8/3/2019 Chapter 14 - Econ (1997 - 2003)

1/42

8/3/2019 Chapter 14 - Econ (1997 - 2003)

2/42

Rent as return to fixed factorsUnless you are planning to run your company from aballoon, land is an essential factor of production for

any business. The unusual feature of land is that itsquantity is fixed and completely unresponsive toprice.

The price of using land or other inputs in fixedsupply is called its rent (or pure economic rent)

Economists apply the term rent not only to landbut also to any factor that is fixed in supply Rent (or pure economic rent) is the payment for the

use of factors of production that are fixed in supply

8/3/2019 Chapter 14 - Econ (1997 - 2003)

3/42

Market equilibriumThe supply curve for land is completely inelastic that is,vertical because the supply of land is fixed.

Suppose the land can be used only to grow corn. If the demandfor corn rises, the demand curve for cornland will shift up and to

the right, and rent will rise. This leads to an important pointabout land: The price of land is high because the price of corn ishigh. This is fine example of derived demand which signifiesthat the demand for the factor is derived from the demand forthe product produced by the factor

Because the supply of land is inelastic, land will always work

whatever it can earn. Thus the value of the land derives entirelyfrom the value of the product, and not vice versa

8/3/2019 Chapter 14 - Econ (1997 - 2003)

4/42

After taxing the land, the total demand for the landsservices will not have changed.At a price (including tax) of$200 in slide 7, people will continue to demand the entire

fixed supply of land. Hence, with land fixed in supply, themarket rent on land services (including the tax) will beunchanged and must be at the original market equilibrium at

point E. What will happen to the rent received by the landowners?

Demand and quantity supplied are unchanged, so themarket price will be unaffected by the tax. Therefore, the taxmust have been completely paid out of the landownersincome

8/3/2019 Chapter 14 - Econ (1997 - 2003)

5/42

Landowners will surely complain. But under perfectcompetition there is nothing they can do about it, since theycannot alter the total supply and the land must work whateverit can get. Half a loaf is better than none

You might at this point wonder about the effects of such a tax

on economic efficiency. The striking result is that tax on rentwill lead to no distortions (deformation) or economicinefficiencies. This surprising result comes because a tax onpure economic rent does not change anyones economicbehavior. Demanders are unaffected because their price isunchanged. The behavior of suppliers is unaffected because the

supply of land is fixed and cannot react. Hence, the economyoperates after the tax exactly as it did before the tax with nodistortions or inefficiencies arising as a result of the land tax.

8/3/2019 Chapter 14 - Econ (1997 - 2003)

6/42

8/3/2019 Chapter 14 - Econ (1997 - 2003)

7/42

8/3/2019 Chapter 14 - Econ (1997 - 2003)

8/42

Economic analysis traditionally divides factors ofproduction into three categories: land, labor, and

capital. The first two of these are called primary ororiginal factors of production, whose suppliers aredetermined largely outside of the marketplace. Tothem we add a produced factor of production,

capital Capital (or capital goods) consists of those durable

produced goods that are in turn used as productiveinputs for further production.

8/3/2019 Chapter 14 - Econ (1997 - 2003)

9/42

Some capital goods might last a few years, whileothers might last for a century or more. But theessential property of a capital good is that it is bothan input and an output

There are three major categories of capital goods:structures (such as factories and homes), equipment(consumer durable goods like automobiles andproducer durable equipment like machine tools andcomputers), and inventories of inputs and outputs(such as cars in dealers lots).

8/3/2019 Chapter 14 - Econ (1997 - 2003)

10/42

Capital goods are bought ad sold in capital-

goods markets. For example, Dell sells

computers to businesses; these computersare used by firms to help improve the

efficiency of their payroll systems orproduction management. When sales occur,

we observe the prices of capital goods

Payments for the temporary use of capital

goods are called rentals

8/3/2019 Chapter 14 - Econ (1997 - 2003)

11/42

One of the most important tasks of any economy,business, or household is to allocate its capitalacross different possible investments. Should a

country devote its investment resources to heavymanufacturing like steel or informationtechnologies like the internet?

In deciding upon the best investment, we need a

measure that yield or return to capital.Oneimportant measure is the rate of return on capital,which denotes the net dollar return per year forevery dollar of invested capital

8/3/2019 Chapter 14 - Econ (1997 - 2003)

12/42

You might be considering different investments: rental cars,oil wells, apartments, education, and so forth. Your financialadvisers tell you that you do not have sufficient cash toinvest in everything, so how can you decide which

investments to make? One useful approach is to compare the rates of return on

capital of the different investments. For each one, you firstcalculate the dollar cost of the capital good. Then estimatethe net annual dollar receipts or rentals yielded by the asset.

The ratio of the annual net rental to the dollar cost is the rateof return on capital: it tells you the amount of money you getback for every dollar invested, measured as dollars per yearper dollar of investment

8/3/2019 Chapter 14 - Econ (1997 - 2003)

13/42

I buy a grape for $10 and sell it a year later as winefor $11. If there are no other expenses, the rate of

return on investment is 10% per year. ($11 - $10)/$10= 10% I plant a tree with labor cost of $100.At the end of

25 years the grown tree sells for $430. The rate of

return on this capital project is then 330 percent perquarter-century, which a calculator will show, isequivalent to a return of 6% per year. That is, $100 x(1.06) to the power of 25 = 430

8/3/2019 Chapter 14 - Econ (1997 - 2003)

14/42

Tangible assets consist of land and capital goodslike computers, buildings, and automobiles that are

used to produce further goods and services Financial assets are monetary claims by one party

against another party.An important example is amortgage, which is a claim by a bank against a

homeowner for monthly payments of interest andprincipal; these payments will repay the originalloan that helped finance the house purchase(essentially pieces of paper)

8/3/2019 Chapter 14 - Econ (1997 - 2003)

15/42

When people save, they expect a return. This is theinterest rate, or the financial return on funds, or the

annual return on borrowed funds Households and other savers provide financial

resources or funds to those who want to invest intangible or intangible capital. The rate of interest

represents the price that a borrower pays to alender for the use of the money for a period of time;interest rates are quoted as a certain percent yieldper year

8/3/2019 Chapter 14 - Econ (1997 - 2003)

16/42

The difference between real and nominal interest ratesis particularly dramatic during periods of high inflation

We call the real yield of funds the real interest rate, as

opposed to the nominal interest rate, which is the dollarreturn on dollar invested. For low rates of interest andinflation, the real interest rate is very close to thenominal interest rate minus the rate of inflation

The real interest rate is the return on funds in terms ofgoods and services; we generally calculate the realinterest rate as the nominal interest rate minus the rateof inflation

8/3/2019 Chapter 14 - Econ (1997 - 2003)

17/42

Capital goods are durable assets that produce astream (flow) of rental or receipts over time

Suppose you become weary of tending the buildingand decide to sell it. To set a fair price for thebuilding, you would need to determine the valuetoday of the entire stream of future income. Thevalue of that stream is called the present value ofthe capital asset

The present value is the dollar value today of astream of income over time. It is measured bycalculating how much money invested today wouldbe needed, at the going interest rate, to generatethe assets future stream of receipts

8/3/2019 Chapter 14 - Econ (1997 - 2003)

18/42

We present the first way of calculatingpresent value by examining the case ofperpetuity, which is an asset like land that

lasts forever and pays $N each year from nowto eternity

V = $N/I Where V = present value of the land $N = perpetual annual receipts ($ per year) i = interest rate I decimal terms (e.g., 0.05, or

5/100 per year)

8/3/2019 Chapter 14 - Econ (1997 - 2003)

19/42

This says that if the interest rate is always 5percent per year, an asset yielding a constant

stream of income will sell for exactly 201 / (5/10) times its annual income. In this case,

what would be the present value of a

perpetuity yielding $100 every year?At a 5

percent interest rate its present value wouldbe $ 2,000 ( = 100 / 0.05)

8/3/2019 Chapter 14 - Econ (1997 - 2003)

20/42

Having seen the simple case of the perpetuity, wemove to the general case of the present value of anasset with an income stream that varies over time

V = N1/(1+i) + N2/(1+i) to the power of two + Nt/(1+i) to the power of time

For example, assume that the interest rate is 10percent per year ad that I am to receive $ 1,100 ext

year and $ 2,662 in 3 years. The present value of thisstream is:

V = 1,100/(1.10) + 2,662/(1.10) = 3,000

8/3/2019 Chapter 14 - Econ (1997 - 2003)

21/42

There is one rule that gives correct answers to

all investment decisions. Calculate the

present value resulting from each possibledecision. Then always act so as to maximize

present value. In this way you will have morewealth to spend whenever and however you

like

8/3/2019 Chapter 14 - Econ (1997 - 2003)

22/42

8/3/2019 Chapter 14 - Econ (1997 - 2003)

23/42

The lower, rust area shows the present valueof a machine giving net annual rentals of

$100 for 20 years with an interest rate of 6percent per year. The upper, gray area has

been discounted away. Explain why raising

the interest rate increases the gray area and

therefore depresses the market price of anasset

8/3/2019 Chapter 14 - Econ (1997 - 2003)

24/42

In addition to wages, interest, ad rent, economiesoften talk about a fourth category of income called

profits. What are profits? How do they differ frominterest and the returns on capital more generally? Accountants define profits as the difference

between total revenues and total costs

To the economist, business profits are ahodgepodge (mixture) of different elements ,including returns on owners capital, reward for riskbearing, and innovational profits

8/3/2019 Chapter 14 - Econ (1997 - 2003)

25/42

Much of reported business profits is primarily thereturn to the owners of the firm for the capital andlabor provided by the owners of the firm such as

the doctor or lawyer who works in a smallprofessional corporation. Part is the ret return onland owned by the firm. In large corporations, mostprofits are the opportunity costs invested capital.

These returns are called implicit returns (or costs)which is the name given to the opportunity costs offactors owed by firms

8/3/2019 Chapter 14 - Econ (1997 - 2003)

26/42

Profits also include a reward for the riskiness

of the investments.Most businesses must

incur (earn) a risk of default, which occurswhen a loan or investment cannot be paid,

say when the borrower went bankrupt

In addition, there are may insurable risks, such

as those for fires or hurricanes, analyzed inChapter 11, which can be covered through

purchase of insurance

8/3/2019 Chapter 14 - Econ (1997 - 2003)

27/42

A third kind of risk is the uninsurable or systematic riskofinvestments. A company may have a high degree ofsensitivity to business cycles, which means that its earningsfluctuate a great deal when aggregate output goes up ordown. Yet a fourth category is sovereign risk, which occurswhen a nation defaults on its obligations and (because thegovernment is sovereign (ruler) and exercises ultimatelegal authority) there is no recourse in the legal systems

Because they contain elements of these four kinds of risk,corporate profits are the most volatile (unstable) component

of national income. The rights to earn corporate profits corporate stocks or equities must therefore provide asignificant premium (payment) to attract risk-averseinvestors.

8/3/2019 Chapter 14 - Econ (1997 - 2003)

28/42

A third kind of profits consists of the returns to innovation

and invention.A growing economy is constantly producingnew products from telephones in the nineteenth century to

automobiles early in the twentieth century to the computer-related goods ad services in the present era. These newproducts are the result of research, development, and

marketing. We call the person who brings a new product orprocess to market a innovator or entrepreneur

Every successful innovation creates a temporary pool ofmonopoly. We can identify innovational profits (sometimescalled Schumpeterian profits) as the temporary excess return

to investors or entrepreneurs

8/3/2019 Chapter 14 - Econ (1997 - 2003)

29/42

Amodern industrial economy has accumulatedlarge stocks of capital, or capital goods. These arethe machines, buildings, and inventories that are so

vital to an economys productivity The annual dollar earnings on capital are called

rental. When we divide the net earrings (rentals lesscosts) by the dollar value of the capital generatingthe rentals, we obtain the rate of return on capital

(measured in percent per year) Capital is financed by savers who lend funds and

hold financial assets. The dollar yield on thesefinancial assets is the interest rate , measured inpercent per year

8/3/2019 Chapter 14 - Econ (1997 - 2003)

30/42

Capital goods and financial assets generate astream of income over time. This stream can beconverted into a present value, that is, the valuethat the stream of income would be worth today.

This conversion is made by asking what quantity ofdollars today would be sufficient to generate theassets stream of income at going market interestrates

Profits are residual income item, equal to total

revenues minus total costs. Profits contain elementsof implicit returns (such as return on ownerscapital), return for risk bearing, and innovationalprofits

8/3/2019 Chapter 14 - Econ (1997 - 2003)

31/42

Roundaboutness investment in capital goods involvesindirect or roundabout production. Instead of catching fishwith our hands, we find it ultimately more worthwhile first tobuild boats and nets to catch many more fish than we could

by hand Put differently, investments in capital goods involves

forgoing present consumption to increase futureconsumption. Consuming less today frees labor for makingnets to catch many more fish tomorrow. In the most generalsense, capital is productive because by forgoingconsumption today we get more consumption in the future

By sacrificing current consumption and building capitalgoods today, societies ca increase their consumption in thefuture

8/3/2019 Chapter 14 - Econ (1997 - 2003)

32/42

8/3/2019 Chapter 14 - Econ (1997 - 2003)

33/42

The graph shows two islands begin with equal

endowments (natural quality or ability) oflabor and natural resources. Lazy islandA

invests nothing and shows a modest growth

in per capita consumption. Thrifty Island Bdevotes an initial period to investment,

forgoing consumption, and then enjoys theharvest of much higher consumption in the

future

8/3/2019 Chapter 14 - Econ (1997 - 2003)

34/42

Lets take the example of computers. The firstcomputers were expensive and used intensively.Three decades ago, scientists would eke every last

hour of time from an expensive mainframecomputer that had less power than todays personalcomputer

The marginal product of computer power thevalue of the last calculation or the last byte of

storage had diminished greatly as computerinputs increased relative to labor, land, and othercapital.More generally, as capital accumulates,diminishing returns set in ad the rate of return onthe investments tends to fall

8/3/2019 Chapter 14 - Econ (1997 - 2003)

35/42

Short-run equilibriumThe rate of return on capital exactly equals the marketinterest rate.Any higher interest rate would find firms

unwilling to borrow for their investments; any lower interestrate would find firms clamoring (shouting) for the too scarcecapital.Only at the equilibrium interest rate of 10 percent aresupply and demand equilibrated

Long-run equilibriumIn the long-run equilibrium, the interest rate is at the levelwhere the desired capital stock held by the firms matchesthe desired wealth that people want to own.At the long-runequilibrium, et savings stops, net capital accumulation iszero, and the capital stock is no longer growing

8/3/2019 Chapter 14 - Econ (1997 - 2003)

36/42

8/3/2019 Chapter 14 - Econ (1997 - 2003)

37/42

8/3/2019 Chapter 14 - Econ (1997 - 2003)

38/42

Taxes and inflationRecall that inflation tends to reduce the quantity of goodsyou can buy with your dollars. Therefore, we want tocalculate the real interest rate or the real return to our

investments, removing the effect of the changing yardstick(standard) of money.Another important feature is taxes.Part of our incomes goes to the government programs.Therefore, investors will want to focus on the postax returnon investments

Technological disturbancesHistorical studies show that inventions and discoveries raisethe return on capital and thereby affect equilibrium interestrates. Indeed, the tendency toward falling interest rates viadiminishing returns has been just about cancelled out byinventions and technological progress

8/3/2019 Chapter 14 - Econ (1997 - 2003)

39/42

Almost any loan or investment has an element ofrisk.Machines break down; a oil well may turn outto be a dry hole; you favorite internet company may

go belly up. Investments differ in their degree ofrisk, but no investment is completely risk-free Investors are generally averse to holding risky

assets. They would rather hold an asset that is sureto yield them 10 percent than an asset that is

equally likely to yield 0 or to 20 percent. Investorsmust therefore receive an extra return, or riskpremium, to induce (bring) them to holdinvestments with high systematic or uninsurablerisk

8/3/2019 Chapter 14 - Econ (1997 - 2003)

40/42

Economists emphasize that a free market in capitaland land will promote high rates of saving andinvestment, rapid economic growth, and healthy

productivity growth. Three final thoughtsa. Competitive factor markets promote efficiency.Peoples market incomes are determined by rents,interest, and wages. We may or may not like the

competitive distribution of income, but we mustrecognize that competitive pricing helps solve thequestion of how goods are to be produced in anefficient manner

8/3/2019 Chapter 14 - Econ (1997 - 2003)

41/42

B. Capital markets balance saving and investment. Whenpeople look at profits, they usually think about the dollarsthat corporations are paying to management andstockholders. These perceptions overlook the basic pointabout the role of capital in a market economy. The

accumulation of capital and its return are drive by twofundamental forces.On the one hand, the demand forcapital results from the fact that indirect or roundaboutproduction processes are productive; by abstaining fromconsumption today, society can raise consumption in thefuture.On the other hand, people must be willing to abstain

from consumption in order to accumulate financial assets,lending funds to firms that will make the productiveinvestments in roundabout productive processes.

8/3/2019 Chapter 14 - Econ (1997 - 2003)

42/42

C. Governments can reduce inequality without impairing(spoiling) efficiency. Finally, we must remember thatincomes are not carved in granite. Factor prices are affectedby government policies, and incomes can be modified by

transfer payments. If society dislikes the inequality broughtabout by high land rents or fabulous wages of uniqueindividuals, taxes on these factors can reduce inequalitywithout inducing great inefficiencies. Well-designed taxes onhigh incomes and inheritances, efficient wage subsidies to

low-wage workers, and transfer programs to help the trulyneedy ca reduce the worst inequalities of a market economy without impairing the ability of factor prices to guidemarkets to efficient allocations