Marginal Productivity of Theory of Distribution

(i) Functional distribution means the distribution of income among the four factors of production.
(ii) The four factors of production are land, labour, capital and organisation.

Liquidity preference means the preference of the people to hold wealth in the form of liquid cash rather than in non-liquid assets like bonds, securities, gold, building.

(i) Profit is earned by the entrepreneur for his entrepreneurial function.
(ii) It is the amount left with the entrepreneur after he has paid for all the other factors.

(i) Interest is a payment made by a borrower to the lender for the money borrowed.
(ii) It is the price paid for the use of capital.

(i) Uncertainty theory was propounded by the American Economist Frank H. Knight.
(ii) According to him, profit is the reward for "uncertainty-bearing".
(iii) He distinguishes between "insurable" and "Non - insurable" risks.
Insurable Risks:
(i) Certain risks are measurable.
(ii) Hence they are insurable.
(iii) For Example: Risk of fire, theft etc.
Non - Insurable Risks:
(i) There are some risks which are immeasurable.
(ii) For Example Market condition, technology changes etc.
(iii) Hence they are non - insurable risks.

(a) Gross profit: Gross profit is the surplus which accrues to a firm when its total expenditure is subtracted from its total revenue.
(b) Net Profit:
(i) Net (or) pure (or) economic (or) true profit is the residual left with entrepreneur after deducting all expenses.
(ii) Net Profit = Gross Profit - Implicit cost
(c) Normal Profit: It refers to the minimum expected return to stay in business.
(d) Super Normal Profit: Super Normal Profits are over and above the normal profit.

(i) According to Hawley profit is the reward for risk taking in business.
(ii) Every business involves some risks. Since the entrepreneur undertakes the risks, he receives profit.
(iii) If the entrepreneur does not receive the reward, he will not be prepared to undertake the risks
(iv) Thus higher the risks, the greater are the profit.
(v) Every entrepreneur produces goods in anticipation of demand.
(vi) If his anticipation of demand is correct, then there will be profit.
(vii) It is the profit that induces the entrepreneur to undertake such risks.

(i) According to Schumpeter profit is the reward for innovation.
(ii) Innovation means invention put into commercial practice.
(iii) Innovation may consist of introduction of a new product or a new method of production or opening a new market or discovery of new raw materials or reorganisation of an industry.
(iv) The cost of production decreases and so profit increases.
(v) Innovation should be done continuously.

(i) According to Clark profit is the difference between price and cost of production.
(ii) Profit is the reward for dynamic changes in society-like increase in population, increase in volume of capital, improvement in methods of production, change in forms of industrial organisation and increase in wants of consumers.

The supply of loanable funds depends upon the following four sources.
(i) Savings (S)
(ii) Bank Credit (BC)
(iii) Dis hoarding (DH)
(iv) Disinvestment (DI)
(i) Savings (S):
1. Supply of loanable funds comes form savings.
2. Savings may be of two types.
They are
(i) "ex-ante savings" and
(ii) "ex-post savings".
(ii) Bank Credit (BC):
1. Commercial banks create credit and supply of loanable funds to the investors.
(iii) Dishoarding (DH):
1. Dishoarding means bringing out the hoarded money into use.
2. It constitutes a source of supply of loanable funds.
(iv) Disinvestment (DI):
1. Disinvestment is the opposite of investment.
2. Not providing sufficient funds for depreciation of equipment.
3. All the four sources of supply of loanable funds vary directly with the interest rate.

Introduction:
In his book "The general theory of employment, interest and money" in 1936, Keynes propounded the liquidity preference theory of Interest.
Theory:
Interest is the reward for parting with liquidity for a specified period of time.
Meaning:
Liquidity preference means the preference of people to hold wealth in the form of liquid cash and not in non-liquid assets like bonds, securities, bills of exchange, land, building, gold.
Motives:
Transaction motive:
It relates to the desire of the people to hold cash for the current transaction. M_t = f(y)
Precautionary motive:
It relates the desire of the people to hold cash to meet unexpected expenditures such as sickness, accidents, fire. M_P = f(y)
Both these motives depend on the income level.
Speculative motive:
It relates to the desire of people to hold cash in order to take advantage of market movements regarding the future changes in the price of bonds
There is inverse relation between liquidity preference and interest rate. M_s = f(i)
Determination of interest rate:

(i) The rate of interest is determined by the demand for and the supply of money.
(ii) The demand for money is liquidity preference for speculative motive.
(iii) The supply of money is determined by the policies of the government and the central bank.
(iv) The supply of money consists of coins, currency notes and bank deposits.
Equilibrium:
(i) In the short run supply of money is constant.
(ii) LP is liquidity preference curve M₂ M₂ is supply curve of money.
(iii) Both curves interest at E, which is the equilibrium point.
(iv) If LP increases from LP to L₁P₁ & money supply being constant, the interest rate increases from OI to OI₁. (fig a)
(v) Suppose LP is constant (fig b).
(vi) If supply of money is OM₂, the interest is OI₂ & if the supply of money is reduced from OM₂ to OM₃, the interest would increase from OI₂ to OI₃. If money supply increases, interest rate decreases.
Criticism:
(i) This theory does not explain the existence of different interest rates prevailing in the market at the same time.
(ii) It explains interest rate in the short-run.
Conclusion:
The Keynesian liquidity preference theory is an improvement over other theories.

Introduction:
The loanable funds theory also called Neo-classical theory was developed by Swedish economists Wicksell, Bertil Ohlin, Viner, Gunnar Myrdal and others.
Theory:
Interest is the price paid for the use of loanable funds.
Demand for loanable funds:
Investment:
Business firms borrow money for buying capital goods.
Consumption:
Individuals borrow money for consumption.
Hoarding:
People hoard money because of people's preference for liquidity, idle cash balance. The demand for C, I and H varies inversely with rate of interest.
Supply of loanable funds:
(i) Savings is of 2 types savings planned by individuals are called ex-ante savings. (eg) LIC premium, EMI payment.
(ii) Unplanned savings is ex-post savings. It is saving left out after spending.
(iii) Bank credit commercial banks create credit and supply loanable funds to investors.
(iv) Dishoarding means bringing out the hoarded money into use. After 1991, public sector undertakings are being sold to private to mobilize funds.
(v) Disinvestment means not providing sufficient funds for depreciation of equipment.
(vi) The supply of loanable funds of S, BC, DH, DI vary directly with interest rate.
Equilibrium:
The rate of interest is determined by the equilibrium between the total demand for and the total supply of loanable funds.
Diagram Explanation:

x axis demand for and supply of loanable funds.
y axis rate of interest.
LS curve- total supply of loanable funds.
(S + BC + DH + DI)
LD curve - total demand for loanable funds
(I + C + H)
LD & LS curves intersect at E. OR = rate of interest OM = amount of loanable funds.
Criticism:
(i) Asymmetric information & moral hazard have not been included.
(ii) Some large firms due to their political powers get huge bank credit at lower interest rate.
(iii) But due to non-performing assets (NPAs) small firms & depositors lose their interest income.
(iv) The loanable funds theory is indeterminate unless the income level is already known.
(v) It is difficult to combine real factors like savings & investment with monetary factors like bank credit & liquidity preference
Conclusion:
Loanable fund theory is wider in scope compared to classical theory.