chapter 30 rent, interest, and profit 30-1 copyright 2002 by the mcgraw-hill companies, inc. all...

Chapter 30

Rent, Interest, and Profit

30-1Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter Objectives• What is land?• Economic rent• Are prices high because rents are high, or are rents

high because prices are high?• What is capital?• How is the interest rate determined?• The net productivity of capital• The capitalization of assets• The present value of future income• How are profits determined?• Theories of profit


What Is Rent?

• What is land?– Land is a resource or a factor of production– The owner of land is paid rent for allowing

its use in the production process– The amount of rent paid for a piece of land

is based on the supply of and the demand for land


What Is Land?

• Land is land

• How land is used depends on its location, its fertility, and whether it possesses any valuable minerals

• Sometimes we confuse land with what is built on it– Land with an apartment building on it will

rent for more than a vacant lot• However in economic terms we pay rent on the

land itself


How Does One Piece of Land Differ From Another?

• A plot of land may have a few alternative uses

• If it is used at all, it will be used by the highest bidder – the one willing to pay the most for it

• The basic way one piece of land differs from another is location– An acre of land in the middle of a desert is

worth a lot less than an acre of land in a metropolitan area


How Is the Supply of Land Arrived at?

• In economics we say the supply of land is fixed

• We can make more efficient use of land

• We represent the supply of land as a vertical line


How Is the Demand for Land Derived?

• The demand for land, like the demand for labor and capital, is derived from a firm’s MRP curve

• The land will go to the highest bidder• The demand curve for land slopes

downward to the right because its marginal physical product declines with output (due to diminishing returns)– If the firm is an imperfect competitor, it

must lower price to increase sales, thereby further depressing MRP as output expands


Determination of Rent


10,000

8,000

6,000

4,000

2,000

D

Amount of land

S

The demand for rent is the MRP schedule of the highest bidder for a specific piece of land. The supply of land is fixed, so its supply curve is perfectly inelastic. The rent, like the price of anything else, is set by supply and demand

Increase in Demand for Land


200,000

160,000

120,000

80,000

40,000

Amount of land

S

D2

D1

Since the supply of land is perfectly inelastic, an increase in demand is reflected entirely in an increase in price (and not an increase in the quantity of land).

Economic Rent

• Economic rent is payment in excess of what people would be willing to accept

• Rent paid to landlords (exclusive of any payment for buildings and property improvement ) is, by definition, economic rent


Are Prices High Because Rents Are High, or Are Rents High Because

Prices Are High?

• High rents don’t cause high prices• Desirable locations attract many prosperous

renters, who bid up rents because they believe they will get a lot of business

• Rents are high because the demand for the final product(s) – and consequently the derived demand – is high

• If low rents lead to low prices mom and pop stores would have lower prices, but they have higher prices


Capital• What is capital

– Capital consists of office buildings, factories, stores, machinery and equipment, computer systems, and other synthetic goods used in the production process

– When we invest we are spending money on new capital

– The stock of capital increases by means of a flow of investment

• Say you have a capital stock of four machines. You buy two more. That’s your investment for the year. Now you have a capital stock of six machines


How Is the Interest Rate Determined?


D

Quantity of loanable funds

Q1

2

4

6

8

10

12

14

16 SThe interest rate is determined by the demand for loanable funds and the supply of loanable funds

The supply of loanable funds (or savings) slopes upward to the right because the amount of money people save is somewhat responsive to interest rates

Interest Rates and Consumer Loans

• High interest rates deter borrowing for consumer loans

• Banks arguably charge too much on credit card loans

• Should this justify a legal ceiling (usury laws) on the interest that may be charged on these and other loans?


Usury Laws

• Usury laws place limits on how much interest may be charged

• Usury laws are price ceilings because they prevent the interest rates from rising to their equilibrium level– This creates a shortage of loanable funds


Usury Laws• How do usury laws hurt borrowers?

– Since usury laws create a shortage of loanable funds, the funds that are available go to the most creditworthy individuals and businesses first

– Borrowers with poor credit ratings are completely left out

• These borrowers are left with consumer finance companies that may not be subject to usury laws

• This means that if they can find money to borrow they will end up paying much higher interest rates than without usury laws


Interest Rate Ceiling


Quantity of loanable funds (in $billions)

100 200 300 400 500 600 700 800

Ceiling

D

S

4

8

12

16

20

24

28

32

36

Shortage of $350 billion

Determination of the Level of Investment


Amount of investment (in $millions)

10 20 30 40 50 60

2

4

6

8

10

12

14

16

18

20

22

24

Net productivityof capital

Net Productivity of Capital

The net productivity of capital is, in effect, a firm’s MRP schedule. In this case, given this firm’s net productivity of capital, it would borrow $40 million if the interest rate were 10 percent. The lower the interest rate, the more that would be borrowed and invested

The Net Productivity of Capital

• Economist have developed the concept of net productivity of capital, which translates into the expected profit rate– Subtract all cost (including an allowance for

a normal profit) from sales. This give us the dollar value of net productivity

– Assuming this value is positive, we divide it by capital cost to give us the net productivity of capital, which we express as a percentage



The Net Productivity of CapitalFind the net productivity of capital if sales = $150,000; labor cost = $30,000; raw materials = $10,000; fuel and maintenance = $5,000; normal profit = $5,000; and capital cost = $80,000

Sales $ 150,000 - Total Cost ________ x Dollar value of net productivity

Labor cost $30,000 Raw materials 10,000 Fuel and Maintenance 5,000 Normal Profit 5,000 Capital cost 80,000 Total Cost $130,000

$130,000$ 20,000


The Net Productivity of CapitalFind the net productivity of capital is sales = $150,000; labor cost = $30,000; Raw materials = $10,000; Fuel and maintenance = $5,000; Normal profit = $5,000; and Capital Cost = $80,000 ( are included in Total Cost)

Sales $ 150,000 - Total Cost ________ x Dollar value of net productivity

$ 130,000$ 20,000

----------------------------------------------------- = Net productivity of capital (25 percent)

Dollar value of net productivity ($20,000)

Capital cost ($80,000)

You would invest right up the point (or just short of the point) at which the interest rate equals the net productivity of capital

The Capitalization of Assets

• The capitalization of assets is just an alternate way of dealing with capital investment

• This concept enables a business firm to make a decision about purchasing a capital asset

• To make this decision a firm needs to know what is the value of that asset– To do this the firm must also know what the current

interest rate is


Value of Asset


How much is the value of a building that provides an annual income of $200 when the going rate of interest is 8%?

Value of Asset



Value of asset = ---------------------------------------------Annual income from asset

Interest rate

Value of Asset



Value of asset = --------------------------------------------- = ----------------- = $2,500Annual income from asset

Interest rate

$200

.08

If the interest rate rises, the value of an asset falls. If the interest rate falls, the value of an asset rises.

The Present Value of Future Income

• A dollar today is worth more than a dollar in the future– Because of inflation– Because the dollar can be lent out to earn

interest




Present value of a dollar received n years from now = -------------------------------------

1

(1 + r)n

r = the interest rate; n = the number of years




1

(1 + r)n


If the interest rate were 5%, how much would a dollar received one year from now be worth today?

= --------------------------------1

(1 + .05)1




1

(1 + r)n


If the interest rate were 5%, how much would a dollar deceived one year from now be worth today?

= --------------------------------1

(1 + .05)1

= ----------------------------------1

1.05= 95.24 cents




1

(1 + r)n


What is the present value of $1,000 that will be paid to you in three years if the interest rate is 5%. Work out to the nearest cent




1

(1 + r)n


= $1,000 X --------------------------------1

(1.05)3





1

(1 + r)n


= $1,000 X -------------------------------1

(1.05)3

= $1,000 X ---------------------------------- 1

1.157625





1

(1 + r)n


= $1,000 X -------------------------------1

(1.05)3

= $,1000 X ---------------------------------- 1

1.157625

= $1,000 X .863838 = $863.84


How Are Profits Determined?

• Economist treat profits as a residual left to the entrepreneur after rent, interest, and wages have been paid– One could argue that because these three

resource payments are determined by supply and demand, then what is left over, profits, are indirectly determined by supply and demand


Theories of Profiting

• The Entrepreneur as a Risk Taker

• The Entrepreneur as an Innovator

• The Entrepreneur as a Monopolist

• The Entrepreneur as an Exploiter of Labor


The Entrepreneur as a Risk Taker

• The entrepreneur is indeed a risk taker

• Starting a business is a risky endeavor– Most new businesses fail in the first five

years

• Why then do people start a new business?– If they succeed they will get a high rate of

return


The Entrepreneur ss an Innovator

• An innovation is not an invention– An invention is a new idea, a new product, or

a new way of producing things– An innovation is the act of putting the

invention to practical use– Innovation is what entrepreneurs do


The Entrepreneur as a Monopolist

• Monopolist and oligopolist make profits (economic) because of a shortage of competition

• If this shortage of competition is due to hard work, foresight, and innovation, one could hardly complain of the evils of big business– The shortage of competition is due to “natural

scarcities”

• If this shortage of competition is due to “contrived scarcities” and the business restricts output so it can make monopoly profits, that is another story –


The Entrepreneur as an Exploiter of Labor

• Karl Marx based his theory of profits on the supposition that the capitalist exploits the worker by taking the surplus value of the worker’s labor (profits) and using this to buy more capital to be able to exploit even more workers– Marx sees the capitalist’s role as that of exploiting

the employees– Have you ever worked for an organization that fit

this model?


Conclusion

• Which theory of profits is correct?

• Whichever theory you choose as correct– There is a lot of truth in each of the four theories

• We may conclude, then, that everybody’s right and that nobody has a monopoly on the truth


chapter 30 rent, interest, and profit 30-1 copyright 2002 by the mcgraw-hill companies, inc. all...

Documents

supply of land

land slopes

owner of land

plot of land

quantity of land

mcgrawhill companies

demand slide

specific piece of land