Theory of Distribution Questions and Answers AP Inter 1st Year Economics Chapter 7

Andhra Pradesh BIEAP AP Inter 1st Year Economics Study Material 7th Lesson Theory of Distribution Class 11 Textbook Exercise Questions and Answers.

Theory of Distribution Class 11 Questions and Answers AP Inter 1st Year Economics 7th Lesson

I. Multiple Choice Questions (1 Mark)

Question 1.
According to the modern theory of rent, rent accrues to:
(1) Land only
(2) Capital only
(3) Any factor of production
(4) Labour only
Answer:
(3) Any factor of production

Question 2.
If the marginal revenue product is greater than the marginal factor cost, the firm should hire:
(1) Fewer factors
(2) More factors
(3) The same factors
(4) All of the above
Answer:
(2) More factors

Question 3.
The return to manmade appliances due to a fixed supply in the short period is called:
(1) Quasi rent
(2) Contract rent
(3) Economic rent
(4) Scarcity rent
Answer:
(1) Quasi rent

Question 4.
Find the incorrect match:
(1) Dynamic theory of profit – J.B. Clark
(2) Risk theory of profit – Prof. Hawley
(3) Modern theory of wages – Prof. Knight
(4) Wages fund theory – J.S. Mill
Answer:
(3) Modern theory of wages – Prof. Knight

Question 5.
Which of the following is not a determinant of the supply of loanable funds ?
(1) Savings
(2) Investment
(3) Bank Credit
(4) Dishoarding
Answer:
(2) Investment

II. Fill in the Blanks (1 Mark)

Question 1.
The law of …………….. is the base for marginal productivity theory operating under perfect competition.
Answer:
Diminishing marginal returns

Question 2.
According to Mrs. Joan Robinson, rent is the surplus earned by a factor over and above its ……………. .
Answer:
Transfer earning

Question 3.
According to Keynes, the ………….. is determined by the interaction of a perfectly inelastic money supply curve and a downward-sloping liquidity preference curve.
Answer:
Interest rate

Question 4.
According to Walker, a worker is a ………….. claimant.
Answer:
Residual

Question 5.
According to Schumpeter, net profit is the reward paid for an entrepreneur’s ………….. skills.
Answer:
Innovative

III. Answer the following questions in one word. (1 Mark)

Question 1.
Who ssaid that rent is the difference between superior and inferior land ?
Answer:
David Ricardo

Question 2.
Which theory of wages is termed as the ‘Iron law of wages’ ?
Answer:
Subsistence theory of wages

Question 3.
How does the interest rate react to the fall in bond prices ?
Answer:
Increase (or) Rise

Question 4.
Which term was substituted for ‘abstinence’ by Marshall in the Nassau Senior abstinence theory of interest?
Answer:
Waiting

Question 5.
Who classified risks as foreseen insurable, and unforeseen, non insurable risks ?
Answer:
Prof. Knight.

IV. Briefly explain the following concepts in two to three sentences. (2 Marks)

Question 1.
Contractrent
Answer:
In common usage, rent or the price which is actually paid for the services of land, building, vehicle, etc., according to an agreement made earlier for a specified period of time its called gross contract rent.
For example, the rent that a tenant pays to the house owner monthly, as per an agreement made earlier, hiring Charges for a garage per day, hiring charges of a bicycle at Rs. 12 per hour etc.

Question 2.
Economic rent
Answer:
Classical economists used the term ‘economic rent’ as that part of payment made for the use of land only. Economic rent is the payment made to a fixed factor over and above its opportunity cost. Economic rent is a surplus that arises by deducting interest, depreciation and profit from gross rent.

Question 3.
Scarcity rent
Answer:
prof. Marshall explained the concept of scarcity rent based on demand and supply. In general, land has indirect demand or derived demand. If there is an explosion of population, demand for land increases resulting in a rise in its price. The surplus earned by the land above its price is called scarcity rent. Since the supply of land is inelastic and fixed, the demand for land determines the rent by largely influencing its price. Consequently, rent arises due to the scarcity in the supply of any factor of production.

Question 4.
Quasi rent
Answer:
The concept of quasi rent was first introduced in economics by Alfred Marshall According to quasi rent refers to the income derived from machines and other man-made appliances. It is the surplus earned over and above the price of the factors of production.

Question 5.
Transfer earnings
Answer:
Transfer earnings are the return that the factor earns in the next best alternative use. If a factor has no alternative use, its transfer earnings will be ‘zero’. According to Mrs. Joan Robinson, rent is the surplus earned by a factor over and above its transfer earnings. In other words, rent is the difference between the actual or current earnings of a factor and its transfer earnings.

Question 6.
Real wages
Answer:
Real wages represent the purchasing power of money wages. They are expressed in terms of the goods and services a worker can buy with their money wages. Real wages are considered high when labourers can obtain a larger quantity of goods and services with their money income.

Question 7.
Loanable funds
Answer:
Loanable fund refers to the amount created or available for lending. Loanable funds is the sum total of all the money people and entities in an economy have decided tb save and lend out to borrowers as an investment rather than use for personal consumption.

Question 8.
Innovations
Answer:
Innovation refers to the process of bringing about new ideas and methods of production that have a significant positive impact on productivity. Joseph Schumpeter’s Innovation Theory of Profit explains that profit is the reward for an entrepreneur’s inventive skills. Profits arise from the difference between price and production cost due to innovations.

Question 9.
Net interest
Answer:
Net interest is the amount that remains with the lender after deducting the rewards for risk taking, inconvenience, and management from the gross interest.
This is the payment made to the lender of capital exclusively for the services of capital in the production process. Interest paid on government bonds, securities, and loans constitutes net interest.

Question 10.
Net profit
Answer:
Net profit is the reward paid for the organiser’s entrepreneurial skills. It is the reward they receive for their performance. Net profit is the reward paid for bearing uninsurable risks and uncertainties.
Net Profit = Gross profit – (Implicit rent + Implicit wage + Implicit interest + Depreciation charges + Insurance premium)

Question 11.
Piece wages
Answe:
Piece wages refer to payments made based on the amount of work completed by a labourer. Here, the skill and expertise of the labourers play a crucial role in determining their earnings. For example; a cobbler may be paid Rs. 200 for manufacturing a pair of shoes or a painter may be paid Rs. 100 for painting one square meter of a wall.

Question 12.
Time wages
Answer:
Time wages refer to payments made based on the duration of time worked, irrespective of the worker’s contribution to production. Wages may be paid daily weekly, monthly, or yearly. For example, the basic salary of a bank employee is Rs. 50,000 per month.

V. Write the answers briefly for the following questions. (4 Marks)

Question 1.
What factors determine factor prices ?
Answer:
Determination of factor price ;The demand and supply of a factor of production determine its price.
The factors that determine factor demand are as follows:

• The demand for a factor of production is a derived demand. It depends on the demand for the goods produced by it.
• The price of the factor.
• The prices of other factors or cooperative factors.
• Technological changes.
• Operation of the law of returns to scale. (Increasing returns to scale increase the demand for labour)

The factors that determine factor (labour) supply are as follows:

• The size of the population and its age composition
• Mobility of the factor of production
• Efficiency of the factor of production
• Geographical conditions
• Opportunity cost of a factor
• Prices of the factors

Question 2.
Explain the concept of quasi rent with the help of a diagram.
Answer:
The concept of quasi rent was first introduced in economics by Alfred Marshall. According to Marshall, quasi rent refers to the income derived from machines and other man-made appliances. It is the surplus earned over and above the price of the factors of production.

Example: When the demand for houses in rural areas suddenly increases due to the establishment of colleges, industries, etc., rent rises sharply. This leads to extra income above the normal price. However, this extra income will disappear in the long run.

Certain man-made appliances like machinery, buildings, and tools have an inelastic supply in the short run. If the demand for these factors increases, their prices will also rise due to inelasticity of supply in the short period. However, the rent or surplus above the factor price will disappear in the long run.

In the above diagram, man-made appliances are represented on the OX-axis, and rent is shown on the OY-axis. The short-period supply curve is denoted as SPS, while the long-period supply curve is LPS. In the short run, rent equals to RRj arises as a result of an increase in demand from DD to D₁D₁, where the supply of the factor is inelastic. As a result, equilibrium shifts from E to E₁, causing a rise in rent per unit (RR₁). In the long run, however, rent will disappear due to the elastic supply of the factor, shifting equilibrium from E₁ to E₂ and causing a fall in rent per unit (R₁R).

Question 3.
Illustrate the concept of scarcity rent with the help of a diagram.
Answer:
Prof. Marshall explained the concept of scarcity rent based on demand and supply.
In general, land has indirect demand or derived demand. If there is an explosion of population, demand for land increases resulting in a rise in its price. The surplus earned by the land above its price is called scarcity rent. Since the supply of land is inelastic and fixed, the demand for land determines the rent by largely influencing its price. Consequently, rent arises due to the scarcity in the supply of any factor of production.

• In the given diagram, the supply and demand for land are shown on the OX-axis, while rent is shown on the OY-axis.
• SL represents the supply curve of land, which is perfectly inelastic.
• When the demand for land increases, the demand curve shifts to the right from DD to D₁D₁.
• Consequently, the price increases from OR to OR₁.
• Thus, RR, surplus price or rent arises due to scarcity of land.

Question 4.
What is a real wage and what are the factors that determine real wages ?
Answer:
Meaning: Real wages represent the purchasing power of money wages. They are expressed in terms of the goods and services a worker can buy with their money wages. Real wages are considered high when labourers can obtain a larger quantity of goods and services with their money income.

Factors Determining Real Wages :
a) Purchasing power of money: Given the price level, if the money wage is high, the real wage will also increase, and vice versa. Similarly, if prices rise, the purchasing power of money decreases, leading to lower real wages, and vice versa.

b) Method of payment: In addition to money wages, labourers often receive ad-ditional benefits from their management, such as free housing, medical facilities, education for children, or transportation, etc. The rise in prices of these benefits does not directly affect labourers’ income as they are provided by the management. Hence, if such facilities are high, the real wages of labourer’s will also be high.

c) Regularity of employment: Real wages depend on the regularity of employment. If a job is permanent, the real wage will be high even if the money wage is low. In contrast, temporary employment results in lower real wages, even though money wages are high.

d) Nature of work Real wages are influenced by the risk and danger involved in the work. Jobs with high risk, such as submarine captains or miners, may offer high money wages, but the real wages are considered low due to the risks involved.

e) Conditions of work: Working conditions significantly affect real wages. Jobs with better facilities, such as shorter working hours, proper ventilation, light, fresh air, and recreation, etc., result in higher real wages. Poor working conditions reduce real wages, even if money wages are high.

f) Subsidiary earnings ; If labourers earn extra income in addition to their primary wage, their real wages are higher. For instance, a government doctor may increase his earnings through private practice.

g) Social prestige : Social status also affects real wages. For instance although the money wages of a bank officer and a judge maybe equal, the judges’ real wages are higher due to the greater social prestige associated with the position.

Question 5.
Explain the concepts of gross profit, net profit and their components.
Answer:
1) Gross Profit: Gross profit is considered the difference between total revenue and the cost of production. It includes the following constituents :

1. Net profit of the organiser.
2. The rent payable for the entrepreneur’s own land or buildings.
3. The wage payable to the entrepreneur for his management services.
4. The interest payable on the entrepreneur’s own capital in the business.
5. Depreciation charges, user costs of production, and insurance charges etc.

2) Net Profit: Net profit is the reward paid for the organiser’s entrepreneurial skills. It is the reward they receive for their performance, which includes :

1. Reward for risk-bearing: Net profit is the reward paid for bearing uninsurable risks and uncertainties.
2. Reward for coordination: Net profit is the reward paid for coordinating the factors of production in the right proportion during the production process.
3. Reward for marketing services: Net profit is the reward paid to the entrepreneur for his ability to utilise the services of factors of production and sell their products as superior compared to others.
4. Reward for innovations: Net profit is the reward paid for innovations such as new products, new techniques of production, and alternative uses of natural resources.
5. Windfall gains: These gains arise as a result of natural calamities, wars, and artificial scarcity, and are included in net profits.

Question 6.
Explain the concepts of gross interest, net interest and their components.
Answer:
1) Gross interest: The payment that the lender receives from the borrower, excluding the principal amount, is gross interest. Gross interest comprises the following elements.
a. Net interest: This is the payment made only for the services of capital or money in the production process. This interest is true in the economic sense.

b. Reward for risk taking: Gross interest includes a reward for risk-taking. The lender is exposed to risks when he lends money. Marshall divided these risks into two types, i) Business risks are related to fluctuations in the price and demand for the production of capital ii) Personal risks are related to the dishonesty or incapability of the borrower to repay. Hence, mcrrtey lenders charge a certain amount to cover these risks.

c. Reward for inconvenience: The moneylender faces a few inconveniences when lending money, such as :

• The lender may not receive the money on time,
• The lender foregoes the use of money until it is repaid,
• The lender may lose favourable opportunities due to the non-availability of cash on hand. Therefore, interest must be paid as a reward for these inconveniences.

d. Reward for management: The lender has to incur expenses in maintaining accounts for borrowers. The lender purchases account books and even employs staff for collecting loans. Sometimes, he has to file a suit for the recovery of loans, which is expensive. The lender charges an amount to cover these managerial services.
Gross Interest = Net interest + (Reward for risk taking + Reward for inconvenience + Reward for management)

2) Net Interest: This is the payment made to the lender of capital exclusively for the services of capital in the production process. Interest paid on government bonds, securities, and loans constitutes net interest. Net interest is the amount that remains with the lender after deducting the rewards for risk taking, in-convenience, and management from the gross interest.
Net Interest = Gross interest – (Reward for risk taking + Reward for inconvenience + Reward for management)

VI. Write an essay on the following questions. (8 Marks)

Question 1.
Explain the marginal productivity theory of distribution.
Answer:
This theory was developed by J.B. Clark. According to his theory, the remuneration of a factor of production will be equal to its marginal productivity. The theory assumes perfect competition in the market for factors of production.

Assumptions of the theory:
The theory is based on the following assumptions. .

1. There is perfect competition in the factor market.
2. All the units of a factor are homogeneous and divisible.
3. The theory assumes full employment of the factors.
4. There is perfect mobility of the factors of production.
5. Substitution is possible between the factors.
6. The marginal productivity of an individual factor is measurable.
7. The theory is based on the law of variable proportions.
8. The theory is applicable only in the long run.

Few Concepts of this theory:
a) Marginal Physical Product (MPP): MPP is the additional output obtained by using an additional unit of the factor of production.
MPP = TPP_n – TPP_n-1

b) Marginal Revenue Product (MRP): MRP is the additional revenue that a firm earns, when it employs an additional unit of the factor in production. It means the increase in the total revenue.
MRP = TRP_n – TRP_n-1

c) Average Physical Product (APP): It is the output per unit of factor of produc-tion. It is obtained by dividing the total physical product bTy the number of factor units employed.

APP = \(\frac{TPP}{\text { No. of factor units }}\)

d) Average Revenue Product (ARP): ARP is the revenue per unit of the factor. It can be obtained by dividing the total revenue product by the number of factor units employed.
APP = \(\frac{TRP}{\text { No. of factor units }}\)

e) Average Factor Cost (AFC): AFC can be calculated by dividing the total factor cost by the total factor units employed.

f) Marginal Factor Cost (MFC): MFC is the additional cost incurred by employing an additional unit of a factor of production.

Explanation:
For instance, if four tailors can stitch twelve shirts in a day and five tailors can stitch fifteen shirts in a day, then the Marginal Physical Product (MPP) of the fifth tailor is three shirts. If the stitching charge for a shirt is Rs. 100, then the Marginal Value Product (MVP) of three shirts is Rs. 300. According to the theory, the fifth person will be remunerated Rs. 300.

Initially, as additional units of a factor of production are employed, the Marginal Revenue Product of these additional units increases up to a certain point and then diminishes due to the law of variable proportions. Similarly, the Average Revenue Product (ARP) increases up to a certain point and then decreases. As a result, the ARP and MRP curves have an inverted ‘U’ shape.

When both MRP and ARP are rising, the MRP will be higher than the ARP. While falling, the MRP curv e intersects the ARP curve at the maximum point of the ARP curve. Similarly, under perfect competition market average cost and marginal cost of each unit of a factor of production are the same and are equal to price. Therefore, AFC = MFC and this curve is horizontal to the OX-axis.

In Diagram, units of labour are shown on the OX-axis, while price, cost, and revenue are shown on the OY-axis. The firm will be in equilibrium at point ‘E’ where the MRP and MFC curves intersect.

At the equilibrium point ‘E’ the firm gains normal profits, where the ARP = MRP = AFC = MFC. Thus, each unit of labour will be paid a price of ‘OP’ with OL units of labour employed.

Suppose the factor price rises to OP₁ where OL₁ units of labour are employed. In this case, the factor price or AFC paid to each unit of labour exceeds its ARP (AFC > ARP). Hence, the firm will incur a loss of ‘ab’ per unit of labour. This situation induces some firms to leave the industry, causing the price or AFC to fall to ‘OP₂ If the factor price falls to OP₂, where OL₂ units of labour are employed, the AFC is less than its ARP (AFC < ARP).

Hence, the firm will gain a profit of ‘cd’ per unit of labour. As a result, new firms will enter the industry, and the price or AFC will rise again to OP. These variations take place in the short run, but in the long run equilibrium position will remain at point E where P = AFC = MFC = ARP = MRP.

Question 2.
Define rent and explain the Ricardian theory of rent.
Answer:
The remuneration or price paid for the use of ‘land’ is rent. Rent is the difference between the produce of superior land and that of inferior or marginal land. Accord-ing to Ricardo, “Rent is that portion of the produce of the earth which is paid to the landlord for the use of the original and indestructible powers of the soil.”

Assumptions of the theory:

1. Land is a natural gift. It has no cost of production.
2. Land supply is perfectly inelastic. It has indestructible powers of the soil.
3. Land has no alternative use except cultivation.
4. Land is heterogeneous i.e., it differs in fertility.
5. Land is subject to the law of diminishing returns whenever it is cultivated.
6. Land of the last grade has no rent i.e., such a land is marginal or ‘no rent’ land.
7. Land’s soil differences generate rent under perfect competition in the economy.
8. Land accrues rent in the long run and rent is determined by the price of the produce.

Example: According to this theory, land in a country is of different grades, i.e., A, B, C, etc. If some people go and settle in a new country, the first batch of settlers will cultivate the most fertile lands, i.e., ‘A’ grade lands. Here, the cost of production in the form of wages and the cost of other inputs is Rs. 6000 to produce 250 bags of paddy. The return from the sale of the produce will be just equal to the cost of production. Rent does not arise on ‘A’ grade lands until ‘B’ grade lands are cultivated.

If another batch of settlers goes to the country, they will cultivate the second-grade lands, ‘B’ grade lands. Hence, the same Rs. 6000 worth of production cost on the same extent of land will result in an output of 200 bags of paddy. No rent arises in the case of ‘B’ grade lands, as the cost of production is equal to the valuetof its produce. However, whenever ‘B’ grade lands are cultivated, rent arises on A’ grade lands, equal to 50 bags of paddy or Rs. 1500 = (6000 ÷ 200 × 50).

If there is an explosion of population, another batch of settlers will go to the country and be forced to cultivate ‘C’ grade lands, which are less fertile than ‘B’ grade lands. Hence, the same Rs. 6000 worth of production cost will result in an output of 150 bags of paddy. Since the cost of production is equal to its yield, no rent arises on ‘C’ grade lands. However, whenever ‘C’ grade lands are cultivated, rent arises equal to 100 bags of paddy on A’ grade lands and 50 bags of paddy on ‘B’ grade lands. According to this theory, ‘C’ grade lands are called “marginal lands” or no rent lands. According to this theory, rent does not include the cost of production. Hence, rent is a surplus above the price.

A’ grade land yields 250 bags of paddy at the same cost of production, Rs. 6000, which is equal to its return, i.e., Rs. 6000. Similarly, ‘B’ grade land yields 200 bags of paddy worth Rs. 6000, which is equal to its cost of production, i.e., Rs. 6000. If‘C’ grade land earns normal profits by producing 150 bags of paddy, then A and B grade lands will also earn normal profits by producing 150 bags of paddy. Grade ‘C’ land earns Rs. 40 per bag (6000/150). However, ‘B’ grade land yields a surplus of 50 bags of paddy or Rs. 2000 (40 × 50), and A’ grade land yields a surplus of 100 bags of paddy or Rs. 4000 (40 × 100). Thus, A and B grade lands accrue rent. The above illustration shown in table.

Observation : By comparing the obtained rents of A,B,C we, conclude that Rent is a pure surplus.

Graphical Illustration:

In diagram, the shaded area represents the rent or differential surplus. Rent does not arise on ‘C’ grade land. The rent on grade-A land is 100 bags equivalent to Rs. 4000 and on grade-B land is 50 bags equivalent to Rs. 2000. In contrast, rent does not arise on grade-C land. Hence grade-C lands are called marginal lands.

Question 3.
What is meant by wages ? Briefly explain the various theories of wages.
Answer:
Wages are payments made for the services of labour, either mental or physical. Definition: Wages are “the sum of money paid under contract by an employer to a worker for the services rendered.” – Benham.

Theories of Wages:
1. Subsistence Theory of Wages:
The Subsistence Theory of Wages was formulated by a group of French economists known as the physiocrats in the 18th century. According to this theory, wages will always remain at a level that enables the labourer and their family to meet the minimum subsistence level. If wages rise above the subsistence level, supply of labour will increase. As a result, wages will decrease to the subsistence level. If wages fall below the subsistence level, the labour supply will decrease This reduction in the labour supply will lead to an increase in wages back to the subsistence level. Hence, wages will always remain at the subsistence level. This theory is also known as the “Iron Law of Wages.”

2. Wage Fund Theory:
J.S. Mill explained the “Wage Fund Theory” in his book, The Principles of Political Economy. According to this theory, every entrepreneur sets aside a portion of variable capital to pay wages, as labourers cannot wait for their wages until goods are sold. This portion of variable capital is known as the wage fund or circulating capital. The total wage fund is a fixed sum that depends on past savings. Wages are determined by the demand for and supply of labour. Wages are inversely related to the supply of labour. Wages can increase only if there is an increase in the wage fund, which takes time. Otherwise, wages can rise if there is a decrease in the supply of labour.

3. Residual Claimant Theory of Wages:
Professor Walker proposed the Residual Claimant Theory of Wages. According to Walker, a worker is a residual claimant. After paying rent, interest, and profit from the total revenue, the remaining amount or the residual amount is paid as wages to the labourers. Thus,
Wages = Total Revenue – (Rent + Interest + Profit)

4. Modern Theory of Wages:
The modern theory of wages was refined by Alfred Marshall and J.R. Hicks. According to this theory, the wages of labourers are determined by the demand for and supply of labourers. It is similar to commodity pricing. The demand for labourers is influenced by various factors, such as the demand for the product to be produced, wage rates, prices of complementary factors, technology, the marginal productivity of labourers, the demand for other factors, etc.

The supply of labourers depends on factors like the size of the population, the age composition of the population, qualifications, skills, willingness to work at the current wage rate, and the mobility of labourers. Hence, wages are determined at the point where the demand for and supply of labour are equal.

Question 4.
Define interest. Briefly explain the various theories of interest.
Answer:
Interest: Interest is the payment made by a borrower to a lender, expressed as “a rate per hundred rupees borrowed for a year”.
Theories of Interest: In the case of interest, many theories of interest have been proposed. Among them, a few theories focus on real factors, while others focus on monetary measures.

1. Abstinence (or) Waiting Theory of Interest:
In economics, different theories of interest have been proposed over time. Nassau Senior proposed the Abstinence Theory of Interest. According to him, capital can be created by postponing consumption.

This means that when people save, they abstain from consumption. Ab-staining from consumption is considered disagreeable and painful. As lending involves sacrifice, it is necessary to reward the lender in the form of interest. In the case of the rich, there is no real abstinence. Hence,Marshall substituted the word “waiting” for “abstinence,” and interest is then considered the reward for waiting.

2. Productivity Theory of Interest:
The Productivity Theory of Interest was proposed by J.B. Clark and F.H. Knight. The theory explains that the rate of interest is determined by marginal productivity. When additional units of capital are used, productivity increases up to a certain point and then begins to decrease, due to the law of diminishing returns. According to this theory, the rate of interest is equal to the productivity of capital. Thus, the higher the demand for capital, the lower the rate of interest, and vice-versa.

3. Loanable Funds Theory of Interest:
The Loanable Funds Theory was formulated by Knut Wicksell. According to this theory, interest rate is determined by the equilibrium between the demand for and supply of loanable funds.

A. Supply of Loanable Funds: The supply of loanable funds arises from the following sources:

1. Savings: Savings by individuals, households, and the corporate sector constitute savings out of their disposable income. The higher the rate of interest, the higher the incentive to save.
2. Dishoarding: It refers to bringing idle cash into use. If the rate of interest is higher, larger funds will come out of hoards, and vice versa.
3. Bank credit: Commercial banks create credit money by purchasing and selling securities to influence the supply of loanable funds. The creation of credit money and the rate of interest are inversely related.
4. Disinvestment: Due to structural changes in the economy, firms reduce fixed capital, variable capital, and depreciation reserves, supplying them as loanable funds. The rate of interest and disinvestment are positively related.

B. Demand for Loanable Funds: The demand for loanable funds arises for the following purposes:

1. Investment: Loanable funds are demanded for investment when the expected rate of return on investment is equal to or greater than the rate of interest. The rate of interest and the demand for capital are inversely related.
2. Consumption: Generally, people purchase durable goods in excess of their income and savings. At a lower rate of interest, people borrow more for consumption.
3. Hoarding : People prefer to hoard money because of its liquidity. The rate of interest and the demand for money are inversely related. The rate of interest is determined when the demand for loanable funds equals the supply of loanable funds.

4. Keynes’ Liquidity Preference Theory:
Keynes, in his book “The General Theory of Employment, Interest, and Money,” proposed a monetary explanation of the rate of interest. According to Keynes, interest is determined by both the demand for and the supply of money. According to Keynes “Interest is the reward paid for parting with liquidity for the specified period”.

A. Supply of money: The supply of money refers to the total quantity of money in circulation which is fixed or perfectly inelastic at a given point of time. It is determined by the central bank of country.

B. Demand for money: The desire to hold ready cash is referred to as liquidity preference. Liquidity preference is negatively related to the rate of interest.
People demand money for three primary reasons :
1. Transactions motive : People’s desire to keep cash for current trans-actions in personal and business exchanges, considering their level of income and the state of business activity.

2. Precautionary motive: People keep cash in reserve to meet unforeseen expenses like illness, accidents, and unemployment. Businessmen keep cash in reserve to benefit from unexpected deals in the future, such as purchasing new machines, deal with fire accidents and unexpected needs, etc.

3. Speculative motive The speculative demand for money relates to the desire to hold cash to take advantage of future changes in the rate of interest and bond prices. If bond prices are expected to rise, the rate of interest is expected to fall. As a result, businessmen will buy bonds to sell them when prices rise, and vice versa.

Question 5.
Explain the difference between risk beating and uncertainty theories of profit.
Answer:
The Risk Theory of Profit:

1. Prof. Hawley’s Risk Theory of Profit proposes that profits are the reward for an entrepreneur’s risk taking.
2. Only the entrepreneur assumes risks in production, and the residual income, after paying all other factors, goes to the entrepreneur as a reward for risk taking.
3. Fluctuations in prices, changes in demand, and unforeseen contingencies are involved in risk taking. Consequently, the reward for risk taking must exceed the actual value of the risk. While some risks are insurable, not all risks are insurable.
4. If all risks were transferred to an insurer, the profit would go to the insurer, and the entrepreneur would only earn wages.
5. Thus, entrepreneurs who face risks can earn profits beyond the actual value of those risks. According to this theory, profit is a reward for wisely selected risks.

Uncertainty Theory of Profit:
1. Prof. Knight formulated the Uncertainty Theory of Profit, a modified version of the risk bearing theory of profits.

2. According to Knight, profit is the reward for bearing uninsurable risks and uncertainties, which he classified into two types :

• foreseen insurable risks, such as fire, theft, and natural calamities, and
• unforeseen non insurable risks, such as changes in prices, demand and supply, and competition, trade cycles, and government interference, which cannot be calculated.

3. Profit arises from the entrepreneur’s ability to manage such uncertainties, depending on the degree of uncertainty and risk.

4. Knight proposed that profit should not be viewed exclusively as a reward for risk taking. Instead, the entrepreneur’s ability to bear uncertainty is considered as a factor of production with a supply price.

5. Thus, profit compensates entrepreneurs for their ability to bear uncertainty, which exceeds the supply price of their services.

Question 6.
Explain J.M. Keynes liquidity preference theory of interest.
Answer:
Keynes’ Liquidity Preference Theory. Keynes, in his book “The General Theory of Employment, Interest, and Money,” proposed a monetary explanation of the rate of interest. According to Keynes, interest is determined by both the demand for and the supply of money.

A. Supply of money: The supply of money refers to the total quantity of money in circulation which is fixed or perfectly inelastic at a given point of time. It is determined by the central bank of a country.

B. Demand for money: The desire to hold ready cash is referred to as liquidity preference. Liquidity preference is negatively related to the rate of interest. People demand money for three primary reasons :
i) Transactions motive: People’s desire to keep cash for current transactions in personal and business exchanges, considering their level of income and the state of business activity.

ii) Precautionary motive: People keep cash in reserve to meet unforeseen expenses like illness, accidents, and unemployment. Businessmen keep cash in reserve to benefit from unexpected deals in the future, such as purchasing new machines, deal with fire accidents and unexpected needs, etc.

iii) Speculative motive: The speculative demand for money relates to the desire to hold cash to take advantage of future changes in the rate of interest and bond prices. If bond prices are expected to rise, the rate of interest is expected to fall. As a result, businessmen will buy bonds to sell them when prices rise, and vice versa.