Rewards to factors of production: rent, wages, interest and profit

1. The Basic Economic Problem

1.1 Scarcity and Unlimited Wants

• Resources – land, labour, capital and enterprise – are limited.
• Human wants are unlimited and constantly changing.
• Because of scarcity societies must decide how to allocate resources.

1.2 The Three Fundamental Economic Questions

• What goods and services should be produced?
• How should they be produced?
• For whom are they produced?

1.3 Opportunity Cost

• Definition – the value of the next best alternative that is fore‑gone when a choice is made.
• Examples:
  • A student studies economics instead of biology – the opportunity cost is the benefit they would have obtained from studying biology.
  • The government spends £1 billion on a new highway rather than on a hospital – the opportunity cost is the health benefits the hospital would have provided.

1.4 Production‑Possibility Curve (PPC)

• Shows the maximum combinations of two goods that an economy can produce with its current resources and technology.
• Key features:
  • Efficiency – points **on** the curve.
  • Inefficiency – points **inside** the curve (resources not fully utilised).
  • Unattainable – points **outside** the curve with current resources.
  • Economic growth – an outward shift of the curve when resources increase or technology improves.
  • Opportunity cost – the slope of the curve; moving along the curve shows the trade‑off between the two goods.

2. Allocation of Resources

2.1 Demand and Supply

2.1.1 Demand

• Law of demand – ceteris paribus, a higher price leads to a lower quantity demanded.
• Demand curve slopes downwards (price on the vertical axis, quantity on the horizontal).
• Determinants of demand (shifts of the curve):
  • Income (normal vs. inferior goods)
  • Prices of related goods (substitutes and complements)
  • Tastes and preferences
  • Expectations of future prices or income
  • Number of buyers

2.1.2 Supply

• Law of supply – ceteris paribus, a higher price encourages a larger quantity supplied.
• Supply curve slopes upwards.
• Determinants of supply (shifts of the curve):
  • Input prices (labour, capital, raw materials)
  • Technology (more efficient production shifts supply right)
  • Expectations of future prices
  • Number of sellers
  • Taxes, subsidies and regulation

2.1.3 Market Equilibrium

• Equilibrium price (or wage, rent, interest) is where quantity demanded equals quantity supplied.
• At equilibrium there is no tendency for the price to change unless the curves shift.

2.2 Price Elasticity

2.2.1 Price Elasticity of Demand (PED)

• Formula: PED = (% change in quantity demanded) ÷ (% change in price)
• Interpretation:
  • Elastic (|PED| > 1) – quantity responds strongly to price changes.
  • Inelastic (|PED| < 1) – quantity responds weakly.
  • Unit‑elastic (|PED| = 1).
• Determinants of PED:
  • Availability of close substitutes
  • Proportion of income spent on the good
  • Time‑period considered
  • Nature of the good (luxury vs. necessity)

2.2.2 Price Elasticity of Supply (PES)

• Formula: PES = (% change in quantity supplied) ÷ (% change in price)
• Interpretation follows the same three categories as PED.
• Determinants of PES:
  • Availability of spare capacity
  • Flexibility of inputs (e.g., ability to hire extra labour quickly)
  • Time‑period (short‑run supply is usually less elastic than long‑run supply)
  • Mobility of factors of production

2.3 Market Systems

System	Key Features	Typical Advantages	Typical Disadvantages
Market (Free‑market) economy	Decisions made by households & firms through price mechanism; minimal government interference.	Efficient allocation, encourages innovation.	May under‑provide public goods; can lead to inequality.
Mixed economy	Market system combined with government intervention to correct market failure, provide public goods and achieve redistribution.	Balances efficiency with equity; can address externalities.	Risk of excessive bureaucracy; possible distortion of price signals.
Command economy	Central authority decides what, how and for whom to produce.	Can mobilise resources quickly for large projects.	Often inefficient; lacks consumer choice; prone to shortages.

2.3.1 Government Tools in a Mixed Economy (required by the syllabus)

• Price controls – ceilings (e.g., rent control) and floors (e.g., minimum wage).
• Taxes – to discourage demerit goods or to raise revenue.
• Subsidies – to encourage merit goods or positive externalities.
• Regulation – health & safety standards, environmental limits.
• Public provision – schools, hospitals, defence.
• Nationalisation & privatisation – transfer of ownership between state and private sector.
• Quotas – limits on imports/exports to protect domestic industries.

2.4 Market Failure

• Public goods – non‑rival and non‑excludable (e.g., street lighting). Markets under‑provide them.
• Merit goods – socially desirable goods that individuals may undervalue (e.g., education). Often subsidised.
• Demerit goods – socially undesirable goods (e.g., cigarettes). Usually taxed or regulated.
• Externalities
  • Positive – benefit to third parties (e.g., vaccination).
  • Negative – cost to third parties (e.g., pollution).
• Information failure – buyers or sellers lack sufficient information (e.g., hidden defects).
• Monopoly
  • Definition – a single firm supplies the whole market and can set price above marginal cost.
  • Diagram (suggested): Demand (D), marginal cost (MC), and marginal revenue (MR) curves. Profit‑maximising output where MR = MC; price taken from the demand curve; the area between price and MC up to the output level shows dead‑weight loss.
  • Government intervention – price regulation, antitrust legislation, public ownership, or imposing a tax equal to the monopoly’s marginal profit.

3. Micro‑economic Decision‑Makers

3.1 Money and Banking

3.1.1 Functions of Money

• Medium of exchange
• Unit of account
• Store of value
• Standard of deferred payment

3.1.2 Characteristics of Money (Cambridge requirement)

• Durability
• Portability
• Divisibility
• Uniformity
• Acceptability
• Limited supply (scarcity)

3.1.3 The Banking System

• Central bank (e.g., Bank of England) – issues currency, controls the money supply, sets the base interest rate, acts as lender of last resort.
• Commercial banks – accept deposits, provide loans, create money through the multiplier effect.
• Money supply and interest‑rate policy – when the central bank lowers the base rate, borrowing becomes cheaper, encouraging consumption and investment; raising the rate has the opposite effect.

3.2 Households

• Decide how much to consume, save and borrow.
• Key influences:
  • Disposable income
  • Interest rates (cost of borrowing, reward for saving)
  • Consumer confidence
  • Expectations of future income or prices
  • Age, culture and lifestyle
• Household expenditure is a major component of aggregate demand.

3.3 Workers (Labour Market)

• Demand for labour – derived from the marginal productivity of labour; firms hire up to the point where wage = marginal revenue product.
• Supply of labour – depends on population size, alternative employment opportunities, working conditions and wage rates.
• Factors influencing wage levels:
  • Skill, education and experience
  • Demand for the specific type of labour
  • Trade‑union activity and collective bargaining power
  • National Minimum Wage (NMW) legislation

3.4 Firms

• Objectives – profit maximisation is primary; secondary objectives may include growth, market share and corporate social responsibility.
• Cost concepts (required by the syllabus)

  Cost	Definition
  Fixed Cost (FC)	Does not vary with output (e.g., rent).
  Variable Cost (VC)	Varies directly with output (e.g., raw materials).
  Total Cost (TC)	TC = FC + VC.
  Average Fixed Cost (AFC)	AFC = FC ÷ Q.
  Average Variable Cost (AVC)	AVC = VC ÷ Q.
  Average Total Cost (ATC)	ATC = TC ÷ Q = AFC + AVC.
  Marginal Cost (MC)	MC = ΔTC ÷ ΔQ (the cost of producing one extra unit).

• Revenue concepts
  • Total Revenue (TR) = Price × Quantity.
  • Average Revenue (AR) = TR ÷ Q (equals price in perfect competition).
  • Marginal Revenue (MR) = ΔTR ÷ ΔQ.
• Profit – π = TR − TC.
• Cost curves diagram (suggested) – ATC, AVC and MC plotted against output; MC cuts AVC and ATC at their minimum points, illustrating economies and diseconomies of scale.

3.4.1 Market Types (short overview)

• Perfect competition – many sellers, identical products, price‑taker, free entry and exit.
• Monopolistic competition – many sellers, differentiated products, some price‑setting power.
• Oligopoly – few large firms, inter‑dependent decisions, possible collusion.
• Monopoly – single seller, price‑setter, high barriers to entry (see Section 2.4).

4. Rewards to the Factors of Production

Factor of Production	Reward	Source of Reward	Typical Example
Land (natural resources)	Rent	Payment for the use of land or natural resources.	Farmer pays rent to lease a field.
Labour	Wages (or salaries)	Payment for time, effort and skill supplied by workers.	Hourly wage paid to a factory operative.
Capital (machinery, equipment, money)	Interest	Payment for the use of borrowed funds or capital equipment.	Interest on a loan taken to purchase a delivery van.
Enterprise (entrepreneurship)	Profit	Residual income after all other factor costs have been paid.	Net earnings of a small‑business owner.

4.1 Rent

• Earned by owners of land and natural resources.
• Reflects the scarcity of the resource and its opportunity cost.
• In a competitive factor market, rent tends toward the marginal productivity of the land.

4.2 Wages

• Compensate labour for time, effort and skill.
• Determined by:
  • Skill level, education and experience
  • Demand for that type of labour
  • Trade‑union bargaining power
  • National Minimum Wage legislation

4.3 Interest

• Price paid for the use of capital (money or physical assets).
• Two functions:
  1. Compensates the lender for postponing consumption.
  2. Provides a return that reflects the risk of the loan.

4.4 Profit

Reward to entrepreneurs for organising production, taking risks and innovating.

Formula: π = TR − TC where π = profit, TR = total revenue and TC = total cost.

• Positive profit signals efficient use of resources.
• Losses may indicate over‑capacity, poor management or an unfavourable market environment.
• In the long run, firms in perfect competition earn only normal profit (zero economic profit).

5. Interaction of Factor Markets

• Factor markets (labour, land, capital, enterprise) operate like product markets – price is set by the interaction of supply and demand.
• Supply of a factor = the amount owners are willing to sell at each price (e.g., workers willing to work at different wage rates).
• Demand for a factor = the amount firms are willing to purchase at each price (e.g., firms’ demand for labour depends on the marginal productivity of workers).
• Changes that shift the curves:
  • Technological progress – raises marginal productivity, shifting factor demand right.
  • Population growth or education – shifts labour supply right.
  • Government policies – taxes, subsidies, minimum‑wage laws, land‑use regulations.
• Resulting shifts alter the rewards earned by each factor (rent, wages, interest, profit).