A PROJECT ON

FACTOR PRICING

Submitted By
Mukesh choudhary
Roll No. 73
BA LLB (HONS)
Semester I Batch XII

Submitted To
Ms. Kiran Bala Das
(Faculty Economics)

HIDAYATULLAH NATIONAL LAW UNIVERSITY

RAIPUR CHHATTISGARH
Submitted On 31st august 2012

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 ACKNOWLEDGEMENTS

First and foremost, I would like to thank Ms. Kiran Bala Das for offering this subject, Factor
pricing and for her valuable guidance and advice. She inspired me greatly to work in this project.
Her willingness to motivate me contributed tremendously to my project. I also would like to
thank her for showing me some example that related to the topic of my project.

Besides, I would like to thank the Hidayatullah National Law University for providing me with a
good environment and facilities to complete this project

Last but not least, my friends who helped me do this project by sharing their ideas when we
combined and discussed together.

Mukesh choudhary

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OBJECTIVES

 To study factor pricing or theory of distribution

 To know the various factor of pricing a product.
 To know the importance of factor pricing for any product

RESEARCH METHODOLOGY

 This research paper is descriptive and analytical – based on secondary sources, i.e., books
and electronic sources (internet).
 Books and other references as guided by Faculty of Economics have been primarily
helpful in giving this project a firm structure. Websites, dictionaries and articles have also
been referred.
 Footnotes have been provided wherever needed to acknowledge the source.

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 Table of contents

• Acknowledgment.............................................................................2
• Objectives and research methodology.............................................3
• Introduction......................................................................................5
• Land..................................................................................................6
• Labour...............................................................................................8
• Capital..............................................................................................10
• Entrepreneur....................................................................................12
• Criticism..........................................................................................15
• Conclusion......................................................................................17
• Bibliography....................................................................................18

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 Introduction

Factor pricing means the price paid for the services rendered by the factor of production but
not the price of the factor itself.

As goods are produced through the combined efforts of the factors of production, the income
earned through sale of products or remuneration for services is distributed among the four
factors of production.

Theories of factor pricing suggest the ways to distribute the income among the factors of
production.

The process of income distribution can be done in two ways. They are: personal distribution
and functional distribution.

Personal Distribution: In this form of income distribution, the national income of a country
is distributed among the owners of various factors of production such as rent for land rented,
wages for labour, interest on the capital invested, and profit for entrepreneurship. Thus, the
pattern of individual income generation is studied under personal distribution.

Functional Distribution: Functional distribution of income distribution deals with the

distribution of income among the four factors of production - land, labour, capital, and the

entrepreneur. It lays emphasis on the sources of income for factors of production such
as

1. Rent for land,

2. Wages for labour,
3. Interest for capital, and
4. Profit for entrepreneur. 1

1. Land
1
http/www.tutorsonnet.com/micro_economic/factors_of_production

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 Term land does not mean soil or earth surface alone but refers to all free gifts of nature which
would include besides the land, in common parlance, natural resources, fertility of soil,
water, air, natural vegetation etc. It becomes difficult at time to state precisely to what part of
a given factor is due solely to the gift of nature and what part belongs to human effort made
on it in the past.

Since land is a natural product and cannot be reproduced, the supply of land is permanently
fixed and in general perfectly inelastic. Usually the term rent refers to the payment made to
the owner of the factor to use the same for a specific period of time.

Land is the factor of production which is in almost completely inelastic supply as more land
cannot be produced to meet a greater demand for it.

Here, the term land includes any material asset which has a fixed supply. For instance,
payment made to use a house, vehicle, or machine is termed as rent.

1.1.Rent
Rent is payment for the use land and other resources which are completely fixed in total supply.
Land rent is an unearned income. To differentiate the concept of rent in economics from
everyday life or common use we term it as Economic Rent. Economic rent is taken as surplus
payment.

In the early study of economics, land was considered a somewhat passive resource, a resource
that wasn't actively involved in the production process like labour and capital. Hence the rent
paid for the use of land was viewed as an "extra" payment.2

The modern study of economics recognizes the importance of land as a factor of production and
that rent is an important factor payment to compensate for the opportunity cost of using land.

2
D.K. Sethi and U. Andrews , Frank isc economics (class 12th ) ,page288

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The phrase "economic rent" is holdover from this early view and is used in reference to a
payment received by a resource over above the opportunity cost.

The supply of land is unique --it is generally considered to be fixed. People can clear land drain
swamps, and fertilize it, but it's difficult to change the total supply of land with human effort.

Graph shows relation between land and rent.

R2 -----------------------------

D2
REN T R1 -----------------------------
D1
R -----------------------------
D

Q
LAN D

2. Labour

3
http://www.amosweb.com/cgi-bin/awb_nav.pl?s=wpd&c=dsp&k=rent+seeking

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 Labour is one of the four factors of production. In economics, the term labour refers to both
physical and mental work.

It refers to various types of humane efforts which require using of physical exertion, skill and
intellect.

Labour, to have economic significance, must be one which is done with motive of economic
reward. Anything done out of love and affection, although very useful in increasing humane
well being, is not labour in economic sense of the term.4

It includes the services of a factory worker, any professional workers such as engineers, doctors,
teachers, lawyer etc. If a person paints or sings in order to please someone or himself without
any target or for monetary benefits he won't be called a labour. But if he intends to sell the
painting or sing against any monetary reward then it involves labour. Thus labour forms an
essential aspect of production.5

Payment made to labour for services are wages both for physical and mental labour.

2. 1. Wages

Wage is the remuneration paid for labour. Payment of wages can be done in different modes
such as time wages, piece wages, task wages, cash wages, kind wages and service wages.

Time wages are the wages which are paid on the basis on number of hours worked.

Piece wages are the wages which are paid depending on the quantity of output produced.

Task wages are the wages which consider accomplishment of a task for payment of wages.

Cash wages are the wages which are paid in money form.

Kind wages are the wages which are paid in the form of commodities.

Service wages are the wages which are paid through a return service for the service rendered

4
General economics, board of studies icai 2009
5
ibid

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Real Wages:

Organizations provide various facilities to workers apart from paying salaries. The additional
facilities such as transportation facilities, medical facilities, accommodation, and other
allowances paid in addition to the salary constitute the real wages of workers.
“Real wages or real earnings refer to the purchasing power of the worker's remuneration i.e., the
amount of necessaries, comforts and luxuries which the worker can command in return for his
services."

Nominal Wages:

"Nominal wages or nominal earnings refer to the amount of the wages as measured in terms of
money.” Nominal wages are also known as money wages and refers to the payment to a worker
for the service rendered in terms of money.

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 3. Capital

Capital means all human-made materials such as tools, equipments, infrastructure, machinery,
seeds, plants, modes of transportation such as rail, road and air etc. In general it encompasses all
affluences eliminating land as land is utilized for supplementary production of affluence.

Now-a-days, capital not only includes physical capital but also involves human capital which is
defined as "process of increasing knowledge, the skills and capacities of all people of the
country." Human capital is more vital than the physical capital since without human's
interference the materialistic capital cannot be utilized effectively. Prof. Galbraith defines as "We
now get the larger part of our industrial growth not from more capital investment but from
investment in men and improvements brought about by improved men."

Capital is not a primary or original factor; it is a produced factor of production. It has been
produced by man by working with nature. Therefore, capital may be defined as manmade
instruments of production. The reward for capital is known as interest. The owner of the capital
receives interest for lending his/her capital to others. 6

3.1. Interest

Interest is the income earned only on the variable capital. Interest is earned only on that portion
of capital which is given by the owner to the borrower. In other words, it is the price paid by the
borrower to the lender who parted with his money.

Gross interest: When the borrower pays an amount to the lender for borrowing the lender's
money, the amount so paid by the borrower is known as 'interest'. Therefore, when people refer
to interest, they generally refer to 'gross interest'. Gross interest is the total amount paid by the
borrower to the lender of the money.

Net interest: Net interest is the amount paid to 'capitalists' only for the use of 'capital'. It is the
reward paid to the capitalists exclusively for the use of capital. Net interest is the compensation

6
ibid

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for lending capital to others under conditions where there is no risk or inconvenience due to
investment (investments made with no savings motive) and the lender is not required to perform
any work other than lending his money.

Therefore, net interest is a part of the gross interest. Gross interest consists of some charges
along with the net interest.

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4. Entrepreneur

 The entrepreneur is not merely an idea man, but rather an owner, who exercises judgment over
the capital assets he owns and manages

The capacity and willingness to undertake conception, organization, and management of a

productive venture with all attendant risks, while seeking profit as a reward.7

Entrepreneurship is sometimes considered a factor of production as individuals usually have

ideas and attempt to make an economic profit from their idea using the factors of production.
Entrepreneurs often have education or knowledge that helps them gathers, transform and produce
products for individuals or businesses to use in their daily lives or operations. The entrepreneur
also carries most if not all risks associated with turning his idea into a lucrative business.8

4.1. Profit

Just like rent is the reward for land, wages for labour and interest for capital, profit is the reward
for entrepreneurship.

Profit is the income of an entrepreneur for utilizing his entrepreneurial abilities and
running a business.

While the rewards for other factors of production are paid by the entrepreneur, profit is the
reward received by entrepreneur himself.

Profit is nothing but the surplus amount left with the entrepreneur after paying all the factors of
production.

If the income earned by him is in excess of the costs incurred on the factors of production, then
the income can be called as profit.

7
http://www.businessdictionary.com/definition/entrepreneurship.html
8
http://smallbusiness.chron.com/factors-production-economics-1718.html

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Therefore, profit can also be defined as the difference between the total value of output (total
revenues received by the businessman) and the total value of inputs (total costs incurred by
the businessman) of a business.

Profit =Value of Outputs - Value of Inputs

(Profit consists of two major components - gross profit and net profit.)

• Gross profit: Generally, people consider profit as the residual income left with the
entrepreneur after making all the payments to other factors of production. However, it should
be noted that this is gross profit. The gross profit is arrived at after excluding all the explicit
costs from the revenues received by the business. It does not exclude implicit costs such as
rent forgone by entrepreneur for utilizing his own land for business purposes, interest forgone
on his own capital, etc.

Gross Profit =Total Revenues - Total Explicit Costs

Gross profit thus includes those costs which go unrecorded in the books of accounts, but
which are nevertheless important to determine the profit made by the business.

• Net profit: The net profit can be arrived at by subtracting the implicit costs from gross
profits. This is also sometimes referred to as 'pure profit'. Net profit is the surplus leftover
after deducting explicit and implicit costs from the sales receipts of a business.

Net Profit =Gross Profit - Implicit Costs

Thus, it can be observed that net profit is a portion of the gross profit. When a business gets
zero net profit, it means that the profit attained is just enough to meet the explicit costs of the
business.

In other words, the entrepreneur's revenues could not pay off his efforts (or implicit costs)
such as utilizing his own resources, undertaking risk and uncertainty of business, etc.

Entrepreneur is to bear uncertainties in business in the form of risks that cannot be insured
against. Risk can be defined as the measurable probability of the occurrence of profit or loss
situation.

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With a view to differentiate between risk and uncertainty, Knight divided risks into:

Insurable risks

Non-insurable risks

 . Insurable risks insurable risks are those risks which the entrepreneur can avoid through
insurance. These risks can be in the form of loss of assets due to fire, accident, theft, etc. An
entrepreneur gets cover for these losses by paying a premium to the insurance companies and
reclaiming the same in the event of mishap. Therefore, he does not have to bear uncertainties
for insurable risks.

 Non-insurable risks These risks can be in the form of changes in people's habits, price
level fluctuations, etc. Non-insurable risks are unpredictable and unavoidable and hence are
uncertainties. Profits or losses are the rewards an entrepreneur receives for bearing these
uncertainties. Uncertainty arises for non-insurable risks. Non-insurable or unpredictable risks
are those risks which are unforeseen and for which no information is available to estimate or
forecast. Also, non-insurable risks cannot be covered under insurance coverage

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 CRITICISMS

Several economists have criticisms for the above factors of production economist Bentham
has objected to a broader meaning of land as a factor of production. As per him, it is
convenient to consider only land as factor of production, rather than such elements as
sunshine, climate etc. which does not enter directly into costs. Likewise, it is incorrect to
group together the services of an untalented worker with that of professionals. Yet again,
there is tiny tip in syndicating mutually as capital, as assorted as canals, diesel, seeds and
machinery. It would consequently, be more appropriate to chunk collectively all standardized
units, whether hectares of land, workers or capital goods and to regard each group as an
individual factor of production. This method gives us a hefty integer of factors of production
and each group is regarded as a separate factor.

Over and again, the distinction amidst land, labour and capital are not apparent. To take land
and capital, it is said that land is a gift of nature whose supply cannot be amplified while
capital is human made whose supply is amendable. This is not correct for the reason that the
supply of land can also be greater than before by cleaning it, draining and irrigating it and
fertilizing it by the pains of human and capital. The supply of land does not consign to its
area alone, but to its productivity.

We might regard each unit of a factor as discrete from other units of that factor, but one
factor can be substituted for some other factor. For instance, land can be used intensively by
employing more labour or more capital in the form of fertilizers, better seeds and superior
techniques. By doing so, we substitute labour or capital for land. Likewise labour can be
substituted for capital and capital for labour in a factor. In the former case, labour intensive
techniques are used. The level of swap of one factor for another will, nevertheless depend on
the most competent scheme of production to be used relatively to the cost of the factor to be
substituted.

Moreover, we find that land, labour and capital frequently get mingled into one another and it
is tricky to specify the involvement of each individually. For example, when land is vacant
canals are dug and fences are erected, the efficiency of land enhances. But all these

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development on land are feasible by making capital investments and through labour. In such
a condition, it is feasible to stipulate the involvement of land, labour and capital escalating
efficiency. Likewise, the sum of money spent on cultivating and exercising workers is
integrated under capital. So when such workers produce articles by functioning machines in a
factory, they put in their labour as well as ability by using raw materials which are also the
product of labour and machines used on land. Thus it is hard to unravel the contribution of
land, labour and capital in such cases.

The complexity begins as to whether the contribution of land, labour and capital should be
taken as such, or of their services. If the community is to plan for the prospect or find out the
production possibilities open to it, then the contribution of the factors of production should
be measured. Keeping the outlook in view, land may be put to more fruitful uses, labour may
be trained for diverse occupations requiring higher skills and capital may be used for
producing more roundabout means of production and machinery. Thus "the central economic
problem for any community is how to make the best use of its labour and other resources and
for this purpose the community must consider the various alternatives. It must consider what
the men and the land and the capital might contribute towards output if they were used in
different ways and not merely what in fact they are contributing now."

Finally, it is habitual not to treat organization as discrete from labour. This is ambiguous and
misjudges the role of the entrepreneur as a factor of production. As a substance of statement,
labour and entrepreneur are quite dissimilar from each other. An entrepreneur is a man of
special managerial aptitude who controls, organizes and manages the entire business of a
firm. It is he who utilizes all types of workers and puts them at the places where they are the
most appropriate by quality of their education and training.

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 CONCLUSION

The concept of the factor of production is of great significance in modern economic study. It
is used in the theory of production in which the a range of combinations of factors of
production help in generating output when a firm functions under rising or declining costs in
the short-run and when the proceeds to scale boosts or shrinks in the long run. Moreover, we
can also know how the least cost combination of factors can be attained by a firm.
The theory of cost of production also depends upon the combination of factors engaged in
business and the prices that are paid to them. From the point of view of the theory of costs of
production, factors of production are divided as fixed factors are variable factors.
Fixed factors are those whose costs do not vary with the variation in output, such as
machinery, tube well etc. Variable factors are those whose quantities and costs vary with the
variation in output. Larger outputs entail larger quantities of labour, raw materials power etc.
So long as a firm covers the costs of production of the variable factors it employs, it will
persist to produce even if it fails to cover the costs of production of the hired factors and
sustains loss. But this is only feasible in the short-run; in the long-run it must cover the costs
of production of both the fixed and variable factors. Thus the distinction amidst fixed and
variable factors is of much value for the theory of the firm.
Finally the concept of factor of production is used in elucidating the theory of factor-pricing.
For this idea, factors of production are divided into specific and non-specific. A factor of
production which is specific in use earns a higher reward than a non-specific factor. This also
solves the problem of distribution of earnings to the various resource owners.

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 BIBLIOGRAPHY

• General economics, board of studies icai 2009

• D.K. Sethi and U. Andrews , Frank isc economics (class 12th )
• D.N. Dwivedi, Principles of economics(2009)
• S.k. aggarwal, introduction to micro economics

WEBLIOGRAPHY

 http://www.tutorsonnet.com/homework_help/micro_economics/production_theory/factors_o
f_production_assignment_help_online_tutoring.htm (20th august 2012)
 http://www.amosweb.com/cgi-bin/awb_nav.pl?s=wpd&c=dsp&k=rent+seeking (21st
august 2012)
 http://www.businessdictionary.com/definition/entrepreneurship.html (21st august 2012)
 http://smallbusiness.chron.com/factors-production-economics-1718.html
(22nd august2012)

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