Distribution of Income and Factor Pricing
Distribution of Income and Factor Pricing explains how wages, rent, interest and profit are determined. BIEAP tests marginal productivity theory, Ricardian rent, wage theories, interest theories and the role of risk and uncertainty.
Core rules
- Factor demand is derived demand, based on the marginal revenue product: MRP = marginal physical product × marginal revenue.
- A profit-maximising firm hires a factor until MRP equals its marginal factor cost.
- Ricardian rent is the surplus earned by land due to its fixed supply and differing fertility. Economic rent is payment above transfer earnings.
- Wages are influenced by marginal productivity, collective bargaining, government regulation and labour supply conditions.
- Interest theories include the loanable funds theory and liquidity preference theory; profit rewards entrepreneurship and risk-bearing.
- Quasi-rent is a short-run surplus earned by fixed factors other than land.
Worked example
A worker produces 10 units per day, and each unit sells for ₹50. MRP = 10 × 50 = ₹500. If the wage is ₹400, the firm gains ₹100 from hiring that worker and should hire more until MRP falls to ₹400.
Traps
Do not equate economic rent with house rent. Do not confuse transfer earnings with total earnings. MRP uses marginal revenue, not price, unless the firm is a perfect competitor. Real wages adjust for prices; nominal wages do not. Profit is a residual and can be negative.