Ch 29: Interest, Rent, and Profit

Del Mar College

John Daly©2003 South-Western Publishing, A Division of Thomson Learning

Interest

• Sometimes refers to the price for credit or loanable funds.

• Interest can also refer to the return earned by capital as an input in the production process.

Loanable Funds: Demand and Supply

• The equilibrium interest rate is determined by the demand for and supply of loanable funds.

• The Demand for loanable funds is composed of the demand for consumption loans, the demand for investment loans, and government’s demand for loanable funds.

• The supply of loanable funds comes through people’s saving and newly created money.

Demand and Supply for Loanable Funds

• Supply: The higher the interest rate, the greater the quantity supplied of loanable funds; The lower the interest rate, the lower the quantity supplied of loanable funds.

• Consumption Loans: Loanable funds are demanded by consumers because they have a positive rate of time preference – consumers prefer earlier availability of goods to later availability.

Demand For Loanable Funds

• Investors demand loanable funds so they can invest in roundabout methods of production. A firm using a roundabout method of production first directs its efforts to producing capital goods and then uses those goods to produce consumer goods.

• The capital-investive roundabout method of production is highly productive, which makes the production worthwhile. This makes firms prepared to borrow now to enter into the roundabout method of production.

The Loanable Funds Market

The sum of the demand for consumption loans and the demand for investment loans is the total demand for loanable funds. The interest rate and quantity demanded of of loanable funds are inversely related.

The Price for Loanable Funds and the Return on Capital Goods

Tend to Equality• Given: the return on capital is 10% and the

price for loanable funds is 8%

• Therefore: Firms will borrow in the loanable funds market and invest in capital goods.

• The return on capital and the price for loanable funds approach each other

Risk, Loan Terms, and Making the Loan

• The more risk associated with a loan, the higher the interest rate; the less risk associated with a loan, the lower the interest rate.

• The longer the term of the loan, the higher the interest rate; the shorter the term of the loan, the shorter the interest rate.

• Loans that cost more to process and administer will have higher interest rates than loans that cost less.

Nominal and Real Interest Rates

• Nominal interest rate is the interest rate determined by the forces of supply and demand in the loanable funds market.

• Nominal Interest rate will change if the demand for or supply of loanable funds changes.

• Individuals’ expectations of inflation are one of the factors that can change both the demand for and supply of loanable funds.

Expected Inflation and Interest RatesWe start at an 8% interest rate and an actual and expected inflation rate of 0%. Later, both borrowers and lenders expect an inflation rate of 4%. Borrowers are willing to pay a higher interest rate because they will be paying off their loans with cheaper dollars. Lenders require a higher interest rate because they will be paid back with cheaper dollars. The demand and supply curves shift such that Q1 borrowers are willing to pay and lenders require a 4%higher interest rate. The nominal interest rate is now 12%. The real interest rate is 8%.

Real Interest Rate

• The Real Interest Rate is the nominal interest rate adjusted for the expected inflation rate.

• Real interest rate=nominal interest rate – expected inflation rate

• The real interest rate, not the nominal interest rate, matters to borrowers and lenders.

Present Value

• Present Value refers to the current worth of some future dollar amount.

• PV=An/(1+i)n

Deciding Whether to Purchase A Capital Good

• Business firms often compute present values when trying to decide whether or not to buy a capital good.

• As the interest rate decrease, present values increase and firms will buy more capital goods; as interest rates increase, present values decrease and firms will buy fewer capital goods, all other things held constant.

Q & A

• Why does the price for loanable funds tend to equal the return on capital goods?

• Why does the real interest rate, and not the nominal interest, matter to borrowers and lenders?

• What is the present value of $1,000 two years from today if the interest rate is 5%?

• A business firm is thinking of buying a capital good. The capital good will earn $2,000 a year for the next four years and will cost $7,000. The interest rate is 8%. Should the firm buy the machine? Explain your answer.

Rent

• Economic Rent is a payment in excess of opportunity costs.

• Pure Economic Rent is a payment in excess of opportunity costs, when opportunity costs are zero

Pure Economic Rent and the Total Supply of Land

The total supply of land is fixed at Q1. The payment for the services of this land is determined by the forces of supply and demand. Because the payment is for a factor in fixed supply it is refereed to as pure economic rent.This depicts the supply of land as fixed. This is the case when the total supply of land is in question.

Economic Rent and Other Factors

• The concept of economic rent applies to economic factors besides land. An example is labor.

• Economic rent differs depending on the perspective from which the factor is being viewed.

Economic Rent and the Supply of Land (Competing Uses)

A particular parcel of land, as opposed to the total supply of land has competing uses, or positive opportunity costs. For example, to obtain land to build a shopping mall, the developers must bid high enough to attract existing land away from competing uses. The supply curve is upward sloping. At a payment of R1, economic rent is identified as the payment in excess of (positive) opportunity costs.

Artificial and Real Rents

• Individuals and firms will compete for both artificial rents and real rents.

• An artificial rent is an economic rent that is artificially contrived by government; it would not exist without a government.

• Competing for real rents is different: if the rent is real and there are no barriers to competing for it, resources are used in a way that is socially productive.

Q & A

• Give an example that illustrates that land rents are price determined, not price determining.

• Nick’s salary is pure economic rent. What does this imply about Nick’s “next best alternative salary”?

• What are the social consequences of firms competing for artificial rents as opposed to competing for real rents (where there are no barriers to real rents)?

Profit

• The “profits” that appear in newspaper headlines are accounting profits, not economic profits.

• Economic profit is the difference between total revenue and total cost, where both explicit and implicit costs are included in total cost.

Theories of Profit1. Profit and Uncertainty: Uncertainty exists

when a potential occurrence is so unpredictable that a probability cannot be estimated.

• Risk exists when the probability of a given event can be estimated.

• Risks can be insured against, while uncertainties cannot. Anything that can be insured against can be considered “a cost of doing business.”

• The investor-decision maker who is adept at making business decisions under conditions of uncertainty makes a profit.

Theories of Profit

2. Profit and Arbitrage Opportunities: “Buy Low, Sell High”.

• What is usually bought and sold is the same item.• Sometimes this refers to buying factors in one set

of markets at the lowest possible prices, combining the factors into a finished product, then selling the product for the highest possible price

3. Profit and Innovation: Profit is the return to the entrepreneur as innovator.

Monopoly Profits

• Monopolies can earn positive economic profits owing to the high barriers to entry.

• Monopoly profits can exist for a long time.

• Monopoly profits may be competed for and may disappear altogether if the monopoly market is contestable

Profit and Loss as Signals• Profit and loss signal how a market may be changing.• When a firm earns a profit, entrepreneurs in other industries

view this as a signal that the profit earning firm is producing and selling a good that buyers value more than the factors that go into making the good. The profit causes entrepreneurs to move resources into the production of the particular good to which the profit is linked.

• Resources follow profit.• If a firm is taking a loss, this is a signal that the firm is

producing a good buyers value less than the factors that make up the good. Thus, entrepreneurs turn away from making that particular good.

• Resources turn away from losses.

Q & A

• What is the difference between risk and uncertainty?

• Why does profit exist?• “Profit is not simply a

dollar amount, it is a signal.” Comment.