimum wages, Wage Differentials Loanable funds Theory of Interest. Innovations theory of Profits. MARGINAL PRODUCTIVITY THEORYThe marginal productivity the...

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UNIT V THEORIES OF DISTRIBUTION Syllabus: 1. Marginal Productivity theory of Distribution. 2. Ricardian Theory of Rent 3. Wages – Nominal and Real wages, Minimum wages, Wage Differentials 4. Loanable funds Theory of Interest. 5. Innovations theory of Profits.

MARGINAL PRODUCTIVITY THEORY The marginal productivity theory of distribution determines the prices of factors of production. Marginal productivity theory was first put forward to explain the determination of wages, i.e., reward for labour but later on prices of other factors of production such as land, capital etc. also were explained with marginal productivity. The origin of the concept of marginal productivity can be traced to Ricardo and West. But both Ricardo and West applied the marginal productivity doctrine only to land. The concept of marginal productivity is implicit in the Ricardian theory of rent. But the idea of marginal productivity did not gain much popularity till the last quarter of 19th century, when it was re-discovered by economists like J.B. Clark. Jevons, Wicksteed, Walras and later Marshall and J.R. Hicks popularised the doctrine of marginal productivity. This theory states that a factor of production is paid price equal to its marginal product. For example a laborer gets his wage according its marginal product. He is rewarded on the basis of contribution he makes the total output. Factors of production are demanded because they have productivity. Higher the productivity of a factor, greater will be its price. Marginal product or otherwise called marginal physical product (MPP) refers to addition to the total physical product by employing one more unit of a factor. When MPP is multiplied by price it is called value of marginal product (VMP). Marginal revenue product (MRP) is the addition made to total revenue by employing an additional unit of a factor. Average revenue product (ARP) is the average revenue per unit of a factor of production. Assumptions of the theory, 1. Prevalence of perfect competition in factor as well as product market. 2. All factors are identical.

3. Factors are perfect substitute for each other. 4. Factors are perfectly mobile. 5. Perfect divisibility of factors. 6. The theory operates in the long-run. 7. The theory is based on full employment. Explanation of the Theory: Marginal productivity theory explains the following facts, (a) Reward of each factor is equal to its marginal productivity: Under perfect competition a firm employs various units of a factor up to that point where the price paid to the factor is equal to its marginal productivity. Every producer compares the price with its productivity. The price paid to a factor is income to it while it is cost to the producer. The point of equilibrium reaches at that point where MPP=price. If the producer employs less units of factors the productivity will be more and the cost will be less. Thus in such a case the producer will increase his profit by employing more units of factors and reaches the equilibrium point. On the other hand if the number of factor employed is more than the equilibrium level, the cost will be more than the productivity. The producer will lower the units of factors so long he reaches equilibrium. Thus his profit is maximized at the point of equilibrium, where marginal revenue product equals marginal cost (MRP=MC). In other words a producer will employ the factors only up to the point where the cost of an additional factor unit equals its marginal revenue. (b) Reward for each factor is same in every use. Marginal productivity theory assumes that productivity of a factor is equal in all its uses. If the factor cost in two different uses is not uniform i.e. if the factor cost in one use is greater than other use, factors will move to that use where the factor cost is high so that they can earn more.This movement will continue so long as the productivity of a factor becomes equal in all its uses. Besides this the marginal productivity of all factors is the same in a particular use and thus they are the perfect substitutes of each other. The producer goes on substituting dearer factors by the cheaper factors so long as the marginal productivity of the factor becomes proportional to their prices. This condition for achieving equilibrium is stated as follows. When a producer employs more and more of a factor unit, the marginal physical productivity of additional factor will start diminishing. That is why Marginal Productivity Curve diminishes after a particular point of employment of a factor. Since the objective of a firm is to maximize profit, he will always compare the cost of employing (MC) an additional laborer with the contribution (MP) made by that additional laborer.

He will go on employing additional factor so long as Marginal factor cost is equal to Marginal Productivity. The moment the productivity of an additional factor equals the marginal factor cost, i.e., the point where marginal revenue product of the factor equals its price. (MRP = MC), he will stop employing additional factors and thereby his profit is maximized. The equilibrium situation is explained by the following diagram. Diagram:

In the figure 18.1, the supply of labor is perfectly elastic since there is perfect competition in the market. The wage (W) is equal to average wage (AW) and marginal wage, (MW) = W = AW = MW. At point E, the MRP of labor is equal to marginal wage (MW). The producer is in equilibrium at point E. He will employ ON units of labor because when ON units of labor are employed, the marginal revenue productivity of labor MRPL = Wage. To the left of E the MRP of labor is higher than wage (MRP > W), the producer will increase the units of labor. To the right of E, the MRPL< wage, so the firm will curtail the units of labor. It is only at point E, the firm is in equilibrium where MRPL = Wage. Criticism: (1) Unrealistic assumptions:

The theory is founded on certain unrealistic assumptions like prevalence of perfect competition and they are perfectly mobile. In reality there assumptions are not found. (2) Difficulty in the measurement of MRP: It is difficult to measure marginal revenue productivity of a factor. Marginal revenue productivity is the addition made to total revenue by employing an additional unit of a factor. But actually it is difficult to get it. In a large-scale industry if the work of a laborer is decreased, it will have no fall in total production. (3) Factors are not perfectly identical: In reality, different units of a factor are not identical. They are heterogeneous and hence cannot be substituted by one another. Land and capital cannot be substituted for each other. Labor as a factor cannot be equal in health and efficiency. They are not equally productive. (4) Reward determines productivity: The reward of a factor is determined by the factor's marginal productivity. Hence MRP is the cause and reward is the effect. When a laborer is given higher wages, his living standard will develop and his health and efficiency will increase.

WAGES Meaning of Wages: Wages are the reward paid to the worker for his labour. The term ‘labour’, as used in Economics, has a broad meaning. It includes the work of all who work for a living, whether this work is physical or mental. It also includes the exertions of independent professional men and women like doctors, lawyers, musicians and painters who render service for money. In fact, ‘labour’ in Economics means all kind of work for which a reward is paid. Any type of reward for human exertion whether paid by hour, day, month or year and paid in cash, kind, or both is called wages. “A wage may be defined as a sum of money paid under contract by an employer to a worker for services rendered.”— (Ben- ham). It is essentially a price for a particular commodity, viz., labour services. Methods of Wage Payment: From the point of view of payment, wages can be classified as:

(a) Cash wages or wages in kind, according as the payment is made in cash or kind; (b) Time wages, when the wage rate is fixed per hour, per day or per month; (c) Piece wages, when the worker is paid according to the work done; (d) Task wages, which is a payment on a contract basis, i.e., payment for finishing a specified job. Wages are given different names, e.g., salaries for the higher staff, pay to the lower staff like clerks and typists, wages for the workers, fees for persons in independent professions like lawyers and doctors, commission for middle men, brokers, etc., and allowance for special work or for special reasons, e.g., travelling allowance, dearness allowance, etc. Real Wages and Nominal Wages: Economists have differentiated between nominal wages and real wages. Nominal wages are the wages received by a worker in the form of money. Therefore, nominal wages are also called money wages. For example, a worker gets Rs. 200 from his/her organization in exchange of services rendered by him/her. In this case, the amount of Rs. 200 is regarded as a nominal wage. On the other hand, real wages can be defined as the amount of goods and services that a worker purchases from his/her nominal wages. Therefore, real wages are the purchasing power of nominal wages. According to classical theories, the supply of labor is determined by the real wages. However, according to Keynes, the supply of labor depends on the wages received in terms of money or nominal wages. Let us understand the difference between nominal wages and real wages with the help of an example. Suppose a worker earns Rs. 100 per day and his/her wages are increased to Rs. 120. In such a case, it is not necessary that his/her economic condition or purchasing power will increase. The economic condition of a worker depends on the amount of goods and services he/she can purchase with nominal wages. In case, the prices of goods and services are doubled, the worker would need the double amount of his/her nominal wages what he/she is getting at present to purchase goods and services. Therefore, the economic condition of an individual is determined by his/her real wages. The following is the formula for determining real wages: W= (NW/P) * 100 Where W= Real wages

NW=Nominal Wages P= Level of price. Factors Influencing Real Wages: The following factors have to be taken into account when estimating real wages: Purchasing Power of Money: Money is only a medium of exchange. We value it for its power to buy goods and services. Let us take an example. We see that, according to the general index maintained by the Economic Adviser to the Government of India, average wholesale prices have gone up to nearly double as compared to 100 in 1970-71. The monthly earnings of persons with fixed salaries have not gone up to the same extent. They are, therefore, proportionately much lower than before. Therefore, to say that salaries have gone up is a pitiful joke! For such persons, real wages have fallen, as the purchasing power of money has gone down to about 50%. Price level, therefore, is an essential factor to be taken into account while estimating real wages of a Worker or a group of workers. Additional Receipts in Kind: The money income of a person may be increased by free quarters, cheap rations, a free uniform, special gifts on festival days, and the like. A person improves his living from such sources. A pension after retirement or a free bungalow adds to an officer’s real income. Hence, such additional receipts must be taken into account while estimating a person’s real income. Possibility of Supplementing Income: Some employments are such as give time or create an opportunity for increasing one’s income. Thus, a professor may write articles or books or a teacher may coach students privately and supplement his income. Salaried doctor may have private practice. Such supplementary earnings add to a person’s real income. Working Hours: We have also to consider the hours worked per day, the days per week, as well as the off-days in a year while computing a person’s real income. Frequent rest intervals-add to one’s real wages and comfort. In some occupations, workers have to put in extra work without extra payment. For instance, the staff of a bank has a hard time at the half-yearly close. Sometimes senior officers get unauthorized work from their juniors. Such unpaid over-time work reduces real wages. Regularity of Employment:

If a person is frequently out of work, even a high money-wage ultimately means a low real wage. Continuous employment on a lower wage is preferred to work which is more paying but is uncertain or temporary. That is why an ordinary lawyer or a doctor may take to service as against independent practice. Expenses of Starting a Trade: Some occupations require much initial expenditure. Good furniture and other equipment, latest surgical instruments and medicines are necessary for a doctor to start his practice. One forms a poor impression of a lawyer if his office is not furnished with at least half a dozen book-shelves stuffed with bulky volumes. Such expenses have to be deducted from money wages when estimating real wages. These are some of the factors that have to be taken into account while estimating the real wage of a worker as distinguished from his nominal wage. Minimum Wages The Minimum Wages Act 1948 is an Act of Parliament concerning Indian labour law that sets the minimum wages that must be paid to skilled and unskilled labourers. The Indian Constitution has defined a 'living wage' that is the level of income for a worker which will ensure a basic standard of living including good health, dignity, comfort, education and provide for any contingency. However, to keep in mind an industry's capacity to pay the constitution has defined a 'fair wage'. Fair wage is that level of wage that not just maintains a level of employment, but seeks to increase it keeping in perspective the industry’s capacity to pay. To achieve this in its first session during November 1948, the Central Advisory Council appointed a Tripartite Committee of Fair Wage. This committee came up with the concept of Minimum Wages. A minimum wage is such a wage that it not only guarantees bare subsistence and preserves efficiency but also provides for education, medical requirements and some level of comfort.India introduced the Minimum Wages Act in 1948, giving both the Central government and State government jurisdiction in fixing wages. The act is legally non-binding, but statutory. Payment of wages below the minimum wage rate amounts to forced labour. Wage Boards are set up to review the industry’s capacity to pay and fix minimum wages such that they at least cover a family of four’s requirements of calories, shelter, clothing, education, medical assistance, and entertainment. Under the law, wage rates in scheduled employments differ across states, sectors, skills, regions and occupations owing to difference in costs of living, regional industries' capacity to pay, consumption patterns, etc. Hence, there is no single uniform minimum wage rate across the country and the structure has become overly complex. The highest minimum wage rate as updated in 2012 is Rs. 322/day in Andaman and Nicobar to Rs. 38/day in Tripura.

Wage Differentials

Wage differential is a term used in labour economics to analyze the relation between the wage rate and the unpleasantness, risk, or other undesirable attributes of a particular job. The wage paid to workers varies greatly. These wage differentials are mostly the result of differences in worker ability and the workers' effort in performing the job. There are also wage differentials across occupations, because of differences in the demand and supply of laborers for particular job or occupation. These differences arise primarily because of differences in the amount of education or training required and in the desirability of the job itself. If wage rates differ between occupations, then we have ‘horizontal differences’ in wages. ‘Vertical differences’ in wages occur when wage rates vary between different persons within the same occupation.

We know that money wages are not uniform for all occupations. Money wages may be high in one occupation or low in another occupation. This kind of difference in money wages is known as horizontal differences in wages. If differences in wages are attributed to differences in ability or efficiency, then such differences are called vertical differences in wages. The following important factors are responsible for the differences in wages between occupations. 1. Difference in efficiency: All persons are not equally efficient. They differ in abilities. Some are more efficient and some are less efficient. Some others are not efficient at all. An efficient worker gives better output. Hence, he is paid higher wages than others are. Moreover, the efficiency requirement in different jobs varies. A doctor requires more skill than a nurse does. A district collector is entrusted with heavy responsibilities and the job necessitates ability and intelligence. On the contrary, the job of a sweeper does not require them. Hence, wages differ between occupations. 2. Presence of noncompeting groups: Society is divided into a number of working groups, which are noncompeting. Caste system creates such groups in India. As a result, a child born to a sweeper will most likely be a sweeper just as a black smith’s son will be a black smith. Besides, the chances of receiving training for better-paid occupations depend on the resources of the family. Thus, inheritance, environment, training and sex are some factors, which create noncompeting groups in the society. Hence, workers belonging to different groups are paid at different wage rates. 3. Immobility of labour: Labour is not perfectly mobile. It is normally shy to move. It has a tendency to stick to one job. Sometimes, people are not prepared to accept higher wages if it necessitates a change of place. This accounts for difference in wage in different places. The presence of noncompeting groups in society makes labour more immobile. Political barriers against the free movement of labour from one country to another result in the difference in wages in different countries.

4. Nature of employment: The nature of work also influences wage rates. Dangerous and disagreeable work brings higher money wages to attract larger supply of labour. For example, a coal miner gets higher wages than a clerk in the office. High money wages act as compensation. Such types of wage differential is called compensating differential. Contrarily, safe, pleasant, comfortable and socially prestigious jobs carry lower money wages. 5. Training and Qualification: Jobs requiring special qualification and apprenticeship generally command higher wages than jobs learnt easily and for which no special training is required. 6. Productivity: This differs in different occupations. The Cobbler’s job is not as productive as that of a skilled motor mechanic or of clerk as that of a principal of a college. 7. Regularity of employment: If there is regular employment in a job, one may demand lower wages. If the job is irregular or seasonal, wage has to be higher. In case of India, young men prefer low paid jobs under government due to security and regularity of employment to irregular and insecure private jobs with more remuneration. 8. Future Prospects: There are some jobs where promotion prospects are better than other jobs. Even if initial salary is low, if promotion prospects are there people prefer these jobs to others jobs. 9. Scope for extra earning: If a job has scope for extra earnings, the regular wage may be lower. A doctor may start with a lower salary than a lecturer but the former can make up the deficiency by private practice. 10. Trade unions and their collective bargaining power: Unions might exercise their bargaining power to offset the power of an employer in a particular occupation and in doing so achieve a mark-up on wages compared to those on offer to non-union members.

RICARDIAN THEORY OF RENT

The Ricardian theory of rent follows from the views of classical writers about the operation of law of diminishing returns in agriculture. Ricardo defined rent as follows: “Rent is that portion of the produce of earth which ...