Neo Classical Approach to Investment PDF

UNIT – V DISTRIBUTION THEORIES 5.1. NEO CLASSICAL APPROACH The modern approach to business investment is based on Dale Jorgenson’s approach known as the neo-classical theory of investment. Jorgenson’s theory provides the micro- foundation of the aggregate investment functio...

UNIT – V DISTRIBUTION THEORIES 5.1. NEO CLASSICAL APPROACH The modern approach to business investment is based on Dale Jorgenson’s approach known as the neo-classical theory of investment. Jorgenson’s theory provides the micro- foundation of the aggregate investment function. For analytical convenience, we classify an economy’s firms into two broad categories, viz., (i) production firms that produce goods and services using capital owned by other firms by paying lease rental and (ii) rental firms, which buy capital and lease (rent) it to the producing units. The Rental Price of Capital: The focus of attention in Jorgenson’s theory is on the typical production firm. The firm, operating in a pure competitive model, is guided by the neo-classical marginalist rule of profit maximisation. The key concept in the neo-classical theory is the rental price of capital. A profit-seeking firm compares the cost and benefit of each unit of capital while taking decision on how much of capital to lease in by paying a fixed rental per period. Let us, for instance, take the case of a construction company which has got the contract to construct a multi- storeyed building within a year’s time. It requires an earth- moving equipment for three months. There is no point in buying this machine at a high cost. It gains by hiring this machine from another company (the rental firm) by paying a lease rental. The rental price of capital is the periodic payment that has to be made by the construction company to the leasing firm (which specialises in leasing out the machine) for a certain period to hire the earthmoving equipment. The construction company obtains the equipment by paying a rental of R per period and it sells its output at a price of P. So the real cost of a unit of capital to the production firm is R/P. The real benefit of a unit of capital to a producing firm is its marginal product. The marginal product of capital (MPK) is the addition made to the total product of the firm by one extra unit of real capital. So long as the MPK exceeds the rental price of capital, a firm makes extra profit by hiring and using an extra unit of capital. However, as more and more capital is used, MPK falls and a production firm maximises profit by 163  Fig.5.1 Equilibrium in the rental market for capital equating MPK with the real rental price. In other words, a profit-maximising firm takes capital on lease rental basis until the MPK falls to equal the real rental price. Fig. 5.1 shows the equilibrium in the rental market for capital. The demand curve of capital is the MPK curve. It slopes downward from left to right because as more and more units of capital are used, MPK falls. In other words, MPK is low when the level of capital is high. The aggregate supply of real capital remains fixed in the short run. So the supply curve of capital (indicating the amount of capital available in the economy per period) is a vertical straight line. The real rental price of capital is (R/P)0. This is indeed the equilibrium rental price because it is the rate which brings the demand for capital (as determined by MPK) in line with the fixed supply. The Cost of Capital and its Determinants: The benefit of the rental firm from owning capital is the revenue it gets from renting it to the production firms. It receives the real rental price of capital (R/P) for each unit of capital it owns and rents out. There are three types of costs of owning and renting out a unit of capital: 1. Interest on loan: When a rental firm borrows funds to buy a unit of capital for the purpose of renting it out, it has to pay interest on the loan. The interest cost is iPK where i is the nominal interest rate and PK is the purchase price of a unit of capital. 2. Capital loss: It is quite possible for the price of capital (the firm is renting out) to fall, in which case the rental firm loses. The reason is that the market value of the firm’s capital usually falls. The cost of this loss is -ΔPK. 3. Depreciation: 164 The rate of depreciation of capital is another component of the cost of owning and renting out real capital. The rate of depreciation (d) is measured by the proportion of value of the capital lost per period due to wear and tear, i.e., dPK. So the total cost of renting out a unit of capital for one period is thus: Cost of capital = iPK – ΔPK + dPK = PK(i – ΔPK/PK + d) … (1) So there are four determinants of cost of capital, viz., PK, i, the rate at which PK is changing and d. We put a negative sign before ΔPK/PK because PK is assumed to be falling. If we make the assumption that the price of capital goods rises with the prices of other goods, as is the case during inflation, then (ΔPk/Pk) is interpreted as the overall rate of inflation (π). Since the real rate of interest (r) is the nominal rate of interest (i) less the rate of inflation (π), the cost of capital (CK) is CK = PK(i – π + d) = PK(r + d) … (2) So there are three determinants of the cost of capital, viz., PK, r and d. The real cost of capital (Cr) is expressed as Cr = (PK/P) (r + d) … (3) where P is the overall price index. It is the weighted average of all prices. Equation (3) expresses the cost of capital relative to the prices of other goods in the economy. The real cost of capital is the cost of acquiring and leasing out a unit of capital measured in units of real GDP and has three determinants — PK/P, the relative price of capital goods, r and d. The Determinants of Investment: Since all economic decisions are taken at the margin, a rental firm, whose objective is profit maximisation, has to take decisions regarding whether to increase or decrease its capital stock on the basis of its own benefit-cost calculations. By renting out each unit of capital, the firm earns revenue (R/P) and incurs the real cost (PK/P) (r + d). So its real profit per unit of capital or the rate of profit is p = (R/P) – (PK/P) (r + d) … (4) Rate of profit = Real revenue from capital – real cost of capital. Since the real rental price of capital equals the MPK, in equilibrium, the rate of profit may be expressed as: 165 p = MPK – (PK/P) (r + d) … (5) The rental firm makes a profit (i.e., p > 0) if MPK exceeds the real cost of capital. The converse is also true. Net investment refers to the absolute change in the capital stock of a firm (I = ΔK = Kt – Kt-1,). Equation (5) suggests that investment decision of the rental firm, i.e., decision regarding whether to add to its capital stock or allow it to wear out completely depends on whether owning and leasing out capital is a profitable proposition. So long as MPK exceeds (PK/P) (r + d), the rental firm finds it profitable to make net investment, i.e., add to its existing stock of capital. The converse is also true. If MPK is less than (PK/P) (r + d) the firm will not care about even its existing stock of capital and just allow it to depreciate and shrink. The Investment Function: What is true of a firm which owns and rents out capital is equally true of a firm which both uses and owns capital. So we can write ΔK = In[MPK – (PK/P) (r + d)] … (6) Where In depends on or is a function of the difference between the MPK and the real cost of capital (Cr). This difference shows how much net investment responds to the incentive to invest. There is an incentive to invest if MPK > (PK/P) (r + d). The investment function is I = In[MPK – (PK/P) (r + d)] + dK … (7) Where I is gross investment which is equal to net investment ln plus depreciation dK. Thus total spending on business fixed investment depends on MPK, the real cost of capital and the amount of depreciation (i.e., the rate of depreciation times the amount of capital). Shift of the Investment Schedule: Any favourable development in the economy which raises the MPK increases the profitability of investment and causes the investment schedule I of Fig. 18.3(b) to shift to the right to I’. This means that more investment takes place at the same real rate of interest. 166 For example, a favourable technological change which raises the MPK increases the amount of capital goods that lease-renting firms desire to buy at the same real rate of interest. Inter temporal Adjustment of Capital Stock: If MPK is initially above the real cost of capital, the capital stock will rise and the MPK will fall. If MPK is initially below the real cost of capital, the capital stock will fall and MPK will rise. So, ultimately, as the economy’s capital stock adjusts, the MPK approaches the real cost of capital and the steady-state level of capital is expressed as: MPK = (PK/P) (r + d) Since in such a situation total profit from capital is maximum (constant) and marginal profit is zero, no addition is made to society’s stock of capital, i.e., ΔK = I = 0 Because MPK – (PK/P) (r + d) = 0. So there is no incentive to make further investment in fixed capital. Thus in the long run when the adjustment of capital stock continues over time MPK equals the real cost of capital. The speed of adjustment toward the steady state depends on the speed with which firms adjust their capital stock. This, in its turn, depends on the cost of building, delivering and installing new capital. 5.2. MARGINAL PRODUCTIVITY THEORY The oldest and most significant theory of factor pricing is the marginal productivity theory. It is also known as Micro Theory of Factor Pricing. It was propounded by the German economist T.H. Von Thunen. But later on many economists like Karl Mcnger, Walras, Wickstcad, Edgeworth and Clark etc. contributed for the development of this theory. According to this theory, remuneration of cache factor of production tends to be equal to its marginal productivity. Marginal productivity is the addition that the use of one extra unit of the factor makes to the total production. So long as the marginal cost of a factor is less than the marginal productivity, the entrepreneur will go on employing more and more units of the factors. He will stop giving further employment as soon as the marginal productivity of the factor is equal to the marginal cost of the factors. 167 Definitions: “The distribution of income of society is controlled by a natural law, if it worked without friction, would give to every agent of production the amount of wealth which that agent creates.” -J.B. Clark “The marginal productivity theory contends that in equilibrium each productive agent will be rewarded in accordance with its marginal productivity.” -Mark Blaug Assumptions of the Theory: The main assumptions of the theory are as under: 1. Perfect Competition: The marginal productivity theory rests upon the fundamental assumption of perfect competition. This is because it cannot take into account unequal bargaining power between the buyers and the sellers. 2. Homogeneous Factors: This theory assumes that units of a factor of production are homogeneous. This implies that different units of factor of production have the same efficiency. Thus, the productivity of all workers offering the particular type of labour is the same. 3. Rational Behaviour: The theory assumes that every producer desires to reap maximum profits. This is because the organizer is a rational person and he so combines the different factors of production in such a way that marginal productivity from a unit of money is the same in the case of every factor of production. 4. Perfect Substitutability: The theory is also based upon the assumption of perfect substitution not only between the different units of the same factor but also between the different units of various factors of production. 5. Perfect Mobility: The theory assumes that both labour and capital are perfectly mobile between industries and localities. In the absence of this assumption the factor rewards could never tend to be equal as between different regions or employments. 6. Interchangeability: 168 It implies that all units of a factor are equally efficient and interchangeable. This is because different units of a factor of production are homogeneous, since they are of the same efficiency, they can be employed inter- changeable, and e.g., whether we employ the fourth man or the fifth man, his productivity shall be the same. 7. Perfect Adaptability: The theory takes for granted that various factors of production are perfectly adaptable as between different occupations. 8. Knowledge about Marginal Productivity: Both producers and owners of factors of production have means of knowing the value of factor’s marginal product. 9. Full Employment: It is assumed that various factors of production are fully employed with the exception of those who seek a wage above the value of their marginal product. 10. Law of Variable Proportions: The law of variable proportions is applicable in the economy. 11. The Amount of Factors of Production should be Capable of being varied: It is assumed that the quantity of factors of production can be varied i.e. their units can either be increased or decreased. Then the remuneration of a factor becomes equal to its marginal productivity. 12. The Law of Diminishing Marginal Returns: It means that as units of a factor of production are increased the marginal productivity goes on diminishing. 13. Long-Run Analysis: Marginal productivity theory of distribution seeks to explain determination of a factor’s remuneration only in the long period. Explanation of the Theory: The marginal productivity theory states that under perfect competition, price of each factor of production will be equal to its marginal productivity. The price of the factor is determined by the industry. The firm will employ that number of a given factor at which price is equal to its marginal 169 productivity. Thus, for industry, it is a theory of factor pricing while for a firm it is a factor demand theory. Analysis of Marginal Productivity Theory from the Point of View of an Industry: Under the conditions of perfect competition, price of each factor of production is determined by the equality of demand and supply. As the theory assumes that there exists full employment in the economy, therefore, supply of the factor is assumed to be constant. So, factor price is determined by its demand which itself is determined by the marginal productivity. Thus, under such conditions, it becomes essential to throw light on the demand curve or marginal productivity curve of an industry. As the industry consists of a group of many firms, accordingly, its demand curve can be drawn with the demand curves of all the firms in the industry. Moreover, marginal revenue productivity of a factor constitutes its demand curve. It is only due to this reason that a firm’s demand or labour depends on its marginal revenue productivity. A firm will employ that number of labourers at which their marginal revenue productivity is equal to the prevailing wage rate. Fig. 2 shows that at wage rate OP 1, the demand for labour is ON 1 and marginal revenue productivity curve is MRP 1. If wage rate falls to OP, firms will increase production by demanding more labour. In such a situation the price of the commodity will fall and marginal revenue productivity curve will also shift to MRP 2. At OP wages, the demand for labour will increase to ON. DD 1 is the firm’s demand curve for labour. The summation of demand of all the firms shows demand curve of an industry. Since the number of firms is not constant under perfectly competitive market, it is not possible to estimate the 170 summation of demand curves of all firms. However, one thing is certain that is the demand curve of industry also slopes downward from left to right. The point where demand for and supply of a factor are equal will determine the factor price for the industry. This theory assumes the supply of a factor to be fixed. Thus factor price is determined by the demand for factor i.e. factor price will be equal to the marginal revenue productivity. It has been shown by Fig. 3. In the Fig. 3, number of labour has been taken on OX axis whereas wages and MRP have been taken on OY axis. DD 1 is the industry’s demand curve for labour. This is also the Marginal Revenue Productivity curve. Factor Price (OW) = Marginal Revenue Productivity MRP. Thus under perfect competition, factor price is determined by the industry and firm demands units of a factor at this price. 171 Analysis of Marginal Productivity Theory from the Point of View of Firm: Under perfect competition, number of firms is very large. No single firm can influence the market price of a factor of production. Every firm acts as a price taker and not a price maker. Therefore, it has to accept the prevailing price. No employer would like to pay more than what others are paying. In other words, a firm will employ that number of a factor at which its price is equal to the value of marginal productivity. Therefore, from the point of view of a firm, the theory indicates how many units of a factor it should demand. It is due to this reason that it is also called Theory of Factor Demand. Other things remaining the same, as more and more labourers are employed by a firm, its marginal physical productivity goes or- diminishing. As price under perfect competition remains constant, so when marginal physical productivity of labour goes on diminishing, marginal revenue productivity will also go on diminishing. Therefore, in order to get the equilibrium position, a firm will employ labourers up to a point where their respective marginal revenue productivity is equal to their wage rate. Table 2 indicates that wage rate of labour is Rs. 55 per labourers. Price of the product produced by the labourer is Rs. 5 per unit. Now, when a firm employs one labourer, his marginal physical productivity is 20 units. By multiplying the MPP with price of the product we get marginal revenue productivity. Here, it is Rs. 100 for the first labour. The marginal revenue productivity of second labourer is Rs. 85 and of third labourer it is Rs. 70. The marginal revenue productivity of fourth labourer is Rs. 55 which is equal to wage rate. The firm will earn maximum profits if it employs up to the fourth labourer. If the firm employs fifth labourer, it will have to suffer 172 losses of Rs. 15. Therefore, to get maximum profits, a firm will employ a factor upto a point where MRP is equal to price. In Fig. 4 number of labourers has been measured on OX-axis and wage rate on Y-axis. MRP is marginal revenue productivity curve and WW is the wage rate prevailing in the market. Since, under perfect competition wage rate will remain constant that is why WW wage line is parallel to OX-axis. MRP curve is sloping down-ward. It cuts WW at point E which is the equilibrium wage rate of Rs. 55. At point E, firm will demand only four labourers. Thus, from the above, we can conclude that a factor is demanded up to the limit where its marginal productivity is equal to prevailing price. Under perfect competition, in long period in the equilibrium position, not only the marginal wages of a firm are equal to marginal revenue productivity, even the average wages of the firm are equal to average net revenue productivity as has been shown in Fig. 5. The fig. 5 shows that at point ‘E’ marginal wages of labour are equal to marginal revenue productivity and the firm employs OM number of workers. At this point, even the average net revenue productivity is equal to average wages. Thus firm earns only normal profit. If wage line shifts from NN to N[N] then the demand for labour increases from OM to OM 1. Determination of Factor Pricing under Imperfect Competition: Marginal productivity theory applies to the condition of perfect competition. But in real life we face imperfect competition. Therefore, economists like Robinson, Chamberlin have analyzed factor pricing under 173 imperfect competition. There are various firms under imperfect competition. But here we shall analyze only Monopsony. Under monopsony, there is perfect competition in product market. Consequently MRP is equal to VMP. There is imperfect competition in factor market. It indicates that there is only one buyer of the factors. Therefore, monopsony refers to a situation of market where only a single firm provides employment to the factors. If the firm demands more factors, factor price will go up and vice-versa. However, the determination of factor price under monopsony can be explained with the help of Fig. 6. In Fig. 6 number of labourers has been shown on X-axis and wages on Y- axis. MW is marginal wage curve and ARP is the average wage curve. MRP is the marginal revenue productivity curve and AW is the average revenue productivity curve. In the fig. 6 a monopsony will employ that number of labourers at which their marginal wage is equal to MRP. In the fig. 6 firm is in equilibrium at point E. Here, firm will employ ON labourers and they will be paid wages equal to NF. In this way, ON labourers will get less wages than their MRP i.e. EN. Monopsony firm will have EF profit per labourer which arises due to exploitation of labourers. Total profit SFWW’ is due to exploitation of labour. 5.3. PRODUCT EXHAUSTION THEOREM The product exhaustion theorem states that since factors of production are rewarded equal to their marginal product, they will exhaust the total product. 174 The way this proposition is solved has been called the adding-up problem Wick-steed in the Coordination of the Laws of Distribution demonstrated with the help of Euler’s Theorem (developed by Leonhard Euler, a Swiss mathematician of the eighteenth century) that payment in accordance with marginal productivity to each factor exactly exhausts the total product. The adding-up problem states that in a competitive factor market when every factor employed in the production process is paid a price equal to the value of its marginal product, then payments to the factors exhaust the total value of the product. It can be shown numerically as under: Q = (MPL) L + (MPc) C where Q is total output, MP is marginal product, L is labour and K is capital. To find out the value of output, multiply through P (price). Thus PxQ = (MPL x P) L + (MPC x P) С (MPL x p) — VMP, and (MPc x P) = VMPC PO = VMPL x VMPC Where VMP, is the value of marginal product of labour and VMPc is the value of marginal product of capital. Importance of Product Exhaustion Theorem: Euler’s theorem plays an important role in the theory of distribution. The total product is produced by combining different factors of production. The question that arises is how the total output should be distributed among the factors of production? If the production function is homogeneous of degree one, then Eular’s theorem can solve this question. It provides the solution to the producer’s long-run problem of allocation of total product to each factor and the distribution of the total outlay among the different inputs. The theorem also suggests how a firm should employ the various inputs. It tells us that the firm should employ its inputs to that extent at which the reward to the factor equals its marginal revenue product. However, Prof. Watson questions the existence of constant returns to scale in the economy. According to him, “The rejoinder here is that in the long-run competitive equilibrium price equals minimum average cost, the firm’s cost 175 curve at that point being horizontal. The momentary constancy of unit cost corresponds to a momentary constancy of returns to scale at the point of equilibrium.” 5.4. MODERN THEORY OF DISTRIBUTION The marginal productivity theory, only tells us how many workers an employer will engage at a given wage-level in order to maximise his profit. It does not tell us how that wage-level is determined. The marginal productivity theory approaches the problem of the determination of the reward of a factor of production from the side of demand only. It ignores the supply side. Hence, the marginal productivity theory is not in adequate explanation of the determination of the factor prices. The modern theory of factor pricing which provides satisfactory explanation of factor prices is the Demand and Supply Theory. Just as the price of a commodity is determined by the demand for, and supply of, a commodity, similarly the price of a productive service also is determined by demand for, and supply of, that particular factor. Demand for a Factor: Let us first consider the demand side. In the first place, we should remember that the demand for a factor of production is not a direct demand if is an indirect or derived demand. It is derived from the demand for the produce… that the factor produces. For instance, labour does not satisfy our wants directly. We want labour for the sake of the goods that it produces. It follows, therefore, that if the demand for goods increases, the demand for the factors which help to produce these goods will also increase. Also, if the demand for goods is elastic or inelastic, the demand for the factors too will be elastic or inelastic. The demand for a factor of production will also depend on the quantity of the other factors required in the process. Generally speaking, the demand price for a given quantity of a factor of production will be higher, the greater the quantities of the co-operating productive services. If more of a factor of production is employed, the marginal productivity of the factor will fall, and 176  Fig.5.2 the lower will be the demand price for the unit of a productive service. This is another rule connected with the demand for a factor of production. The demand price of a factor of production also depends on the value of the finished product in the production of which the factor is used. The demand price will generally be greater; the more valuable is the finished product in which the factor is used. Also, the more productive the factor, he higher will be the demand price of a given quantity of the factor. These are a few points connected with the demand for a productive service. We know that the demand curve of the industry is the sum-total of the demand curves of the various firms in the industry. By a similar summing up, we can have the demand curve of all the industries using a particular productive service. The demand of the employer for a factor depends on its marginal revenue productivity (in short, marginal productivity), and the quantity of the factor that a firm will employ will depend on the prevailing wage-level. That is more labour will be employed if wages are low and less if wages are high. Figure 5.2 (a) illustrates the position of a firm regarding the employment of a factor, say, labour. When the wage is OW, the firm is in equilibrium at the point E and the demand for the factor is ON; similarly, at OW’ wage, the demand is ON’, and at OW” the demand is ON”. MRP (marginal revenue productivity) curve is the demand curve for a factor of production by an individual firm. But for determining the price of a factor, it is not the demand of the individual firm for it that matters. What matters is the total demand, i.e., the sum-total 177 of the demands of all firms in the industry. The total demand curve is derived by the lateral summation of the marginal revenue productivity curves of all the firms. This curve DD is shown in the Fig. 5.2(b). It can be seen that Y-axes in both curves are drawn to the same scale, but X- axes are drawn on different scales. We have supposed that there are 100 firms in the industry. At OW wage, the demand of the individual firm is ON, but the demand of the whole industry at the same wages is OM, which is equal to 100 ON (because the number of firms in the industry is 100). In the same manner, at OW’ the demand of the firm is ON’ but of the entire industry OM’, which is equal to 100 ON’, and at OW”, the demand of the firm is ON” and that of the industry OM”, which is equal to 100 ON”. It can be seen that the demand curve DD slopes downward to the right. The reason is that MRP curve, whose summation is represented by DD, also slopes down similarly to the right in the relevant portion. This means that according to the law of diminishing marginal productivity, the more a factor is employed the lower is the marginal productivity. This is all about the demand side. Supply Side: As for the supply side, the supply curve of a factor depends on the various conditions of its supply. Take the case of labour—a very important productive service. The supply of labour will depend on the size and composition of population, its occupational and geographical distribution, labour efficiency, cost of education and training, cost of movement, the expected income, relative preference for work and leisure, and so on. In this manner, by considering all the relevant factors, it is possible to construct the supply curve of a productive service. At the same time, we must note that the supply is a bit of complicated thing. We generally say that the supply of land is limited. But the fact is that, although for the whole community land is limited, for a particular firm or an industry, its supply is not limited. The supply can be increased if higher rent is offered. In the case of commodities, we see that generally an increase in price brings forth larger supplies. This, however, does not necessarily hold well in the case of the factors of production. It may happen in some cases that, if wags go up, 178  Fig.5.3. labour may be able to satisfy its needs by working for less time than before. They may prefer leisure to work. In this case, when the price of factor (or its remuneration) is increased, the supply is reduced. This peculiarity will be represented by a backward sloping curve after a stage. Also, the supply of labour does not merely depend on economic factors; many non-economic considerations also enter. All the same, we can say that, if the price of a factor increases, its supply will also generally increase, and vice versa. Hence, the supply curve of a factor rises from left to right upwards. This is shown in Fig. 5.3. Interaction of Demand and Supply: Now we have worked our way to the demand curve and the supply curve of a factor of production. Both these curves are needed for the determination of the price of a productive service. That price will tend to prevail in the factor market at which the demand and supply are in equilibrium. This equilibrium is at the point of intersection of the demand and supply curves. In Fig. 5.3, they intersect at the point R, and the price of the factor will be OW. At OW’ demand W’M’ is less than the supply W’L’. In this case, competition among the sellers of the service will tend to bring down the price to OW. On the other hand, at OW” price, the demand W”L” is greater than the supply W”M”; hence price will tend to go up to OW at which the demand and supply will be equal. This is how the price of a factor of production in the factor market is determined by the interaction of the forces of demand and supply relating to 179 that factor of production. This is the correct and satisfactory theory of distribution. 5.5. FACTOR PRICING IN IMPERFECT PRODUCT AND FACTOR MARKETS The price of a factor of production is determined when there prevails perfect competition both in the product and factor markets. Before the theories of imperfect competition and monopolistic competition were introduced in economic theory no distinction was made between value of marginal product (VMP) and marginal revenue product (MRP). That when there is imperfect competition (i.e. monopoly, oligopoly or monopolistic competition) in the product market, marginal revenue differs from the price of the product. As a result, under conditions of imperfect competition in the product market, marginal revenue product (MRP) of the factor differs from value of the marginal product (VMP). This affects the demand for a factor and the price it will get under conditions of imperfect competition Determination of Factor Price when there exists Monopoly (or Imperfect Competition in the Product Market but Perfect Competition in the Factor Market or monopoly in the product. Determination of Factor Price when there is Imperfect Competition (or Monopoly) in the Product Market and Perfect Competition in Factor Market: The determination of prices and employment of factors under imperfect competition in the product and factor markets in general. We will explain below the employment of a factor by a firm and the price it will pay to a factor when the firm is working under conditions of imperfect competition or monopoly in the product market. However we assume in this section that as far as factor market is concerned perfect competition prevails in it. Since perfect competition is assumed to be prevailing in the factor market, price of the factor will be determined by demand for and supply of the factor of production, as explained above. But now the demand for the factor of production is determined not by the value of the marginal product (VMP) but by the marginal revenue product (MRP) of the factor. 180 As we will see below, in this case price of the factor, which is determined by demand for and supply of the factor, will be equal to the marginal revenue product, but will be less than the value of the marginal product (VMP) of the factor. The conditions of firm’s equilibrium in factor market developed above will also apply in the present case. The firm working under perfect competition in factor market but monopoly or imperfect competition in the product market would also be in equilibrium position where MRP = MFC, and MRP curve cuts MFC curve from above. But there are some differences between this case and the case explained above. Since in this case, as in the previous, the firm is working under perfect competition in the factor market it will not be able to affect the price of the factor and factor-cost line will be a horizontal straight line. Therefore, the firm will be in equilibrium, that is, will be maximising profits when MRP = MFC = Price of the factor. But because the firm in the present case is working under conditions of monopoly or imperfect competition in the product market, it will be able to exercise some influence or control over the price of the product. AR curve for it will slope downward and MR curve will be below it. Consequently, MRP which is equal to MPP x MR will not be equal to VMP which is equal to MPP x price of the product. Since MR is less than the price of the product under monopoly or imperfect competition, MRP would be less than VMP. In symbolic terms: MRP = MPP x MR VMP = MPP x Price of the product Since, under imperfect competition or monopoly in the product market, MR < Price of the product. Therefore MRP < VMP In equilibrium in the factor market, the firm will make PF =MRP Therefore, PF = MRP < VMP It is, therefore, concluded that under conditions of monopoly or imperfect competition in the product market, assuming perfect competition in the factor market, the factor will get price less than the value of its marginal product. 181 The equilibrium of the firm when it is working under conditions of perfect competition in the factor market and monopoly or imperfect competition in the product market is shown in Figure. Since VMP is greater than MRP when there is imperfect competition in the product market, VMP curve will be above MRP curve (for the sake of convenience, we have drawn only the downward- sloping portions of MRP and VMP curves). The firm will be in equilibrium at E, where MRP = P. The equilibrium employment of the factor is ON. It will be noticed from the figure that the price of the factor OP is, in equilibrium, equal to marginal revenue product EN but is less than its value of marginal product which is equal to RN. Therefore, factor gets RE less than the value of its marginal product. Meaning of Factor Exploitation: It follows from above that price of a factor will be less than the value of the marginal product of the factor under conditions of monopoly and imperfect competition in the product market. According to Joan Robinson a factor is exploited when it is paid less than the value of its marginal product (VMP). Therefore, according to Joan Robinson, when imperfect competition prevails in the product market, labour and other factors, (i.e., factors other than the entrepreneur) are exploited by the entrepreneur. But many economists, especially E.H. Chamberlin, do not agree with Robinson’s definition of exploitation of labour. According to Chamberlin, a factor is exploited only when it is paid less than the marginal revenue product (MRP). As explained above, when there prevails imperfect or monopolistic competition (including monopoly and oligopoly) with perfect competition in the factor market, price of a factor is equal to the marginal revenue product, though it is less than the value of the marginal product. Therefore, according to Chamberlin, there is 182 no any exploitation of labour or any other factor by the entrepreneur when imperfect competition exists in the product market if there is perfect competition in the factor market. 5.6. DETERMINATION OF WAGES Wage Determination under Perfect Competition in the Labour Market. The analysis of wage determination under conditions of perfect competition is exactly the same as given there. In the case of wage determination, it should be remembered that average factor cost (AFC) becomes average wage (AW) and marginal factor cost becomes marginal wage (MW). When there prevails perfect competition in the labour market, wage rate is determined by the equilibrium between the demand for and supply of labour. Demand for labour is governed by marginal revenue product of labour (MRP). Wage rate determined by demand for and supply of labour is equal to the marginal revenue product of labour. Thus, under perfect competition in labour market, a firm will employ the amount of labour at which wage rate = MRP of labour. As regards the supply of labour, it may be pointed out that supply of labour to the whole economy depends upon the size of population, the number of workers available for work out of a given population, the number of hours worked, the intensity of work, the skills of workers and their willingness to work. The size of population depends upon a great variety of social, cultural, religious and economic factors among which wage rate the size of population rises or falls with a rise or fall respectively in the wage rate, and from this they had deduced a law called “Iron Law of Wages”. But the history has shown that rise in the wage rate may have just the opposite effect on the size of population from what the subsistence theory of wages conceives. Moreover, the historical experiences have revealed that the size of population is dependent upon the great variety of social, cultural, religious and economic factors among which wage rate plays only a minor determining role. However, the willingness to work may be influenced greatly by the changes in the wage rate. On the one hand, as wages rise, some persons will do not work at lower wages may now be willing to supply their labour. But, on the other hand, as wages rise, some persons may be willing to work fewer hours and others like 183 women may withdraw themselves from labour force, since the wages of their husbands have increased. Thus there are two conflicting responses to the rise in wages and therefore the exact nature of supply curve of labour is difficult to ascertain. It is, however, generally held that the total supply curve of labour rises up to a certain wage level and after that it slopes backward. This is shown in Fig. 5.4. As wage rate rises up to OW, the total quantity supplied of labour rises, but beyond OW, the quantity supplied of labour decreases as the wage rate is increased. Fig.5.4. Supply curve of labour is backward sloping But so far as supply of labour to a particular industry is concerned it slopes upward. As the wages in an industry are increased labourers from other industries will shift to this industry. The elasticity of the supply curve of labour to an industry will also depend upon the transfer earnings of labourers. Similar is the case of supply of workers to a particular occupation. If wages in one occupation go up, some persons from other similar occupations would be attracted to it and thus the supply of labour to that occupation will increase. Thus because of occupational shifts, the supply curve of labour to a particular occupation is elastic and rises upwards. The long-run supply curve of labour is more elastic than the short-run supply curve since, in the long- run, besides the occupational shift in the labour force, new entrants in the labour market (who are now children) can also adopt the occupation by getting 184 training for it in the very first instance. How the wage rate is determined by demand for and supply of labour is shown in Figure 33.6 where DD represents Fig.5.5.Determination of wages the demand curve for labour and SS represents its supply curve. The two curves intersect at point E. This means that at wage rate OW, quantity demanded of labour is equal to quantity supplied of it. Thus, given the demand for and supply of labour wage rate OW is determined and at this wage rate labour market is cleared. All those who are willing to work at the wage rate OW get employment. This implies that there is no involuntary unemployment and full employment of labour prevails. It is important to note that there will be no equilibrium at any wage rate higher or lower than OW. For example, at a higher wage OW c supply of labour exceeds quantity demanded of it and as a result involuntary unemployment equal to UT emerges. Given the competition among labourers, this unemployment would push down the wage rate to OW. On the other hand, at a lower wage rate OWC the demand for labour exceeds the amount of labour which people are willing to supply. In view of the excess demand for labour, the wage rate will go up to OW where the demand for labour equals the amount supplied of it. Thus wage rate OW will finally settle in the labour market. Though wage rate is determined by demand for and supply of labour, it is equal to the value of marginal product of labour. This is so because in order to maximise its profits, a firm will equalise the wage rate with the value of the marginal product (VMP) of labour. If the firm stops short of this equality, the value of the marginal product (VMP) will be greater than the wage rate which would imply that there was still scope for earning more profits by increasing the employment of 185 labour. On the other hand, if the firm goes beyond and employs more labour than the equality point, the value of the marginal product of labour will become smaller than the wage rate. As a result, the firm will incur losses on workers employed beyond the equality point and it will therefore be to the advantage of the firm to reduce the employment of labour. Thus in order to maximise profits and be in equilibrium the firm working under conditions of perfect competition in the factor and product markets will employ so much labour that the wage rate is equal to the value of marginal product (or marginal revenue product) of labour. It will be seen from Fig. 5.5 that the firm working in perfect competition in the labour market will take the wage rate OW as given and equates it with value of marginal product (VMP) and employs OM labour. To sum up, the wage rate is determined by demand for and supply of labour, but is equal to the value of marginal product (or marginal revenue product) of labour. It is worth mentioning that when the firms are in equilibrium by equating value of marginal product of labour to the wage rate, they may be making profits or losses in the short run. Consider Figure 5.6 which depicts the equilibrium position of the firm in the short run. It will be seen from Fig. 5.6 that at the wage rate OW, the firm is in equilibrium when it is employing OM amount of labour. It will be further seen that the firm is making super-normal profits since in equilibrium employment OM, average revenue product of labour (ARP) which is equal to RM is greater than the wage rate OW (=ME). 186 This can happen in the short run, but not in the long run. When firms are earning super-normal profits in the short run more entrepreneurs will enter Fig.5.6 the market in the long run to purchase labour to produce the products made by it. Entry of more entrepreneurs to the labour market will compete away the super-normal profits. As a result, the demand for labour will rise and the demand curve for labour will shift outward to the right, which will raise the wage rate and will eliminate the profits. It should be carefully noted that a firm will not employ labour if wage rate exceeds average product of labour. Unlike machines labour is a variable factor and if its employment is not sufficient to recover its wages, it will be laid off even in the short run. Consider Figure at wage rate OW1, a firm will be incurring losses if it employs ON1 amount of labour at which wage rate OW1 = VMP = MRP. Therefore, at wage rate OW1, the firm will not employ labour. To sum up, in the long run, the equilibrium between demand for and supply of labour is established at the level where the wage rate of labour is equal to both the VMP (MRP) and ARP of labour and thus the firms earn only normal profits. The long-run equilibrium position of the firm working under perfect competition is depicted in Fig. 5.7 where it will be seen that the firm is in equilibrium at ON level of employment (i.e., at point T) at which wage rate is not only equal to value of marginal product but also average revenue product of labour. Given the ARP and v MP curves, if the wage rate is lower than OW (= N.T.), the number of firms employing labour will change causing changes in demand for labour. As a result of this, the wage rate will ultimately settle at the level OW or NT. 187  Fig.5.7. Long Run Equilibrium of the Firm Changes in Equilibrium Wage Rate: We have explained above how through interaction of demand for and supply of labour determines the market wage rate. Now, if any of the factors causes a shift either in demand curve or in supply curve of labour, the equilibrium will be disturbed causing a change in the wage rate. Both demand for and supply of labour can shift. Shift in Demand Curve for Labour: Demand for labour increases if its productivity increases, say through technological improvement. This will cause a rightward shift in the demand curve for labour and as shall be seen from Figure this will bring about a rise in the wage rate. Similarly, if the demand for a product, say of a textile cloth, increases, the demand for textile workers being a derived demand will also go up. This too will cause an upward shift in the demand for textile workers causing a rise in their wage rate. Further, if the price of a textile cloth rises, it will increase the value of marginal product, (VMP = Price x MPP) of textile workers. With this higher value of marginal product, it will become profitable for the producer to hire more workers. As a result, demand for textile workers will increase causing a rise in their wage rate. Factors that influence the wage rate The eight main factors that influence the determination of wage rates. The factors are: 1. Ability to Pay 2. Demand and Supply 3. Prevailing Market Rates 4. Cost of Living 5. Bargaining of Trade Unions 6. Productivity 7. Government Regulations 8. Cost of Training. 1. Ability to Pay: 188 The ability of an industry to pay will influence wage rates to be paid. If the concern is running into losses, then it may not be able to pay higher wage rates. A profitable enterprise may pay more to attract good workers. During the period of prosperity, workers are paid higher wages because management wants to share the profits with labour 2. Demand and Supply: The labour market conditions or demand and supply forces to operate at the national and local levels and determine the wage rates. When the demand for a particular type of skilled labour is more and supply is less than the wages will be more. On the other hand, if supply is more demand on the other hand, is less then persons will be available at lower wage rates also. According to Mescon, the supply and demand compensation criterion is very closely related to the prevailing pay comparable wage and on-going wage concepts since, in essence of all these remuneration standards are determined by immediate market forces and factors. 3. Prevailing Market Rates: No enterprise can ignore prevailing wage rates. The wage rates paid in the industry or other concerns at the same place will form a base for fixing wage rates. If a unit or concern pays low rates then workers leave their jobs whenever they get a job somewhere else. It will not be possible to retain good workers for long periods. 4. Cost of Living: In many industries wages are linked to enterprise cost of living which ensures a fair wages to workers. The wage rates are directly influenced by cost of living of a place. The workers will accept a wage which may ensure them a minimum standard of living. Wages will also be adjusted according to price index number. The increase in price index will erode the purchasing power of workers and they will demand higher wages. When the prices are stable then frequent wage increases may not be required. 5. Bargaining of Trade Unions: 189 The wage rates are also influenced by the bargaining power of trade unions. Stronger the trade union higher will be the wage rates. The strength of a trade union is judged by its membership, financial position and type of leadership. 6. Productivity: Productivity is the contribution of the workers in order to increase output. It also measures the contribution of other factors of production like machines, materials and management. Wage increase is sometimes associated with increase in productivity. Workers may also be offered additional bonus, etc., if productivity increases beyond a certain level. It is common practice to issue productivity bonus in industrial units. 7. Government Regulations: To improve the working conditions of workers, government may pass a legislation for fixing minimum wages of workers. This may ensure them a minimum level of living. In under developed countries bargaining power of labour is weak and employers try to exploit workers by paying them low wages. In India, Minimum Wages Act, 1948 was passed to empower government to fix minimum wages of workers. Similarly, many other important legislation passed by government help to improve the wage structure. 8. Cost of Training: In determining the wages of the workers in different occupations, allowances must be made for all the expenses incurred on training and time devoted for it. 5.7. ROLL OF TRADE UNIONS AND COLLECTIVE BARGAINING A trade union is an association of workers formed with the object of improving the conditions of workers. It is formed for protecting the interests of workers. Workers have little bargaining capacity when they are unorganized. In fact, trade union movement began against the exploitation of workers by certain managements under the capitalist system. The trade union has been defined by different authors as follows: 190 (1) Webb: Trade union may be defined as “a continuous association of wage earners for the purposes of maintaining or improving the conditions of their working lives.” (2) Lester: “A trade union is an association of employees designed primarily to maintain or improve the condition of employment of its members.” (3) Indian Trade Union Act 1926: “Any combination whether temporary or permanent formed primarily for the purpose of regulating the relations between the workmen and employers”. Objectives of Trade Union: The following are the objectives of trade union: (1) To improve the economic lot of workers by securing they better wages. (2) To secure for workers better working conditions. (3) To secure bonus for the workers from the profits of the enterprise/organization. (4) To ensure stable employment for workers and resist the schemes of management which reduce employment opportunities. (5) To provide legal assistance to workers in connection with disputes regarding work and payment of wages. (6) To protect the jobs of labour against retrenchment and layoff etc. (7) To ensure that workers get as per rules provident fund, pension and other benefits. (8) To secure for the workers better safety and health welfare schemes. (9) To secure workers participation in management. (10) To inculcate discipline, self-respect and dignity among workers. (11) To ensure opportunities for promotion and training. (12) To secure organizational efficiency and high productivity. (13) To generate a committed industrial work force for improving productivity of the system. Functions of Trade Unions: (1) Collective bargaining with the management for securing better work environment for the workers/ employees. (2) Providing security to the workers and keeping check over the hiring and firing of workers. 191 (3) Helping the management in redressal of grievances of workers at appropriate level. (4) If any dispute/matter remains unsettled referring the matter for arbitration. (5) To negotiate with management certain matters like hours of work, fringe benefits, wages and medical facilities and other welfare schemes. (6) To develop cooperation with employers. (7) To arouse public opinion in favour of labour/workers. Benefits of Trade Union: Workers join trade union because of a number of reasons as given below: 1. A worker feels very weak when he is alone. Union provides him an opportunity to achieve his objectives with the support of his fellow colleagues. 2. Union protects the economic interest of the workers and ensures a reasonable wage rates and wage plans for them. 3. Union helps the workers in getting certain amenities for them in addition to higher wages. 4. Union also provides in certain cases cash assistance at the time of sickness or some other emergencies. 5. Union organize negotiation between workers and management and are instruments for settlement of disputes. 6. Trade union is also beneficial to employer as it organizes the workers under one banner and encourages them follow to peaceful means for getting their demands accepted. 7. Trade union imparts self-confidence to the workers and they feel that they are an important part of the organization. 8. It provides for promotion and training and also helps the workers to go to higher positions. 9. It ensures stable employment for the workers and opposes the motive of management to replace the workers by automatic machines. 10. Workers get an opportunity to take part in the management and oppose any decision which adversely effects them. 192 5.8. COLLECTIVE BARGAINING Industrial disputes between the employee and employer can also be settled by discussion and negotiation between these two parties in order to arrive at a decision. This is also commonly known as collective bargaining as both the parties eventually agree to follow a decision that they arrive at after a lot of negotiation and discussion. According to Beach, “Collective Bargaining is concerned with the relations between unions reporting employees and employers (or their representatives). It involves the process of union organization of employees, negotiations administration and interpretation of collective agreements concerning wages, hours of work and other conditions of employees arguing in concerted economic actions dispute settlement procedures”. According to Flippo, “Collective Bargaining is a process in which the representatives of a labor organization and the representatives of business organization meet and attempt to negotiate a contract or agreement, which specifies the nature of employee-employer union relationship”. “Collective Bargaining is a mode of fixing the terms of employment by means of bargaining between organized body of employees and an employer or association of employees acting usually through authorized agents. The essence of Collective Bargaining is bargaining between interested parties and not from outside parties”. According to an ILO Manual in 1960, the Collective Bargaining is defined as: “Negotiations about working conditions and terms of employment between an employer, a group of employees or one or more employers organization on the other, with a view to reaching an agreement.” It is also asserted that “the terms of agreement serve as a code defining the rights and obligations of each party in their employment relations with one another, if fixes large number of detailed conditions of employees and during its validity none of the matters it deals with, internal circumstances give grounds for a dispute counseling and individual workers”. Collective Bargaining Involves: (i) Negotiations (ii) Drafting 193 (iii) Administration (iv) Interpretation of documents written by employers, employees and the union representatives (v) Organizational Trade Unions with open mind. Forms of Collective Bargaining: The working of collective bargaining assumes various forms. In the first place, bargaining may be between the single employer and the single union, this is known as single plant bargaining. This form prevails in the United States as well as in India. Secondly, the bargaining may be between a single firm having several plants and workers employed in all those plants. This form is called multiple plants bargaining where workers bargain with the common employer through different unions. Thirdly, instead of a separate union bargaining with separate employer, all the unions belonging to the same industry bargain through their federation with the employer’s federation of that industry. This is known as multiple employer bargaining which is possible both at the local and regional levels. Instances in India of this industry-wide bargaining are found in the textile industry. The common malady of union rivalry, small firms and existence of several political parties has given rise to a small unit of collective bargaining. It has produced higher labour cost, lack of appreciation, absence of sympathy and economic inefficiency in the realm of industrial relationships. An industry- wide bargaining can be favourable to the economic and social interests of both the employers and employees. Essential Pre-Requisites for Collective Bargaining: Effective collective bargaining requires the following prerequisites: (i) Existence of a strong representative trade union in the industry that believes in constitutional means for settling the disputes. (ii) Existence of a fact-finding approach and willingness to use new methods and tools for the solution of industrial problems. The negotiation should be based on facts and figures and both the parties should adopt constructive approach. 194 (iii) Existence of strong and enlightened management which can integrate the different parties, i.e., employees, owners, consumers and society or Government. (iv) Agreement on basic objectives of the organisation between the employer and the employees and on mutual rights and liabilities should be there. (v) In order that collective bargaining functions properly, unfair labour practices must be avoided by both the parties. (vi) Proper records for the problem should be maintained. (vii) Collective bargaining should be best conducted at plant level. It means if there are more than one plant of the firm, the local management should be delegated proper authority to negotiate with the local trade union. (viii) There must be change in the attitude of employers and employees. They should realise that differences can be resolved peacefully on negotiating table without the assistance of third party. (ix) No party should take rigid attitude. They should enter into negotiation with a view to reaching an agreement. (x) When agreement is reached after negotiations, it must be in writing incorporating all term of the contract. It may be emphasised here that the institution of collective bargaining represents a fair and democratic attempt at resolving mutual disputes. Wherever it becomes the normal mode of setting outstanding issues, industrial unrest with all its unpleasant consequences is minimised. Main Features of Collective Bargaining: Some of the salient features of collective bargaining are: 1. It is a Group Action: Collective bargaining is a group action as opposed to individual action. Both the parties of settlement are represented by their groups. Employer is represented by its delegates and, on the other side; employees are represented by their trade union. 2. It is a Continuous Process: Collective bargaining is a continuous process and does not end with one agreement. It provides a mechanism for continuing and organised 195 relationship between management and trade union. It is a process that goes on for 365 days of the year. 3. It is a Bipartite Process: Collective bargaining is a two party process. Both the parties—employers and employees— collectively take some action. There is no intervention of any third party. It is mutual given-and-take rather than take-it-or-leave-it method of arriving at the settlement of a dispute. 4. It is a Process: Collective bargaining is a process in the sense that it consists of a number of steps. The starting point is the presentation of charter of demands by the workers and the last step is the reaching of an agreement, or a contract which would serve as the basic law governing labour-management relations over a period of time in an enterprise. 5. It is Flexible and Mobile and not fixed or static: It has fluidity. There is no hard and fast rule for reaching an agreement. There is ample scope for compromise. A spirit of give-and-take works unless final agreement acceptable to both the parties is reached. 6. It is Industrial Democracy at Work: Collective bargaining is based on the principle of industrial democracy where the labour union represents the workers in negotiations with the employer or employers. Industrial democracy is the government of labour with the consent of the governed—the workers. The principle of arbitrary unilateralism has given way to that of self-government in industry. Actually, collective bargaining is not a mere signing of an agreement granting seniority, vacations and wage increase, by sitting around a table. 7. It is Dynamic It is relatively a new concept, and is growing, expanding and changing. In the past, it used to be emotional, turbulent and sentimental, but now it is scientific, factual and systematic. 8. It is a Complementary and not a Competitive Process: Collective bargaining is not a competitive process. The behavioural scientists have made a good distinction between “distributive bargaining” and “integrative bargaining”. The former is the process of dividing up the cake 196 which represents what has been produced by the joint efforts of management and labour. In this process, if one party wins something, the other party, to continue the metaphor of the cake, has a relatively smaller size of the cake. So it is a win-lose’ relationship. The integrative bargaining, on the other hand, is the process where both the parties can win—each party contributing something for the benefit of the other party. Constituents of Collective Bargaining: There are three distinct steps in the process of collective bargaining: (1) The creation of the trade agreement, (2) The interpretation of the agreement, and (3) The enforcement of the agreement. Each of these steps has its particular character and aim, and therefore, each requires a special kind of intellectual and moral activity and machinery. 1. The Creation of the Trade Agreement: In negotiating the contract, a union and management present their demands to each other, compromise their differences, and agree on the conditions under which the workers are to be employed for the duration of the contract. The coverage of collective bargaining is very uneven; in some industries almost all the workers are under agreement, while in others only a small portion of the employees of the firms are covered by the agreement. The negotiating process is the part of collective bargaining more likely to make headline news and attract public attention; wage increases are announced, ominous predictions about price increase are reduction in employment are made. 2. The Interpretation of the Agreement: The administrative process is the day-to-day application of the provisions of the contract to the work situation. At the time of writing the contract, it is impossible to foresee all the special problems which will arise in applying its provisions. Sometimes, it is a matter of differing interpretations of specific clause in the contract, sometimes; it is a question of whether the dispute is even covered by the contract. Nevertheless, each case must somehow be settled. The spirit of the contract should not be violated. 3. Enforcement of the Agreement: 197 Proper and timely enforcement of the contract is very essential for the success of collective bargaining. If a contract is enforced in such way that it reduces or nullifies the benefits expected by the parties, it will defeat basic purpose of collective bargaining. It may give rise to fresh industrial disputes. Hence, in the enforcement of the contract the spirit of the contract should not be violated. However, new contracts may be written to meet the problems involved in the previous contract. Furthermore, as day-to-day problems are solved, they set precedents for handling similar problems in future. Such precedents are almost as important as the contract in controlling the working conditions. In short, collective bargaining is not an on-and-off relationship that is kept in cold storage except when new contracts are drafted. Theories of Collective Bargaining: There are three important concepts on collective bargaining which have been discussed as follows: 1. The Marketing Concept and the Agreement as a Contract: The marketing concept views collective bargaining as a contract for the sale of labour. It is a market or exchange relationship and is justified on the ground that it gives assurance of voice on the part of the organised workers in the matter of sale. The same objective rules which apply to the construction of all commercial contracts are invoked since the union-management relationship is concerned as a commercial one. According to this theory, employees sell their individual labour only on terms collectively determined on the basis of contract which has been made through the process of collective bargaining. The uncertainty of trade cycles, the spirit of mass production and competition for jobs make bargain a necessity. The trade union’s collective action provided strength to the individual labourer. It enabled him to resist the pressure of circumstances in which he was placed and to face an unbalanced and disadvantageous situation created by the employer. The object of trade union policy through all the maze of conflicting and obscure regulations has been to give to each individual worker something of the indispensability of labour as a whole. 198 It cannot be said whether the workers attained a bargaining equality with employers. But, collective bargaining had given a new- relationship under which it is difficult for the employer to dispense without facing the relatively bigger collective strength. 2. The Governmental Concept and the Agreement as Law: The Governmental Concept views collective bargaining as a constitutional system in industry. It is a political relationship. The union shares sovereignty with management over the workers and, as their representative, uses that power in their interests. The application of the agreement is governed by a weighing of the relation of the provisions of the agreement to the needs and ethics of the particular case. The contract is viewed as a constitution, written by the point conference of union and management representative in the form of a compromise or trade agreement. The agreement lays down the machinery for making executing and interpreting the laws for the industry. The right of initiative is circumscribed within a framework of legislation. Whenever, management fails to conform to the agreement of constitutional requirements, judicial machinery is provided by the grievance procedure and arbitration. This creates a joint Industrial Government where the union share sovereignty with management over the workers and defend their group affairs and joint autonomy from external interference. 3. The Industrial Relations (Managerial) Concept as Jointly Decided Directives: The industrial relations concept views collective bargaining as a system of industrial governance. It is a functional relationship. Group Government substitutes the State Government. The union representative gets a hand in the managerial role. Discussions take place in good faith and agreements are arrived at. The union joins with company officials in reaching decisions on matters in which both have vital interests. Thus, union representatives and the management meet each other to arrive at a mutual agreement which they cannot do alone. To some extent, these approaches represent stage of development of the bargaining process itself. Early negotiations were a matter of simple 199 contracting for the terms of sale of labour. Developments of the latter period led to the emergence of the Government theory. The industrial relations approach can be traced to the Industrial Disputes Act of 1947 in our country, which established a legal basis for union participation in the management. Importance of Collective Bargaining: The collective bargaining advances the mutual understanding between the two parties i.e., employees and employers. The role of collective bargaining may be evaluated from the following point of view: (1) From Management Point of View: The main object of the organisation is to get the work done by the employees at work at minimum cost and thus earn a high rate of profits. Maximum utilization of workers is a must for the effective management. For this purpose co-operation is required from the side of the employees and collective bargaining is a device to get and promote co-operation. The labour disputes are mostly attributable to certain direct or indirect causes and based on rumors, and misconceptions. Collective bargaining is the best remedial measure for maintaining the cordial relations. (2) From Labour and Trade Union Point of View: Labour has poor bargaining power. Individually a worker has no existence because labour is perishable and therefore, the employers succeed in exploiting the labourers. The working class in united form becomes a power to protect its interests against the exploitation of the employers through the process of collective bargaining. The collective bargaining imposes certain restrictions upon the employer. Unilateral action is prevented. All employees are treated on equal footings. The conditions of employment and rates of wages as specified in the agreement can be changed only through negotiations with labour. Employer is not free to make and enforce decisions at his will. Collective bargaining can be made only through the trade unions. Trade unions are the bargaining agents for the workers. The main function of the trade unions is to protect the economic and non- economic interests of 200 workers through constructive programmes and collective bargaining is one of the devices to attain that objective through negotiations with the employers, Trade unions may negotiate with the employer for better employment opportunities and job security through collective bargaining. (3) From Government Point of View: Government is also concerned with the process of collective bargaining. Government passes and implements several labour legislations and desires it to be implemented in their true sense. If any person violates the rules and laws, it enforces them by force. Collective bargaining prevents the Government from using the force because an amicable agreement can be reached between employer and employees for implementing the legislative provisions. Labour problems shall be minimised through collective bargaining and industrial peace shall be promoted in the country without any force. Collective bargaining is a peaceful settlement of any dispute between worker and employers and therefore it promotes industrial peace and higher productivity resulting an increase in the Gross National Product or the national income of the country. Main Hindrances for Collective Bargaining: The main objective of developing collective bargaining technique is to improve the workers-management relations and thus maintain peace in industries. The technique has developed in India only after India got independence and got momentum since then. The success of collective bargaining lies in the attitude of both management and workers which is actually not consistent with the spirit of collective bargaining in India. There are certain problems which hinder the growth of collective bargaining in India. The following factors or activities act as hindrances to effective collective bargaining: (1) Competitive Process: Collective bargaining is generally becoming a competitive process, i.e., labour and management compete each other at negotiation table. A 201 situation arises where the attainment of one party’s goal appears to be in conflict with the basic objectives of the other party. (2) Not Well-Equipped: Both the parties—management and workers—come to the negotiation table without doing their homework. Both the parties start negotiations without being fully equipped with the information, which can easily be collected from company’s records. To start with, there is often a kind of ritual, that of charges and counter charges, generally initiated by the trade union representatives. In the absence of requisite information, nothing concrete is achieved. (3) Time to Protest: The immediate objective of the workers’ representatives is always some kind of monetary or other gains, accrue when the economy is buoyant and the employer has capacity to pay. But in a period of recession, when demand of the product and the profits are falling, it is very difficult for the employer to meet the demands of the workers, he might even resort to retrenchment or even closure collective bargaining is no answer to such a situation. (4) Where Prices are fixed by the Government: In industries, where the prices of products are fixed by the Government, it becomes very difficult for the employer to meet the demands of workers which would inevitably lead to a rise in cost of the products produced. Whereas the supply price to the consumers cannot be increased. It will either reduce the profits of the firm or increase the loss. In other words, it will lead to closure of the works, which again is not in the interest of the workers. (5) Outside Leadership: Most of the Indian trade unions are led by outsiders who are not the employees of the concerned organisations. Leader’s interests are not necessarily to be identical with that of the workers. Even when his bonafides are beyond doubt, between him and the workers he leads, there cannot be the degree of understanding and communication as would enable him to speak on behalf of the workers with full confidence. Briefly, 202 in the present situation, without strong political backing, a workers’ organisation cannot often bargain successfully with a strong employer. (6) Multiplicity of Trade Unions: One great weakness of collective bargaining is the multiplicity of trade unions. In a multiple trade union situation, even a well-recognised, union with long standing, stable and generally positive relationship with the management, adopts a militant attitude as its deliberate strategy. In Indian situation, inter-union rivalries are also present. Even if the unions combine, as at times they do for the purpose of bargaining with the employer they make conflicting demands, which actually confuse employer and the employees. (7) Appointment of Low-Status Executive: One of the weaknesses of collective bargaining in India is that the management deputes a low-status executive for bargaining with the employees. Such executive has no authority to commit anything on behalf of the management. It clearly indicates that the management is not at all serious and the union leaders adopt other ways of settling disputes. (8) Statutory Provisions: The constraints are also imposed by the regulatory and participative provisions as contained in the Payment of Wages Act, the Minimum Wages Act, and Payment of Bonus Act etc. Such provisions are statutory and are not negotiable. (9) Fresh Demands at the Time of Fresh Agreement: At the time when the old agreement is near expiry or well before that, workers representatives come up with fresh demands. Such demands are pressed even when the industry is running into loss or even during the period of depression. If management accepts the demand of higher wages and other benefits, it would prefer to close down the works. (10) Agreements in Other Industrial Units: A prosperous industrial unit in the same region may agree with the trade unions to a substantial increase in wages and other benefits whereas a losing industry cannot do that. There is always pressure on the losing 203 industries to grant wages and benefits similar to those granted in other (relatively prosperous) units in the same region. Reasons for the Growth of Collective Bargaining: The growth of collective bargaining in India may be attributed to the following factors: (1) Statutory Provisions: Which have laid down certain principles of negotiations, procedure for collective agreements and the character of representation of the negotiating parties? (2) Voluntary Measures: Such as tripartite conferences, joint consultative boards, and industrial committees at the industry level have provided an ingenious mechanism for the promotion of collective bargaining practices. (3) Several Governments Measures: Like schemes for workers’ education, labour participation in management, the evolution of the code of Inter-union Harmony, the code of Efficiency and Welfare, the Code of Discipline, the formation of Joint Management Councils, Workers Committees and Shop Councils, and the formulations of grievances redressal procedure at the plant level— have encouraged the collective bargaining. (4) Amendments to the Industrial Disputes Act: The Amendments to the Industrial Disputes Act in 1964 provided for the termination of an award or a settlement only when a proper notice is given by the majority of workers. Agreements or settlements which are arrived at by a process of negotiation on conciliation cannot be terminated by a section of the workers. (5) Industrial Truce Resolution: The Industrial Truce Resolution of 1962 has also influenced the growth of collective bargaining. It provides that the management and the workers should strive for constructive cooperation in all possible ways and throws responsibility on them to resolve their differences through mutual discussion, conciliation and voluntary arbitration peacefully. 204 Advantages of Collective Bargaining: Perhaps the biggest advantage of this system is that, by reaching a formal agreement, both sides come to know exactly what to expect from each other and are aware of the rights they have. This can decrease the number of conflicts that happen later on. It also can make operations more efficient. Employees who enter collective bargaining know they have some degree of protection from employer retaliation or being let go from the job. If the employer were dealing with just a handful of individuals, he might be able to afford to lose them. When he is dealing with the entire workforce, however, operations are at risk and he no longer can easily turn a deaf ear to what his employees are saying. Even though employers might need to back down a little, this strategy gives them the benefit of being able to deal with just a small number of people at a time. This is very practical in larger companies where the employer might have dozens, hundreds or even thousands of workers on his payroll. Working with just a few representatives also can make the issues at hand seem more personal. Agreements reached through these negotiations usually cover a period of at least a few years. People therefore have some consistency in their work environment and policies. This typically benefits the company’s finance department because it knows that fewer items related to the budget might change. On a broad scale, using this method well can result in more ethical way of doing business. It promotes ideas such as fairness and equality, for example. These concepts can spill over into other areas of a person’s life, inspiring better general behavior towards others. Disadvantages of Collective Bargaining: A major drawback to using this type of negotiation system is that, even though everyone gets a say in what happens, ultimately, the majority rules, with only a few people determining what happens too many. This means that a large number of people, particularly in the general workforce, can be overshadowed and feel like their opinion doesn’t really matter. In the 205 worst case scenario, this can cause severe division and hostility in the group. Secondly, it always requires at least two parties. Even though the system is supposed to pull both parties together, during the process of trying to reach an agreement, people can adopt us-versus-them mentality. When the negotiations are over, this way of looking at each other can be hard to set aside, and unity in the company can suffer. Collective bargaining can also be costly, both in terms of time and money. Representatives have to discuss everything twice—once at the small representative meetings, and again when they relay information to the larger group. Paying outside arbitrators or other professionals quickly can run up a fairly big bill, and when someone else is brought in, things often get slower and more complex because even more people are involved. Some people point out that these techniques have a tendency to restrict the power of employers. Employees often see this as a good thing, but from the company’s perspective, it can make even basic processes difficult. It can make it a challenge to deal with individual workers, for example. The goal of the system is always to reach a collaborative agreement, but sometimes tensions boil over. As a result, one or both parties might feel they have no choice but to muscle the other side into giving up. Workers might do this by going on strike, which hurts operations and cuts into profits. Businesses might do this by staging lockouts, which prevents members’ of the workforce from doing their jobs and getting paid, negatively effecting income and overall quality of living. Lastly, union dues are sometimes an issue. They reduce the amount of take-home pay a person has, because they usually are deducted right from his paycheck. When things are good in a company and people don’t feel like they’re getting anything from paying the dues, they usually become unhappier about the rates. The idea of collective bargaining emerged as a result of industrial conflict and growth of trade union movement and was first given currency in the United States by Samuel Crompers. In India the first collective bargaining agreement was conducted in 1920 at the instance of Mahatma Gandhi to regulate labour management relation 206 between a group of employers and their workers in the textile industry in Ahmadabad. 5.9. THEORIES OF INTEREST 5.9.1. Productivity Theory of Interest: This theory was propounded by Physiocrats and developed by German economists. According to this theory, interest is paid for the productivity of capital. According to Wicksell, “interest is the payment by the borrower of capital by virtue of its productivity”. Capital is productive in the sense that labour, assisted by capital produces more than labour without capital, for example, a fisherman with a net can catch more fish than without it. An agricultural labour with tractor can produce more than without a tractor. Thus capital is as productive as other factors of production. Criticisms: 1. Economists criticize this theory for having ignored the scarcity, efficiency and supply of capital that determine the rate of interest. 2. If interest depends merely on productivity, interest rates should vary in proportion to the productiveness of capital. Actually pure rate of interest tends to be the same in the market. 3. Even if loans are taken for consumption purposes, interest has to be paid on them. But loans for consumption purposes are not productive. 4. Productivity theory explains interest from the side of demand only and ignores the supply side altogether. 5. Mere physical productivity of capital does not explain interest. If people are willing to lend unlimited amounts of loans (money) without interest, business would expand. Interest would not be a cost. But interest is a cost which every entrepreneur must bear with. Hence price in the long-run, must cover all costs including interest. 5.9. 2. Abstinence or Waiting Theory: Senior, the classical economist is the exponent of the abstinence theory of interest. According to J.S.Mill, interest is the remuneration for mere abstinence. Abstinence theory explains interest from the side of supply whereas the productivity theory explains from the demand side. According to Senior saving involved a sacrifice which he calls it ‘abstinence’. Senior 207 explains that capital is the result of savings, which in turn are the result of abstinence. People usually may consume their entire income. They save a part of their income only by abstaining from the present consumption. Thus saving was an act of abstaining from consumption. It was necessary to reward people to abstain from consumption since abstinence is regarded as painful. Interest is thus the reward paid for those who saved rather than consumed their incomes. Criticism: 1. This theory has failed to explain the demand for capital, hence it is one- sided theory. 2. This theory emphasises that all capital is the result of abstinenc e, but it is not true. 3. This theory is also criticised on the ground that rich people save without least inconvenience and they do not undergo discomfort on account of saving. 4. Marshall substituted the term waiting for ‘abstinence’. Saving means waiting. When a person saves, he does not abstain from consumption for- ever. He just postpones present consumption to a future date. Generally people do not like to wait; an incentive is necessary to encourage this postponement of consumption. Interest is thus an incentive. 5.9.3. Agio or Austrian Theory of Interest: This theory was first advanced by John Rae and later developed by Bohm Bawerk of the Austrian School of Economics. According to this theory interest arises because people prefer present goods to future goods. If people prefer the present goods, there cannot be savings and capital. To induce people to save and accumulate capital an agio or premium or price must be given. Thus agio is nothing but interest. People generally prefer the present goods to the future goods for three reasons. According to Bohm Bawerk the first reason is an under valuation of the future purchasing power as compared with the present purchasing power, moreover future is uncertain. In the second place present wants are felt more keenly than the future good. 208 Yet another reason is that a person expects improvement in economic position in future as a result of which the marginal utility of his income will decline. He therefore prefers to use his income at the present when the marginal utility of his income is high. A premium or agio must be given to the lender if he has a part with his income at the present. This premium is the so- called interest. Criticism: 1. This theory failed to explain the forces of demand and supply for capital that determine the rate of interest. 2. The reasons given by Bohm Bawerk do not apply always. 3. The technical superiority of present goods of Bohm Bawerk has been criticised by Irving fisher. 5.9.4. Fisher’s Time Preference Theory: This theory is associated with Irving Fisher who emphasises time preference as the central point in the theory. This theory is based on the subjective valuation of income and people’s time preference. According to this theory “interest is the price of time”. In the words of Fisher “interest is an index of community’s preference for a dollar of present over a dollar of future income’. People in general prefer the present to the future. This is what he calls the time preference. By time preference Fisher means individual’s preference for the present to the future or people’s discounting or under estimating the future. There is a tendency on the part of the people to vary the income meant for consumption from time to time by saving and borrowing. Interest is the price paid to the people for present income rather than for future income. According to Fisher the rate of interest varies according to the time preference. The time preference depends upon the size of income, the distribution of income over the period of time, the composition of income, the certainty of enjoying income in the future, the temperament and the character of the individuals and expectation of the life of the people. If the income size is 209 large, individual will satisfy present wants more and discount the future at a lower rate. The distribution of income may take place in three different ways. It may be uniform throughout the life or increase with age or decrease with age. If it is uniform individuals will have their time preference according to the size of their income and temperament. But if the income increases with age, individuals will tend to discount the future at a higher rate because their future is well provided. If the income decreases with age, the future will be discounted at a lower rate. Regarding the degree of enjoying the income in the future, greater the certainty of enjoying income in the future smaller is the degree of time preference. But if the enjoyment of income is not certain the degree of time preference will be greater. The character of individuals also influences time preference. A person of forethought discounts the future at a low rate compared to a spend thrift. Similarly a person who expects to live long has less time preference than one who expects to live short. These factors determine individual’s rate of time preference. When the rate of time preference is higher than the market rate of interest, the individuals will borrow; if it is lower he will lend to the market. Criticism: 1. Fisher’s theory fails to show the influence of the banking system on rate of interest. 2. This theory gives too much importance to willingness or preference; moreover this theory lays much emphasis on consumption expenditure out of income. 3. Fisher did not give importance to the impact of expectations on interest rate. The concept of productivity is free from the element of uncertainty. Both the factors namely expectation and uncertainty are crucial factors to Keynesian concept of marginal efficiency of capital. 4. The theory is based on the assumption of fixed purchasing power of money between the present and the future. In the real world, fluctuations in the value of money are the most common. 210 The time preference theory is superior to the other theories since it explains the rate of interest by reference to demand for and supply of capital. The demand for capital depends upon the marginal productivity of capital to investors while the supply of capital depends upon the time preference of individuals. The rate of interest will be determined at the point of equilibrium between demand for and supply of capital. The time preference theory is a complete theory and is the basis of the modern loanable funds theory of interest rate. 5.9.5. The Classical Theory of Interest: The classical theory of interest was propounded by the old classical economists. Later it was developed by Marshall, Pigou, Walras, Taussig and Knight. According to this theory rate of interest is determined by the demand for and supply of capital. The rate of interest settles at the point where the demand for capital is equal to supply of capital. The demand for capital arises from investment and supply of capital from savings. This means that the rate of interest is determined by the volume of savings and volume of investment. This theory explains the rate of interest in terms of saving and investment; this theory is called the saving investment theory of interest. Classical theory is also known as real or non-monetary theory of interest. This theory refers to saving as real savings and investment as real investment. Real saving refers to those goods which are employed for investment purposes instead of consumption. Real investment refers to the production of capital goods like machinery, buildings, etc., rather than monetary investment, such as stocks and shares. Thus money does not play an important role in the determination of rate of interest. According to classical economist the rate of interest is determined by the demand for savings to invest in capital goods and the supply of savings. The two sides of the interest determination, namely, the demand for capital and the supply of capital can be analysed. Demand for Capital 211 Demand for capital arises on account of its productivity. Firms desire to make new capital goods which are demanded to produce consumer goods. For any type of capital good it is possible to draw a marginal revenue productivity curve showing the addition made to the total revenue by an additional unit of a capital at various levels of the stock of that capital. The more the capital assets an entrepreneur has, the less revenue or income he will earn by purchasing one more unit of capital. Under perfect competition, it is profitable for a firm to purchase any capital up to the point at which the price of that capital equals its marginal revenue productivity. The entrepreneur will demand capital goods up to the point at which the expected rate of return on the capital goods equals the rate of interest. At a higher rate of interest the demand for capital is low and it is high at a lower rate of interest. Thus the demand for capital is inversely related to rate of interest and the demand schedule for capital slopes downward from left to right. However there are certain other factors which govern the demand for capital such as the growth of population, technical progress, the standard of living of the community, etc. Supply of Capital: The supply of capital depends upon savings and hence the will to save and the power to save of the community. Some people save irrespective of the rate of interest. They would save even if the rate of interest is zero. Others save because the current rate of interest is just enough to induce them to save. There are potential savers who will save if the rate of interest increases. In an economy, there may be three types of savers, viz., individual savers, institutional savers like banks, insurance companies, etc., and the government. Saving involves certain inconvenience like sacrifice, or waiting as they have to forgo present consumption which has to be compensated. The higher the rate of interest, the larger will be the community savings and the more will be the supply of funds. The supply curve of capital thus 212 slopes upward indicating that more funds will be saved and supplied at a higher rate of interest. Determination of the Rate of Interest: The rate of interest is determined by the intersection of the demand for capital (or investment demand) and supply of savings. This is shown in the figure given below: The point of equilibrium is E at which investment demand is equal to saving. V is the natural rate of interest. OQ quantity of capital is demanded and supplied, at ‘Or’ rate of interest. Rate of interest cannot be higher or lower than ‘r’ since charges in saving and investment will force the rate back to ‘r’. For example, if the rate of interest rises above to Or 1 the demand for investment funds will fall and the supply of funds will increase. Since the supply of capital is more than the demand by ‘ds’ the rate of interest will come down to the equilibrium level ‘Or’. If the rate of interest falls to Or 2 the demand for capital will be greater than the supply by S1d 1 and the rate of interest will rise to ‘Or’. At the lower rate of interest, people will save less but the demand for investible funds will increase which will raise the rate of interest to the equilibrium level. Criticism: The real theory of the classical economists as propounded by Marshall and Pigou has been criticised by Keynes. 1. Keynes has condemned the classical theory as a useless and unrealistic theory. Keynes does not agree with the classical idea that saving is interest