Unit-5 Rental Principles POE | BBA First Year 2023

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Rental Principles

• David Ricardo, an English classical economist, first developed a theory to explain the origin and nature of economic rent in 1817.
• Ricardo used economics and rent to analyze a particular question. The Napoleonic Wars (1805–1815) caused a sharp increase in the prices of corn and land.
• Did increased land prices increase the price of corn, or did the higher price of corn increase the demand for land and therefore increase land prices. Ricardo defined rent as “that portion of the produce of the earth paid to the landowner for the use of the original and indestructible powers of the soil.” In his theory, rent is nothing else than the surplus or differential profit of the producer, and it is found only in land.

          Assumptions of the theory       

• The Ricardian theory of rent is based on the following assumptions:

1. Land rent arises due to differences in the fertility or condition of different land plots. It arises due to the basic indestructible powers of soil.
2. Ricardo considers the operation of the law of diminishing marginal returns in the case of land cultivation. Since the fertility of different plots of land varies, the yield from lower plots decreases, although the total cost of production in each plot of land is the same.

• Ricardo looks at the supply of land from the perspective of the overall society.

1. In Ricardian theory it is believed that land is a gift of nature, it has no supply price and no cost of production. Rent is therefore not part of the cost, and being so it is not and cannot be included in the cost and price. This means that from the society’s perspective the entire return from land is additional income.

Reasons for the existence of rent

According to Ricardo, rent arises due to two main reasons:

1. Scarcity of land as a factor and
2. Difference in soil fertility.

Reduction Fare

• Ricardo believed that land could only be used to grow maize. This meant that its supply was fixed, as shown in Figure 13.1. Therefore the price of land was entirely determined by the demand for land. In other words, in a perfectly inelastic supply all the price of a factor of production is economic rent, with no transfer income.

Differential Fare

• According to Ricardo, land rent arises because different plots of land have different degrees of productive power; Some lands are more fertile than others. Hence there are different grades of land. The difference in rent between the produce of higher land and the produce of lower land is called differential rent. Let us clarify the Ricardian concept of differential rent.

Fare and Price

• From the Ricardian theory we can show the relationship between rent (of land) and price (of wheat). Since the market price of wheat is determined by the marginal producer’s costs and since, for this marginal producer, rent is zero, Ricardo concluded that economic rent is not the determinant of market price. Rather, the price of wheat is determined entirely by the demand for wheat in the market and the availability of fertile land.

Deduction from principle

• If rent depends on price and on the superiority of rent-producing land over marginal land, we can draw the following conclusions:

1. Improved methods of farming:

• Better farming methods may lead to a decline in rents (demand will remain unchanged). This is because increasing production on better grade land will make farming on lower grade land unnecessary.

2. Population Growth:

• Population growth is likely to increase rents, as increased demand for land will bring poor quality land for farming, reducing the production of marginal land. Thus, if the price of food increases, the rent on existing land will increase.

3. Better transport facilities

• Fares are likely to decline due to improvement in transportation facilities. This is because production from less fertile lands abroad may be able to compete more with domestic produce. Therefore there will be no need for farming in the following domestic areas. As a result the production of marginal land increases and rent falls.
• Therefore, it is difficult to say whether fares increase with economic progress or not. However, if population growth is unable to completely neutralize the effects of technological progress and improvements in transportation facilities, fares are likely to fall with economic progress.

Criticisms of the theory:

The Ricardian theory has been criticized on the following grounds:

1. Ricardo considers the supply of land as fixed. Of course, the land is completely fixed. But there are alternative uses of land as well. Therefore the supply of land for any particular use is not fixed (inefficient). For example, the land supply of wheat is not absolutely fixed at any time.
2. Ricardo’s order of land cultivation is also not realistic. If wheat prices fall, marginal land is not necessarily the first to go out of cultivation. If such land is demanded for other purposes (for example, for building houses) due to a fall in the price of its produce, the better grade land may go out of cultivation.

• The productivity of land does not completely depend on fertility. It also depends on factors like position, investment and effective capital. Using the

1. Critics have pointed out that the land has no original and indestructible powers, because unless fertilizers are applied regularly, the fertility of the land gradually decreases.
2. Ricardo’s concept of untaxed land is actually unrealistic; Every plot of land yields some rent, although the amount may be small.
3. Ricardo limited rent only to land, but modern economists have shown that rent arises in exchange for any factor of production, the supply of which is inelastic.

• According to Ricardo, rent is not included in price (cost), but from the point of view of the individual farm rent forms a part of cost and price.

Productivity Theory

1. According to productivity theory, interest can be defined as the reward for availing the services of capital for production purpose.
2. A worker who has good amount of capital produces more than a worker who does not have the help of good amount of capital.

• For example, a farmer who has a tractor to plow his field produces more than a farmer who does not have a tractor. Thus, interest is payment for the productivity of capital.

1. However, productivity theory is criticized on the following grounds:
2. Focuses only on the reasons for interest payments and not on the determination of interest rates.
3. By assuming that interest is paid due to the productivity of capital. In such a case, the net interest should vary according to the productivity of capital. However, the net interest in the money market during the same period remains the same.
4. Emphasizes the demand for interest, but ignores the supply side of capital.
5. Failed to explain how interest is paid on loans borrowed for consumption purposes.

Abstinence or Waiting Principle:

• The principle of restraint was propounded by Senior. According to him, interest is the reward of restraint. When a person saves money from his income and lends it to another person, he makes a sacrifice. The term sacrifice implies that the person refrains from consuming his entire income which he can easily spend. The senior advocated that abstinence from consumption is unpleasant. Therefore, the lender should be rewarded for this. Thus, according to Senior, interest can be considered a reward for refraining from the use of capital.
• The restraint theory has also been criticized by many economists. According to the theory, when a person saves he feels unpleasant because it reduces his consumption. However, rich people do not feel unpleasant when they save because they need to. able to meet them
• Therefore, Marshall replaced the word abstinence with waiting and described saving in terms of waiting. He says that saving is done by transferring the present requirement to the future and the person has to wait for those requirements to be fulfilled. However, people do not want to wait but are motivated to save money by providing a fixed amount of interest.

Austrian or Aegio theory:

• The Austrian theory is also called the psychological theory of interest. This theory was advocated by John Rae and Böhm Bawerk in the Austrian school. According to the Austrian theory, interest came into existence because present goods are preferred to future goods. Therefore, there is a premium in the form of interest on current goods. In other words, present satisfaction is of greater concern than future satisfaction.
• Therefore, there is some kind of discount in future satisfaction if compared to present satisfaction. Interest is the discounted amount that is required to be paid to induce people to invest or transfer their present needs to the future. For example, a person has to choose between two options.
• He has either Rs. It is possible. 500 now or the same amount after a year. In such a case, he/she would prefer to keep Rs. Currently Rs 500. However, if the individual has the option to receive Rs. Currently Rs 500. Rs 600 after one year.
• In such a case, he will be more inclined towards getting Rs. Rs 600 after one year. Thus, additional payment of Rs. 100 will compensate for the sacrifice involved in delaying his present satisfaction. Additional payment of Rs. In the given case 100 is considered as interest.

1. The Agio theory has been criticized by various economists on the following grounds:
2. Gives too much emphasis to the supply aspect and ignores the demand aspect
3. Does not pay attention to determination of interest rate

4. Classical or Real Theory

• The classical theory helps in determining the interest rate with the help of demand and supply forces. Demand refers to demand for investment and supply refers to supply of savings. According to this theory, interest rate refers to the amount paid for savings.
• Therefore, the interest rate can be determined with the help of demand for savings and supply of savings to be invested in capital goods. Let us understand the concept of investment demand. Capital goods are used to produce consumer goods and provide consistent returns for many years.
• However, there is a certain degree of uncertainty associated with capital goods because of their future use. Furthermore, the use of capital goods involves operation and maintenance costs. This helps organizations calculate the net expected return on marginal cost expressed as a percentage of the cost of capital goods.
• If an organization has similar types of capital goods, an increase in one more capital good will not give them higher revenues. Increase in interest rate will lead to decline in demand for capital goods.

Figure-18 shows the demand for capital investment:

2 Classical or Real Theory

• In Figure-18, MRP represents the marginal revenue productivity curve. When the demand for capital is OM, the rate of interest is Or. The net rate of return becomes equal to the current rate of interest (OR) on the OM demand of capital.
• If the interest rate decreases to Or’, the demand for capital increases to OM’. The net rate of return is equal to ‘Or’ when the quantity of capital demanded is OM’. Demand for capital goods increases with decrease in interest rate.
• On the other hand, the amount saved by an individual increases the supply of capital and saving is done by transferring present need to future need. The interest rate will increase with the increase in the amount of savings by an individual.
• The interest rate can be determined with the help of demand for investment and supply of savings. This will be the point of equilibrium where demand and supply intersect or become equal.

3Classical or Real Theory

Figure-19 shows the determination of interest rate with the help of demand and supply curves:

• In Figure-19, SS is the supply curve of savings and II is the demand curve of investment which intersect each other at the rate of interest with the quantity of savings and investment OM. OM represents the amount that is lent, borrowed and used for investment. The interest rate can be changed by changing the demand and supply of savings and investments.

The classical theory has been criticized by Keynes for various reasons, which are as follows:

1. Assumes full employment of resources, which is actually not true. This is because if a resource is reduced from one production process, it will be used for another production process. On the contrary, if resources are available in abundance then there is no need to save them.
2. It believes that investment can be increased only if individuals reduce their consumption. This is because if consumption decreases, savings will increase, which will increase investment. However, if the demand for capital goods decreases, the incentive to produce capital goods will also decrease. This will reduce investment.
3. It is assumed that there is no change in the income level of an individual. Thus, according to the classical theory, savings and investment become equal due to change in interest rate. However, according to Keynes theory, savings and investment become equal due to changes in the income level of an individual.

Loanable Funds Principles:

• Loanable funds theory agrees with the view that time preference plays an important role in determining the occurrence of interest. This theory is also called neo-classical theory of interest. According to neo-classical economists, interest is the amount paid for loanable funds. It focuses on the determination of interest rate with the help of demand and supply of loanable funds in the credit market. Let us understand the concept of supply of loanable funds.
• The supply of loanable funds depends on the following factors:

Savings:

• Act as one of the sources of loanable funds. Loanable funds in the form of savings are classified as ex-ante savings and Robertsonian meaning. Anticipated savings refers to the savings that a person plans according to his expected income and expenditure at the beginning of a year or a financial year or for a month.
• On the other hand, the Robertsonian meaning refers to the savings that are generated by taking the difference between income of the previous period and consumption of the current period. In both types of savings, savings are made at different interest rates. Savings depend on the income level which decreases with the interest rate. Increase in interest rate will increase the level of savings and vice versa.
• In the context of organizations, the amount left after distributing profits as dividends is called savings of an organization. The savings of an organization depends on the interest rate prevailing in the market. The increased interest rate will encourage organizations to increase savings instead of borrowing money from the loan market.
  

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Disrespect:

• It involves a reduction in the wealth reserves of an organization. Therefore, there is more liquidity in the former currency reserves which can be used as loanable funds in the present time. The higher the interest rate, the more money will be lost and vice versa. Loan by Bank:
• Refers to loans provided by banks to organizations. Banks can increase or decrease the amount of money they lend to an organization based on certain criteria. The supply of loanable money increases with the increase in money created by banks. The supply curve for loanable funds is interest elastic. The higher the interest rate, the more money the bank will lend and vice versa.

Disinvestment:

• Refers to the situation when the existing capital items of an organization are reduced or the stock of the organization becomes less than the previous stock. In such a situation, the funds used for replacement purposes are used as loanable funds.
• According to Bober, “Disinvestment is encouraged to some extent by the high interest rate on loanable funds. When the rate is high, some portion of existing capital cannot produce the marginal revenue product to match this interest rate.” The firm may decide to let this capital dissipate and inject the depreciation into the restricted market.”
• After determining the factors affecting the supply of loanable funds, let us study the demand for loanable funds. Consumption demand for loanable funds depends on accumulation and investment of income. Organizations require loanable funds to a large extent to expand the stock of capital goods like machines and buildings.

2Disinvestment:

• The demand for loanable funds depends on the extent to which organizations require loanable funds. Interest is the price at which loanable funds can be purchased. Organizations require loadable funds at which the net rate of return on capital goods is equal to the interest rate.
• High rates of interest discourage organizations from purchasing capital goods or expanding their stock of capital goods. Therefore, the demand for loanable funds for organizations is interest elastic; Therefore, the demand curve will slope downwards.
• Another major component of the demand for loanable funds is the need of individuals (B) for consumption funds. Generally, individuals require loanable funds when they want to purchase something beyond their budget or consumer goods that they cannot afford with their current income. The lower the interest rate, the greater the demand for loanable goods. Therefore, the demand for loanable funds for individuals is interest elastic; Thus the demand curve slopes downwards.
• Along with organizations and individuals, there are also some people who require loanable items for the purpose of hoarding. Hoarding refers to individuals retaining some part of their income for future use. In hoarding, the supplier and buyer of loanable funds is the same person.

3Disinvestment:

• A person may want to keep money when interest rates are low. On the contrary, when interest rates are high he can use his money by investing in new projects. Therefore, the demand for loanable funds for the purpose of hoarding is interest elastic; Thus, the demand curve slopes downwards.

Figure-20 shows the interaction between the demand and supply curves of loanable funds to reach the equilibrium position:

• In Figure-20, DH represents the hoarding curve, BM represents the bank credit curve, S represents the saving curve, and DI represents the disinvestment curve. LS represents the supply of loanable funds, which is constructed by joining the DH, BM, S and DI curves. Similarly, H represents hoarding, C stands for consumption, and I stands for investment, which together form LD.
• In Figure-20, LD is the demand for loanable funds. The point at which the demand and supply curves of loanable funds intersect is called the equilibrium point (E). At point E, the interest rate on loanable funds is OR. Therefore, OR will be the equilibrium rate of interest in the credit market.

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