# AP Inter 1st Year Economics Study Material Chapter 6 Theory of Distribution

Andhra Pradesh BIEAP AP Inter 1st Year Economics Study Material 6th Lesson Theory of Distribution Textbook Questions and Answers.

## AP Inter 1st Year Economics Study Material 6th Lesson Theory of Distribution

Essay Questions

Question 1.
Define Rent and explain Ricardian theory of Rent.
David Ricardo was a 19th century economist of England, who propounded a systematic theory of rent. Ricardo defined rent as “that portion of the procedure of earth which is paid to the landlords for the use of the original and indestructible powers of soil”. According to Ricardo, rent arises due to differential in surplus occurring to agriculturists resulting from the differences in fertility of soil of different grades of land.

Rica rdiarz theory of rent is based on the principle of demand and supply. It arises in both extensive and intensive cultivation of land. When land is cultivated extensively, rent on superior land equals the excess of its produce over that of the inferior land. This can be explained with the following illustration.

We can imagine that a new island is discovered. Assume a batch of settlers go to that Island. Land in this Island is differ in fertility and situation. We assume that there are three grades of land A, B, and C. With a given application of labour and capital superior lands will yield more output than others. The difference in fertility will bring about differences in the cost of production, on the different grades of land. They first settle on A’ grade land for cultivation of com. A’ grade land yields say 20 quintals of corn with the investment of ₹ 300. The cbst of production per quintal is ₹ 15 (300/20). The price of corn in the market has to cover the cost of cultivation.

Otherwise the farmer will not produce com. Thus the price in the present case should be atleast ₹ 15 per quintal. As time passes, population increases and demand for land also increases. In such a case people have to cultivate next best land, i.e., ’B’ grade land. The same amount of Rs. 300 is spent of ‘B’ grade land gives only 15 quintals of corn as ‘B’ grade land is less fertile. The cost of cultivation on ‘B’ grade land risen to ₹ 20 (300/15) per quintal of corn. If the price of com per quintal in the market is then ₹ 20, the cultivator of ‘B’ grade and will be not cultivated. Therefore, the pride has to be high enough to cover the cost of cultivation on ‘B’ grade land. Hence the price also rises to ₹ 20. There is no surplus on B’ grade land. But on A grade land. But on A grade land, the surplus is 5 quintals or ₹ 100 (5 × 20).

Further, due to growth of population demand for land and corn increased. This necessitates, the cultivation of ‘C’ grade land with ₹ 300 investment cost. It yields only 10 quintals of com. Therefore the per quintal production cost rises to 30 (300/10). Then the price per quintal must be atleast ₹ 30 to cover the cost of production. Otherwise ‘C’ grade land will be withdrawn from cultivation. At price ₹ 30. ‘C grade land yield no surplus or rent. But A grade land yields still layer surplus of 10 quintals or ₹ 300 (10 × 30). But surplus or rent on ‘B’ grade land has 5 quintals or ₹ 150 (5 × 30). But there is no surplus or rent on ‘C’ grade land. It covers just the cost of cultivation. Hence, ‘C’ grade land is a marginal land which earns no rent or surplus.
This can also be explained with the following table.

The essence of Ricardian theory of rent.

1. Rent is a pure surplus.
2. Rent is differential surplus.
3. Rent does., not determine or enter into price.
4. Diminishing returns applies to agricultural production.
5. Land is put to only one use i.e., for cultivation.

Ricardian theory of rent can be explained with the help of diagram.
In the above diagram the shaded area represents the rent or differential surplus. The least fertile land i.e., C does not carry any rent. So it is called marginal land or no rent land.

Question 2.
Explain Marginal Productivity Theory of Distribution.
This theory was developed by J.B.Clark. According to his theory, the remuneration of a factor of production will be equal to its marginal productivity. The theory assumes perfect competition in the market for factors of production. In such a market, average cost and marginal cost of each unit of factor of production are the same as they are equal to the price or cost of a factor of production.

For example if four tailors can stitch ten shirts in a day and five tailors can stitch thirteen shirts in a day, then the marginal physical product of the 5th tailor is 3 shirts. If stitching charge for a shirt is ₹ 100/-, then the marginal value product of three shirts is ₹ 300/-. According to this theory the 5th person will be remunerated ₹ 300/- marginal physical product is the additional output obtained by using an additional unit of the factor of production. If we multiply the additional output by market price we will get marginal value product or marginal revenue product.

At first stage when additional units of labour are employed the marginal productivity of labourer increases up to certain extent due to economies of scale. If additional units of labour are employed beyond that point the marginal productivity of labour decreases. This can be shown in the following figure.

In the figure OX axis represent units of labour and OY represent price/revenue/cost. At a given price OP the firm will employ OL units of labour where price OP = L. If it employees less than ‘OL’ i.e., OL1 units MRP will be E1L1 which is higher than the price OR If firm employers more than OL units upto OL2 price is OP is more than E2L2. So the firm decreases employment until price = MRP till OL. At that point ‘E’ the additional unit of labour is remunerated equal to his marginal productivity.

Question 3.
What is meant by Real Wages ? And what are the factors that determine Real wages ?
The amount of goods and services that can be purchased with the money wages at any particular time is called real wage. Thus real wage is the amount of purchasing power received by worker through his money wage.
Factors determining the real wage :
1. Methods of form of payment: Besides money wages, normally the labourers get same additional facilities provided by their management. Ex : Free housing, free medical facilities etc. As a result this real wage of the worker will be high.

2. Purchasing power of money : An important factor which determines the real wage is the purchasing power of money which depends upon the general price level. A rise in general price level will mean a full in the purchasing power of money, causes decline in real wages.

3. Nature of work: The working conditions also determine the real wages of labourer. Less duration of work, ventilation fresh air etc., result in high real wages, lack of then facilities real wages are low eventhough money wages are high.

4. Future prospects : Real wage is said to be higher in those jobs where there is possibility of promotions hike in wages and vice-versa.

5. Nature of work : Real wages are also determined by the risk and danger involved in the work. If work i\$ risky wages of labourer will be low though money wages are high. Ex : Captain in a submarine.

6. Timely payment : If a labourer receives payment regularly and timely the real wages of the labourer is high although his money wage is pretty less and vice-versa.

7. Social prestige : Real wage depends on social prestige. The money wages of Bank officer and judge are equal, but the real wage of a judge is higher than bank officer.

8. Period and expenses of education : Period and expenses of training also affect real wages.

Question 4.
What is meant by wages ? Explain briefly various theories of wages.
Wages are a payment made for the services of labour, either mental or physical.
According to Benham “sum of money paid under contract by an employer to a worker for the services rendered”.
Theories of wages:
1. Subsistence theory of wages : This theory was formulated by a group of French Economics known as Physiocrats. This theory is also termed as “Iron Law of wages”. According to this theory, wages will always be at a level to enable the labourer and his family to fulfill the minimum subsistence level. If the wages are raised above the subsistence level, supply of labour will increase. If wages will decrease to the subsistence level, the supply of labour will decrease. Hence wages will always be at the subsistence level.

2. Wage fund theory : This theory developed by J.S.Mill. According to this theory every entrepreneur will keep aside a part of the variable capital to pay wages as the labourers cannot wait for their wages till goods are sold. Such part of variable capital is known as ‘Wages fund” or “Circulating capital”.
Average wage rate = $$\frac{\text { Amount of wage fund }}{\text { Number of labourers }}$$

3. Residual claimant theory of wages : This theory proposed the residual claimant theory of wages. According to Walker is a residual claimant. After paying rent, interest and profit from total revenue, the balance will be paid as wages to labourers.
Wages = Total Revenue – (Rent + Interest + Profit)

4. Taussig’s theory of wages: This theory modified by Taussig. According to Taussig, wages are equal to the discounted marginal product of labour. According to him, the labourer cannot get full value of the marginal productivity. In order to meet the expenditure of labourer in course of production, the employer will have to pay wages in advance. Hence, the employers deducts a certain percentage from the final output inorder to compensate the risk involved in advance payments to the labourers.

5. Modern theory of wages : This theory proposed by Marshall and J.R.Hicks. According to this theory, the wages of labourers are determined by the demand for and supply of labourers wage is determined at that point where the demand and supply of labourer are equal.

Question 5.
What is meant by interest ? Explain briefly various theories of interest.
In Economics, interest is regarded as the payment for the use of the service of capital.
Carver said “Interest is the income which goes to capital”.
Theories of interest:
1. Abstinence or Waiting theory of interest: Nassau Senior proposed the Ah f inence theory of interest. According to him capital can be created by postponing consumption. It means when people save, they abstain from consumption. Abstaining from consumption is disagreeable and painful. As lending involves sacrifice, it is necessary to reward the lender in the form of interest.

2. Agio theory of interest or Bohm – Bawerk’s theory: According to Bohm – Bawerk, interest arises because people prefer present goods to future goods of the same kind and quantity. People prefer present enjoyment to future enjoyment. As a result of saving, people lose present enjoyment.
Bohm-Bawerk gave three reasons for the emergence of rate of interest. They are :

1. The demand for goods is greater now than in future as people have different demands for goods in the present than in the future.
2. People under estimate future wants due to lack of imagination to judge the intensity of their future wants, lack of will to resist temptation of satisfying present wants and they think they may not be alive to satisfy wants as future is uncertain.
3. Present goods are considered technically superior over future goods. By consuming goods at present lead to accumulation of productive capital for future. Hence interest is paid as a premium for the postponement of consumption.

3. Productivity theory of interest : According to Classical Economists, capital is demanded because of its productivity. Whenever additional units of capital are used, productivity will increase upto a certain point and later decreases beyond that point. Additional units of capital are not as productive as the earlier units as a result of the law of variable proportions.

According to this theory, rate of interest is just equal to the productivity of capital. Hence, higher the demand for capital, lower will be the rate of interest and vice versa. As per the theory, rate of interest is inversely related to the demand for capital.

4. Loanable funds theory of interest: The lonable funds theory or the neo classical theory was first formulated by Knutt Wicksell. According to this theory, interest is determined by the equilibrium of demand for and supply of loanable funds in the market.

5. Time preference theory : Irvin’g Fisher proposed the time preference theory of ! interest. Fisher’s theory emphasized time preference as a cause of interest. He also considered the role of marginal productivity or “rate of return over cost that determines interest”. Hence, rate of interest is determined by time preference.

6. Keynes’ liquidity preference theory: Keynes proposed a monetary explanation of the rate of interest. According to Keynes, interest is determined by both the demand for and supply of money.
According to Keynes “Interest is the reward paid for paring with liquidity for the specified period”.

7. Supply money: Supply of money refers to the total quantity of money in circulation. Supply of money is fixed or perfectly inelastic at a given point of time. Supply of money is determined by the central bank of a country.

8. Demand for money : People demand money for its liquidity. The desire to hold ready cash is liquidity preference. Liquidity preference is positively related to the rate of interest. People demand money basically for these reasons.

1. Transactions motive
2. Precautionary motive
3. Speculative motive.

Question 6.
What is meant by profit ? Explain briefly various theories of profit.
Profit is the reward paid to the entrepreneur for his services as an organizer in the process of production.
Theories of profit:
1. Dynamic theory of profit: This theory was propounded by J.B. Clark. According to Clark “Profit is the difference between the price and cost of production of commodity”. He viewed that profit as a reward for entrepreneurial dynamism. Dynamic changes like increase in population, new method of production etc., result increase in profit. In a static economy due to lack of these changes entrepreneurs receive only wages but not profit. Hence profits are the result of the dynamic changes only.

2. Innovation theory: This theory was developed by Joseph Schumpeter. According to Schumpeter, “profit is the reward paid to the entrepreneur for his inventive skills”. Because of these inventions profits arise as a difference between prices and costs of production.
According to Schumpeter, entrepreneur must break the circular flow by introducing innovations they are :

1. Introduction of new good.
2. Introduction of new method of production.
3. Reorganisation of industry.
4. Opening up of a new market.
5. Discovery of new source of raw materials.

So these innovations, the cost of production remains below its selling price and thus profit arises.
Thus profit is paid to entrepreneur for innovating but not for risk taking.

3. The risk theory of profit: This theory was proposed, by Prof. Hawley. Profits are the reward for an entrepreneur for risk-taking. So the residual part of income after paying all factors of production goes to the entrepreneur for risk taking. Fluctuations in future prices, demand etc., are involved in risk taking.
According to Prof. Hawley those who face risks in business will be able to earn an excess of payment above the actual value of risk in the form of profit.

4. Uncertainty theory of profit: This theory formulated by Prof. Knight. It is a modified version of risk bearing theory of profits. According to him profit as the reward for bearing uninsurable risks and uncertainties. He classified risks into two types.

1. Unforseen insurable risks like fire, theft.
2. Unforseen non insurable risks like changes in prices, demand and supply. These uninsurable risks cannot be calculated.

According to Prof. Knighit, “Profit cannot be treated as the reward for risk taking only for reward for uncertainty bearing”.

5. Walker’s theory of profit: This theory developed by Walker. According to Walker “Profits are a rent paid for the abilities of entrepreneur”. Walker theory states that profits arise due to the differences in efficiency and ability of entrepreneurs. Hence efficient and able entrepreneurs’ are paid profits.

Question 1.
Explain the concept of Distribution.
Distribution refers to that branch of economies which analyses how the national income of a community is divided among the various factors of production, distribution then refer to the sharing of the wealth that is produced among factors of production. It is the pricing of factors of production. The distribution of income may be personal or functional economies is concerned with functional distribution. The distinction between them is briefly explained here.

1. Functional distribution : Functional distribution deals with the study of factor incomes. It means the theory of factor pricing. The prices of land, labour, capital and organisation are called rent, wages, interest and profit respectively. Therefore, it is the study and determination of rent, wages, interest and profit. It concern the pattern of distribution of national income as rent, wage, interest and profits. Thus it is not concerned with individuals and their individual income, but with the agents’of production. The study of functional shares has been carried on both at the macro and micro levels.
Micro-distribution: The theory of micro-distribution explains how the prices of factors of production are determined.
Ex : Micro-distribution we study how wage rate of labour is determined.

Macro-distribution : Macro distribution explains the share of a factor of production in the national income.
Ex : The share of labour in the national income.

2. Personal distribution: It refers to the distribution of income or wealth of a country among its people. It studies how income or wealth is distributed among individuals or persons. It studies how much income is earned by an individual, but not how it is earned or in how many forms it is earned. The causes of income inequalities can be known by studying personal distribution.

Question 2.
What are the factors that determine factor prices ? [March 16]
The demand and supply of a factor of production determine its price. The demand for a factor of production depends on the following.

1. It depends on the demand for the goods produced by it.
2. Price of the factor determines its demand.
3. Prices of other factors or co-operative factors determine the demand for a factor.
4. Technological changes determine the demand for a factor.
5. The demand for a factor increases due to increase in its production.

Factors that determine the supply of a factor of production.

1. The size of the population and it’s age composition.
2. Mobility of the factor of production.
3. Efficiency of the factor of production.
4. Geographical conditions,
5. Wage also determines the supply of this factor.
6. Income.

Question 3.
Explain the concept of Quasi-rent. [March 17]
The concept of Qliasi rent was first introduced by Marshall. According to Marshall, quasi rent is the income derived from machines and other man made appliances of production. Whose supply is inelastic in the short run in relation to their demand. If the demand for these factors increases, their prices will also increase due to their inelasticity of supply in R the short period. The rent or surplus above the factor price will disappear in the long run.

In the above diagram man made appliances are shown in ‘OX’ axis and ‘OY’ axis shown rent SPS is short period supply curve. LPS is long period supply curve. In the above diagram it is observed that rent will disappear in the long run.

Question 4.
Explain the concept of Scarcity rent. [March 18]
Marshall explained the concept of scarcity rent on the basis of demand and supply. In general land has indirect demand or derive demand. If there is an explosion of population demand for land increases this result rise in its price. The surplus earned by land above its price is called scarcity rent.

The supply of land is fixed and inelastic. The demand for land will determine the rent by influencing its price. Hence rent arises due to the scarcity in the supply of factors of production.

In the given diagram on ‘OX’ axis represent supply and demand for land. ‘OY axis represents Rent. SL is supply of land. It is perfectly inelastic. When DD curve shifts upward to D1D1. So price increases from OR to OR1. Similarly if demand curve further shifts from D1D1 to D2D2 rent price further increases from OR1 to OR2.

Question 5.
Explain the concepts of Gross interest, Net interest and their components.
Gross interest: The payment which the lender receives from the borrower excluding the principal is gross interest. Gross interest includes net interest or pure interest also.
Gross interest include the following four elements :
a) Net interest: Net interest is the reward for the services of the capital alone. Interest paid on government bonds and government loans is the net interest. If capital has mobility. The net interest any where will be the same.

b) Insurance against risk : Lending money as alone to somebody always involves a risk that the borrower may not repay it. These risks are two types :
2. Personal risk
In order to cover these risks. The lender charges some extra amount in addition to the net interest.

c) Compensation for inconvenience: Lending may also some inconvenience because the lender lends money only by saving i.e. by restricting his consumption out of income. In addition to this the lender may not get back his money when he requires for his own use.. He thus suffers from certain inconveniences. In order to compensate this sort of inconvenience he charge some extra over and above net interest.

d) Reward for management services : The lender has to maintain a record of all repayments and charges. He has to remind the debtors about the repayment of loan by post or by personal visits. He has maintain an office and clerical staff. Sometimes he has to approach the court also in case of non-payment of loan by the debtor for all these sorts of management work. He deserves some payment.

Question 6.
Explain the components of Gross profits and Net profits.
Gross profit is considered as a difference between total revenue and cost of production. The following are the components of gross profit.

1. The rent payable to his own land or buildings includes gross profit.
2. The interest payable to his own business capital.
3. The wage payable to the entrepreneur for his management includes gross profit.
4. Depreciation charges or user cost of production and insurance charges are include in gross profit.
5. Net profits are reward paid for the organiser’s entrepreneurial skills.

Components :

1. Reward for risk bearing : Net profit is the reward for bearing uninsurable risks and uncertainities.
2. Reward for coordination : It is the reward paid for co-ordinating the factors of production in right proportion in the process of production.
3. Reward for marketing services : It is the profit paid to the entrepreneur for his ability to purchase the services of factors of production.
4. Reward for innovations: It is the reward paid for innovations of new products and alternative uses to natural resources.
5. Wind fall gains : These gains arise as a result of natural calamities, wars and artificial scarcity are also include in net profits.

Question 1.
Contract rent [March 16]
It is the hire charges for any durable good. Ex : Cycle rent, room rent etc. It is a periodic payment made for the use of any material good. The amount paid by the tenant cultivator to the landlord annually may be also called contract rent. Ex. : The rent that a tenant pays to the house owner monthly as per an agreement made earlier or the hiring charges of a cycle ₹ 10 per hour is also contract rent.

Question 2.
Economic rent
The ordinary use of the term ‘rent’ means any periodic payment for the hire of anything such as garriages, .buildings etc. Economic rent is the pure rent payable as a reward for utilising the productivity of land. It is derived by subtracting the elements like interest, wages, profits and depreciation from the gross rent 6r contract rent. To David Ricardo; it is surplus over costs or expenses of cultivation.

Question 3.
Scarcity rent
Prof. Marshall explained the concept of scarcity rent on the basis of demand and supply. Scarcity rent is the surplus earned by land which has inelastic supply. In general land has indirect demand or derived demand. If there is an explosion of population, demand for land increases resulting in a rise in its price. The surplus earned by land above its price is called scarcity rent.

Question 4.
Quasirent
The concept of quasi-rent was first introduced by Marshall. Quasi rent according to Marshall is the surplus earned by instruments of production other than land. It is the income earned from man made factors of production! Such as machinery, buildings, tools etc. This is short term concept.

Question 5.
Transfer earnings [March 18]
Transfer earnings refer to the surplus earned by a factor of production is its present use-over its next best use.

Question 6.
Money wages
Money ’ ages are the remuneration received by the labourer in the form of money for the physical and mental service rendered by him or her in the production process.
Ex : If a labourer is paid ₹ 30/- per day. ₹ 30/- is the money wage.

Question 7.
Real wages [March 16]
Real wage is the purchasing power of money wages in terms of goods and services.

Question 8.
Time wages
Time wage is the amount paid for labourers for a fixed period of work i.e. weakly, daily, monthly etc.

Question 9.
Piece wages
Piece wage is the amount paid for labourers according to volume of work done by them.

Question 10.
Gross interest
The payment which the lender receives from the borrower excluding the principal is gross interest.
Gross interest = Net interest + [Reward for risk taking + Reward for Inconvenience + Reward for management]

Question 11.
Net interest [March 18, 17]
Net interest is tjie reward for the service of the capital loan.
Ex : Net interest paid on government bonds and government loans.

Question 12.
Gross profit