Unit 4: Theory of Factor Pricing (B)

1. Capital, Investment, and Depreciation

In economics, capital refers to the man-made tools, machinery, and infrastructure used in production.

• Capital: A stock concept representing produced means of production.
• Investment: A flow concept referring to the addition made to the existing stock of capital during a specific period.
• Depreciation: The monetary value of the wear and tear or obsolescence of capital assets over time.

2. Classical Theory of Interest

The Classical theory, supported by economists like Marshall and Pigou, views interest as a reward for abstinence or waiting.

• Equilibrium: The rate of interest is determined by the intersection of the Demand for Capital (Investment) and the Supply of Capital (Savings).
• Demand for Capital: Derived from the marginal productivity of capital; it is negatively related to the interest rate.
• Supply of Capital: Derived from savings; it is positively related to the interest rate as higher rates incentivize people to postpone consumption.

3. Keynes's Liquidity Preference Theory of Interest

John Maynard Keynes challenged the classical view, defining interest as a purely monetary phenomenon—a reward for parting with liquidity.

Interest is the price which equilibrates the desire to hold wealth in the form of cash with the available quantity of cash in the system.

Three Motives for Holding Cash:

1. Transaction Motive: Holding cash for day-to-day personal and business transactions.
2. Precautionary Motive: Holding cash for unforeseen emergencies or future contingencies.
3. Speculative Motive: Holding cash to take advantage of future changes in interest rates or bond prices. This is highly sensitive to interest rates.

4. Risk, Uncertainty, and Profits

Profit is the reward for the entrepreneur for coordinating production and bearing the risks of the business.

Risk vs. Uncertainty (Knight's Theory)

• Risk: Refers to outcomes that are "insurable" because their probability can be calculated (e.g., fire, theft).
• Uncertainty: Refers to "non-insurable" risks arising from unpredictable changes in market conditions, technology, or government policy.
• The Core Idea: True profit arises as a reward for bearing non-insurable uncertainty.

Innovation Theory of Profit

Proposed by Schumpeter, this theory suggests that profits are a reward for innovations—such as introducing new products, new techniques of production, or opening new markets. These profits are temporary until the innovation is adopted by others.