Class XI, Principles of Economics, "Why Interest is Paid?"

Why Interest is Paid?

Interest is paid for the following reasons:

1. Capital is Productive

Capital improves the quality and increases the quantity of out put with in a given time. It means that capital contributes in the national dividend and therefore it is demanded and paid as a share of capital in the national dividend.

2. Capital Involves Lending

Capital has a lending cost behind it. This why interest is demanded and paid to cover the lending cost.

3. Capital is Capable of Alternative Uses

Capital is a secure commodity so it commands price. Therefore interest is demanded because of scarcity of capital.

4. Capital Increases the Efficiency of Land and Labour

Capital increases the efficiency of land and labour and reduces the cost per unit of out put. Interest is therefore demanded and paid because it reduces cost per unit and also brings out a standard in the production.

5. Capital is Mobile

Capital is mobile and it moves easily from one channel of production to another within a country. Sometimes it also moves out side the country. Interest is demanded because of its productivity and scarcity due to mobility and is therefore paid.

6. Capital is a Result of Saving + Lending

Both saving and lending are painful in the sense that saving involves sacrifice of present consumption and lending. It involves the risk of bad debts and it also involves the risk for long term waiting for the amount to be returned. Interest is demanded for such a sacrifice and inconvenience.

7. Capital Serves as a Substitute for Land and Labour

Interest is demanded for the service of capital which substitutes land and labour and is accordingly paid.