Production is a process of combining various material inputs and

immaterial inputs (plans, know-how) in order to make output for

consumption and exchange. It is the act of creating output, a good or service
which has value and contributes to the utility of individuals.

Production is the processes and methods used to transform tangible inputs

(raw materials, semi-finished goods, sub-assemblies) and intangible inputs
(ideas, information, knowledge) into goods or services for consumption and
exchange. Resources are used in this process to create an output that is
suitable for use or has exchange value.

Types of production

There are two types of production;

 Direct production. When a person produces what he needs by himself,

it is called direct production. It is called as self-production. E.g. growing
vegetables needed by the family in the home garden itself.

 Indirect production. When a person produces goods, services and ideas

with the intention of selling them in the market. It is because goods are
produced aiming at the market.

Branches of Indirect production (Levels of Production)

Indirect Production can basically be divided into three categories:

 Primary production or Extractive. This is the first stage at which

primary products are extracted to make goods. Example of these
includes: Felling down trees to make furniture, harvesting sugar cane
to make sugar

 Secondary or Manufacturing. This is the second stage of production

process. It usually involves taking the output form the first or primary
stage and using it as input to the second stage. Example; crude oil is
obtained at the primary stage and refined into petrol, lubricating oils,
and other by-products of the manufacturing stage

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  Tertiary or Service. At this stage goods are not produced, but they
offer services. This sector is dominated by schools, hospitals, retailing,
banks and insurance

Modes of Production
The method of producing the necessities of life (whether for health, food,
housing or needs such as education, science, development, etc.).

The Mode of Production is the unity of the productive forces and the relations
of production

 Productive forces. It’s further divided into two categories;

Labor a factor of production consisting of the effort and time of human
beings engaged in the production of goods or services. and
Means of production is a sum of materials which make production
possible. It have two elements; Means of Labor and Object of Labor
Means of labor all things (materials) that aid labor to act upon objects
of lobor. Examples; railways, tractors, hoes, and also includes simple
tools like stones, woods and complex tools like computers
Object of Labor include all natural resources which man transforms
them into consumable good

 Production relations. The relations that people enter during production

process. These can be Slave and Slave owner, Serfs and Landlord,
Worker and Capitalist

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Karl Max identified five modes of production

1. Primitive Communism
2. Slavery Mode of Production
3. Feudalism
4. Capitalism
5. Socialism

Primitive Communism
It was the first stage of human development where man was depending on
what nature could produce. Men lived in cave and they did depend on
hunting and gathering.

Characteristics
 Collective ownership
 The level of tech. is very low
 Production relation was non-antagonistic
 Distribution was equal
 No exploitation

Slavery Mode of Production

In this second mode of production some few men not only owns means of
production but also owns other men (Slaves). This was a brutal mode of
exploitation because slaves were treated like equipment and killing a slave
was not a murder case

Characteristics
 Private ownership including human being
 Low level of development
 Antagonistic relation (slave and slave master)
 Unequal distribution of wealth
 The instrument of labor were much improved
 Existence of classes

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Feudal Mode of Production
In this third mode of production only few owns land (Landlord) and use it to
exploits the tenants or serfs

Characteristics
 Improvement in the productive forces
 Private ownership based on land
 Antagonistic relation
 Unequal distribution of wealth
 Existence of classes

Capitalist Mode of Production

In this mode of production Capitalists uses capital to exploit workers.

Characteristics
 Private ownership
 Existence of classes
 High improvement of productive forces
 Exploitation is dominant

Socialist Mode of Production

Is the highest stage of human development where there is dictatorship of the
working class. All means of production are under the public ownership

Characteristics
 The level of productive forces is very higher
 There is public ownership
 No classes
 No exploitation

Factors of Production

 An input to a productive process producing a good or service. Before

the eighteenth century it was common to classify all factors as either
land or labor; later, CAPITAL and the ENTREPRENEUR were considered
as separate factors of production. In many modern economics models,
only labor and capital are included as factors of production.
 Resources that are used to produce a good
 Economic resources: land, capital, labor, and entrepreneurial ability.

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  The combination of labor, materials, and machinery that is used to
produce goods and services

Classification of Factors of Production

Before the eighteenth century it was common to classify all factors as either
land or labor; later, CAPITAL and the ENTREPRENEUR were considered as
separate factors of production. Therefore, there are kinds of it;

 Land
 Capital
 Labor
 Entrepreneur

Land

Land is rewarded with rent. Although it is easy to think of land as property,

the economic
definition of land is not quite what you might suppose. Land consists not only
of property (the land element only: buildings are capital) but also the natural
resources that grow on the land or that are extracted from the land (i.e. the
natural resources of the soil and woodlands and extracted minerals such as
coal).

 The physical space on which production occurs, and the natural

resources that comes with it.
 Land means much more to the economist than it does to most people.
To the economist land includes all natural resources (“gifts of nature”)
used in the production process, such as arable land, forests, mineral
and oil deposits, and water resources.
 The fixed factor of production described by Ricardo as ‘the original and
indestructible powers of soil’.
 According to Marshall, “By land is meant… materials and forces which
nature gives freely for man’s aid in land, water, air, light and heat.”
Therefore, land is a stock of free gifts of nature

It, therefore, means all the free gifts of nature. These natural gifts include: (i)
rivers, forests, mountains and oceans; (ii) heat of sun, light, climate,

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weather, rainfall, etc. which are above the surface of land; (iii) minerals
under the surface of the earth such as iron, coal, copper, water, etc..

Characteristics of Land:

Free Gift of Nature: Man has to make efforts in order to acquire other factors
of production. But to acquire land no human efforts are needed. Land is not
the outcome of human labor. Rather, it existed even long before the
evolution of man.

Fixed Quantity: The total quantity of land does not undergo any change. It is
limited and cannot be increased or decreased with human efforts. No
alteration can be made in the surface area of land.

Land is Immovable: It cannot be transported from one place to another. For

instance, no portion of Tanzanian’s surface can be transported to some other
country.

Land Differs in Fertility: Fertility of land differs on different pieces of land.

One piece of land may produce more and the other less.

Supply of Land is Inelastic: The demand for a particular commodity makes

way for the supply of that commodity, but the supply of land cannot be
increased or decreased according to its demand.

Land has Many Uses: We can make use of land in many ways. On land,
cultivation can be done, factories can be set up, roads can be constructed,
buildings can be raised and shipping is possible in the sea and big rivers.

Land is a Passive Factor of Production: This is because it cannot produce

anything by itself. For example, wheat cannot grow on a piece of land
automatically. To grow wheat, man has to cultivate land

Land is a Primary Factor of Production: In any kind of production process, we

have to start with land. For example, in industries, it helps to provide raw
materials, and in agriculture, crops are produced on land.

Capital

Capital is rewarded with interest. It is easy to think of capital as financial

resources, and the
rate of interest is the price mechanism in balancing the supply and demand

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for money.
However, capital in an economic sense is not 'money in the bank'.

 Refers to man-made items such as plant, machinery and tools which

are made and used not for their own sake, but to aid the production of
other goods and services. The cost of using machinery and plant and
so on is 'interest',
 Durable goods capable of producing a stream of goods or services over
a period of time
 A factor of production distinct from land, the entrepreneur and the
labor currently being used.
 Consists of the long-lasting tools people use to produce goods and
services. This includes physical capital, such as buildings, machinery,
and equipment, as well as human capital—the skills and training that
worker possess.
 Includes all manufactured aids used in producing consumer goods and
services. Included are all factory, storage, transportation, and
distribution facilities, as well as tools and machinery

Characteristics of Capital:

Capital is a direct result of savings Capital can be obtained by postponing the

present consumption. This means that when people save money, it becomes
capital. If savings in a country is high, the capital will also be high.

Capital is man-made resource over a period. Capital is not a natural

resource. According Knut Wicksell, capital is a saved labor that is
accumulated in the course of years.

Capital is variable. Capital can be increased or decreased according to your

will and wish.

Capital depreciates. Fixed machines in an industry are also known as capital.

When you use machinery continuously, it is subject to normal wear and tear.

Capital is a passive factor. Capital is a dependent factor. It means that

capital alone cannot produce anything. Capital should work with other
factors of production in order to produce any goods. At the same time, other
factors cannot function without capital also.

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Labor

 Labor is rewarded with wages. Labor consists of both the mental and
the physical resources of human beings. (Salaries as well as weekly-
paid wages are defined collectively as 'wages' in economics.)
 A factor of production consisting of the effort and time of human
beings engaged in the production of goods or services.
 The time human beings spend producing goods and services.
 The resource labor consists of the physical and mental talents of
individuals used in producing goods and services. The services of a
logger, retail clerk, machinist, teacher, professional football player, and
nuclear physicist all fall under the general heading “labor.”

Characteristics of Labor

Labor is Perishable: Labor is more perishable than other factors of

production. It means labor cannot be stored. The labor of an unemployed
worker is lost forever for that day when he does not work. Labor can neither
be postponed nor accumulated for the next day. It will perish. Once time is
lost, it is lost forever.

Labor cannot be separated from the Laborer: Land and capital can be
separated from their owner, but labor cannot he separated from a laborer.
Labor and laborer are indispensable for each other. For example, it is not
possible to bring the ability of a teacher to teach in the school, leaving the
teacher at home. The labor of a teacher can work only if he himself is
present in the class. Therefore, labor and laborer cannot be separated from
each other.

Labor is both the Beginning and the End of Production: The presence of land
and capital alone cannot make production. Production can be started only
with the help of labor. It means labor is the beginning of production. Goods
are produced to satisfy human wants. When we consume them, production
comes to an end. Therefore, labor is both the beginning and the end of
production.

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Differences in the Efficiency of Labor: Laborer differs in efficiency. Some
laborers are more efficient due to their ability, training and skill, whereas
others are less efficient on account of their illiteracy, ignorance, etc.

Demand for Labor is derived: The consumer goods like bread, vegetables,
fruit, milk, etc. have direct demand as they satisfy our wants directly. But the
demand for laborers is not direct, it is indirect. They are demanded so as to
produce other goods, which satisfy our wants. So the demand for laborers
depends upon the demand for goods which they help to produce. Therefore,
the demand for laborers arises because of their productive capacity to
produce other goods.

Labor is an Active Factor of Production: Land and capital are considered as

the passive factors of production, because they alone cannot start the
production process. Production from land and capital starts only when a man
makes efforts. Production begins with the active participation of man.
Therefore, labor is an active factor of production

Division of Labor and Specialization

Division of labor:

Now, a day’s production has become so technical and complex that different
workers are put to different tasks according to their capacity and ability. One
becomes specialized in the production of those goods for which he or she is
best suited.

Different workers perform different parts of production on the basis of their

specialization. The result is that goods come to the final shape with the co-
operation of many workers. For example – In a large scale readymade
garment factory, a man does cutting of cloth, the second man stitch clothes
with machines, the third buttons, the fourth makes folding and packing etc.

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  Means that the main process of production is split up into many simple
parts and each part is taken by different workers who are specialized in
the production of that specific part.

 Specialization of productive activity either by persons in different

occupational groups undertaking particular tasks or by dividing a task
into its component operations

 In the words of Prof. Watson – “Production by Division of Labor consists

in splitting up the productive process into its component parts,
concentrating specialized factor on each sub-division and combining
their output into particular forms of consumption output required.”

 According to Hanson – “Division of Labor means specialization of

process.”

 According to Chapman – “The specialization of works is called Division

of Labor.”

 The breaking down of a production process into specific tasks and roles
to be performed by cooperating individuals.

 Is the separation of a work process into a number of tasks, with each

task performed by a separate person or group of persons. Scottish
economist, Adam Smith, saw this splitting of tasks as a key to
economic progress by providing a cheaper and more efficient means of
producing goods.

Specialization:

 A method of production in which each person concentrates on a

limited number of activities

 Subdivision or division of labor

 A reduction in the number of economic activities of a country with a

view to reducing costs and maximizing output

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  Is the concentration of the productive efforts of an individual, a firm, or
a country in a given aspect of economic activity on a particular line of
production n which it has the greatest comparative advantage

 Is a method of production in which a business or area focuses on the

production of a limited scope of products or services in order to gain
greater degrees of productive efficiency within the entire system of
businesses or areas.

Advantages of Division of Labor and Specialization

The general results of Division of Labor are an increase in the output of the
product (which is usually of a better quality and is obtained at less cost per
unit), together with a great improvement in the economic conditions of the
workers.

Increase in Production: With the adoption of Division of Labor, the total

production increases. Adam Smith has written in his book that the advantage
of Division of Labor can be ascertained when a worker can produce only
twenty pins daily. If the making of pins in a modern factory is divided in
various processes, then eighteen workers can produce 20,000 pins in a
single day.

Reduction in the Cost of Production: Division of Labor increases production

which reduces the average cost of production. Saving of capital tools and
machinery etc. also help in the reduction of cost of production.

Saving of Time: There is no need for the worker to shift from one process to
another. He is employed in a definite process with certain tools. He therefore
goes on working without loss of time, sitting at one place. Continuity in work
saves time and helps in more production at less cost.

Encouragement to Inventions: In Division of Labor each work is divided into

small parts which help much in the invention of new things. In this
connection Robbin’s has said—”By Division of Labor the work is divided in
small divisions which helps much in new inventions.”

Full Utilization of Natural Resources: Division of Labor in the country helps

much in the full utilization of natural resources, because large scale
production is carried on.

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Development of International Trade: Division of labor increases the tendency
of specialization not only in the workers or industries, but in different
countries also. On the basis of specialization, every country produces only
those goods in which it has a comparative advantage and imports such
goods from those countries which have also greater comparative advantage.
Therefore, division of labor is beneficial for the development of international
trade also.

Increase in Efficiency of Labor: With division of labor, a worker has to do the

same work time and again, and he gets specialization in it. In this way, the
division of labor leads to a great increase in efficiency.

Increase in Mobility of Labor: Division of labor facilitates greater mobility of

labor. In it, the production is split up into different parts and a worker
becomes trained in that very specific task in the production of the
commodity which he performs time and again. He becomes professional,
which leads to the occupational mobility. On the other hand, division of labor
implies a large-scale production and laborers come to work from far and
near. Thus, it increases geographical mobility of labor.

Increase in Use of Machines: The division of labor is the result of the large-
scale production, which implies more use of machines. On the other hand,
the division of labor increases the possibility of the use of machines in the
small-scale production also. Therefore, in modern times the use of machines
is increasing continuously due to the increase in the division of labor.

Increase in Employment Opportunities: Division of labor leads to the diversity

of occupations which further leads to the employment opportunities. On the
other hand, the scale of production being large, the number of employment
opportunities also increases.

Goods of Superior Quality: Division of labor is beneficial in making goods of

superior quality. When the worker is entrusted with the work for which he is
best suited, he will produce superior quality goods.

Disadvantages of Division of Labor and Specialization

Monotony: Doing the same work over and over again without any change
produces mental fatigue. Work becomes joyless and boring. There is no
pleasure in the job. The worker cannot be expected to take any interest. The
quality of work suffers.

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Loss of Skill: The worker deteriorates in the technical skill, instead of making
the whole item, he is required just to repeat a new simple movements. The
skill gradually dies out.

Checks Mobility: The worker is doing only a part of the job. He knows only
that much and no more. It may not be easy for him of find exactly the same
job elsewhere, if he desires a change. In his way, the worker loses mobility.

Loss of Sense of Responsibility: None can be held Responsible for bad

production because none makes the complete article. When the thing is bad,
everybody tries to shift the responsibility to somebody else.

Dependence: The dependence of one country upon another which is the

necessary consequence of division of labor proves dangerous in times of war.
Division of labor is no doubt attended with a number of drawbacks, but the
advantages far outweigh the disadvantages Division of labor, as pointed out
earlier, is universal and found or all societies. Rudimentary in pre-literate
society it is elaborately stratified in advanced societies. Economy has moved
from self-employment to bureaucratic employment.

Risk of Unemployment: If the worker is dismissed from one victory he may

have to search far and wide before he secures a job at which he has
specialized. He may be making only the legs of a hair. It is doubtful if he can
get the same job. On the other hand, he knew how to make the complete
chair his chance of getting job elsewhere would be brighter.

Mobility of Labor

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Is the movement of members of the LABOR FORCE between areas
(geographical mobility), between industries (industrial mobility) or between
occupations (OCCUPATIONAL MOBILITY)

Types of Mobility of Labor

Geographical Mobility: Is when a worker moves from one place to another

within a country or from one country to another. For example, the movement
of labor from Kirinjiko Islamic to Nyasaka Islamic or from Tanzania to China is
geographical mobility.

Occupational Mobility: Occupational mobility refers to the movement of

workers from one occupation to another. This mobility is further divided into
the following two types:

Horizontal Mobility: The movement of labor from one occupation to another

in the same grade or level is called horizontal mobility. For example, a bank
clerk joins as an accounts clerk in a company.

Vertical Mobility: When a worker of a lower grade and status in an occupation

moves to another occupation in a higher grade and status, it is vertical
mobility. Just as a school lecturer becomes a college lecturer, a clerk
becomes a manager, etc.

Mobility between Industries: The movement of labor from one industry to

another in the same occupation. For example, a fitter leaving a steel mill and
joining an automobile factory

Factors Determining Mobility of Labor

Education and Training: The mobility of labor depends on the extent to which
labor is educated and trained. The more a person is educated and skilled, the
greater are his chances of moving from one occupation or place to another.
Geographical and vertical mobility depend on education and training.

Means of Transport: Well developed means of transport and communications

encourage mobility labor. The worker knows that in case of emergency at
home, he can easily communicate with his father phone or travel back by
train within the country or by airplane if he is abroad.

Trade: The development of business and trade leads to the spread of their
offices and institutions related to them in different parts of the country. As a
result, workers move from one place and occupation to another to work in
trade and business offices, banks, insurance companies, etc.

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Advertisement: Advertisements relating to jobs in newspapers also
determine the mobility of labor. Accordingly, workers move between places
and occupations

Agricultural Developments: With agricultural development, labor moves from

high population to low population areas during busy seasons.

Industrialization: The mobility of labor is determined by industrial

development. Workers move from different occupations and places to work
in factories. Industrialization also leads to urbanization and workers move
from rural and semi-urban areas to industrial centers and big cities.

State Help: When the state starts industrial centers, and estates,
employment exchanges, dams, public works, etc., they encourage mobility of
labor.

Peace and Security: The mobility of labor depends to a large extent on law
and order in the country. If the life and property of the people are not safe,
they will not move from their present places and occupations to others.

Efficiency of Labor

The working capacity of the labor

Factors Determining the Efficiency of Labor

Education: It is the basic and essential element which determines the

efficiency of labor. Educated laborer is more efficient as compared to the
illiterate worker.

Training and Skill: The modern world requires highly skilled laborers. A
laborer with sound technical training will be more effective as compared to a
laborer who has no training. It increases the efficiency of the laborer.

Climatic Conditions: Climates also plays an important role in increasing or

decreasing the efficiency. Hot weather has a vital factor for the low efficiency
of labor in Asia and Middle East. On other hand cold weather is an important
element for increasing the efficiency in labor in U.S.A and Europe.

Wages and Benefits: If wages, allowances, bonuses and other benefits are
given to the workers, then their working efficiency increases. Laborer works

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very hard if he has attractive salary. On other hand if wages rate is low then
efficiency of the laborer will be also low.

Combination of Production Factors: If the other three factors of production

combination is ideal then efficiency of laborer will be high otherwise low.

Working Hours: If working hours of laborer are reasonable then the efficiency
will be high. If the working time is very long and without extra payment then
efficiency of the worker will be low.

Environment: If the working environment is pleasant then efficiency of

laborer will be high. It is observed that laborer working in air conditions
rooms and healthy conditions are more efficient as compared to others.

Entrepreneur

The fourth FACTOR OF PRODUCTION, after land, labor and capital, which
organizes production and undertakes the risk of an enterprise

The idea of entrepreneurship was introduced into economics by CANTILLON,

literally to mean the ‘undertaker’, i.e. a person who buys at a fixed price and
sells at an uncertain price.
Subsequently different economists debated alternative definitions, which
include riskbearer, organizer of production, innovator and decision-maker in
circumstances which give people unequal access to information. New
entrepreneurs are often well-educated persons with managerial experience
having small firms in areas with wealthy local markets.

Business enterprise involves risk and uncertainty, and actual profits might be
higher or lower than expected; and it is the entrepreneur's role to bear the
burden of this uncertainty

Characteristics of Entrepreneur

Management and Organization

Major Decision-Making

Risk Bearing

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Functions of an Entrepreneur:

He conceives the idea of launching the project.

He mobilizes the resources for smooth running of the project.

The decision of what, where and how to produce goods are taken by the
entrepreneur.

He undertakes the risks involved in production.

He is an innovator. He innovates new techniques of production, new

products and brings improvements in the quality of existing products. He is
in fact the captain of the industry.

Techniques of Production

Are the methods adopted to produce commodities.

Mostly there are two techniques of production;

 Labor intensive technique

 Capital intensive technique

Labor intensive technique: Is a technique whereby more labor is used in

production than other factors of production.

Advantages of Labor Intensive

 High employment, both skilled and non-skilled.
 It leads to fair income distribution in the society
 Reduce unemployment problem
 Reduce cost of production as labor especially in LDC'S is cheap
 It widens the tax base
 It reduces importation of capital

Disadvantages of Labor Intensive

 Low quality of output may be produced

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  It discourage technological developments
 Labor may demand higher wages or benefits which will increase cost of
production

Capital Intensive technique: This is a technique of production whereby more

units of capital are used in production process than units of labor.

Advantages of Capital Intensive

 It lead to increase in output and quality

 Employment opportunities may be generated due to economies of
scale
 Leads to effective utilization of resources
 Less supervision is needed
 It encourages technological development
 It reduces cost of production where labor is expensive

Disadvantage of Capital Intensive

 It reduces demand for labor hence it may cause unemployment

 It may be very expensive to operate and purchase
 Maintenance of capital sometimes is costly
 It may lead to problem of market due to the resulting large output.

Factors which determine the choice of technique of Production

Price of the factor: Assuming other factors remain constant (ceteris paribus).
"If a certain factor of production is sold at a lower price, producers will use
more units of that factor of production. Where if it is sold at a higher price,
producers will use less units of that factor of production.

Efficiency of factor: Producers will choose the factor of production/ technique

of production, which is more efficient than other factors or techniques of
production. For example; if producing by using capital creates more
efficiency than by using labor then producers will adopt capital intensive
technique of production.

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Degree of substitutability of a factor of production: If a certain factor of
production cannot be substituted with other factors of production, producers
will have to use more units of that factor for example a highly specialized
medical doctor cannot be substituted with other factors in this case
entrepreneur will have to use more units of the specialist. than other
factors. On the other hand, some factors of production can be easily
substituted with other factors in some kinds of jobs such as digging,
cleanliness and construction. In this case producers can use/choose to use
any type of a factor.

Government policy: Government policy can affect choice of technique of

production, for example, if a policy of the government is to promote
technological advancement, the government will insist on the use of capital
intensive technique of production while if the policy is to create employment
to the people the government will insist on labor intensive technique of
production.

Scale of Production

Refers to the size of the production unit of a firm or business. Depending on

the size of production, it can be classified into large scale and small scale
production.

Scale of production depends on the following;

 Technological levels: Advanced technology enables large-scale

production to take place while poor technology limits the size of
production. It is possible to increase production by using advanced
technology than by using poor technology.

 Availability of capital and labor: If capital and labor are available in

large quantity they facilitate the increase in the scale of production
while if capital and labor are available in a small quantity then
production becomes low leading to the small scale of production.

 Availability of raw materials: if raw materials are readily available and

accessible this will facilitate production in large scale and if raw
materials are not easily found leads to small scale production

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  Availability of infrastructures: Availability of efficient and effective
infrastructure like transport and communication network stimulates
production activities and facilitate the transferring (ferrying) of goods
from areas where they are produced to areas where they are needed
for consumption

 Size of the market: If the size of the market is large it will stimulate
more production and the scale of production will increase but if the
size of the market is small it will discourage production and
consequently the scale of production will be small.

Types of Scale of Production

 Small scale production and

 Large scale production

Small scale

Small scale production refers to the production of a commodity with a small

plant size firm. It requires less amount of capital and is labor intensive in
nature. The investment in machinery is lower, the business produces non-
standardized products, and the market size is limited

Merits of small scale production:

Need of small Capital: The small scale production can be started with small
capital. Where there is shortage of capital, the small scale industries are of
great advantage for the development of industries.

Close Supervision: The small producer can himself supervise the minutest
details of the business. Nobody is allowed to spoil machinery or waste
materials. The master’s eye is everywhere. There can be no fraud or
idleness. He will exercise utmost economy to achieve the aim of maximum
profits.

More Employment: In the face of large scale unemployment existing in the

country, the development of cottage and small scale industries is of great
help to create more employment opportunities. Small scale production is
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more labor-intensive i.e., there is more use of labor than machinery. Thus,
many unemployed persons are employed in the newly developed small scale
industries.

Direct Relation between the Workers and the Employers: In small scale
production fewer workers are employed. Therefore, a close relationship
exists between the employer and the workers. Because of this close
relationship, the employer can look after the well-being of his employees and
employees, too, consider their work as their own and the work goes on
smoothly without any disputes between the two parties.

Direct Relation between the Customers and the Producers: The small scale
producers generally cater to the local demand. Hence, they remain in touch
with their customers. A small producer personally knows his customers.
Therefore, he can produce goods according to the taste and fashion of each
individual customer.

External Economies: The small scale production secures all kinds of external
economies, which are available to large units also. These economies are:
better transport, electricity, and communication facilities; banking and
insurance services; technical workers, etc.

Disadvantages of Small Scale Production:

High Cost of Production: The cost of production per unit increases because
there is a high cost of labor, a very little scope for division of labor and lesser
use of machinery.

Less Use of Machines: In the small scale production, there is less scope for
the use of machines. As a result, these firms cannot take advantages of the
use of the machinery.

Lack of Division of Labor and specialization: In the small scale industries, the
size of production is small, and there is lack of division of labor and less
profits to the entrepreneurs.

Difficulty in Getting Loans: It cannot enjoy the financial economies. Funds are
either not available and if available, they have to pay higher rate of interest.

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Difficult to Face Economic Crisis: Because of the limited resources and
financial weakness, the small scale producers cannot face economic crisis.
The producers do not have the capacity to bear losses for long. In fact, under
a small economic crisis, many small factories are closed down.

Costly Raw Materials: In the small scale production, raw materials are
purchased in small quantities which are available to the small producer at
higher prices.

Lack of Standardised Goods: The quality of goods is not standardised or upto

the mark in the small scale production. It is difficult to sell goods because of
their low standard and inferior quality.

Lack of Research: The small scale industries have limited means at their
disposal. They cannot spend much on research in the field of science and
technology. In this way, the small scale industries are a obstacle in the way
of technical research and, industrial development.

Large scale

Large scale: refers to the production of a commodity on a large scale with a

large sized firm. It requires huge investments in plant and machinery. Large
scale production can be carried out if the market size is large and expanding.
Large scale firms are characterized by mechanization, division of labor and
production and sale of goods in large quantities

Advantages of Large Scale Production:

Standard Goods: The production of standardised goods is possible on

account of the large-scale production. Only a big motor company can
produce standardised motor parts. Besides, it is possible to sell and transport
these goods to distant places only by big business houses.

Advertisement and Salesmanship: A big industry can afford to spend large

amounts of money on advertisement and salesmanship. Ultimately, they do
bear fruit. The amount of money spent on advertisement per unit comes to a
low figure when production is undertaken on a very large scale. The
salesmen can make a careful study of the individual markets and thus

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acquire a hold on new markets or strengthen it on the old ones. Thus, a large
scale producer has a greater competitive strength.

Research: The large scale production is conducive for the development of

technology also. With larger amount of capital and financial resources, the
large scale firms can afford to spend more on research and experiments
which ultimately lead to the discovery of new machines and cheaper
techniques of production.

Economy of Buying and Selling: A large concern usually buys things in large
quantities and therefore, at low rates. It also sells things in large quantities
and can secure better terms.

Low Cost of Production: The large scale production gives many types of
economies. Suppose, there are two different factories, each producing 500
units of a commodity. For these two factories, there must be two managers.
But if the scale of production is enlarged and in one factory we start
producing 1000 units of the same commodity, the work can be supervised by
one manager. In this way, in the large scale production, the salary of one
manager is saved. So, the cost of production is reduced.

Cheap and Easy Loans: A large business can secure credit facilities at
cheaper rates, because these firms enjoy credit and reputation in the market
due to their fixed assets. Banks and other financial institutions willingly
advance loans to these enterprises at a very low rate of interest.

Division of Labor: The large scale production is always associated with more
and more division of labor. With the division of labor per worker output
increases. Hence, per unit labor cost is reduced in large scale production.

Use of machines: The large scale production always makes use of machines.
So, all the advantages of the use of machinery are available.

Disadvantages of Large Scale Production:

Evils of Factory System: The large scale production is accompanied by all the
evils of the factory system like over-crowding, density, pollution, bad morals,
etc. Dirty habits of drinking and gambling spread very easily.

Danger of Over-Production: The large scale organisation results in over

production at times, so demand cannot be properly estimated. At last, prices
fall and depression sets in.

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Less Supervision: A large scale producer cannot pay full attention to every
detail in various departments. Costs often rise on account of the dishonesty
of workers. Thus, due to inefficient and inadequate supervision, the cost of
production goes up.

Rise of Monopoly: The large scale production results in the localisation of

industries. As a result, the bigger fish swallows the smaller ones, and cut-
throat competition and monopolies result.

Class Struggle: The large scale production gives rise to class struggle, the
struggle between the laborers and the capitalists. Their interests cannot go
together, as they are very different from each other. As a result, there is a
struggle between the two groups.

PRINCING OF THE FACTORS OF PRODUCTION

(THEORY OF DISTRIBUTION)

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The theory of distribution is the one dealing with rewarding the factors of production
for the services rendered by them.

The rewarding (pricing) of the factors of production is a follows:-

 Labor is paid rent.

 Land is paid rent.
 Capital is paid interest.
 Entrepreneur is paid profit loss.

THE ROLE OF FACTOR PRICE IN AN ECONOMY

i. Price determines the amount of factors of production to be employed i.e. the

higher the price the lower the amount of the factor to be employed.

ii. Price determines the allocation of resources i.e. the commodity with higher
prices will be produced more & vice versa.
iii. Price determines the utilization of the factor i.e. if the factor is of high price it
will be utilized effectively e.g. land will be utilized effectively since it is paid
for Rent.
iv. Price determines the level of National income obtained by the factors of
production it wage for labor, Rent for land, interest for capital, profit for
Entrepreneur.

THE GENERAL THEORIES OF DISTRIBUTION

There are 2 main theories of Distributions

1. The Marginal Productivity theory of the factor.

2. The Modern theory (Market theory).

1. THE MARGINAL PRODUCTIVITY THEORY OF DISTRIBUTION

According to this theory the factor must be paid according to its Marginal
Productivity. Marginal Product is the additional output resulting from the
employment of one more unit of inputs. According to this theory the Entrepreneur

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will continue to employ the factor up to the point where the cost of that factor is
equal to its marginal product. If the factor is paid below its Marginal productivity
the factor will be exploited and if is paid above its marginal productivity
Entrepreneur will get loss.

Assumption of the Marginal Productivity Theory

a. The units of the same factor are homogeneous.

b. The factors are perfectly substitutable.
c. There is free mobility of the factors of production.
d. The efficiency of the factor depends on the factor itself.
e. The Entrepreneur can continue to vary the units of the factor to any level.
f. The Marginal productivity of the factor can be measured.
g. It assumes existence of the conditions of the perfect market structure.
h. It assumes the law of diminishing Returns which state that, “As more and
more units of variable factor are added to the fixed factor the average
product & marginal product will initially increase and eventually decrease.

CRITICISMS OF THE MARGINAL PRODUCTIVITY

a. The assumption that factors are homogeneous is unrealistic since factors

differ in efficiency.
b. The efficiency of one factor depends on other factors e.g. Efficiency of labor
depends on capital.
c. The factors of production are not perfectly mobile.
d. The entrepreneur can’t vary the factors continuously since it can lead to
capital intensive & land to increase in cost of production.
e. It assumes prefect market while it is non-existent.
f. It difficult to measure marginal productivity of the factor.
g. Perfect substitutability of the factor is difficult since there are some of the
jobs required to be done by a specific factor e.g. Capital.
h. The law of Diminishing rent is highly doubtable since it is possible to increase
productivity of the land by for example applying the fertilizers.
i. According to the theory unemployment problem can be reduced by reducing
the price of already employed factor.

II. THE MODERN THEORY (MARKET THEORY) OF DISTRIBUTION

The modern theory of distribution explains that the prices of the factors are
determined at the point where the supply of that factor is equal to the demand for
that factor. According to this theory the price of the factor is determined as how
other prices for commodities are determined in the market (at the equilibrium
level).

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Hence the price of the factor will be determined at the point where dd & ss are
equal

PRINCING OF THE FACTOR LABOR

(i) Subsistence theory of wage (ii) Wage – fund theory of wage (iii) Market theory of
wage (iv) Bargaining theory of wage (v) Residual theory of wage (vi) Marginal
Productivity theory of wage.

1. SUBSISTENCE THEORY OF WAGE (IRON LAW OF WAGE)

This theory was propounded by David Recardo (1772-1823). According to

this theory, “The laborers are paid to enable them to survive and continue
the race without increase or decrease”. This payment is also called as
‘subsistence wages’. The basic assumption of this theory is that if workers
are paid wages more than subsistence level, workers’ number will increase
and, as a result wages will come down to the subsistence level.

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On the contrary, if workers are paid less than subsistence wages, the number
of workers will decrease as a result of starvation, death, malnutrition,
disease etc. and many would not marry. Then, wage rates would again go up
to subsistence level. Since wage rate tends to be at, subsistence level at all
cases, that is why this theory is also known as ‘Iron Law of Wages’. The
subsistence wages refers to minimum wages.

CRITICISMS OF THE THEORY

a) The theory is one sided theory i.e. it considers only the supply of labor but
completely ignore the demand side.
b) There is no agreed subsistence level in the country
c) It is not true that the increase in wage will only result to early marriages, but
raise standard of living.
d) The human behavior tends to charge time over time hence the subsistence level
will also charge accordingly this will bring difficulty in determining the wage
rate.

II. WAGE – FUND THEORY OF WAGE

This theory was developed by Adam Smith (1723-1790). His theory was
based on the basic assumption that workers are paid wages out of a pre-
determined fund of wealth. This fund, he called, wages fund created as a
result of savings. According to Adam Smith, the demand for labour and rate
of wages depend on the size of the wages fund. Accordingly, if the wages
fund is large, wages would be high and vice versa.

Wage fund
Wage rate =
Employee(labour )
According to this theory the wage rate will increase only if

 The employer increases the wage fund without changing the number of
employee.
 The employer reduces the number of employees without changing the wage
fund available.

CRITICISMS

i. There is not wage fund set by the Employer in any production the wage rate will
depend on the profits obtained
ii. The theory has failed to Explain as to why wage tend & differ among workers.

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III. THE MARKET THEORY OF WAGE

According to this theory the wage rate is determined at the point where the supply
for and demand for labor is equal is at equilibrium.

FACTORS INFLUENCING DEMAND FOR LABOR

The demand for labor is a derived demand i.e. we demand labor not for its own sake
but it is because we demand a certain output to be produced by that labor.

Hence the demand for labor depends on:-

a) Degree of substitutability of labor.

b) The rice of labor.

c) The Education level for labor.

d) The demand for finished goods.

e) The productivity of labor (Efficiency of labor).

f) The technique of production used ie If its labor intensive technique.

Hence the wage rate is determined at the point of Equilibrium i.e. where demand
for labor is equal supply of labor.

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 Hence the wage will be determined at point “We” where dd for and SS of labor
Intersect.

IV. THE MARGINAL PRODUCTIVITY OF WAGES

This theory was propounded by Phillips Henry Wick-steed (England) and John
Bates Clark of U.S.A. According to this theory the price of labor (wage) is
determined by the productivity of the labor. The employer will continue to employ
the labor up to the point where the marginal production by of labor equals to its
assets.

Assumptions (Refer to the assumptions of the General theory of distribution) i.e.

Marginal Productivity theory.

NOTE: Where there is a factor put labor instead.

Criticisms (Refer to the Marginal Productivity theory of Distribution).

V. RESIDUE THEORY OF WAGE

This theory owes its development to Francis A. Walker (1840-1897).

According to Walker, there are four factors of production or business activity,
viz., land, labour, capital, and entrepreneurship. He views that once all other
three factors are rewarded what remains left is paid as wages to workers.
Thus, according to this theory, worker is the residual claimant.

CRITICISMS

i. Labor is not the one paid Residue, But Entrepreneur.

ii. The theory failed to explain why the trade unions succeed to raise the wage.

VI. THE BARGAINING THEORY OF WAGES

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According to this theory wages are determined through the influence of a Trade
Union. Trade union is the union of the employees (workers) whose functions are
demands for high wages, improving working conditions, fighting against
discrimination and any other form of exploitation

COLLECTIVE BARGAINING

This is the form of bargaining in which the members of the trade union usually
leaders bargain together (collectively) with their employers so as to raise their
wages and other affairs for them.

FACTORS DETERMINING THE STRENGHT OF TRADE

a. Size of the membership available: If the members are many the Trade Union
will be strong and vice versa
b. The Unity among the members: If the members have strong unity and solitarily
the trade union will be strong and vice versa.
c. The Financial position of the trade union: If the union is strong financially the
stronger will be the union and vice versa.
d. The degree of substitutability: If the labors are easily substitutable the lower
will be the strength of the trade union and vice versa
e. The supply of labor in the factor market: If there is more labor supply the trade
union will be weak
f. The labor law of the country: If the labor law of the country favors labors and
their rights trade union will be strong and vice versa.
g. The Elasticity of demand of the commodity produced by the labor: If inelastic
demand the Trade union will be strong and vice versa.
h. The Economic conditions of the country: If the country is in the depression
period the trade union will be weak & is in boom the trade union will be very
strong.
i. Productivity of the labor.

The Effects Of A Trade Union Having Succeeded To Raise The Wages

Above Equilibrium Level

In the trade union have succeeded to raise the wages above equilibrium the
following effects will accurse

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 Positive

a) The standard of living for workers will increase

b) It may stimulate production due to increase in demand
c) It can lead to increase in government revenue through income tax.

Negative

a) It can lead to inflation.

b) It can lead to increase in unemployment.
c) It can lead to increase in cost of production.
d) It can lead to fall in production due to increase cost of production.
e) It can force the Entrepreneurs to substitute labor for capital.

WAGE DIFFERENTIALS

This is the situation whereby the wages among the workers either in the same job
or in the same firm differs from one another.

FACTORS FOR DIFFERENCE IN WAGES AMONG WORKERS

a) Level of Experience in that job: The higher the experience the higher the
wages and vice versa.
b) The level of Education: The higher the level of education the higher the
wages and vice versa.
c) The length of training: The higher the length of training period the higher the
wages and vice versa.
d) The Risk involved in the job: The higher the risk involves in the job the higher
the wages and vice versa.
e) The strength of the Trade Union: The stronger the Trade union the higher the
wages and vice versa.
f) Regularities and Irregulaties in job: Part time people paid more than full time
workers.
g) Productivity of the labor: The more the productivity of the labor the higher
the wages and vice versa.
h) The Economic system in the country: If the worker is in the private sector
(capitalist) the higher the wages but if is in the movement sector (socialist)
the lower the wages.
i) The working conditions: If the labor is in bad working conditions e.g. Rural
areas the higher the wages in order to encourage that labor to tolerate but if
is in urban areas the lower the wages at ceteris paribus.

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Factors (Principles) Governing Wage Determination in the Country

i. The productivity of the factor: The wage rate will be determined where
marginal productivity of labor equals to the cost
ii. The strength of Trade Union: The wage rate will be determined through the
strength of the Trade Union
iii. The minimum level required to sustain the factor (labor)
iv. The amount of wage fund available
v. The government can fix the maximum + minimum wage level
vi. The demand for and supply for labor.

SYSTEM OF PAYING WAGES

There are different systems using in paying wages.

(i) Piece rate wage system (ii) Time rate wage system (iii) Profit sharing wage
system (iv) Bonus wage system (v) Standard rate wage system.

I. PIECE RATE WAGE SYSTEM

This is the system used in payment whereby the labor is paid according to work
done i.e. the more the piece of work done by the labor the higher the wags and vice
versa.

Advantages

a) It does not need supervision.

b) More output is produced.

c) It becomes easily to calculate the cost of each labor

i.e. Wage = Cost of each labor x Output produced.

d) It is very easily to determine the hard worker & lazy one.

e) No additional cost involved since labor is paid only when there is a job to do.

f) The hard-worker obtains high level of income compared to the lazy one.

Disadvantages

a) The worker may overwork themselves.

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b) Output produced is likely to be of low quality.

c) The more efficient labor who wish to work carefully so as to produce high quality

output is paid less.

d) The labor can easily harm against themselves

e) Not suitable for these jobs which cannot be measured quantitatively e.g.
Teaching.

II. TIME RATE WAGE SYSTEM

This is the system of paying wages whereby labor is paid according to certain fixed
time e.g. hourly, weekly, monthly etc.

Advantages

a) It is suitable for job that cannot be measured quantitatively.

b) It does not encourage the workers to overwork themselves.

c) It can’t lead to the labor to harm among themselves

d) The labor can be paid extra amount when working more time than required

(overtime payment).

e) It become easy to calculate the cost of each labor

i.e. Wage = Hour x cost per labor.

Disadvantages

a) It encourage inefficient in work.

b) The labor may produce less output.

c) The hard worker and lazy one are paid the same.

d) It needs cost in supervision.

e) It leads to additional cost even if no work is done.

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III. PROFIT SHARING WAGE SYSTEM

This is the system used to pay wages whereby the labor is paid an extra amount
apart from his wage i.e. The profit obtained is shared among the workers.

Advantages

a) It creates good relationship between employees and employer.

b) The efficiency of labor increases.

c) The income for labor tends to increase.

Disadvantages

a) When no profit earned no any extra payment made to labors.

b) The labor may be discouraged when the firm continuously gets loss

c) Between hard worker and lazy people are paid equally if the profit obtained.

IV. BONUS WAGE SYSTEM

This is the system of wage payment whereby the workers are paid a certain amount
(extra payment) after reaching a certain standard rate of production.

Advantages

a) It stimulates production

b) It leads to more outputs.

c) It increases incomes for the workers who reach that standard rate of production.

Disadvantages

a) It is not very clear to many people since sometimes the standard rate is not well
given.

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b) It can bring some conflicts in the work since when certain earn several times
other labor can think that there are some tricks used among those workers and
the Employer.

V. THE STANDARD WAGE RATE SYSTEM

This is the system of wage payment whereby labors doing the same jobs are paid
equally.

Advantages

a) It is easy to calculate the cost for each labor.

b) It doesn’t encourage income inequality.

c) It makes the trade union to be strong.

Disadvantages

a) The hard and lazy workers are paid the same.

b) It leads to in efficiency in production.

c) It needs high supervision.

d) It leads to small output produced.

OTHER CONCEPT OF WAGE

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I. Nominal wages (Money wages)

There are the amounts of wage paid to the labor without considering the purchasing
power of that money. It doesn’t take into account about inflation or deflation.

II. Real wages

These are the amount of wage paid to the labor by considering the purchasing
power of that money ie It consider inflation and deflation.

PRINCING OF THE FACTOR LAND (RENT)

Economic Rent is that part of the earnings of a factor of production in excess

of its TRANSFER EARNINGS arising from its scarcity

DIFFERENT CONCEPTS OF RENT

There are mainly three concepts (i) Quasi Rent (ii) Transfer Earning (iii) Economic
Rent.

I. QUASI RENT

MARSHALL described this as the income an owner receives from allowing

others to use machines and other productive appliances made by man. This
return is in excess of the OPPORTUNITY COST of using that piece of FIXED
CAPITAL.

This is the amount of rent paid to the factor whose supply in short-run is inelastic
but elastic in long run hence the quasi rent is paid only in short-run but disappears
in long-run.

Quasi rent is paid in all factors except land since the supply of land is perfectly
inelastic.

E.g. If the doctor is supposed to be paid 1.5 million but instead is paid 2 million in
short-run due to deficit of doctor the extra payment ie (2mill – 1.5mill) is called
Quasi rent. This amount will disappear in long-run when many doctors will be
trained and become employed.

II. TRANSFER EARNINGS (RENT)

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These are the minimum amount required to sustain (maintain) the factor in its
present occupation. E.g. if one is paid 80,000 in its present occupation but occurs
another job which that labor will be paid more amount, say 100,000, automatically
at ceteries paribus that worker may leave his present job due to extra earning of
20,000. But if that next job earn the same amount as the previous one i.e. 80,000;
there could no transfer (at ceteries peribus)

Hence the amount 80,000 is the minimum amount required to maintain the labor in
its present occupation. Hence it is called TRANSFER EARNING.

III. ECONOMIC RENT

This is the extra earning above the Transfer earning. From the previous example,
the Economic Rent is equal to 20,000 (ie 100,000 – 80,000). The main different
between Quasi rent & economics rent is that, the Economic Rent can be earned in
both short-run and long run periods while the Quasi Rent is earned only in short-run
and disappear in long-run.

THEORIES OF RENT

(i) Ricardian Theory (ii) Modern (market) Theory.

RICARDIAN THOERY

The theory of economic rent was first propounded by the English Classical
Economist David Ricardo (1773 -1823). David Ricardo in his book. "Principles
of Political Economy and Taxation", defined rent as that:

"Portion of the produce of the earth which is paid to a landlord on account of

the original and indestructible powers of the soil. Ricardo in his theory of rent
has emphasized that rent is a reward for the services of land which is fixed in
supply. Secondly, it arises due to original qualities of land which are
indestructible". (The original indestructible powers of the soil include natural
soil, fertility, mineral deposits, climatic conditions etc., etc.).

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 ASSUMPTION OF RICARDO THEORY

i. He assumed that rent is paid because of difference fertility

ii. He assumed that rent is paid on land only.
iii. He assumed that the land is only used for Agriculture.
iv. He assumed that the rent paid is not the part of cost.
v. He assumed the law of diminishing rent.
vi. Descending Order of Cultivation: Theory assumes that different tracts
of land are brought under cultivation in a descending order of fertility.
In the words of Ricardo, “The most fertile and most favorably situated
land will be first cultivated”

CRITICISMS OF RICARDIAN THEORY

i. The rent is not paid because of difference in fertility but because land scarce.
ii. Land has alternative uses not only for agriculture.
iii. The fertility of the land can be improved eg. By appliying fertilizers hence the
law of diminishing when doesn’t apply.
iv. The first land to be cultivated must not be the fertile one as assumed by
recolor but the one more assessable (near to the farmer).
v. Rent is not only paid to the land but any factor whose supply is fixed in short-
run.
vi. Rent paid is the part of cost of production.

MODERN THEORY OF RENT

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 William Stanley Jevons, Vilfredo Pareto, Alfred
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.

Modern Definitions of Rent

“Rent is a payment in excess of transfer earning.”

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“The essence of the conception of rent is the conception of a surplus earned
by a particular part of a factor of production over and above the minimum
sum necessary to induce it to do its work”.

Features of Modern Theory of Rent:

a. Rent can be a part of the income of all factors of production.

b. Amount of rent depends upon the difference between actual earning
and transfer earning.
c. Rent arises when supply of the factor is either perfectly inelastic or less
elastic.

Determination of rent by Modern economists

Modern economists opined that rent arises due to scarcity of land. Scarcity of
land means that demand for land exceeds its supply. Rent will be determined
at a point where demand for land is equal to its supply

Demand for Land:

Land has derived demand. It means that demand for land depends on the
demand for agricultural products. If demand for food grains increases,
demands for land will also increase and vice-versa. Moreover, demand for
land is influenced by its marginal productivity. It means as more and more
land is used its MP1 goes on diminishing.

Supply of Land:

Supply of land is fixed. Its supply is perfectly inelastic. It means, increase in

the price of land will not evoke any increase in its supply.

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In Fig. 5 units of land have been measured on X-axis and rent on Y-axis. SS is
the supply curve of land which is parallel to Y-axis indicating that the supply
of land remains fixed. Rent will be determined at a point where the demand
and supply of land are equal to each other

Initially DD is the demand curve which intersects the supply curve at point E.
At this point, equilibrium rent OR is determined. Now, if the population rises
which gives boost to the demand for food, the demand curve shifts to D’D’
and the equilibrium will be at point E’ and the rent will rise to the extent of
OR’.

Similarly, if the demand curve shifts to D” D” and labour /capital the new
equilibrium point will be E” and the rent will fall to OR”.

PRINCING OF ENTREPRENEUR (PROFIT)

Profit is the amount obtained after deducting Total costs of production from
the Total Revenue obtained.

i.e. Profit=TR−TC .

Types of Profits

Different people have described profit differently. Individuals have

associated profit with additional income revenue, and reward. However,
none of the description of profit is said to be right or wrong; it only depends
on the field which the word profit is described

i. Accounting Profit: It is a return that is calculated as a difference between

revenue and costs, including both manufacturing and overhead expenses.
The costs are generally explicit costs, which refer to cash payments made
by the organization to outsiders for its goods and services
The accounting profit is calculated as:
Accounting=TR−(W + R+ I + M ) = TR−Explicit Costs
TR = Total Revenue

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W = Wages and Salaries
R = Rent
I = Interest
M = Cost of Materials

ii. Economic Profit: Takes into account both explicit costs and implicit costs
or imputed costs. Implicit that is foregone which an entrepreneur can gain
from the next best alternative use of resources. Thus, implicit costs are
also known as opportunity cost. The examples of implicit costs are rents
on own land, salary of proprietor, and interest on entrepreneur’s own
investment.
The economic profit is calculated as:
Economic profit = Total revenue-(Explicit costs + implicit costs)

Features of Profit

i. It is paid after all other factors have been rewarded.

ii. It can be positive or negative.
iii. It charges time over time depending on the Economic conditions in the
country.
iv. They are uncertain and they tend to fluctuate more compared to all
other rewards for factor of production.

Factors Influencing Profits

i. The cost of production incurred.

ii. The level of prices.
iii. The government policy i.e. if high taxes on profits, low profits & vice
versa.
iv. The efficiency of other factors. If more efficiency more profits & vice
versa.
v. The economic condition of the country is if boom more profit and vice
versa.
vi. The Extent of demand if more demand high profits & vice versa.
vii. Number of firms available. If small number more profits and vice
versa.

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 The Roles Of Profits To The Economy

i. It determines the level of investment.

ii. It determines the level of production.
iii. It increases employment chances.
iv. It increase the government revenue
v. It encourages many people to take risks.
vi. It helps the firm to expand.
vii. It can be deposited in banks so as to earn interests.

Theories Of Profit

There are different theories which explain how profit are determined or why
are they paid. These theories are:-

(i) Rent theory of profit (ii) Wage theory of profit (iii) Risk theory of profit

(iv) Uncertainty theory of profit (v) Dynamic theory of profit.

I. RENT THEORY OF PROFIT

Rent theory of profit was propounded by An American economist, Prof

Francis Amasa Walker. According to him “as rent is the difference between
least and most fertile land similarly, profit is the difference between earnings
of the least and most efficient entrepreneurs.” He advocated that profit is
the rent of exceptional abilities that an entrepreneur possesses over others.
Thus, profit is also said to be the reward for differential ability of the
entrepreneur.

However the theory was criticized under the following grounds.

i. A less efficient entrepreneur can also earn profits provided that other
factors
of production are efficient

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 ii. They theory fails to explain why sometimes some efficient entrepreneur’s
firms make losses

II. WAGE THEORY OF PROFITS

According to the theory, profits are paid to the entrepreneur as how wage is
paid to the labor. According to the theory entrepreneur is like a labor only
that is a superior labor. Therefore, since an entrepreneur is also a labor he
must be paid profits as how a normal labor is paid wages so as to encourage
production process.

However the theory was criticized under the following grounds

a. The labor must be paid wages even if the firm incurs loss but the
Entrepreneur can’t be paid when the firm incurs loss.
b. In order the labor to get wages he / she must have exerted the mental
& Physical efforts in production process while on Entrepreneur can
earn profits even without exerting any mental & physical efforts.

III. RISK THEORY OF PROFITS

The risk theory of profit was given by F. B. Hawley in 1893. According to

Hawley, “profit is the reward of risk taking in a business. During the conduct
of any business activity, all other factors of production i.e. land, labor, capital
have guaranteed incomes from the entrepreneur. They are least concerned
whether the entrepreneur makes the profit or undergoes losses.”
Hawley refers profit as a reward for taking risk. According to him, the greater
the risk, the higher is the expected profit. The risks arise in the business due
to various reasons, such as non-availability of crucial raw materials,
introduction of better substitutes by competitors, obsolescence of a
technology, fall in the market prices, and natural and manmade disasters.

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Risks in businesses are inevitable and cannot be predicted. According to
Hawley, an entrepreneur is rewarded for undertaking risks

Criticism

Entrepreneur gets profits so as to encourage to carry out production. Since

the risks can be compensated by the insurance companies since is foreseen.

IV. UNCERAINITY THEORY OF PROFITS

The theory established after the Risk theory has been criticized. According
to this theory profits are paid because of uncertainties and not Risk.

Uncertainty is a state of affairs with an unknown outcome not subject to a

probability. E.g. change in demand, the business cycle and change of
government or governmental policies.

According to this theory there are two types of Risk;

a. Those risk which can be foreseen by the Entrepreneur and

b. Those risks which cannot be foreseen by the Entrepreneurs. These risk
are what called uncertainties.

The risk of first type includes loss by fire or sinking by ship. The risks of this
kind can be compensated by the insurance companies. But the uncertainties
cannot be compensated by the insurance companies. Hence profits are paid
because Entrepreneurs are ready to take uncertainties and not Risks.

V. DYNAMIC THEORY OF PROFITS

According to this theory the profits paid to Entrepreneurs can either be high
or low depending on the dynamic state of the economy is Boom or
depression. The levels of economic activities are dynamic.

These are sometimes there is favorable conditions in the economy i.e. Boom
in this period the profits to Entrepreneur will be paid high but in the
unfavorable conditions i.e. Depression, the level of profit are at minimum

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(low) hence the rate of profits according to this theory is determined by the
Economic condition in the country which are dynamic.

PRINCING OF CAPITAL (INTEREST)

Interest is the reward paid to the owner of the capital asset due to the
services rendered by the capital.

WHY INTEREST IS PAID?

There are various theories which explain why interest is paid on capital.

These theories are:-

(i) Marginal Productivity theory (ii) Waiting or Abstaining theory

(iii) Austrian theory (iv) Liquidity preference theory (Keynesian theory)

(v) Loanable fund theory

I MARGINAL PRODUCTIVITY THEORY

According to this theory interest is paid because capital is productive. The

more productive capital will be paid a higher interest compared to the less
productive capital.

Example

If the fisherman by the use of capital (fishing net or boat) can catch large
number of fish compared to when he is using fishing road, the fisherman has
to pay interest rate to the owner of the capital because it’s productive

However the theory was criticized on the ground that interest is not paid
because of productivity of capital, but capital is SCARCE. If the capital was
plenty and productive no one could pay interest since everyone could be
able to possess that capital.

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II. ABSTAINING or WAITING THEORY

According to this theory Interest is paid on capital since the owner of the
capital has to wait for a certain period before using that capital. E.g. If the
person deposits money in a fixed account, he will be allowed to draw after
waiting for a certain time. Since saving involves waiting for capital
accumulations. Interest rate has to be paid so as to induce people to save
money. When a person deposits his money in Bank he wait for a certain
period before using that money hence the interest must be paid to
compensate the amount which could have been obtained by the use of that
capital in that time.

III. LOANABLE FUND THEORY

This theory is also called Modern or Market theory of Interest. According to

this theory interest is paid because the demand for capital is greater than
the supply for capital i.e. the available loanable fund is less than the demand
for loan by people. Loanable Fund means the amount of money available for
giving loans to people.

Hence if the demand for loans is high the interest rate is higher that when
the demand for loans is low.

IV. LIQUIDITY PREFERENCE THEORY (KEYNESIAN THEORY)

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According to Keynes, there are three main motives (reasons) for holding
money (Demand for money namely: - (a) Transactionary motive (b)
Precautionary motive

(c) Speculative motive.

a) Transactionary motive Mean holding money for day to day transactions.

b) Precautionary motive Means holding money for meeting in foreseen

events

c) Speculative motive. Means holding money mainly in Banks for the

purpose of increasing in amount due to

interest rate.

Since the third motive is the one related to the interest rate, Keynes explains
that interest is paid on capital so as to encourage people to demand money
for speculative only and discourage other motives i.e. transactionary and
precautionary

V. AUSTRIAN THEORY OF INTEREST

According to this theory, saving of money in banks so as to encourage

investment involves postponing present consumption to future
consumptions. When people demand loans for investment the banks will
tend to mobilize people increase saving, but when people save money they
must postpone their present consumption to future, but since people prefer
present consumption to future consumption they will not be ready to save.
Hence something has to be paid so as to encourage them to postpone
present consumption to future. Therefore interest is paid to capital to induce
people to postpone their consumption.

The theory explained that people prefer present consumption to future

consumption because:-

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i) Future is uncertain.

ii) Present consumption is felt more serious than the future one.

RELATIONSHIP BETWEEN INVESTMENT AND INTERES

When the interest rate for loans needed for investment is high people will be
discouraged from taking loans hence investment will decline. Therefore
there is negative relationship between investment and interest rate.

WHY IS INTEREST RATE NOT THE SAME FOR ALL BORROWERS?

i. The time of using capital:- Lon time high interest and vice versa.
ii. Productivity of the capital:- The higher the productivity of capital the
higher the interest rate and vice versa.
iii. Risk involved in taking capital:- If there is high risks involved in taking
capital the interest rate will be high and vice versa
iv. The Elasticity of demand for the capital:- If some borrowers have in
elastic demand the interest rate
will be higher compared to these of Elastic demand.

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