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Introduction to factor Pricing
The theory of determining the prices of factors of production is also known as the theory of distribution. This encompasses the study of how much remuneration or payment factors of production such as land, capital, labor, and entrepreneur receive for their contribution to production.
The payment made to landowners for the use of land in production is called rent, the payment made to capitalists for the use of capital is called interest, the payment made to workers for the use of labor is called wages, and the payment made to entrepreneurs for the use of entrepreneurship is called profit.
Factors of Production
A. Rent
In general terms, rent is the payment made to the owners of real assets with exchange value, such as land, factories, monopoly goods, etc., for the use of those real assets for a specific period.
Classical economist David Ricardo defined rent as the payment received by landowners for the use of the original and indestructible powers of the soil, which he said is only obtained from land. However, modern economists have stated that rent is obtained not only from land but also from other factors of production.
According to them, rent is the difference between the actual income received by the factors of production and the minimum income required to keep those factors in their current use.
In other words, economic rent is obtained by subtracting the alternative or opportunity cost of any factor of production from its current income. Rent is mainly divided into two parts: economic rent and contract rent. These are discussed below.
(a) Economic Rent
Economic rent is also called pure rent. According to David Ricardo, "economic rent is the payment made by a tenant to a landowner solely for the use of land."
It is only a part of the total payment made by the tenant to the landowner. It does not include the payment made by the tenant to the landowner for the expenses incurred by the landowner for land improvement. Therefore, economic rent is only the payment made for the use of land.
According to modern economists, rent (economic rent) is obtained not only from land but also from other factors of production such as capital, labor, and entrepreneur. According to them, economic rent is the surplus remaining after subtracting the transfer income of any factor of production from its current income.
The current income of a factor of production refers to the income obtained from the current or best use of that factor. Similarly, transfer income refers to the income obtained when that factor is used in another best alternative use.
The transfer income of a factor is also called alternative cost, opportunity cost, or the minimum supply price required to keep the factor in its current use.
(b) Contract Rent
Contract rent is also called gross rent. Contract rent is the total or actual payment made by the user to the owner of a factor of production for using the factor or its services for a specific period. Contract rent is similar to the periodic payment made by users to homeowners for the use of houses, landowners for the use of land, and owners of machinery and equipment for the use of machinery and equipment.
Contract rent is determined based on the agreement between the factor owner and the factor user. Contract rent includes payments for improvements made to the factors in addition to economic rent.
For example, expenses incurred by the landowner for constructing a fence around the land, expenses for drainage management, expenses for building canals, wells, or ponds for irrigation, etc., are included in contract rent.
B. Wages
The remuneration paid to a worker for their labor in production is called wages. In other words, wages are the price of labor.
According to economist Frederic Charles Courtanay Benham, "A wage may be defined as the sum of money paid under contract by an employer to a worker for services rendered."
Thus, the payment made by a producer to a worker for the use of their labor, as agreed upon, on an hourly, daily, monthly, or piece-work basis, is wages. There are two main concepts of wages: nominal and real. These are discussed below.
(a) Nominal Wages:
The wages received by a worker in the form of money for their labor in the production of goods and services are called nominal wages. It is also called monetary wages. It is measured in monetary units. It only includes the monetary wages received from the profession in which the worker is employed.
For example, if a worker receives Rs. 500 per day as wages for working in a furniture industry, then that worker's nominal or monetary wage is Rs. 500 per day.
(b) Real Wages:
The total quantity of goods and services that a worker can purchase with the monetary wages they receive for their labor is called real wages. It is measured in units of goods and services or based on the purchasing power of money.
For example, if a teacher receives Rs. 400,000 per year as a salary, the total quantity of all goods and services they can purchase with Rs. 400,000 is their real wage. The formula for calculating real wages is as follows:
Real Wage = (Monetary Wage / Price Level) x 100
Real wages are affected not only by the price level and monetary wages but also by various other factors.
Real wages are determined by various factors such as housing facilities provided to workers, medical facilities, education facilities, transportation facilities, clothing facilities, insurance facilities, potential for additional income, nature of work, regularity and safety of work, work environment, career development and promotion opportunities, social prestige of work, timely payment arrangements, and employment arrangements for family members.
These factors are called the determinants or influencing factors of real wages.
C. Interest
Interest is the payment made for the use of borrowed or loaned funds for a specific period to purchase capital goods used in production. In other words, interest is the price paid for using capital for a specific period in production. Various economists have defined interest in different ways, as follows:
According to economist Edwin Robert Anderson Seligman, "Interest is the return from the fund of capital."
Similarly, in the words of another economist, Thomas Mayer, "The price for the use of loanable funds is called interest."
In the view of economist J.M. Keynes, "Interest is the reward for parting with liquidity for a specific period of time."
Interest is studied under two categories: gross interest and net interest. These are discussed below:
(a) Gross Interest
The term "interest" as commonly used refers to "gross interest." Gross interest is the total amount paid by the borrower to the lender for the use of capital for a specific period. The total interest received by the lender includes net interest and other amounts. The components of gross interest are explained below:
(i) Net Interest: Net interest is the price paid by the borrower to the lender solely for the service or use of the capital. In other words, net interest is only the price of the service provided by capital.(ii) Reward for Risk: When lending, the lender has to bear risk. Therefore, in addition to the price of capital (net interest), the lender charges an additional amount from the borrower as a reward for risk or as an insurance claim against risk. This reward for risk is included in gross interest.
(iii) Reward for Management: The lender charges an additional amount from the borrower for management expenses. This is called the reward for management. This amount is also included in gross interest.
(iv) Reward for Inconvenience or Compensation: When the lender lends money or funds, they lose the liquidity of their money and their freedom to spend it as they wish. As a result, they experience inconvenience. As compensation for these inconveniences, the lender charges an additional amount from the borrower, added to the net interest, which is called the reward for inconvenience or compensation. This amount is also included in gross interest. Thus, gross interest can be briefly expressed as:
Gross Interest = Net Interest + Reward for Risk + Reward for Management + Reward for Inconvenience
(b) Net Interest
Net interest is only a part of gross interest. In economics, the term "interest" refers to net interest. Net interest is also called pure interest. Net interest is the price paid by the borrower to the lender solely for the service or use of the capital or money.
To calculate net interest, the payments for risk, management, and inconvenience are deducted from gross interest.
Thus,
Net Interest = Gross Interest - Reward for Risk - Reward for Management - Reward for Inconvenience
D. Profit
Profit is the income that an entrepreneur receives for bearing risk or uncertainty. Various economists have defined profit in different ways.
In the words of economist Henry Grayson, "Profit may be considered as a reward for making innovations, a reward for accepting risk and uncertainties, and market imperfections."
Similarly, according to Jacob Oser, "Profit is the residual income of the business after all explicit and implicit wages, interest, and rent have been met."
Unlike the prices or incomes of other factors of production, such as land rent, capital interest, and labor wages, which are predetermined before the production of goods and services and are always positive, profit cannot be predetermined. It is a residual and a reward for the entrepreneur.
Since profit is the income remaining after paying the prices of all other factors of production, it is not predetermined. It can be positive, zero, or negative. A negative profit is called a loss. Profit is divided into two parts: gross profit and net profit, which are discussed below.
(a) Gross Profit
Generally, the term "profit" refers to gross profit. It is also called business profit. Gross profit is the difference between total revenue and total explicit costs. Total revenue is the amount received by a firm from selling its production quantity during a specific period. Total revenue is obtained by multiplying the sales quantity of goods by the price per unit.
If a producer or firm does not own the necessary factors or goods and services for production, they have to obtain them from others. The sum of cash payments made to others for using their factors or goods and services in production is called explicit costs.
Thus, gross profit or business profit is the income remaining with the firm after paying rent, interest, and wages, respectively, for the use of factors of production like land, capital, and labor that are not owned by the firm, and after deducting liabilities such as taxes and depreciation.
Gross Profit or Business Profit = Total Revenue – Explicit Costs
The components of gross or business profit are as follows:
(i) Rent for the entrepreneur's own land(ii) Interest for the entrepreneur's own capital
(iii) Wages for the entrepreneur's own labor
(iv) Taxes and depreciation
(v) Insurance expenses
(vi) Net profit or pure profit
(b) Net Profit
In economics, profit refers to net profit. It is also called pure profit. Net profit can be defined as the difference between total revenue and total costs (both explicit and implicit costs). Alternatively, net profit is the amount obtained by deducting implicit costs, depreciation, and insurance expenses from gross or business profit.
Implicit costs refer to the amount set aside by the entrepreneur as payment for using their own resources in production. In other words, implicit costs are the payments or expenses that the entrepreneur would have to make for using their own resources in their own business.
Net Profit = Total Revenue – Total Costs (including both explicit and implicit costs) Or, Net Profit = Gross Profit – Implicit Costs
Net profit includes the reward for risk and uncertainty bearing, capacity and innovation received by the entrepreneur, as well as the entrepreneur's monopoly profit and windfall gains.
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