Factor Pricing Theory: Frequently Asked Questions

Read this article to learn about the top twenty frequently asked questions on Factor Pricing Theory.

Q.1. What is the difference between marginal physical product and marginal revenue product?

Ans. MPP is the change in total product attributable to a change in the use of a variable input.

When MPP is expressed in money firms, we obtain VMP. MRP is the change in total revenue following a change in the employment of a variable input.

Q.2. Why is an input demand called ‘derived demand’?

Ans. An input demand is a derived demand in the sense that inputs are not directly demanded. We first demand goods. To meet the consumers’ demand, producers demand inputs. Thus, first comes consumer demand and after that input demand. As an input demand is obtained from the consumption demand, demand for an input is a derived demand.

Q.3. Under what conditions value of the marginal physical product (VMP) of an input is equal to the marginal revenue product (MRP) of that input and VMP is not equal to MRP?

Ans. If perfect competition in the product market exists, VMP = MRP. But under imperfect competition in the product market, VMP diverges from MRP, and VMP > MRP.

Q.4. How do you explain the demand curve of an input?

Ans. We know that under perfect competition in the product market, VMP = MRP. If the prices of the product and of the inputs remain constant, then VMP = MRP curve of the variable input is the firm’s demand curve for that input. It is a downward sloping curve indicating that at a lower price of the input more of that input will be demanded.

But, under imperfect competition, MRP curve is the firm’s demand curve for the variable input.

Q.5. What is economic rent?

Ans. Economic rent is a producer’s surplus beyond full cost of production. It is never fixed by contract. Economic rent is also defined as payments made for inputs whose supply is inelastic.

Q.6. Will economic rent arise if input supply is perfectly elastic and perfectly inelastic?

Ans. Economic rent is the difference between actual earnings and the minimum supply price of an input. If input supply is perfectly elastic, rent will not arise since actual earnings and the minimum supply price of that input are the same. On the other hand, rent will arise in the case of perfectly inelastic supply since its minimum supply price is zero. The whole of its earning is the rent.

Q.7. Why do people demand money? On what factors these demand for money depend?

Or

What are the motives behind an individual’s demand for money?

Ans. Liquidity preference or the demand for money to hold arises because of three motives:

(a) Transaction motive,

(b) Precau­tionary motive, and

(c) Speculative motive.

Transaction demand for money as well as precautionary demand for money largely and directly depend on the individual’s level of income. Speculative demand for money is a function of the rate of interest, increasing as the interest rate falls and decreasing as the interest rate rises.

Q.8. Distinguish between rent, wages, interest and profit.

Ans. (a) As rent, wages and interest are contractual incomes, they can never be zero or negative. But profit may be zero, positive and negative.

(b) Rent, wages and interest are included in the cost of production. On the other hand, as profit is a surplus income, it cannot be included in the cost of production.

Q.9. What is meant by keeping money in hand for speculative purpose?

Ans. Speculative motive for holding money refers to the desire of the people to hold cash balances to take advantage of market movements regarding the future changes in bond prices or its rate of interest. In other words, money kept for this purpose is used to make speculative gains by dealing in bonds whose prices fluctuate. Thus, money held for this purpose serves as a store of value.

Q.10. If the rate of interest declines in the market, what will be its effect on the holding of money by the public?

Ans. When rate of interest falls people anticipate that it will rise in the future. Conse­quently, prices of securities go down and possibility of capital loss arises. In view of this uncertainty and anticipation regarding the future rate of interest, people will hold money in their possession. In this situation, cash becomes more attractive than securities.

Q.11. If the money income of the people go up, what will be the effect on their liquidity preference?

Ans. Liquidity preference arises because of transaction purpose, precautionary purpose and speculative purpose. The first two types of demand for money (or liquidity preference) are directly related to the level of income. As income rises, demand for money for the said two purposes will rise.

Q.12. If the rate of interest decreases, what will be its effect on the prices of outstanding bonds in the market?

Ans. There is an inverse relationship between the rate of interest of bonds and its prices. When the rate of interest on bonds decline people anticipate that it will rise in the future, Consequently, bond prices tend to decline.

Q.13. People demand money to satisfy 3 motives, e.g., transaction, precautionary and speculative motives. A man keeps some amount in a bank to pay his house rent. What kind of demand for money is it?

Ans. Money is demanded for transaction, precautionary and speculative purposes. Obviously, when a man keeps some amount of money in a bank for paying house-rent it must be a transaction demand for money. It is neither a precautionary demand for money arising out of unforeseen phenomenon nor speculative demand for money (arising out of anticipation regarding the future rate of interest on securities).

Q.14. What is liquidity preference?

Ans. Liquidity preference means desire of the public to hold cash. Of all the assets, the most liquid asset is cash. Therefore, people have the preference to hold cash rather than other assets which are less liquid than money.

Q.15. Can the rate of interest or liquidity preference falls to zero?

Ans. Of all the assets, cash is the most liquid asset. People want to hold liquid money. As people have the preference for liquid money, liquidity preference and, hence, the rate of interest can never fall to zero.

Q. 16. Can profit be zero?

Ans. Gross profit is the difference between total revenue and total explicit cost. Once total revenue and total explicit cost becomes zero, gross profit becomes zero. But net profit is the difference between total revenue and both explicit and implicit costs. Thus, net profit can never be zero since it is the remuneration of the entrepreneur.

Q.17. What is an abnormal profit?

Ans. If total revenue of a firm exceeds total costs of production then the profit that will emerge may be called as an abnormal’ one.

Q. 18. What is non-insurable risk?

Ans. Risks that cannot be anticipated earlier or risks for which insurance companies never ask for insurance policy may be called non-insurable risk or uncertainty. It is uncertainty or non- insurable risk for which profit arises.

Q.19. What is pure profit?

Ans. Profit is the differences between total revenue and total costs. Total costs include both explicit costs and implicit costs or opportunity costs. Pure profit is defined as the difference total revenue and explicit plus implicit costs.

Q.20. Distinguish between money wage and real wage.

Ans. Money wage or nominal wage is the wage that a worker earns after rendering his service in an office or a factory per day/week/month. The amount of goods and services which the labourer gets in exchange of his labour service is called real wage.