chapter 17 interest, rent, and profit gottheil — principles of economics, 7e © 2013 cengage...

Chapter 17Chapter 17

INTEREST, RENT, INTEREST, RENT, AND PROFITAND PROFIT

Gottheil — Principles of Economics, 7e© 2013 Cengage Learning1

Economic PrinciplesEconomic Principles

© 2013 Cengage Learning Gottheil — Principles of Economics, 7e2

Marginal physical product of capital

Marginal revenue product of capital

Loanable funds and equipment capital

Interest rate determination



The ethics of earning interest-based income

The present value of a property

Pure rent, differential rent, and location rent



Wage-related rents

Profit-related income

Interest, Rent, and ProfitInterest, Rent, and Profit


• Economists believe that capital is productive in precisely the same way that people are.

• We calculate the productivity of capital the same way we calculate the productivity of people.



Marginal revenue product (MRP) of capital• The change in total revenue that results from

adding one more dollar of loanable funds to production.



Loanable funds

• Money that a firm employs to purchase the physical plant, equipment, and raw materials used in production.



• The demand curve for loanable funds is identical to the firm’s MRP of capital curve.

• Each borrowed dollar must produce revenue for the firm that is greater than or equal to the rate of interest charged on the loan.



For example, suppose the rate of interest is 15 percent and the quantity of loans demanded by the firm is $8,000. Then each of the first $7,999 produces more than $0.15 in revenue. The $8,000th produces exactly $0.15.


EXHIBIT 1A EDWARDS’S DEMAND FOR LOANABLE FUNDS

© 2013 Cengage Learning11

EXHIBIT 1B EDWARDS’S DEMAND FOR LOANABLE FUNDS

Gottheil — Principles of Economics, 7e

Exhibit 1: Edwards’s Demand Exhibit 1: Edwards’s Demand for Loanable Fundsfor Loanable Funds


1. What will be the quantity of loanable funds demanded by the firm when the interest rate is 20 percent?

• At an interest rate of 20 percent, $7,000 of loanable funds will be demanded.

Exhibit 1: Edwards’s Demand Exhibit 1: Edwards’s Demand for Loanable Fundsfor Loanable Funds


2. What is the marginal revenue product if the firm decides to use $2,000 of loanable funds and the price per ton of coal is $2?

• Marginal revenue product of capital = price per unit × marginal physical product= $2 × 225 = $450.

Converting Loanable Funds to Converting Loanable Funds to Capital EquipmentCapital Equipment


Adding an additional dollar of loanable funds is different than adding another laborer to a firm.



• A firm can hire, lay off, and rehire miners without affecting their individual physical characteristics.

• Unlike adding labor, however, adding loanable funds used in production may require changing the physical character of the first loanable funds employed.



Capital equipment

• The machinery a firm uses in production. Capital equipment is unalterable in the short run.



For example, suppose a mining firm has $1,000 invested in picks and shovels and would like to purchase a $2,000 drill. Obviously the firm can’t add $1,000 to the $1,000 already invested in picks and shovels and end up with a new drill.

Edwards’s Demand for Edwards’s Demand for Loanable FundsLoanable Funds


Interest rate

• The price of loanable funds, expressed as an annual percentage return on a dollar of loanable funds.



Marginal factor cost

• The change in a firm’s total cost that results from adding one more unit of a factor (labor, capital or land) to production.



The MRP = MFC rule

• A firm will continue adding loanable funds to production as long as MRP is greater than or equal to MFC.

Loanable Funds in the Loanable Funds in the Economy: Demand and SupplyEconomy: Demand and Supply


The economy’s demand for loanable funds at the prevailing interest rate is the sum of each firm’s demand for loanable funds at that interest rate.

Loanable Funds in the Loanable Funds in the Economy: Demand and SupplyEconomy: Demand and Supply


Loanable funds market

• The market in which the demand for and supply of loanable funds determines the rate of interest.


EXHIBIT 2 THE ECONOMY’S DEMAND FOR AND SUPPLY OF LOANABLE FUNDS

Exhibit 2: The Economy’s Exhibit 2: The Economy’s Demand for and Supply of Demand for and Supply of

Loanable FundsLoanable Funds


Why is the supply curve of loanable funds upward sloping?• The supply curve reflects the willingness of

people to supply quantities of loanable funds at varying interest rates. At a higher interest rate, more people are willing to supply loanable funds.

The Equilibrium Rate of InterestThe Equilibrium Rate of Interest


• Supply and demand determine the equilibrium rate of interest.

• If conditions change, affecting either demand or supply, then the equilibrium interest rate will change as well.



The demand curve can change as a result of changes in capital’s MRP. Changes in MRP may be caused by:• Change in the marginal physical product of

capital.

• Change in the price of the product produced by that capital.

• New firms entering the market.



Changes in the supply curve are generally a reflection of people’s preferences for more present and less deferred consumption.


EXHIBIT 3 CHANGES IN THE RATE OF INTEREST

Exhibit 3: Changes in the Rate Exhibit 3: Changes in the Rate of Interestof Interest


What is the equilibrium rate of interest when the demand curve for loanable funds increases and the supply curve for loanable funds decreases in Exhibit 3? • The interest rate increases from r = 0.15 to

r = 0.25.

The Ethics of Income from The Ethics of Income from InterestInterest


Some would argue that those who receive income from interest are “unproductive” or “living off the sweat of the working class.”



Others would argue that loanable funds are a person’s property, just as a worker’s labor is their property. The loanable funds, or capital, are working for the person.



It may be the case that an individual worked and saved for many years in order to have funds to loan, while others spent their income on consumption items.



The ethics of earning income from interest brings up questions of property and property rights.• What is property?

• Who has claims to its productive capacity?

The Ethics of Income from InterestThe Ethics of Income from Interest


• Many people possess particular sets of physical or mental properties that work for him or her.

• Examples include athletic ability, musical talent and an exceptional mind.

• All of these are considered forms of property.

The Ethics of Income from InterestThe Ethics of Income from Interest


• Marxists understand how supply and demand for loanable funds determine the interest rate, but question how the supply of loanable funds got into the hands of the suppliers in the first place.

• They believe all private property originates in theft.

Present ValuePresent Value


Present value

• The value today of the stream of expected future annual income a property generates. The method of computing present value is to divide the annual income, R, by the rate of interest, r. That is, PV = R/r.



There is an inverse relationship between interest rates and present value.• As interest rates fall, present value

increases.

• As interest rates climb, present value decreases.



Property, in the world of economics, need not be physical.



For example, suppose you have a bubbling brook running through your property that you can sell access to for $10 per year. If 1,000 people buy access, the value of the brook is ($10 × 1,000)/(rate of interest).

Income from RentIncome from Rent


Rent

• The difference between what a productive resource receives as payment for its use in production and the cost of bringing that resource into production.



Land rent

• A payment to landowners for the use of land. It is the difference between the payment the resource receives and its supply price. In general land costs nothing to bring into being, so its supply price is $0.


EXHIBIT 4 DERIVING LAND RENT AND DIFFERENTIAL LAND RENT

Exhibit 4: Deriving Land Rent Exhibit 4: Deriving Land Rent and Differential Land Rentand Differential Land Rent


1. How does the value of land rent change in panel a of Exhibit 4 as demand shifts to the right?

• At demand curve D, the price per acre is $0, creating no land rent.



• At D1, the price per acre increases to $50, creating a $50-per-acre land rent.





• At D2, the land rent increases again to $75 per acre.



• In panel a, there are 120,000 acres of land available for cultivation, whatever the price, so the supply curve is vertical.

2. How is the supply curve for land in panel b different than in panel a of Exhibit 4?



2. How is the supply curve for land in panel b different than in panel a of Exhibit 4?

• In panel b, there are different supply prices for the 120,000 acres. The supply curve is upward sloping in a steplike fashion.



3. What is the supply price per acre for the first, second, and third 40,000 acre units of land in panel b?

• The first 40,000 acres have a $0 supply price—no improvement is needed in order to utilize the land.



3. What is the supply price per acre for the first, second, and third 40,000 acre units of land in panel b?

• The second 40,000 acres have a supply price of $50 and the third 40,000 acres have a supply price of $75.



4. What is the total land rent in panel b when demand is D1?

• Total land rent = (Land rent per acre) × (number of acres)

• Land rent per acre = (Market price per acre) – (Supply price)

• Total land rent = [$50 – $0]×40,000 = $2,000,000



Differential land rent

• Rent arising from differences in the cost of providing land.



In the Netherlands a system of dikes have been constructed in order to wrest land from the sea. There is a cost associated with securing this land.



The market price of the land is determined by the intersection of demand and supply.



Location rent

• Rent arising from differences in land distances from the marketplace.



• The closer a parcel of land is to the marketplace, the greater the land rent.

• If the location of the market changes, the fortune of the landowner changes.



For example, when shopping malls open in suburban areas, urban downtown property loses a great deal of value and suburban property increases in value.


EXHIBIT 5 A NEW SET OF RENT-YIELDING ACRES

Exhibit 5: A New Set of Rent-Exhibit 5: A New Set of Rent-Yielding AcresYielding Acres


• Because acre c is the furthest from the market, people there must pay the highest transportation cost to market. It becomesno-rent land at $0.

What is the location rent for acres a, b and c when the demand for food requires bringing acre c under cultivation in Exhibit 5?



What is the location rent for acres a, b and c when the demand for food requires bringing acre c under cultivation in Exhibit 5?• Acre b is only 25 miles from market, and

people there pay some transportation cost, but not as much as acre c. It’s location rent is $10.



What is the location rent for acres a, b and c when the demand for food requires bringing acre c under cultivation in Exhibit 5?• Acre a is at the market. As such, people there

have no transportation cost. The location rent is $20.



Wage-related rent

• The difference between what a resource receives and what it takes to bring the supply of that resource to market.



Wage-related rent

• It is the difference between what a person is paid and what they would be paid if they took their next best offer.



For example, suppose a baseball player is paid $2 million to play baseball. If the next best offer for the baseball player is to sell insurance for $30,000, then the wage-related rent = ($2 million - $30,000) = $1,970,000.


EXHIBIT 6 THE RENT COMPONENT IN COAL MINERS’ WAGES

Exhibit 6: The Rent Component Exhibit 6: The Rent Component in Coal Miners’ Wagesin Coal Miners’ Wages


How is the combined rent determined in Exhibit 6?• The combined rent is the sum of the

differences between the $13 equilibrium wage rate and the specific supply prices of each miner.

Income from ProfitsIncome from Profits


Profit

• Income earned by entrepreneurs.



Profit

• It is the reward for undertaking the uncertainties of enterprise.



Profit for the entrepreneur is income adjusted for the implicit costs of that entrepreneur’s labor and money capital.



For example, an entrepreneur with a new income-earning store must subtract from her income the opportunity cost of spending her time running the new store instead of working somewhere else.



She must also subtract the interest she would have received had she invested her money in the loanable funds market, rather than as capital in her store.

chapter 17 interest, rent, and profit gottheil — principles of economics, 7e © 2013 cengage...

Documents

eeconomic principles

dollar of loanable funds

quantity of loanable

loanable fundsmoney

propertypure rent

differential rent

total revenue

unit marginal physical