Returns to a Factor
- When the input of one factor is increasing while all other factors remain constant, then the proportion between the factor is altered.
- Supposing, there are two factors of production, i.e., land and labour. Land is a fixed factor and labour is a variable factor.
- Returns to a factor exhibit three phases.
- Increasing Returns to a Factor
- Constant Returns to a Factor
- Diminishing Returns to a Factor or Law of Diminishing Returns.
Causes of Increasing Returns to a Factor
- In the initial stages, fixed factor (such as machine) remains under-utilised. Its fuller utilisation calls for greater application of the variable factor (labour).
- Hence, initially, additional units of the variable factor add more and more to total output, or, marginal product of the variable factor tends to increase.
- Additional application of the variable factor (labour) facilitates process based division of labour that raises the efficiency of the factor. Accordingly, marginal productivity of the factor tends to rise.
- So long as fixed factor remains under-utilised, additional application of the variable factor tends to improve the degree of co-ordination between the fixed and variable factors
- As a result, total output increases at the increasing rate.
Causes of Constant Returns to a Factor
- Optimum Utilisation of the Fixed Factor : As production is increased by increasing the application of variable factor, a stage comes when the fixed factor gets optimally utilised. It is here that marginal product of the variable factor is maximised and tends to remain constant.
- Ideal Factor Ration : Constant returns to a factor corresponds to an ideal ratio between fixed and the variable factors. Hence, marginal product of the factor stabilises at its maximum.
- Most Efficient Utilisation of the Variable Factor : As more and more of the variable factor is combined with the fixed factor, a stage comes when there is best possible division of labour corresponding to which variable factor (labour) is most efficiently utilised. Accordingly, its marginal product tends to be constant at its maximum.
Diminishing Returns to a Factor or the Law of Diminishing Returns.
- Diminishing returns to a factor or law of Diminishing Returns refers to a situation in which total output tends to increase at the diminishing rate when more of the variable factor is combined with the fixed factor (s) of production.
- In such a situation marginal product of the variable factor must be diminishing. Inversely the marginal cost of production must be increasing.
Causes of Diminishing Returns to a Factor
- Fixity of the Factor : Fixity of the factor(s) is the principal cause that explains the occurrence of the law of diminishing returns. As more and more units of the variable factor continue to be combined with the fixed factor, the latter gets over-utilised. Hence the diminishing returns.
- Imperfect Factor Substitutability : Factors of production are imperfect substitutes of each other. More and more of labour, for example, cannot be continuously used in place of additional capital. Accordingly, diminishing returns to the variable factor becomes inevitable.
- Poor Co-ordination between the Factors : Continuous increasing application of the variable factor along with fixed factor(s) beyond a point crosses the limit of ideal factor-ratio. This results in poor co-ordination between the fixed and variable factors. The law of diminishing returns accordingly set in.
Law of Variable Proportions
- When the number of one factor is increasing while all other factors remain constat, then the proportion between the factors is altered.
- Leftwitch, “The law of variable proportions states that if the input of one resource is increased by increments per unit of time while the inputs of other resources are held constat, total output will increase, but beyond some point the resulting output increases will become smaller and smaller.”
Assumptions of the Law
Occurrence of the Variable Proportions can be fully appreciated only in the light of its assumptions. These are as follows.
- Production is not of ‘Fixed Proportions Type’, instead, it is of Variable Proportions.
- Units of the variable factor are homogeneous or equally efficient, and are increased one by one. So that diminishing returns start operating not because latter units of the variable factors are less efficient than the former ones, but because of sub-optimal combination of fixed and variable factors.
- Some of the factors are fixed, so that output can be increased only by increasing the application of the variable factor.
Relation Between Marginal Product and Total Product
- When marginal product increases, total product increases at increasing rate.
- When marginal product is constant, total product increases at constant rate.
- When marginal product decreases, total product increases at diminishing rate.
- When marginal product is negative, total product starts declining.
Relation between Average Product and Marginal Product
- The average product increases when marginal product is greater than average product.
- The average product decreases when marginal product is less than average product.
- MP can be positive, zero or negative, but average product is always positive.
- Diagrammatically, MP curve is always to the left of AP curve.
Difference between Returns to a Variable Factor and Returns
- Returns to a Factor is studied with reference to short period production function whereas Returns to Scale is studied with reference to long period production function.
- Returns to a Factor apply when one factor alone is variable and other factors remain fixed. Returns to scale apply when all factor of production are variable.
- Returns to a Factor are studied on the assumption that the scale of production does not change. In case of returns to scale, the scale of production ought to change.
- Returns to scale are studied on the assumption that factor ratio remains constant. In case of returns to a factor, factor ratio ought to change.
- In order to produce a commodity, factors of production such as land, labour, capital and entrepreneurship are required.
- Value added as a result of the co-operation of the factor is distributed among them as factor shares.
- The labour gets its share of the produce in the form of wages, capital in the form of interest, land in the form of rent and entrepreneur in the form of profit.
- Chapman, “The economies of Distribution accounts for the sharing of wealth produced by a community among the factors which have been active in its production.”
- The price paid to these factors for their services is called factor price, e.g., wages to labour, interest capital, rent to land and profit to entrepreneur.
- Theory of Factor Pricing is, therefore, concerned with the determination of prices of the services of different factors of production.
- In other words, theory of factor pricing studies how rent to the landlord, wages to the labourer, interest to the capitalist and profit to the entrepreneur are determined.
Theory of Factor Pricing
- Anatol Murad, “The theory of factor pricing deals with the price paid for factor services (land, labour, capital, entrepreneur) and received by the sellers of factor services. It deals with wage rates, interest rates, specific rent and profit.
- In short, theory of factor pricing studies how rent of land, wages of labourer, interest on capital and profit of entrepreneur are determined.”
Theory of Factor Pricing
- Theory of factor pricing deals with the determination of the price of the factors of production, whereas theory of value deals with the determination of the price of the goods produced.
- Both the theories assume that price is determined by the interaction of demand and supply. It can be said that theory of factor pricing is actually a type of general price theory.
Meaning and Types of Marginal Productivity
- Marginal Physical Productivity : When we express marginal productivity in terms of increase in the quantity of output (goods), it is called marginal physical productivity.
- In the words of M.J.Ulmer, “Marginal physical productivity may be defined as the addition to total production resulting from employment of one more unit of a factor of production, all other things being constant.”
- Marginal Revenue Productivity : The concept of marginal revenue productivity is related to change in total revenue.
- M.J.Ulmer, “Marginal revenue productivity may be defined as the addition to total revenue resulting from employment of one more unit of a factor of production, all other things being constant.” Thus
- Value of Marginal Productivity : Value of marginal productivity is calculated by multiplying physical productivity (MPP) of a factor by the price (AR) of the product produced by him.
- Ferguson, “The value of Marginal Product of a variable factor is equal to its marginal product multiplied by the market price of the commodity in question.”
- Demand for a factor of production is derived demand. It is derived from the demand for the product that the factor is producing. Accordingly, demand for the final product (produced by the factor) becomes the principal determinant of demand for the factor.
- Curve for a factor by a firm is identified with the marginal revenue productivity curve of the factor.
- Accordingly, productivity of the factor becomes another important determinant of its demand. Other things remaining constant, a forward shift in productivity should also imply a forward shift in demand for the factor.
- Other things being constant, demand for the factor is inversely related to price of the factor. Higher the price, lower the demand, and vice versa.
- Demand for a factor also depends upon prices of related factors, particularly when the factors are substitutes of each other. Higher price of the substitute factor will raise the demand for the factor under consideration, and vice-versa.
- Elasticity of Demand for a factor refers to proportionate change in demand in response to a given change in the price of the factor. It depends upon the following parameters:
- According to classical economists, payment made for the use of land only is called economic rent.
- In economics the term ‘rent’ is used to connote economic rent only.
- Thus, according to Ricardo and other classical economists, economic rent is that rent which is paid for services of land alone.
- According to Anatol Murad, “Economic rent is the portion of a landlord’ a income which is attributable to his ownership of land.”
- According to modern economists like, Robinson, Boulding etc., the concept of rent is applicable not merely to land but to all factors of production.
- A part of the income or the entire income of a factor of production can be called rent. It will be wrong to confine rent to the income earned by land only.
- The modern economists have made use of the concept of opportunity costs or transfer earnings while explaining economic rent.
- Different factors of production, like land, capital, labour etc. have alternative uses. Each factor will be put to that use in which it can earn maximum income.
- Economic rent of a factor of production is the excess over its transfer earning (opportunity cost) i.e.,. what a factor may be earning in its present employment (use) over what it should earn in its next best alternative use.
- The amount by which the actual earning of a factor is more than its transfer earning will be called rent.
- Rent = Actual Earning – Transfer Earning
- Gross rent is that which is paid for the services of the land and for the use of fixed assets on land. Gross rent has the following components :
- Net rent (it is a payment for the use of land only.)
- payment for the use of fixed assets on land such as wells, farm houses etc.
- Contract Rent is the rent which is settled as per contract between the tenant and the landlord. Generally it is of the nature of gross rent.
- It refers to contractual payment, say for the use of land, residential buildings, factory sheds etc. for a specified period of time.
- “Scarcity rent is the price paid for the use of the homogeneous land when its supply is limited in relation to demand.”
- If the entire land is homogeneous (equally fertile) but its demand is more than its supply then the entire land will earn economic rent due to scarcity. Rent therefore arises when the supply of land is perfectly inelastic, that is, when supply cannot be increased in response to increase in demand.
- Thus, scarcity rent is that rent which arises due to scarcity of a factor. It is attributed to all the units of a factor, marginal or intra-marginal.
- Modern economists have extended the concept of scarcity rent to all factors of production which are scarce in supply.
- According to Ricardo, rent arises due to difference in the fertility of land.
- It is that rent which arises due to the difference in the productivity (efficiency) of different units of a factor.
- Extending the concept of differential rent to all factors of production, modern economists define it as surplus that arises due to difference between transfer earning and actual earning.
Features of Ricardian Theory of Rent
- Rent is the factor income of land alone. It is paid due to original and indestructible powers of the soil.
- Rent is a differential surplus. The superior land earns rent. It is calculated from the marginal land which is no rent land.
- Rent does not determine price. It is the price which determines rent.
- Rent is a pure surplus. As such it is an unnecessary payment.
Modern Theory of Rent
- Modern theory of rent is an amplified and modified form of Ricardian theory of rent.
- It was first of all propounded by J.S.Mill and later developed by Jevons, Pareto, Marshall and Mrs. Robinson etc.
- According to this theory, economic rent is a surplus that arises not only for the use of land but can also be a part of the income to other factor like labour, capital etc.
- According to modern economists, economic rent is a surplus that arises due to difference between transfer earning and actual earning of a factor.