CHAPTER - 5

Factor Pricing

Introduction
Different types of goods and services are produced in an economy. The production of goods and services are
possible because of the factors of production. Traditionally, four types of factors of production are used in the
production process ie; Land, labor, capital, and entrepreneurship. These factors of production incur certain costs
and these costs are the prices of the factors. Rent is paid for the land, the wage for labor, interest for capital and
profit for entrepreneurship. Different types of economic theories have been developed for the determination of
the price of each factor of production. These theories are called theories of factor pricing.

Rent
Rent and its types
In general sense, the payment received by an owner of any real assets in return for its use for a particular period
of time is called rent. In economics, rent refers to the payment for the use of services of those factors of
production which are fixed in supply such as land and also to the payment which are variable in supply such as
capital goods, variables, machines, building, etc.

According to classical economist David Ricardo, “Rent is earned only from the land and rent is the
payment received by the landlord for the use of original and indestructible power of soil”.
Modern economists state that rent is earned from all the factors of production. There are mainly two
concepts of rent which are explained below: -

1. Contract rent:

The rent that we mean in our daily life is called contract rent. It is also called gross rent. Contract rent is the
actual payment made on the factor owner for the use of factor for a period of time. For example- payment made
to the owner of the house, owner of the land, owner of machinery and equipment, etc. by its users.
It is determined by the agreement made between two parties i. e. owner and renter of the factor.

2. Economic rent:

In economics, rent refers to economic rent. It is a part of contract rent which is paid to the owner for the use of
factor. Classical economist David Ricardo argued that economic rent is earned only from the land. It refers to
that part of the payment made by a tenant to landlord only for the use of land.

According to the modern economists, not only land but other factors of production also earn rent. They
define economic rent as the surplus of current earning over transfer earning. Current earning is the earning of a
factor of production from its current use and transfer earning is the earning of the factors of production from its
alternative use.
Difference between the contract rent and economic rent:

S. N. Basis of Contract rent Economic rent

difference
1. Definition It is the total payment made to the It is the part of contract rent which is
factor owner by the renter according paid to the owner for the use of factor.
to their mutual agreement.
2. Constituents It consists of economic rent, interest It does not consist of any other payments.
on capital invested in a land like the
building, fences, drainage, parking
slot.
3. Source It can be obtained from all grades of It cannot be obtained from the marginal
land. land.
4. Change in price The change in the price of the product The change in the price of the product
does not affect the contract rent. influences the economic rent.
5. Inclusion of It is included in the price as it is It is not included in the price because it is
price and cost. included in the cost of production. not included in the cost of production.
6. Determination It depends on the demand and supply It depends on the total product of the
of land. land.

Ricardian theory of rent / Classical theory of rent: -

The Ricardian theory of rent was developed by David Ricardo in his book, “Principles of Political Economy
and Taxation” published in 1817 A. D. According to him, “Rent is that portion of the produce of the earth
which is paid to the landlord for the use of original and indestructible power of soil”.

This theory has the following assumptions:

• Rent is earned only on land.
• The land is fixed in supply.
• The land possesses indestructible and original power.
• Land can be used only for farming.
• Land can be used only in diminishing order of their fertility.
• Law of diminishing returns operates in the land.
• Land differs in quality.
• Perfect competition prevails in the market.
• More population increases more productivity.
• Existence of marginal land.
• It is based on the long-run concept.
Ricardian theory of rent can be developed by intensive technique and extensive technique. The process of rent
formation on both techniques is explained below: -

1. Rent under extensive cultivation: -

Extensive cultivation is a type of farming under which farm production is increased by using more and more
plots of land. Ricardo assumes 4 grades of land which are equal in size but different in quality. Grades of land
A, B, C, and D are ranked in diminishing order of their fertility. People cultivate on grade A land because it is
the most fertile. If the demand for food grains is more, then people cultivate in successive grades of land B, C,
and D. Grade D land is called marginal land because it is least fertile and covers just the cost of production.
Each grade of land is cultivated by using the same unit of labor and capital.

Under extensive cultivation, rent is the surplus produced of intramarginal land over marginal land. So, all
grades of land which produce more than the marginal land earn rent. Rent under extensive cultivation can be
explained with the help of the following schedule and diagram:

Grades of land Production (in kg) Cost of production (in Kg) Rent

A 40 10 40-10=30
B 30 10 30-10=20
C 20 10 20-10=10
D 10 10 10-10=0

In the above figure, the grades of land and production are measured along X-axis and Y-axis respectively. The
amount of rent earned by different grades of land A, B, C, and D are shown by the shaded area. The production
from the land D covers just the cost only. So, land D is called marginal or no rent land. So, rent under extensive
cultivation is the surplus product of intra-marginal land over the production of marginal land.
2. Rent under intensive cultivation:
Intensive cultivation is a type of farming under which the quantities of labor and capital are used successively
on the same plots of land to increase production. In this case, the rent arises due to the operation of the law of
diminishing returns in the cultivation of land. This law states that if more and more units of labor and capital are
employed on a given plot of land per unit of time, the total product increases at a diminishing rate. When first,
second, third, and fourth units of inputs are used successively on the same plots of land, the last dose of labor
and capital employed on land is called marginal units and previous doses are called intra-marginal units. The
surplus of output on these intra-marginal units over the marginal unit is called rent.

Rent under intensive cultivation can be explained with the help of the following schedule and diagram:

Doses of labor and Production (in kg) Cost of production (in kg) Rent
capital
1st 40 10 40-10=30
2nd 30 10 30-10=20
3rd 20 10 20-10=10
4th 10 10 10-10=0

In the above figure, the doses of input and production are measured along the x-axis and y-axis respectively.
The shaded area represents the rent obtained by using different doses of input. It is because, under intensive
cultivation, the rent is the difference between the output produced by an intra-marginal dose of input and the
marginal dose of input. The production from the fourth dose covers just the cost only. It earns no rent.

Criticisms of Ricardian Theory of Rent:

1. No original and indestructible power of soil:
The Ricardian theory assumes that the land possesses original and indestructible power. This view is not
acceptable because the productivity of land can be increased through scientific techniques. Fertility can be
destroyed by intensive use of land, soil erosion, flood, drought, and so on.

2. No single use of land:

Ricardo assumes only one use of land. The land has no next best alternative. However, in real life, land can be
used to grow various types of crops, for industrial purposes or real estate purposes.
3. The wrong assumption of ‘no rent land':
Ricardian theory of rent assumes the existence of land which is available free of rent but in real life, nobody can
obtain any land which is free of rent. Likewise, a plot of land regarded as marginal land for 1 crop maybe intra-
marginal land for other crops.

4. The wrong assumption of perfect competition:

Ricardian theory of rent assumes the existence of competition in the land market. But in real life, the market
that we find in land is imperfect competition. Similarly, the landlord may charge the monopoly rent.

5. Wrong idea of application of the law of diminishing returns:

Ricardian theory of rent is based on the application of the law of diminishing returns in agriculture production.
But the production can be increased at an increasing rate by the use of improved technology, irrigation facility,
modern fertilizers, hybrid and improved seeds.

6. All the factors of production earn rent:

Ricardo assumes that the land is the only one factor of production that earns rent. According to modern
economists, all the factors of production earns rent.

7. Rent arises due to scarcity:

Ricardo opines that rent arises due to the differences in fertility and situation of land. In critics view, rent arises
not only because of the land's fertility and situation but also due to the scarcity of land.

Wage

Wage is the price paid to the labor for the use of his/her service in the production. In economics, the wage is the
reward paid to the worker for his/her mental or physical work.

According to F. Benham, “A wage may be defined as the sum of money paid under contract by an
employer to the worker for services rendered.”

There are mainly two concepts of wage which are explained as follows:-

1. Money wage or nominal wage:

Money wage is the wage received by labor in the form of money. It is also known as nominal wage. Money
wage does not include extra facilities provided to the labor like accommodation, health care, children education
allowance, transportation facilities, clothes allowance, insurance facilities, etc.

2. Real wage:

Real wage refers to the wage in terms of goods and services. It is the sum of goods and services that money
wage can buy and extra benefits of labor’s occupation i.e. the number of necessaries, comfort, and luxury
supply, etc. Real wage depends on various factors like money wage, price level, extra earning possibility, nature
of work, regularity and security of work, working environment, etc.
 Differences between money wage and real wage:

Basis of difference Money wage Real wage

Meaning Money wage is the wage received The real wage is the sum of goods
by labor in the form of money. and services that money wage can
buy and extra benefits of labor
occupation.

Forms of expression It is expressed in terms of money. It is expressed in terms of the

purchasing power of money.

Extra facilities It excludes extra facilities of labor’s It includes extra facilities of

occupation. labor's occupation.

Dimension It is a narrow concept. It is a broad concept.

Indicator of living standard Money wage alone cannot indicate Real wage determines the
the economic position or living economic position or living
standard of labor. standard of labor.

The Subsistence Theory of Wages

David Ricardo and other classical economists propounded the subsistence theory of wages. This theory was
termed the "Iron Law of Wages" by German economist Lassalle and French economist Francois Quesnay,
among other physiocratic economists.

According to the subsistence theory of wages, in the long run, labor wages tend to remain at the subsistence
level and remain fixed. The wages paid to workers should be just enough to cover their basic needs. The wages
that are just enough to cover the basic needs of workers are called subsistence wages. In other words, the wages
that are just enough for workers to eat two meals, buy clothes, and arrange for shelter are called subsistence
wages.
If workers are
paid more wages than necessary for subsistence, they become extravagant, which leads them to marry early and
have more children. As a result, the population increases. This increases the supply of labor. When the supply of
labor exceeds the demand for labor, there is competition among workers for jobs. As a result, wage rates begin
to fall. This process continues until the wage rate falls to the subsistence level.

Similarly, if workers are paid less wages than necessary for subsistence, their living standards become
miserable. As a result, their desire to marry and have children decreases, and they suffer from malnutrition,
diseases, and hunger, and some may even die. This reduces the population and decreases the supply of labor.
When the demand for labor exceeds the supply of labor, wage rates begin to rise. This process continues until
the wage rate rises to the subsistence level. Thus, whether the wage rate is higher or lower than the subsistence
level, it ultimately tends to remain at the subsistence level in the long run.

Subsistence wages refer to the minimum wages necessary to meet the basic needs of workers and their families.
Basic needs include food, clothing, shelter, education, health, and security.

Criticisms of the Subsistence Theory of Wages

The subsistence theory of wages has been criticized in various ways by different economists. Some of the main
criticisms are presented below:

1. According to the subsistence theory of wages, if wages are higher than the subsistence level, the population
increases. However, the experiences and evidence from developed countries have shown that the increased
wages of workers have led to an increase in living standards rather than an increase in population.
2. The subsistence theory of wages is one-sided because it emphasizes the supply side of labor and ignores the
demand side.
3. According to the subsistence theory of wages, workers should be paid only subsistence wages regardless of
their productivity. However, critics argue that workers should be paid wages based on their productivity
rather than subsistence levels.
4. Workers can determine wage rates through bargaining with employers through labor organizations for their
welfare. This aspect is not explained by the subsistence theory of wages.
5. The subsistence theory of wages fails to explain the differences between individuals, professions, locations,
and time periods, and the corresponding differences in workers' wages.
6. This theory is considered pessimistic because it denies the possibilities of improving the economic
conditions of workers.

The wage-fund theory of wages:

The wage-fund theory was first suggested by Adam Smith but the entire credit for formulating the theory goes
to J. S. Mill. He has formulated this theory in his famous book “Principles of Political Economics” published
in 1848 A. D. The wage-fund theory is regarded as a complementary rather than substitute to subsistence
theory of wage.

According to this theory, wages depend upon the relationship between the supply of population and
the capital available to employee workers. The population refers to the number of laboring classes and the
capital refers to the number of funds to be used for the payment of wages. Thus, the available funds for wages
are fixed at any given time which is called wage fund and the only way to increase wages is to reduce the
numbers of laborers to be paid.

Level of wage = Wage paid/ Number of workers.

Assumptions
• Capital is fixed and it is built from the saving of the previous period.
• Wage fund is rose before the employment of workers.
• The level of wage is fixed after the employment of a worker.
• The units of labor are homogeneous.
• Workers are paid equal wages.
• The wage level is flexible to the change in the number of workers employed.
• Money works only as a medium of exchange.
• There exists a direct relationship between the level of wage and wage fund an inverse relationship
between the level of wage and the number of workers.
The determination of wage level under the wage-fund theory of wages can be explained with the help of the
following schedule and diagram:

Wage fund (Rs.) Number of workers Level of wage

10000 50 200

10000 100 100

10000 200 50

10000 250 40
The above table and diagram show the inverse relationship between the number of workers employed and the
level of wage, keeping the wage fund constant. The number of workers and the level of wages are measured
along Y-axis and X-axis respectively. The curve shows that, as the number of workers increases, the wage level
decreases and vice versa.

Criticisms of the wage-fund theory of wages:

1. Fails to explain the difference in wage:
According to this theory, all the workers get the same level of wages. But in reality, the wage paid to workers
differs from person to person, a place to place, occupation to occupation, and time to time.

2. The wrong assumption of a homogeneous unit of labor:

Units of labor are not homogeneous as assumed by this theory. They differ in skill, knowledge, education,
strength, productivity, etc.

3. Neglects efficiency and productivity of labors:

This theory has neglected the efficiency and productivity of laborers in determining the wage rate. A higher
wage should be provided to efficient workers and lower to the inefficient.

4. Wage fund is not raised before employing the workers:

According to this theory, the wage fund is raised before employing the workers. However, it is raised on the
basis of workers employed.

5. Money is not only the medium of exchange:

This theory has taken money only as a medium of exchange. But money has effects on production, employment,
investment, etc.

6. Unable to explain the source of wage fund:

This theory does not explain how the wage fund arises and why it remains fixed. It only states that the wage rate
is found by dividing the given wage fund by the number of workers.

7. Wrong concept of permanent wage fund:

This theory takes the wage fund to be permanent. But, with the increase in the price level, the wage rate should
also be increased.

Interest:

Generally, interest refers to the payment made by a borrower of the fund to the lender for the use of the fund in
a specific time period. In economics, interest is the price paid for the use of the borrowed fund to spend on the
purchase of capital assets used in production.

According to J. M. Keynes, “Interest is the reward for parting with liquidity for a specific period of time.”
According to Seligman, “Interest is the return from the fund of capital.”

There are two concepts of interest which are explained as follows:-

1. Gross interest:
Gross interest is the total amount paid by a borrower to the moneylender in return for the capital borrowed for
a period of time. It is also known as total interest. The gross interest that a lender receives is the aggregate of net
interest and other charges. Net interest is the price paid by a borrower to the lender only for the use of capital.
Other charges include the returns for risk, returns for management, and inconvenience charges. Thus, the
addition of net interest, return for risk, return for management and the return for inconvenience is gross interest.

2. Net interest:
The term interest in economics does not refer to the gross interest but to the net interest. Net interest is also
known as pure interest. It is the price paid only for the use of capital or money. Net interest is that part of the
gross interest that is exclusively paid for the use of capital. Net interest is normally the same during a period of
time in different markets. In order to calculate the net interest, the payments for risk, management, and
inconvenience are to be deducted from the gross interest.

Difference between gross interest and net interest:

Basis Gross interest Net interest

1. Definition It is the total amount paid by a It is the price paid by a borrower
borrower to the lender in return of to the lender only for the use of
the capital borrowed for a period capital.
of time.
2. Calculation It can be calculated by summing It can be calculated by deducting
up net interest and other charges. other charges from gross interest.

3. Dimension It is a broad concept. It is a narrow concept.

4. Interest rate variation The rate of gross interest differs in The rate of net interest remains
the market. almost the same in the market.

5. Use It is a practical concept which is It is purely a theoretical concept

applicable in real life. which has no practical application.

6. Determination It is determined by several factors It is determined by the demand for

besides demand for and supply of the capital and supply of the
the capital. capital.
The Classical Theory of Interest with Criticisms

The theory of interest propounded by classical economists is called the classical theory of interest. This theory
is also known as the real theory of interest because it states that the interest rate is determined by real factors
such as investment and savings. This theory is also known as the demand and supply theory of savings.

J.M. Keynes said, "The classical theory of interest is the savings-investment theory."

According to this theory, the interest rate is the price paid for savings invested as capital. The interest rate is
determined by the interaction of investment and savings.

The classical theory of interest has been presented in a refined form by economists such as Alfred Marshall,
Arthur Cecil Pigou, and Frank William Taussig.

This theory can be explained under the following headings:

(a) Investment Demand

Entrepreneurs demand investment with the intention of investing in capital goods. The amount of investment
depends on the marginal productivity of capital and the interest rate. If the marginal productivity of capital is
higher than the interest rate, then it is beneficial for entrepreneurs to increase investment in capital goods.
However, as entrepreneurs gradually increase the amount of investment in capital goods, the marginal
productivity of capital decreases. Entrepreneurs continue to increase investment until the interest rate decreases
and becomes equal to the marginal productivity of capital.

Thus, given the marginal productivity of capital, as the interest rate decreases, entrepreneurs increase
investment in capital goods. In other words, investment increases when the interest rate decreases. Therefore,
there is an inverse relationship between the interest rate and investment demand. The investment demand curve,
which shows the inverse relationship between the interest rate and investment demand, slopes downward from
left to right or has a negative slope.

(b) Supply of Savings

People save a portion of their income with the aim of solving future emergencies or with the aim of earning
interest by supplying it in the market. Savings made for investment or the supply of savings depends on the
interest rate. The supply of savings increases when the interest rate increases, and the supply of savings
decreases when the interest rate decreases. Thus, there is a positive or direct relationship between the interest
rate and the supply of savings. This gives a positively sloped savings supply curve.

(c) Determination of Interest Rate

According to the classical theory of interest, the equilibrium interest rate is determined by the interaction of
investment demand and savings supply. The equilibrium interest rate determination process is explained below
with the help of a hypothetical table.

Interest Rate (in %) Investment Demand (Rs.) Supply of Savings (Rs.)

2 250 50
 3 200 100
4 150 150
5 100 200
6 50 250

In the given table, as the interest rate increases from 2% to 6%, the investment demand decreases from Rs. 250
to Rs. 50, and the supply of savings increases from Rs. 50 to Rs. 250. The investment demand and supply of
savings are equal, i.e., Rs. 150, when the interest rate is 4%. Therefore, 4% is the equilibrium interest rate.

The interaction of investment demand and savings supply or the equilibrium interest rate determination process
under the classical theory of interest can also be explained with the help of Figure:

In the given figure, investment demand and savings supply are

measured on the X-axis, and the interest rate is measured on the
Y-axis. The investment demand curve is denoted by II, and the
savings supply curve is denoted by SS. These two curves intersect
each other at point E. Therefore, point E is called the equilibrium
point.

Here, the equilibrium interest rate is 4%, and the investment

demand and supply of savings are determined to be Rs. 150. If the
market interest rate is higher than the equilibrium interest rate
(4%), the supply of savings exceeds the investment demand, and
the interest rate starts to decrease. The process of the interest rate
decreasing continues until the investment demand and supply of
savings become equal.

Similarly, if the market interest rate is lower than the equilibrium interest rate (4%), the investment demand
exceeds the supply of savings, and the interest rate starts to increase. The process of the interest rate increasing
continues until the investment demand and supply of savings become equal.

Thus, 4% is the equilibrium interest rate because it equates the investment demand and supply of savings in the
market, i.e., Rs. 150. In this way, according to the classical theory, the equilibrium interest rate is determined
when investment and savings are equal.

Criticisms of the Classical Theory of Interest

J.M. Keynes and other economists have criticized the classical theory of interest on various grounds. Some of
the main criticisms are presented below:

1. According to J.M. Keynes, interest is not the price of savings made for capital investment, as stated by
classical economists, but rather the reward for parting with liquidity.
2. Classical economists have stated that the interest rate equates savings and investment. However, J.M.
Keynes has expressed the view that it is the change in the level of income, not the interest rate, that equates
savings and investment.
3. The classical theory of interest is based on the unrealistic assumption of full employment equilibrium.
However, according to J.M. Keynes, the state of full employment equilibrium is difficult to find in real life.
4. According to the classical theory of interest, the interest rate is determined by real factors such as
investment and savings. However, according to J.M. Keynes, the interest rate is a monetary concept. It is
determined by monetary factors such as the demand for money and the supply of money.
5. The classical theory of interest states that savings are made only for investment purposes, but people also
save for consumption purposes. This aspect is not covered by the classical theory of interest.
6. The classical theory of interest considers savings from current income as the only source of investment, but
critics argue that past savings and bank loans also play a role as sources of investment in addition to current
savings.

Profit:

Profit is a factor income that is enjoyed by an entrepreneur for taking risks and bearing uncertainties. Profit
cannot be fixed in advance of the production. It is the residual amount left over after all the other factor incomes
have been paid.

According to Henry Grayson, “Profit may be considered as a reward for innovations, a reward
for accepting risks and uncertainties, and market imperfections.”

Profit is the residual income of the business after all the explicit and implicit wages, costs, interest, rent have
been paid. Implicit and explicit costs are those costs which occur in a company after a business transaction.
Explicit costs are those costs that are recorded in business documents. They are also known as direct or
accounting costs. Implicit costs are generally described as opportunity cost or the loss of an opportunity in a
given time or situation. They are not really shown or recorded as cost. They are also known as implied costs or
economic costs. The profit as a reward of the entrepreneur, the fourth factor of production, has the following
features:

• Profit is earned by the entrepreneur as a reward for bearing risk and uncertainty.
• Profit is a residual income and not a contractual income.
• Profit may be positive, zero, or negative while all the other factors are always positive.
• Profit is not a fixed income.
• Profit fluctuates over a period of time.
Following are the two concepts of profit:
1. Gross profit:
The difference between the total revenue and total explicit cost is called gross profit. Gross profit is also called
business profit. It is the residual part of the total revenue of a firm which is available to it when all the payments
to the factors of production and all the obligations (liability) i.e. tax, depreciation, etc. have been met.
 Symbolically,
Gross profit = Total revenue – Explicit cost

The main components of gross profit are rent, wage, interest, depreciation, insurance charges, net profit, etc.

2. Net profit:

Net profit can be defined as the difference between total revenue and the total cost including both explicit and
implicit cost. It is also known as economic profit or pure profit or just profit. The net profit is the amount
obtained by deducting implicit costs, depreciation charges, insurance charges from total revenue.

Symbolically,
Net profit = TR-TC

The main components of net profit are the reward of risk-taking, reward for uncertainty-bearing, reward for
ability, the reward for innovations, monopoly gains, and windfall gains.
The differences between Gross Profit and Net profit are discussed below.
S. N Basis of Difference Gross Profit Net Profit
1 Definition Gross profit also known as Net Profit also known as Economic
Business Profit is the difference Profit or Pure Profit is the difference
between Total Revenue and explicit between Total Revenue and Total
Costs. Costs (both explicit and implicit
costs).
2 Inclusion of Implicit costs It does not include implicit costs. It includes both explicit and implicit
costs.
3 Dimension It is a narrow concept as it is a part It is a broad concept as it includes
of Net Profit. Gross profit.
4 Constituents Its constituents are rent, wages, Its constituents are a reward for
interest, depreciation, etc. bearing risk and uncertainties, ability
and innovations, monopoly and
windfall gains, etc.
5 Existence under Perfect A portion of gross profit exists None of the portion of net profit exists
Competition under perfect competition. under perfect competition.
6 Profit and Loss Estimation Actual loss or profit cannot be Actual profit or loss can be estimated
estimated under gross profit. under net profit.
7 Objective The objective of Gross profit is to The objective of Net profit is to show
estimate the profitability of a the financial performance of a
company. company.
8 Credit balance It shows the credit balance of the It shows the credit balance of the
Trading account. profit and loss account.
9 Formula · GP = Total Revenue – Cost of · NP = Total Revenue – Total Costs
Goods Sold
· NP = Total Revenue – (Explicit
Cost of Goods sold includes: costs + Implicit costs)

a. Direct materials, such as raw · NP = GP – Implicit Costs

materials and inventory
· NP = GP — Operating Expenses —
b. Direct labor, such as wages for Other Business Expenses — Taxes —
production workers Interest on Debt + Other Income

c. Equipment costs that are used in

production

d. Repairing costs of equipment

e. Utilities for production facilities

f. Shipping costs, etc.

· GP = Total Revenue – Explicit

Costs

Risk theory of Profit:

The American economist, Professor Frederick Barnard Hawley has put forward the risk theory of profit in
his book “Enterprise and productive process” published in 1907 A.D. According to this theory, the main
function of an entrepreneur is risk-taking. An entrepreneur coordinates various factors of production and these
factors are paid their contractual payments. There is a time lag between the production of goods and their sales.
During this time lag, various changes take place. There occur different risks during this change period. The
entrepreneur will undertake this risk and gets a reward in return. This reward is known as profit.

According to Professor Hawley, “The profit of an undertaking is not the reward of management or
coordination but of the risk and responsibility.”

He has stated that there is a proportional relationship between risk and profit. Prof. Hawley pointed out
4 types of risk that an entrepreneur may have to take. They are replacement risk, risk proper, uncertainties, and
obsolescence. The real producer of the output is the entrepreneur and not the other factors of production because
they are paid fixed remuneration. It is for undertaking all the risk that the entrepreneur is rewarded with profit.
Therefore, the residual income left after paying the costs to the factors of production is profit.
Criticisms of Risk theory of profit:

This theory neglects the difference between insurable risk and uninsurable risks. According to Professor Knight,
those risks which are uninsurable gives rise to profit not all types of risks.

1. The reward for reducing risk:

According to Professor Carver, an entrepreneur does not receive profit because of taking the risk but because of
avoiding risk by using his/her intelligence and ability.

2. No proportional relation between risk and profit:

Critics have pointed out that risk and profit are never proportional. Sometimes more risky enterprise may enjoy
low profit than less risky business.

3. Narrow theory:
Critics have pointed out that profit is not only the reward for the risk-taking function of an entrepreneur but also
the reward for the organizational and coordinating ability of the entrepreneur.

Uncertainty Bearing Theory of Profit:

The uncertainty-bearing theory of profit was propounded by the American economist Prof. F. H. Knight in
his book risk, uncertainty, and profit, published in 1921 A. D. This theory is an improvement over Hawley's
risk theory of profit. Prof. Knight has focused and explained the uncertainty and distinguished it from risk.
According to him, the risk is a situation in which the statistical probability of an outcome can be determined and
can be minimized or reduced to naught (zero). According to Knight, profit is the reward of bearing uncertainties
which are not insurable but the risk can be insured.

Professor Knight has distinguished between insurable risk and uninsurable uncertainties as follows:
1. Insurable risk:
The risks which are predictable and can be insured against on payment of an insurance premium are known as
risks. E.g. Risks of a factory caught fire, theft or accident, etc. The insurable risk will not give any reward to an
entrepreneur.
2. Uninsurable uncertainties:
The risks which are unpredictable or uninsurable are known as uncertainties. E.g. Reduction in demand, change
in government policies, increase in competition, etc. An entrepreneur bears these uncertainties and gets a reward
in return which is called profit. The risks which cannot be predicted are explained as follows:-
a. Uncertainty in market condition:
The change in demand and supply conditions in the market lead the entrepreneur to uncertainty.
b. Competitive uncertainty:
When new firms enter the market, it increases competition among themselves and the profit of existing firm will
become uncertain.
c. Innovation:
Due to the introduction of new technology, machines and capital goods need to be replaced before they become
obsolete. Thus, the uncertainties of entrepreneur increase due to innovations.
d. Economic policies:
Economic policies can be classified into microeconomic policy and macroeconomic policy. Because of the
change in these policies, the entrepreneurs may get windfall gains or suffer losses.
e. Business cycle:
The business cycle also called the trade cycle is a common feature of a capitalist economy. It refers to the
fluctuation in the economic activity which changes aggregate demand and aggregate supply. Consequently,
business uncertainties of the entrepreneur grow.

Criticisms of the uncertainty-bearing theory of profit:

1. No profit despite uncertainty-bearing:

Critics pointed out that sometimes an entrepreneur earns no profit even after taking uncertainties.
2. Incomplete theory:
Profit is not the reward for bearing uncertainties. According to critics, other causes like coordinating,
bargaining, etc. also give profits. So, it is an incomplete theory of profit.
3. Not applicable in case of a joint stock company:
The shareholders of joint stock companies who are entitled to a profit, do not perform any functions of an
entrepreneur.
4. Unable to explain monopoly profit:
This theory does not suit well to expose the phenomenon of monopoly profit, where there is very less
uncertainty involved in a monopoly business.