Name of Student - Jalaj Kushwaha

ID- 22BCOM080
Department of Commerce
Joseph School of Business Studies
And Commerce
Subject- Business Economics
B.COM II Semester
Assignment File
Session – 2022-2023
Date of Submission- 15/04/2023
Submit to Submit By
Mr.Vaibhav Jaiswal Sir Jalaj Kushwaha
 Explain the theory of interest

Theories of Interest
The five theories of interest are as follows: 1. Productivity
Theory 2. Abstinence or Waiting Theory 3. Austrian or Agio
Theory 4. Classical or Real Theory 5. Loanable Fund Theory.

1. Productivity Theory:
According to productivity theory, interest can be defined
as a reward for availing the services of capital for the
production purpose.
Labor that is having good amount of capital produces more
as compared to the labor who is not assisted by good
amount of capital.
For example, farmer having tractor to plough the field
produces more as compared to the farmer who does not
have it. Thus, interest is the payment for the productivity
of capital.
However, the productivity theory is criticized on the
following grounds:
i. Focuses only on the causes for what the interest is paid,
not on the determination of interest rates.
ii. Assumes that interest is paid due to the productivity of
capital. In such a case, pure interest should vary as per the
productivity of the capital. However, pure interest is the
same in money market during the same period of time.
iii. Lays emphasis on the demand of interest, but ignores
the supply side of capital.
iv. Fails to explain how the interest is paid for the loan
borrowed for consumption purposes.
2. Abstinence or Waiting Theory:

The abstinence theory was propounded by Senior.

According to him, interest is a reward for abstinence. When
an individual saves money out of his/her income and lends
it to other individual, he/she makes sacrifice. The term
sacrifice implies that the individual refrains from
consuming his/her whole income that he/she could spent
easily. Senior advocated that abstaining from consumption
is unpleasant. Therefore, the lender must be rewarded for
this. Thus, as per Senior, interest can be regarded as the
reward for refraining from the use of capital.
Abstinence theory was also criticized by a number of
economists. According to the theory, an individual feels
unpleasant when they save as it reduces his/her
consumption. However, rich people do not feel unpleasant
while saving because they are able to meet their
requirements.
Therefore, Marshall has replaced the term abstinence with
waiting and described saving in terms of waiting. He states
that saving is done by transferring the present requirement
to the future and the person needs to wait for meeting those
requirements. However, people do not want to wait rather
they are motivated to save money by providing a certain
amount of interest.
3. Austrian or Agio Theory:

Austrian theory is also termed as psychological theory of

interest. This theory was advocated by John Rae and Bohm
Bawerk in an Austrian school. According to Austrian
theory, interest came into existence because present goods
are preferred over future goods. Therefore, the present
goods have premium with them in the form of interest. In
other words, present satisfaction is of greater concern as
compared to future satisfaction.
Therefore, future satisfaction has certain type of discount
if compared with present satisfaction. The interest is the
discounted amount that is required to be paid for
motivating people to invest or transfer their present
requirements to future. For example, an individual has to
make a choice between two options.
He/she can either have Rs. 500 now or the same amount
after a year. In such a case, he/she would prefer to have Rs.
500 in present. However, in case, the individual has a
choice of getting Rs. 500 in present and Rs. 600 after one
year.
In such a case, he/she would be more inclined toward
getting Rs. 600 after a year. Thus, the extra payment of Rs.
100 would compensate the sacrifice involved in delaying
his/her present satisfaction. The extra payment of Rs. 100
in the given case is considered as interest.
Agio theory’ has been criticized by various economists
on the following grounds:
i. Lays too much emphasis on the supply aspect and ignores
the demand aspect
ii. Does not focus on the determination of rate of interest

4. Classical or Real Theory:

Classical theory helps in the determination of rate of
interest with the help of demand and supply forces.
Demand refers to the demand of investment and supply
refers to the supply of savings. According to this theory,
rate of interest refers to the amount paid for saving.
Therefore, the rate of interest can be determined with the
help of demand for saving money to be invested in the
capital goods and the supply of savings. Let us understand
the concept of demand of investment. Capital goods are
used for the production of consumer goods and provide
returns continuously for many years.
However, a certain degree of uncertainty is associated with
capital goods due to their future use. In addition, operation
and maintenance costs are involved in using capital goods.
This makes organizations to calculate the net expected
return on the marginal cost that is represented as the
percentage of cost of capital good.
In case, an organization has similar type of capital goods,
then the increase in one more capital good would not yield
them high revenue. The increase in the rate of interest
would result in the fall of demand of capital goods.
Shows the demand for capital investment:
 MRP represents the marginal revenue productivity curve.
When the demand of capital is OM, then the rate of interest
is Or. The net rate of return becomes equal to the current
rate of interest (Or) at the OM demand of capital.
In case, the rate of interest decreases to Or’, then the
demand of capital increases to OM’. The net rate of return
is equal to Or’ when the amount of capital demanded is
OM’. The demand for capital goods increases with a
decrease in the rate of interest.
On the other hand, the supply of capital increases by the
amount saved by an individual and the saving is done by
transferring the present requirement to the future
requirement. The rate of interest would increase with the
increase in the amount of saving by an individual.
The rate of interest can be determined with the help of
demand of investment and supply of savings. It would be
the point of equilibrium where demand and supply
intersects each other or get equal.

In SS is the supply curve of saving and II is the demand

curve of investment that intersect each other at Or rate of
interest with quantity of saving and investment is OM. OM
represents the amount that is lent, borrowed and used for
investment. The rate of interest can be changed by
changing the demand and supply of savings and
investment.
The classical theory is criticized by Keynes due to
various reasons, which are as follows:
i. Assumes the full employment of resources, which is not
true in reality. This is because if one resource is reduced
from one production process, then it would be utilized for
other production process. On the contrary, if resources are
available in abundant, then there is no need to save them.
ii. Assumes that investment can be increased only when
individuals reduce their consumption. This is because if the
consumption is less, then the saving would increase, which
would lead to the increase in investment. However, if the
demand of capital goods decreases, then the incentive to
produce capital goods would also decrease. This would
result in the decrease of investment.
iii. Assumes that there is no change in the income level of
an individual. Thus, according to classical theory, saving
and investment become equal due to change in rate of
interest. However, according to Keynes theory, savings and
investment become equal because of changes occur in the
income level of an individual.
5. Loanable Fund Theory:
Loanable fund theory agrees with the view that time
preference plays an important role in determining the
occurrence of interest. This theory is also termed as neo-
classical theory of interest. According to neo-classical
economists, interest is the amount paid for loanable funds.
It focuses on the determination of rate of interest with the
help of demand and supply of loanable funds in the credit
market. Let us understand the concept of supply of loanable
funds.
The supply of loanable funds depends on the following
factors:
i. Savings:
Act as one of the sources of loanable funds. The loanable
funds in the form of saving are classified as ex-ante saving
and Robertsonian sense. Ex-ante saving refers to the saving
that an individual plans according to his/her expected
income and expenditure in the starting of a year or financial
year or for a month.
On the other hand, Robertsonian sense refers to the saving
that is produced by taking the difference of previous period
income and present period consumption. In both the types
of savings, the savings are different at different rate of
interest. Savings are dependent on the income level that
vanes with the rate of interest. The increase in the rate of
interest would result in the increase of the level of saving
and vice versa
In the context of organizations, the amount left after
distributing the profit in the form of dividends is termed as
the saving of an organization. The savings of an
organization depends on the rate of interest prevailing in
the market. Increased rate of interest would encourage
organizations to increase savings instead of borrowing
money from loan market.
ii. Dishoarding:
Involves reduction in the money stock of an organization.
Therefore, in the previous money stock, the liquidity of
money is high that can be utilized in the present time as
loanable funds. The higher the rate of interest, the more
would be the money dishoarded and vice versa.
iii. Credit by bank:
Refers to the loan provided by bank to the organizations.
Banks can increase or decrease the money lend to an
organization on the basis of certain criteria. The supply of
loanable funds increases with the increase in the money
created by banks. The supply curve is interest elastic for
loanable funds. The higher the rate of interest, the more the
bank would lend money and vice versa.
iv. Disinvestment:
Refers to the situation when the existing capital goods of
an organization are reduced or the stock of the organization
is less than the previous stock. In such a condition, the fund
that is used for the replacement purposes are used as
loanable funds.
According to Bober, ”Disinvestment is encouraged by the
somewhat by a high rate of interest on loanable funds.
When the rate is high, some of the current capital may not
produce a marginal revenue product to match this rate of
interest. The firm may decide to let this capital run down
and to put the depreciation finds in the ban market”
After determining the factors that influence the supply of
loanable funds, let us study the demand for loanable funds.
The demand for loanable funds depends on investment,
consumption, and hoarding of income. Organizations
require loanable funds to a greater extent for expanding the
stock of capital goods, such as machines and buildings.
The demand for loanable funds depends on the extent to
which organizations require loanable funds. Interest is the
price at which the loanable funds can be bought.
Organizations require loanable funds at which the net rate
of return on capital goods is equal to the rate of interest.
The higher rate of interest demotivates organizations to buy
capital goods or expand their stock of capital goods.
Therefore, the demand of loanable funds is interest elastic
for organizations; therefore, the demand curve would slope
downwards.
Another major constituent of demand for loanable funds is
the requirement of funds b) individuals for consumption.
Generally, individuals require loanable fund when they
desire to purchase something out of their budget or the
consumer goods that they cannot afford from their present
income. The lower the rate of interest, the higher would be
the demand for loanable goods. Therefore, the demand for
loanable funds is interest elastic for individuals; thus the
demand curve slopes downward.
Along with organizations and individuals, there are some
people who require loanable goods for hoarding purposes.
Hoarding refers to the holding of some part of income by
the individuals for future use. In hoarding, the supplier and
buyer of loanable funds is the same person.
A person may want to hold funds when the rate of interest
is low. On the contrary, he/she may use his/her funds by
investing in new projects, when the rate of interest is high.
Therefore, the demand of loanable funds is interest elastic
for hoarding purpose; thus, the demand curve slopes
downward.
Shows the interaction between the demand and supply
curve of loanable funds to reach at equilibrium
position:
 DH represents dishoarding curve, BM is bank credit curve,
S represents saving curve, and DI is disinvestment curve.
LS represent the supply of loanable funds, which is
produced by summing up the DH, BM, S, and DI curve.
Similarly, H represents hoarding, C is consumption, and I
is investment, which together form LD.
LD is the demand for loanable funds. The point at which
the demand and supply curve of loanable funds intersect
each other is termed as equilibrium point (E). At point E,
the rate of interest is OR with ON loanable funds.
Therefore, OR would be the equilibrium rate of interest
Classical Theory of Interest: Assumptions

The classical theory of interest is based upon the

following assumptions:
(i) Perfect competition exists in the factor market.
This assumption has the following implications:
(a) The equilibrium rate of interest is determined by the
competitive forces of demand and supply in the capital
market.
(b) Interest rate is flexible, i.e., it freely moves to
whatever
(ii) The theory assumes full employment of resource
This assumption has the following implications:
(a) Saving involves sacrifice of abstaining from or
postponing of consumption and interest is the reward for
abstinence or waiting: it is only when all resources are
fully employed, higher rate of interest is paid to induce
people to save or abstain from consumption or postpone
consumption
(b) Income level is assumed to be constant; it is at the full
employment level that income and output do not change
and become constant.
(c) The assumptions of full employment and given level
of income lead to the further assumption that the demand
and supply schedules of capital are independent and do
not influence each other; it is only when income changes
as a result of a change in investment, that saving changes
in consequence.
(iii) Economic agents act rationally, i.e., they are
motivated by self-interest and want to maximize
economic benefit.
(iv)The price level is assumed to be constant. If it changes
then the economic agents do not suffer money illusion,
i.e., savers and investors react to changes in the real
interest rates and not the changes in the money interest
rates.
(v) Money is neutral and serves only as a medium of
exchange and not as a store of value.
 Profit Theory: Assumptions and
Criticisms

In the neoclassical theory of the firm, the main objective of

a business firm is profit maximisation. The firm maximises
its profits when it satisfies the two rules:
(i) MC = MR and,
(ii) MC curve cuts the MR curve from below.
Maximum profits refer to pure profits which are a surplus
above the average cost of production. It is the amount left
with the entrepreneur after he has made payments to all
factors of production, including his wages of management.
In other words, it is a residual income over and above his
normal profits.
The profit maximisation theory is based on the
following assumptions:
1. The objective of the firm is to maximise its profits where
profits are the difference between the firm’s revenue and
costs.
2. The entrepreneur is the sole owner of the firm.
3. Tastes and habits of consumers are given and constant
4. Techniques of production are given.
5. The firm produces a single, perfectly divisible and
standardised commodity.
6. The firm has complete knowledge about the amount of
output which can be sold at each price.
7. The firm’s own demand and costs are known with
certainty.
8. New firms can enter the industry only in the long run.
Entry of firms in the short run is not possible.
9. The firm maximises its profits over some time-horizon.
10. Profits are maximised both in the short run and the long
run.
Criticisms of the Profit Theory:
The profit maximisation theory has been severely
criticized by economists on the following grounds:
1. Profits Uncertain:
The principle of profit maximisation assumes that firms are
certain about the levels of their maximum profits. But
profits are most uncertain for they accrue from the
difference between the receipt of revenues and incurring of
costs in the future. It is, therefore, not possible for firms to
maximise their profits under conditions of uncertainty.
2. No Relevance to Internal Organisation:
This objective of the firm bears little or no direct relevance
to the internal organisation of firms. For instance, some
managers incur expenditures apparently in excess of those
that would maximise wealth or profits of the owners of the
firm. They are observed to emphasize growth of total assets
of the firm and its sales as objectives of managerial actions.
3. No Perfect Knowledge:
The profit maximisation hypothesis is based on the
assumption that all firms have perfect knowledge not only
about their own costs and revenues but also of other firms.
But, in reality, firms do not possess sufficient and accurate
knowledge about the conditions under which they operate.
At the most, they may have a knowledge about their own
costs of production, but they can never be definite about
the market demand curve. They always operate under
conditions of uncertainty and the profit-maximisation
theory is weak in that it assumes that firms are certain about
everything.
4. Empirical Evidence Vague:
The empirical evidence on profit maximization is vague.
Most firms do not rank profits as the major goal. The
working of modem firms is so complex that they do not
think merely about profit maximization. Their main
problems are of control and management.
The function of managing these firms is performed by
managers and shareholders rather than by the entre-
preneurs. They are more interested in their emoluments and
dividends. Since there is substantial separation of
ownership from control in modern firms, they are not
operated so as to maximize profits.
5. Firms do not bother about MC and MR:
It is asserted that the real world firms do not bother about
the calculation of marginal revenue and marginal cost.
Most of them are not even aware of the two terms. Others
do not know the demand and marginal revenue curves
faced by them. Still others do not possess adequate
information about their cost structure.
Empirical evidence by Hall and Hitch shows that
businessmen have not heard of marginal cost and marginal
revenue. After all, they are not greedy calculating
machines. As aptly put by C.J. Hawkins: “To argue that all
firms aim to do nothing else but maximize profits has not
better basis in logic or intuition as to argue that all students
aim only to maximize examination marks”.
6. Principle of Average-Cost Maximizes Profits:
Hall and Hitch found that firms do not apply the rule of
equality of MC and MR to maximize short run profits.
Rather, they aim at the maximization of profits in the long
run. For this, they do not apply the marginalistic rule but
they fix their prices on the average cost principle.
According to this principle, price equals AVC +AFC +
profit margin (usually 10%). Thus the main aim of the
profit maximizing firm is to set a price on the average cost
principle and sell its output at that price.
7. Static Theory:
The neo-classical theory of the firm is static in nature. The
theory does not tell the duration of either the short period
or the long period. The time-horizon of the neo-classical
firm consists of identical and independent time periods.
Decisions are considered as temporally independent. This
is a serious weakness of the profit maximization theory. In
fact, decisions are “temporally inter- dependent. It means
that decisions in any one period are affected by decisions
in past periods which will, in turn, influence the future
decisions of the firm. This inter-dependence has been
ignored by the neo-classical theory of the firm.
8. Not applicable to Oligopoly Firm:
As a matter of fact, the profit-maximization objective has
been retained for the perfectly competitive, or
monopolistic, or monopolistic competitive firm in eco-
nomic theory. But it has been abandoned in the case of the
oligopoly firm because of the criticisms leveled against it.
Hence the different objectives that have been put forth by
economists in the theory’ of the firm relate to the oligopoly
or duopoly firm.
9. Varied Objectives:
The basis of the difference between the objectives of the
neo-classical firm and the modem corporation arises from
the fact that the profit maximization objective relates to the
entrepreneurial behavior while modem corporations are
motivated by different objectives because of the separate
roles of shareholders and managers.