Unit 4: Theory of Factor Pricing (B)

1. Capital, Investment, and Depreciation

Capital is a produced factor of production used to create further goods and services.

• Capital: A stock of man-made assets, such as machinery, buildings, and tools.
• Investment: The flow of expenditure on new capital goods to increase or maintain the existing stock.
• Depreciation: The gradual decrease in the value of capital assets due to physical wear and tear or obsolescence over time.

2. Classical Theory of Interest

The Classical Theory of Interest views the interest rate as the price that balances the supply of savings with the demand for investment.

The Determination of Interest:

• Demand for Capital: This is a derived demand based on the productivity of capital. As the interest rate falls, the demand for investment increases.
• Supply of Capital: This arises from savings. Individuals save more at higher interest rates as a reward for "waiting" or "abstaining" from current consumption.
• Equilibrium: The real rate of interest is determined where the savings (S) and investment (I) curves intersect.

3. Keynes's Liquidity Preference Theory of Interest

Keynes defined interest as a purely monetary phenomenon—the reward for parting with liquidity for a specified period.

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

Motives for Holding Money:

• Transaction Motive: Holding cash for day-to-day transactions.
• Precautionary Motive: Holding cash to meet unforeseen future emergencies.
• Speculative Motive: Holding cash to profit from future changes in interest rates or bond prices. This motive is highly sensitive to the interest rate.

4. Risk, Uncertainty, and Profits

Profits are the reward to the entrepreneur for the services of management, coordination, and bearing the ultimate responsibilities of business.

The Knightian View: Risk vs. Uncertainty

• Insurable Risk: Risks that can be calculated and insured (e.g., fire, theft). These are treated as costs of production.
• Non-insurable Uncertainty: Risks that cannot be calculated or insured (e.g., shifts in consumer tastes, technological changes). Pure profit is the reward for bearing this non-insurable uncertainty.

Schumpeter's Innovation Theory

Profit arises from successful innovation, such as the introduction of new products or more efficient production methods. These profits are temporary, lasting only until the innovation becomes common practice across the industry.