HOW INTEREST ARISES
Productivity Theory The Theory. To take the Productivity Theory first, some older economists thought that capital was productive of goods in the same • sense as land was productive of crops. They held that interest was paid because ·production with the aid of capital was greater than without it. Capital is productive in the sense that labour, assisted by capital,
produces more than labour without capital. A fisherman with a net catches more fish than without it. A farm labourer with a tractor can produce more than without a tractor. Criticism. Physical productivity of capital goods, however, does not explain interest. If people were willing to lend unlimited amounts of money without interest, business would expand up to a point where
the falling price of the product would simply cover other changes (without any interest) in making thereof. Interest  not he a cost. But interest is a cost which every entrepreneur must reckon with. Hence, price, in the long run, must cover all costs  interest. Since demand for capital. when it is free of interest, must exceed the supply of it, interest .