scale production

SCALE OF PRODUCTIONRefers to the size of, from and the technique employed in production. Divided into two

1. Large scale production.
2. Small scale production

The LRAC curve shows the lowest cost of producing different levels of output given the firms production function and factor prices. The LRAC curve is an envelope curve to the firms SRAC.

3. Economies of scale: Falling long run average cost from C1 to C2 as the scale of output increases.
4. Diseconomies of scale: Rising long run average cost as the scale of output increases.

Causes of Economies of Scale:

1. Improvement in production techniques
   Adopting modern or advanced technology helps improve the efficiency of production. As firms scale up, they can afford to invest in better techniques that reduce costs and increase output.
2. Efficient utilization of resources
   Large-scale production allows for better use of available resources (like labor, capital, and materials), leading to reduced waste and more efficient operations.
3. Full utilization of resources
   As firms grow, they can fully utilize their resources, such as machines, workers, and facilities, at optimal capacity. This reduces idle time and increases overall efficiency.
4. Availability of a reliable market
   When there is a stable and growing market for a firm's products, it enables large-scale production. Firms can sell more units at lower costs, benefiting from economies of scale.
5. Effective and economic use of capital goods
   As production increases, firms can make better use of capital goods (such as machinery, equipment, and infrastructure). This helps spread the cost of capital over a larger output, reducing per-unit costs.

Internal economies of scale: are those factors which bring about the reduction in average cost as the scale of production of individual firm rises. External economies of scale: are result from the simultaneous growth or interaction of a number of firms in the same or related industries. These includes specialist companies of supplying and repairing machinery. The expansion of an industry leads to the establishment of many firms specializing in a particular stage of production processes.

Causes of Diseconomies of Scale:

1. Weak market inefficiency
   As firms grow too large, they may struggle to sell their products in the market efficiently. This can lead to oversupply, lower prices, and inefficiencies in production, reducing profitability.
2. Leakage of resources
   In large organizations, resources can be wasted or poorly allocated. As a firm expands, it may face challenges in managing its resources effectively, leading to inefficiencies and increased costs.
3. Applying old techniques of production
   If a firm continues to use outdated production methods as it grows, it can lead to higher costs and lower productivity. The firm might not fully benefit from technological advancements or improved processes.
4. Poor management
   As firms expand, managing them becomes more complex. Poor communication, decision-making, and coordination across departments or locations can lead to inefficiencies and higher operational costs.
5. Unemployment of resources
   With large-scale production, there is a risk of underutilizing resources. For example, some workers or equipment may become redundant or underused, leading to wasted capacity and higher per-unit costs.

LARGE SCALE PRODUCTION Refers to the scale of production in which large output is produced and the amount of inputs used is also large.

Merits of Large-Scale Production:

1. Ability to minimize the cost of production and maximize profit
   Large-scale production allows firms to buy inputs in bulk at lower prices, use advanced technology, and spread fixed costs over a large volume of production, all of which help reduce production costs and increase profitability.
2. Variety of goods due to settled market
   Large firms can produce a variety of goods to cater to different customer needs. A stable, large market gives them the ability to diversify their product offerings.
3. Easy to raise capital from financial institutions
   Bigger firms with established operations and potential for high profits are seen as less risky by financial institutions, making it easier for them to raise capital or secure loans.
4. Expansion of market through advertising and research
   Large firms have the resources to invest in extensive advertising campaigns and market research, helping them reach a broader audience and explore new markets.
5. Ability to increase efficiency in production
   With the use of advanced technology, skilled labor, and heavy investment in capital, large-scale production allows firms to produce goods more efficiently.
6. Specialization and division of labor
   Large firms can divide tasks among workers more effectively, allowing for specialization. This improves productivity as workers focus on specific tasks, leading to greater overall efficiency in production.

Demerits of Large-Scale Production:

1. Large cost of administration
   Running a large-scale operation requires significant administrative costs. Managing departments, personnel, and resources at scale leads to higher overhead expenses.
2. Difficult to make decisions
   With a large workforce and many departments, decision-making becomes more complex and slower. It’s harder to get everyone aligned on objectives and strategies, which can hinder responsiveness and flexibility.
3. Requires large capital to start
   Starting large-scale production often requires substantial investment in equipment, labor, and facilities. This can be a barrier for new firms or those with limited financial resources.
4. Managers have less control
   As a firm grows, managers have less direct control over day-to-day operations. The complexity of managing large teams and operations can reduce the effectiveness of management.

Qn. Why do small scale firms continue to exist side by side with the large scale enterprise? REASONS:

1. Some small scale firm supply inputs to the large scale firms. The large scale firm plays part as a market for small scale firm.
2. Small extent of the market. The output being produced by small scale firms is easily to be disposed then the output produced by the large scale firms.
3. Small scale firms have control with the customers.
4. Easy management in small scale firms due to small resources than in large scale firm which require complicated economies systems.
5. Simplicity in technique of production.
6. There some cost which small scale producers do not like advertising transport.
7. Decision making. It is quick because it involves one person ( owner ).
8. Low operating and administrative system.
9. High commandment to owner of the firm.

Disadvantages of Small-Scale Firms:

1. Limited possibility of expansion due to small capital
   Small firms often struggle to expand because they have limited financial resources. This restricts their ability to invest in new technologies, increase production capacity, or enter new markets.
2. Large average cost
   Small firms typically face higher per-unit costs of production. They can't benefit from economies of scale (cost advantages from large-scale production), which makes their products more expensive to produce compared to larger competitors.
3. Cannot produce a variety of goods
   Small firms usually focus on a limited range of products. This can be risky because if demand for those products drops, the firm may face financial difficulties.
4. Difficult to market products due to low advertising
   With fewer resources, small firms often can't afford extensive advertising campaigns, which makes it harder for them to reach a wide audience and grow their customer base.
5. Inefficient production due to lack of skilled labor
   Small firms might have trouble hiring and retaining highly skilled workers due to budget constraints, which can affect the efficiency and quality of their production.

a) Choice of the appropriate formula and computations b) Interpretation DISTRIBUTION THEORY WAGES This is a payment paid to labour for its efforts rendered in the production process Types of Wages

1. Money or nominal wagesThis refers to the amount of money received by a labourer for performing a certain work without considering the amount of goods and services worth it.
2. Real wagesIs the wage that is measurable in the amount of goods and services worth it and therefore it considers the purchasing power.
3. **Kind wages.**This is the type of wage which is paid in terms of physical goods. E.g. in rural areas labourers are at times paid in terms of such as grains.

Determinants of Real wages

1. The price level The purchasing power of money depends upon the price level. Therefore when the price increases the real wage decreases and the opposite is true.

2. Extra Incomes This is an addition to what the labourer earns from other sources which finally results into high real wages.

3. Extra Facilities. Labourers receive extra facilities such as housing, medical, education etc. such benefit also increase the real wage of the worker.

4. Working hours. When looking at the real wage. Working hours with their distribution leaves and vacations are very important. The less the working hours by provision of leave hours, the higher the real wage.

5. The nature of the work If the work is risky, injurious etc. to the health of the labourers then the real wage in that case is to be considered low and the opposite is true.

6. Regularity of the work Real wage will be more in those professions where work is regular and permanent as compared to the jobs of temporary nature.

Systems of Wage Payment****Pieces rate system: This is a system whereby a worker is paid according to the work done. E.g. the quantity of output produced.

Advantages:

1. Increased output
   Since workers are paid for what they produce, they are motivated to work faster and produce more to earn more.
2. Easy to identify hardworking workers
   It’s simple to see which workers are productive by comparing their output, making it easier to differentiate between hardworking and lazy employees.
3. Minimal supervision needed
   Because workers are motivated to earn more, employers don’t need to supervise them closely, reducing management effort.
4. Clear payment structure
   Both the employer and the employee know exactly how much will be paid based on the quantity of work done, making payments straightforward.
5. Opportunity for quicker workers to earn more
   Workers who are faster and more efficient can earn more than slower workers, which rewards high performance.

Disadvantages:

1. Risk of overworking
   Workers may push themselves too hard in an effort to earn more, leading to exhaustion or burnout.
2. Not suitable for unmeasurable tasks
   This system doesn't work well for tasks where output is difficult to measure, such as quality-based work or services.
3. Quality may suffer
   Workers may focus on quantity over quality in order to produce more, meaning that those who prioritize quality might end up being paid less.
4. Decline in quality due to rushing
   Workers might rush to produce more, leading to a drop in the quality of the output.
5. Increased risk of accidents
   In a rush to increase production, workers may act hastily, leading to more accidents or unsafe working conditions.

Time rate system: This is a system of wage payment which is based on the hours of work by labourers which can be weekly, monthly etc.

Advantages:

1. Regular payments
   Workers are guaranteed a consistent income, regardless of their output, making it easier to plan financially.
2. Suitable for unquantifiable tasks
   Works well for jobs where output can't be easily measured, such as in service industries or creative tasks.
3. Easy calculation of wages
   The wage is based on the time worked, so calculating pay is straightforward and clear for both the employer and employee.
4. Encourages high-quality work
   Workers aren't pressured to rush their work for more pay, so they can focus on producing higher-quality output.
5. Flexibility in wage adjustment
   The system allows for easy adjustments in wages to reflect varying skill levels required for different jobs.

Disadvantages:

1. Potentially low output
   Since workers are paid by the hour, they might not be motivated to produce more, knowing they will still get paid regardless of output.
2. Hard to assess individual performance
   It's difficult to distinguish between hardworking employees and lazy ones, since pay is based on time rather than output.
3. Requires close supervision
   Employers need to supervise workers closely to ensure that they are working efficiently, which increases management costs.
4. No extra reward for high performance
   Since output isn’t tracked by the system, it’s hard to give extra compensation to those who perform exceptionally well.
5. Encourages inefficiency
   Since workers are paid the same for the hours worked, there’s little incentive for them to work quickly or efficiently, leading to potential inefficiency.

Standard rate system:

This is a system of wage payment where by all workers engage in similar works is paid the same.

1. Bonus system
2. Profit sharing system

Wages Differential It refers to a situation whereby labourers are paid different wages, despite the fact that they may be working in the same firm having the same education level etc. Reasons for Wage Differential

1. Difference in the level of education. Highly educated are paid more than the less educated since they have more skills, more knowledge etc.
2. Difference in the level of trust and responsibilities Those who are in the position of more trust are paid more than those employees with low level of trust.
3. Difference in the level of experience More experienced workers are paid more than less experienced workers as they are assumed to be more knowledgeable, experienced and more efficient compared to less experienced workers.
4. Difference in the riskiness of the job Those workers which perform risky and dangerous jobs are paid more compared to other jobs. These dangerous occupations are such as miners. Pilots etc.
5. Difference in Gender In some situation males are paid more than female, because males use more energy and most of the works are done by males and not all of them are done by female.
6. Difference in the level of strength. More energetic workers are paid more compared to less energetic workers. The more energetic a worker he/ she is can be able to perform more work and get more paid
7. Racial factor. At times wages differ among workers due to racial factors, where by the whites are paid more compared to the blacks.
8. Differences in the strength of Trade Unions. Workers who belong to strong trade unions are normally paid more compared to those who belong to weaker trade unions.

Theories of Wage Determination a. Subsistence theory of wagesThis theory was presented by the physiography and was explained by a German economist Sallee. This theory may be known as The Iron Law of Wage According to this theory, wages tend to settle at the level which is just sufficient to maintain the worker and his family at a minimum subsistence. If for some reason, wages are higher than this level, it is said that the workers would be encourage to marry, their number would increase by higher birth rate with the large supply of labour brings down the wage to the subsistence level. If on the other hand, wages are below subsistence level marriages will be discouraged and ultimately labour supply will decrease, hence wages will rise and reach the subsistence level. This theory has been reflected because it is not realistic. Criticisms of the theory.

1. The law is applicable to less developed countries where wages are on low subsistence level unlike in more developed country.
2. The theory only looks at increase in birth rates due to increase in wages neglecting other factors such as; early marriages.
3. The term minimum subsistence is vague, because there is nothing like a fixed minimum subsistence as it keeps on changing.
4. The theory is also unable to explain reasons for differences in wages.
5. It is not always true that increase in wages is always accompanied by increase in the population size

Wages Fund TheoryThis theory is associated with the name of J.S. Mill. According to him, a wage fund is created and the wages are paid by the employer out of this fund. According to this theory, wages depends on two quantities:-

1. The wages fund set aside by the employer for the payment of wages and
2. The number of labourers seeking employment. The actual rate of wages can be found by dividing the fund by the number of workers.

According to this theory, wages cannot rise unless either the wage fund is increased or the number of working class people decreases. Criticism of the theory

1. In real world there is nothing like a fixed wage fund as firms set wages according to the level of production.
2. The theory does not explain the method used in determining the wage fund.
3. The theory does not explain reasons for wage differentials among labourers.

Residual Claimant Theory. This theory was advanced by the American economist John Walker. According to him, wages are the residue left over after other agents of production have been paid. Rent, interest and profit, according to him are determined by definite laws. Out of the total production. When payments have been made to other factors, it is said that the whole of the remainder will go to workers. This theory has also been rejected by most economists. It does not explain how trade unions are able to raise wages. Moreover, it is not the worker who is the residual claimant but the entrepreneur. The theory also ignores the influence of labour supply in wage determination.   **Market theory of Wages.**According to this theory wages are determined by the interaction of demand & supply of the labour in the market and therefore the wage rate would be determined at the point of interaction of demand and supply curve for labour in the market. Demand for labour is derived demand. Therefore when there is increase for demand of goods and services producers will demand more labour and the opposite is true. Supply for labour refers to the number of labourers willing to work at the prevailing wage rate per period of time and it depends on factors such as population size, population composition etc. From the above graph, Qe We is the equilibrium wage rate. Above that wage, demand for labour will be less than supply labour and hence surplus, labour but however that wage, demand for labour will exceed supply of labour and hence a shortage.   Marginal Productivity TheoryAccording to this theory a factor of production specifically labour should be paid according to its marginal productivity. Marginal productivity is the additional output produced by an additional labour employed. Therefore a labour is paid according to his contribution (marginal product) to the firms total output. The higher the marginal productivity of the labourer, the higher the wage and the opposite is true. If the employer pays a labourer more than the value of his marginal productivity it will instead result in to a loss.   **Assumptions of the Theory.**The theory is based on the following assumptions:-

1. All units of labour are homogeneous.
2. The theory assumes that marginal productivity of any factor can be measured
3. It assumes perfect mobility of factors of production e.g. Labor
4. The theory assumes operation of the law of diminishing returns.
5. The theory also assumes that wages are only determined by marginal productivity of labour.

Criticism of the Theory

1. In reality it is not true that all factors such as labour are homogeneous as it differs in terms of strength, experience, skills etc.
2. Perfect mobility of factors of production e.g. labour as at time limited by factors such as old age, fear to lose family ties.
3. The theory only looks at the demand side of labour neglecting the supply side of it
4. Increased wages can as well be determined by other factor besides marginal productivity such as level of experience, education and training.
5. In reality it is also difficult to measure marginal productivity of labour
6. It is also not true that the productivity of labour depends on the labourer himself but however depends on the efficiency of other factors.

**Bargaining theory of Wages.**According to this theory wages are determined according to the bargaining strength of the labourers through their trade unions. Trade unions represent labourers to the management to discuss wage improvement and working conditions. Therefore the stronger the bargaining power, the higher the wages and the opposite is true. Trade Union is an association of workers that aims at advocating for better payment and better working conditions. It has been defined by Prof. Webb in the words “A Trade union is a continuous association of wage earners for the purpose of maintaining and improving the conditions of their employment.”

Methods Used by Trade Unions:

1. Collective Bargaining
   Union leaders negotiate with employers on behalf of workers to secure better wages, benefits, and working conditions.
2. Striking
   Workers stop working as a protest to pressure the employer into meeting their demands.
3. Go-Slow Tactics
   Workers deliberately reduce their pace of work to reduce productivity without going on full strike.
4. Sabotage
   Deliberate disruption of operations or creating a bad public image of the company to force management to act.

Functions of Trade Unions:

1. Demand Wage Increases
   Lobby for better pay for their members.
2. Improve Working Conditions
   Seek safer, healthier, and more favorable work environments.
3. Fight Job Loss
   Work to protect members from being laid off unfairly.
4. Fight Unfair Dismissal
   Provide legal and organizational support in case of wrongful termination.
5. Protect Against Discrimination
   Defend members against unfair treatment based on race, gender, religion, etc.
6. Advise Government
   Provide input on employment policies, wage laws, and labor regulations.
7. Improve Skills
   Organize training sessions, seminars, and workshops to enhance the skills and knowledge of members.

Strength of the Trade Unions Strength of the trade union depends on the extent at which a trade union is able to achieve its objective. Strength of the trade union will depend on the following factors.

1. Unity among members. When there is unity among members, there is strength of the trade union because they tend to have a common stand.
2. The rise of membership The bigger the membership the more strongly the trade union because they contribute more ideas and the voices is high.
3. Financial position of the trade union. When the financial position of the trade union is high the more the stronger the trade union because it can open up more branches and can run up all the financial activities of the business.
4. The(impacts) level of inconvenience of trade union The more the impact of the trade union activities, the stronger the trade union and the opposite in true
5. The labour laws of the Country. If the labour laws are supporting and protecting the interest of the labourers then the trade union will be strong and the opposite is true
6. Trade union leadership. If a trade union is led by committed and competitive leaders, he tends to be stronger as compared to one led by leaders who aim at fulfilling their own objectives.

Problems Faced by Trade Unions in Poor Countries:

1. Lack of Funds
   Limited financial resources restrict operations, training, legal action, and member services.
2. Government Interference
   Governments may impose restrictions, dissolve unions, or influence their leadership to limit their power.
3. Low Member Cooperation
   Members may fail to pay dues or participate actively, weakening the union's influence.
4. Poor Leadership and Management
   Some leaders misuse their positions for personal gain rather than advocating for workers’ rights.
5. Tribal or Ethnic Divisions
   Ethnic differences can hinder unity and weaken collective action.
6. Government as Major Employer
   In many low-income countries, the government is a primary employer and may resist union demands, especially for wage increases or better conditions.

Factors That Determine Wages:

1. Experience Level
   More experienced workers typically earn higher wages.
2. Education Level
   Higher qualifications usually command better pay.
3. Government Policy
   Minimum wage laws directly affect the lowest acceptable pay rate.
4. Job Responsibility
   Jobs with more duties and decision-making roles tend to pay more.
5. Demand and Supply of Labour
   High demand and low supply increase wages, while the opposite reduces them.
6. Physical Strength or Effort Required
   Jobs requiring greater physical effort may offer higher pay to attract workers.
7. Productivity
   More productive workers can earn more based on performance.
8. Cost of Living
   In areas with high living costs, wages may be higher to compensate.
9. Job Risk
   Hazardous jobs (e.g., mining, construction) often pay a risk premium.

a. RentRent is a reward to the land lords for use of the land there it is the price of land. In economics, rent is defined as a payment made to the land lord by the tenants for the use of their land. In ordinary sense rent is defined as a periodical payment made for use of items such as house, a bicycle, and a car and so on. Theories of Rent There are two main theories of Rent

1. Ricardo theory or Ricardian theory.
2. Modern theory or demand and supply theory.

Ricardian Theory of Rent This theory was put forward by David Ricardo and in his ideas he defined Rent as, “That portion of the produce of land which is paid to the land lord for the use of the original and indestructible process of the soil.” In other words Ricardo considered rent as a return to the landlords from the use of their land. In his opinion Ricardo stated that rent is only applicable to land and not any other factor of production because land possesses unique features being a free gift of nature and having fixed supply. He also emphasized that land possesses some power which are free and indestructible and this is what referred to as the fertility power of soil, but however such fertility is not uniform to all portion of land, therefore some portions have high fertility and other low and hence basis of rent. Ricardian theory has two elementsThe first element is that rent arises due to the reasons that certain lands are more fertile as compared to other lands and in this way, surplus production occurs due to the difference in the fertility of land and it is called differential surplus or differential rent The second element is that land is scarce and rent arises due to the security of land. According to Ricardo, the superior lands will pay scarcity rent at the same rate as the inferior lands but they will also pay a differential rent. The Theory is based on the following assumptions:-

1. Land has a fixed supply.
2. Fertility differs among different portions of land.
3. He also assumed the law of diminishing returns to operate.
4. It is also assumed that land possesses original and indestructible power of the soil
5. Basing on all the above Ricardo concludes; that difference in rent among different portions of land depends on the superiority of the fertility and therefore more fertile land will fetch more rent than the less fertile.

Criticism of the Theory

1. In reality rent does not arise because of fertility but because land is scarce.
2. Rent is not only applicable to land but even to other items such as car, bicycle. etc.
3. The law of diminishing return which was assumed to operate can be checked by modern methods of agriculture e.g. use of fertilizers
4. It is also not true that there is such original and indestructible power of soil since fertilized soil tend to lose fertility after being used for a long period of time.
5. Land can as well be used for various uses besides cultivation. It can as well require to pay rent eg construction of commercial buildings.

b. Modern Theory of RentUnder this theory rent is determined by its demand and supply. Demand for land Demand for land is derived demand by individuals and the economy as a whole. When there is more demand from products of land demand for land increase and the opposite is true. Supply of land On the other hand supply of land is fixed (perfectly inelastic) meaning that the supply of land can neither increase nor reduce when rent increases or decreases. Basing on the above rent will be determined at the point of interaction of the demand and supply curve for land From the above Ore is the equilibrium rent determined when demand and supply curve for land meet at point E. Therefore when demand for land increases rent will also increase and the opposite is true.   TRANSFER EARNINGS, ECONOMIC RENT AND QUASI RENTThis is the amount of money that any particular unit of a factor e.g. labour could earn in its next best paid alternative use or employment.   Transfer Earnings means to the minimum amount that any unit of a factor e.g. labour must earn in order to precept it from transferring to another alternative use. This means that any reduction in the actual earnings below the transfer earnings would cause the factor to transfer to the next best alternative use or employment. Therefore transfer earnings are the minimum amount of money that must be paid to a unit factor in order to hold in its present use. E.g. if a labour is paid 70,000/= month in his current employment but would earn 60,000 in his next alternative employment then 60,000 is the transfer earnings. In order for the employer to retain his employee he should pay him a minimum of at least 60,000 or more.   ECONOMIC RENT This is the surplus earning to factors of production e.g. Labour over its transfer earnings. Economic Rent is therefore the excess payment over and above the transfer earnings. Eg. if a labour currently earns 70,000/= at the current employment but could earn 60,000/= in the next best alternative employment then 10,000 is the economic rent. Economic Rent = Actual earnings – Transfer earnings Economic Rent = 70,000 – 60,000 = 10,000   QUASI RENTThis refers to short run earnings to those factors of production which are man made. E.g. machines, buildings etc. whose supply is fixed in the short run. Unlike land whose supply is fixed both in the short and in the long run factor such as machines, buildings and other there supply is inelastic in the short run but elastic in the long run Because of their inelastic supply in the short run when demand increase, their income also increases and hence able to earn a surplus. The surplus earned is however temporary as their supply becomes elastic in the long run. When the supply increase in the long run and adjusted to demand their surplus earnings disappears. In summary quasi rent is the income earned by man-made factors such as machines, building etc. whose supply is inelastic in the short run but elastic in the long run.   Interest This is the price for the use of money capital borrowed. Therefore interest is the reward for capital owners from the capital land out. Interest rate is the price on borrowed capital which is the percentage of the amount borrowed is normally charged annually. Gross Interest means the total amount which a debtor pays to a creditor and the net interest is that part of the payment which is for use of capital only. Reasons why interest is charged on capital

1. Capital increase productivity
2. Is the payment for risk involved in lending out
3. Payment for inconvenience involved when lending out
4. Cost of administering the credit eg. Keeping records.

Reasons Why Interest Rate Differ Among Borrowers

1. The amount of loan The bigger the amount borrowed, the higher the interest to be charged, higher risk involved and the opposite is true.
2. The repayment period. For a shorter repayment period the less will be the interest rate as it is to a longer repayment period.
3. Demand & Supply of Capital When demand capital is higher than its supply interest will be high. However when demand for capital is less than its supply interest will be low.
4. Credit worthiness of the borrower If the borrower is more credit worth interest charged will be low the opposite is true.
5. Difference in distance between the lender and the borrower When the distance between the lender and the borrower is big, interest high because of high administration cost and the opposite is true.
6. The purpose of the loan High interest rates are normally charged for unproductive loan compared to productive loan, for example; investment loans.
7. The Inflationary Condition During Inflation the interest rate is high due to the value of money is low and during the period of deflation, the interest rate is charged because the value of money is high.

Theories of Interest are of two kinds:-

1. Those theories which relate to the problem why interest is paid.
2. Those theories which relate to the problem how rate of interest is determined.

**WHY INTEREST IS PAID?**The following theories explain why interest is paid:-

1. Marginal Productivity Theory
2. Waiting Theory
3. Austrian Theory
4. Liquidity Preference Theory
5. Fisher’s Time Preference Theory

Marginal Productivity TheoryAccording to this theory, interest is paid due to the reasons that capital is productive with the help of capital; it is possible to increase the production of commodities to great extent. Capital is productive in the sense that labour assisted by capital produces more than without capital. E.g. fisherman can catch more fish with a net than without it. But this theory does not explain the concept of interest properly because if people were willing to lend unlimited amount of money without interest, a business would expand up to a point where the falling price of the product would simply cover other charges in making their off. Interest which every entrepreneur must keep in view. This is due to the reason that interest is paid on capital because demand for capital is greater than supply capital it is scarcity rather than productivity which explains interest.   **Waiting Theory or Abstinence Theory.**Another theory of interest is the abstinence theory. It was presented by Prof. Senior. According to him, saving involves a great sacrifice or abstinence, because saving is an act of abstaining from the consumption since to abstain is painful, it was necessary to reward people for this act. This reward was in the form of the interest paid to those who saved rather than consumed their income or a part of their income. Marshall used the term waiting instead of abstinence. According to him saving implies waiting. When a person saves, he does not refrain from consumption forever, but he has to ward since most people do not like to wait an inducement is necessary to encourage this postponement of consumption and interest is this inducement. This theory has a considerable element of truth in it but it does not clearly analyse the force acting on the side of demand for capital.   Austrian or Agro TheoryThis theory is also called the Psychological theory of interest. It was first advanced by John Rae in 1834. But it was presented in the final shape by Prof. Bohm Bawerk of the Austrian School of Thought. According to this theory interest arises because people prefer present goods to future goods. This is due to the reason that present wants are felt more seriously as compared to future wants and in this way, present satisfaction is attached greater importance than the future satisfaction. Interest is the discount which must be paid in order to induce people to lend money or postpone present satisfaction to a future date. Why do people prefer present satisfaction to future satisfaction? Bohm Bawerk gave three reasons for this fact.

1. The future is uncertain.
2. Present wants are felt more seriously than the future wants.
3. Present goods possess a technical superiority over future goods.
4. Fisher’s Time Preference Theory.

This theory was put forward by Professor Irving Fisher. In his view he stated that interest rate is as a result of eagerness to spend on the present consumption rather than the future consumption. People always put a lower value on future goods rather than present goods. It is up on this that they are more eager to spend their income on present consumption other than future consumption. Basing on this if a person lends to another he has to forego his present consumption and this will require him being offered a reward which is called interest. He also stated that the more the eagerness to spend on present consumption the higher will be the interest rate and the opposite is true. Criticisms of the theory

1. The theory assumes no difference between present and future purchasing power which is wrong as in the real world the purchasing power of money goes on changing.
2. The supply of capital in a country does not only depend on the eagerness to spend but however it even depends on other factors such as number of financial institutions.
3. The theory is one sided whereby it mainly looks at the supply-side of capital ignoring the demand side of it.
4. Fisher’s theory is very general as it fails to show the influence of financial institutions on the rate of interest.

Liquidity Preference TheoryAccording to Keynes, interest is not a reward for waiting, nor is it a payment for time preference. The rate of interest is a reward for parting with liquidity. In other words, people have a demand to hold money in cash form. In order to induce people to part with liquidity, they must be paid a reward in the form of interest. The rate of interest depends upon the degree of liquidity preference. The greater the liquidity preference, the higher the rate of interest and vice versa. This theory sounds more realistic HOW IS RATE OF INTEREST DETERMINED?

1. Classical Theory
2. Loanable Fund or New Classical Theory
3. Keynesian or Liquidity Preference Theory

Classical Theory. The classical theory of interest is also called the real theory of interest. According to this theory, the rate of interest is the payment for assistance or waiting or time preference. The rate of interest I this theory is determined by the demand for capital and supply of savings. Demand for capital. The demand for capital goods comes from the firms which desire to invest. Capital goods are demanded because they can be used to produce consumer goods. If the demand for consumer goods is greater capital like other factors of production has marginal revenue productivity. If capital goods are greater than the marginal revenue productivity will be lower and vice versa. Therefore, the marginal revenue productivity curve of capital slopes downwards towards the right. Thus we conclude that demand for individual capital goods and for capital goods in general will increase as the rate of interest falls. Supply of savings According to this theory, the money which is to be used for purchasing capital goods is made available by those who save from their current incomes. Saving involves the element of waiting for future enjoyment of saving. But people prefer the present satisfaction of goods and services to the future enjoyment of them. There, if people are to be persuaded to save money and to lend it to the entrepreneur, they must be offered to some interest as reward. If reward for saving is higher, individual will be induced to save more and vice verso. The supply curve of capital slopes upwards toward the right. The rate of interest is determined by the interaction of the force of demand for capital and the supply of savings. The rate of interest at which the demand for capital and supply of savings are in equilibrium will be determined in the market. Criticism of the Theory. According to the classical theory of interest, more investment can take place only by decreasing consumption but a decrease in demand for consumer goods is likely to decrease the incentive to produce capital goods and therefore it will affect investment adversely. By assuming full employment, the classical theory has neglected the changes in the income level. According to Keynes, equality between savings and investments is brought about not by changes in rate of interest but by changes in the level of income. Classical theory as pointed out by Keynes is indeterminate. Position of the savings schedule depends upon the income level. There will be different savings schedule for different levels of income. Loanable Funds Theory It may also be called Neo classical theory. According to this theory interest is the price paid for the use of loanable funds and also rate of interest is determined according to the forces of demand for and supply of loanable Funds. There are several sources of both supply and demand of loanable funds. Supply of Loanable Funds. It is derived from four basic sources namely (a) savings (b) dis hoarding (c) bank credit (d) Dis- investment

1. **Savings: (S)**Saving by individuals contributes the most important source of loanable funds. At a higher rate of interest, saving will be greater and vice versa.
2. **Dis hoarding: (DH)**It is another source of loanable funds individual may dis hoard money from the horded stock of previous period. At higher rate of interest, more will be dis hoarded and vice versa
3. **Banking credit: (BM)**The banking system provides a third source of loanable funds. Banking by creating money can advance loans to the businessmen. The banks will lend more money at higher rates of interest than at lower ones.
4. **Dis Investment: (DI)**Dis investment is the opposite of investment and takes place due to some reasons the existing stock of machine and other equipment is allowed to wear out without being replaced or when the inventories are drawn below the level of previous period. When this happens, the part of the revenue from the sale of product instead of going in to capital in to capital replacement flows in to the market for loanable funds.

DEMAND FOR LOANABLE FUNDS. The demand for loanable funds comes mainly from three fields, (a)Investment (b) consumption (c) hoarding

1. Demand for loanable funds for investment purpose by business firms is the most important element of total demand for loanable funds. The price of the loanable funds required to purchase the capital goods is oily the rate of interest. It will pay businessman to demand loanable funds up to the point at which the expected rate of return on the capital goods equal the rate of interest. Business on will fund it profitable to purchase large amounts of capital goods, when the rate of interest declines. Thus the demand for loanable funds curve for investment purposes slopes down wards to the right. This is represented by the curve I
2. Consumption The second big demand for loanable funds comes from individual who want to borrow for consumption purposes. Individual demand loanable funds when they wish to make purchases in excess of their current incomes and cash resources. Lower rate of interest will encourage some increase in consumer borrowing. Demand for loanable funds for consumption purpose is shown by the curve which also slopes downwards to the right.
3. Hoarding The demand for loanable funds may come from those who want to hoard money. Hoarding signifies the people desire to hoard their saving as idle cash balance. Demand for hoarding is represented by curve of it. The demand for hoarding money also slopes downwards to the right

According to loanable funds theory, the rate of interest will be determined by the equilibrium between total demand for loanable funds and total supply of loanable funds as shown in the following diagram. In the above diagram, LS is the total supply curve of loanable funds. It has been derived by the later summation of the saving curve (S), dis hoarding curve (DH), Bank total credit curve (BM) and dis investment (DI). Total demand curve for loanable funds is LD which has been found out by the later summation of the curves**, I, C** andH which show respectively the demand for loanable funds for investment, consumption and hoarding purpose. The curves LD and LS interest each other at Point E and in this way the equilibrium rate of interest is OR. The theory has been criticized in the same way classical theory has been criticized. In fact there isn’t much difference in the classical and loanable funds theory. The difference is only in the meaning of savings. Loanable funds theory like classical theory is indeterminate   Keynesian TheoryIt is also called the liquidity Preference Theory. It was presented by Keynes. According to him, “Interest is the reward for parting with liquidity for a specific period.” According to him, interest is a monetary phenomenon in the sense that the rate of interest is determined by the demand for and supply of money. The rate at which interest will be paid depends on the strength of the preference for liquidity in relation to the total quantity of money available to satisfy desire for liquidity. Hence the greater the desire for liquidity, the higher the rate of interest and vice verse. Liquidity preference means the demand for money to hold it in cash form. Liquidity preference of a particular individual depends up on several consideration individual keep money in liquid form due to the following three motives;-

1. **Transaction Motive.**It relates to the demand for money or the need cash for the current transaction of individual and business exchanges. Individual holds cash in order to bridge the interval between the receipt of income and its expenditure. This is called the Income Motive. The businessmen and the entrepreneur need money all the time in order to pay for raw materials and transport, to pay wages and salaries and to meet all other current expenses in curved. This is called the business motive for keeping money
2. Precautionary MotivePrecautionary motive for holding money refers to the desire of the people to hold cash balances for unforeseen contingencies like;-sickness, accident and so on. The amount of money for this purpose depends on the nature of the individual and on the condition in which he lives.
3. **Speculative Motive.**Relates to the desire to hold one’s resources in liquid form in order to take advantage of the market movement regarding the future changes in the rate of interest or bond price. According to Keynes supply of money is not affected by the rate of interest and it remains constant in the short period.

According to Keynes the rate of interest is determined at that point where demand for money is equal to supply of money or in other words where Liquidity curve and supply curve intersect each other. Criticism of the theory. Keynes ignores saving or waiting as a means or source of invertible fund. To part with liquidity without there being any sawing meaningless The Keynesian theory only explains interest in the short run. It gives no due to the rates of interest in the long run. The borrower’s intention is not so much to reward parting with liquidity so as to get a return on investment. Liquidity preference is not the only factor government the rate of interest. There are several other factors which influence the rate of interest by affecting the demand for and supply of invertible funds. Keynes makes the rate of interest independent of the demand for investment funds. Actually it’s not so independent. Liquidity preference theory does not explain the existence of different rate of interest prevailing in the market at the same time. Owing to the perfect homogeneity of cash balance, the rates of interest have to be uniform. Profit Profit is the reward to the entrepreneur for his basic function such as bearing risks of the business. Profit is the surplus of total revenue over expenses ie. â•¥ = TR – TC Gross profit is the total amount which is received by the entrepreneur. Net profit is that part of gross profit which is the reward for organizational services.

Characteristics of Profit

1. Profit is a residual reward
   – It is what remains after all costs (wages, rent, interest, etc.) are paid.
2. It is not contractual
   – Unlike wages or rent, profit is not guaranteed or agreed upon in advance.
3. Profit is uncertain and unpredictable
   – It may or may not occur; it depends on business performance.
4. Profits fluctuate
   – They can vary from time to time based on market conditions, demand, and costs.
5. Profit can be negative
   – A business can make a loss, while other incomes (like rent or wages) are fixed or positive.

Functions of Profit

1. Source of capital for reinvestment
   – Profits can be reinvested into the business to promote growth.
2. Revenue for the government
   – Through corporate taxes, governments earn revenue from company profits.
3. Indicator of performance
   – Profits signal the success and efficiency of a business.
4. Encourages entrepreneurship and investment
   – High profits attract investors and motivate entrepreneurs.
5. Guides resource allocation
   – Entrepreneurs use profit signals to decide how to allocate resources efficien

Theories of profit

1. Rent theory of profitThis theory was presented by American economist Prof. Walker. According to this theory, profit determined just as rent is determined. According to Prof. Walker profit is the rent of ability just as there are different grades of land, there are different grades of entrepreneur. The superior entrepreneurs can earn more as compared to less efficient entrepreneur and profit arises due to the reasons that superior entrepreneurs have some surplus production over the cost of production. In this way profit is the reward for differential ability of the entrepreneur over the marginal entrepreneur or the non- profit entrepreneur. Profits are thus like rent and they do not enter into price. **Criticism of the Theory.**According to the modern economist, there may not be any marginal entrepreneur or non- profit entrepreneur because all entrepreneurs can earn something. The theory does not explain the real nature of profit.

2. **Wages Theory of Profit.**This theory was presented by Prof. Taussing and Devenport. According to this theory, profits are determined just like wages because according to this theory organization is a superior kind of labour and the reward for the services should be determined according to the wages determination theory. Criticism of the Theory

3. • Profits are essentially a reward for taking risks but labourer takes no risks. His reward or wage is primarily for the labour performed by him.
   • Wages are paid in advance. Conversely entrepreneur has to take the responsibility of profit or loss.
   • The partner of limited firms receive profit but they do not undergo any physical exertion

4. **Marginal Productivity Theory.**According to this theory profit are determined according to the marginal productivity of the entrepreneur. The marginal productivity is greater due to the reason that the supply of the entrepreneur is short as compared to their demand. As a result of this, profits are also high. The marginal productivity theory does not help to explain fully how the profits are determined.

5. Dynamic Theory of ProfitThis theory was presented by Prof. J.B Clark. According to this theory, profits occur due to the reasons that the circumstances are always changing. It is stated that in a static world where the size of the population, the amount of capital, the quantity and quality of human wants, the method of production, technical knowledge etc. remain the same profit tend to disappear under the force of competition. Profits represents the difference between selling price and cost. It is a surplus above cost and when there is perfect competition this surplus disappears because when the world is static and everything is known and knowable, there will be risk and no uncertainty and hence no profits. But according to J.B Clark, we are involving a dynamic world and some changes are constantly taking place. A clever entrepreneur forces these changes and by producing new things he can earn profit. It is only because the world is dynamic.

6. Risk Bearing Theory of ProfitThis theory of profit is associated with the name Prof. Hawley. According to this theory, profit is the reward for risk and responsibilities which are come by any entrepreneur. The greater the risk, the higher must be expected gain in order induce entrepreneurs to start the business. According to carver, profit does not arise due to the reason that risk are taken by the entrepreneur by because the superior entrepreneur are able to reduce them.

7. Uncertainty Bearing Theory of ProfitThis theory was presented Prof. Knight. According to this theory it is uncertainty bearing rather than the risk taking which is the special function of the entrepreneur and leads to profit. According to Knight risks are of two kinds:-

   • There are certain risks which can be unforeseen, eg. accidents like fire
   • There are certain risks which are not possible to foreseeRisks of the first kind are borne by the insurance companies. As regards the risks of the second category, these are borne by the entrepreneur. Prof. Knight Calls them not risks but uncertainty. The term risk is applied to those dangers which can be known and foreseen. The entrepreneur gets remuneration for bearing uncertainty. The firm’s risk is applied to those dangers which can be known and foreseen. The entrepreneur gets remuneration for bearing uncertainties and nothing for the risk which have been foreseen.

Like other factors of production, uncertainty bearing has a supply price because no entrepreneur will be induced to face the uncertainty unless a certain return is expected. Criticism of the theory.

1. Uncertainty bearing cannot be elevated to the status of a factor of production.
2. Uncertainty bearing is not the sale function of the entrepreneur.
3. Uncertainty is not the only factor that limits the supply of entrepreneur. Lack of funds, lack of knowledge and lack of opportunities are some of the factors that restrict the supply of entrepreneurs.

Types of Profits

1. **Normal Profit or Zero Profit TR = TC.**This is a return which is just necessary to cover all its cost of production. Normal profits exist when TR = TC therefore it can be called zero profit.
2. Super normal ProfitThese are profits which are above the normal profit. They exist when TR is more than TC, therefore it can as be called Abnormal profit.