c hapter 17 interest, rent, and profit © 2002 south-western

CChapter 17hapter 17

Interest, Rent, and Profit

© 2002 South-Western

2

Economic PrinciplesEconomic Principles

• Marginal physical product of capital and marginal revenue product of capital

• Loanable funds and equipment capital

• Interest rate determination

3

Economic PrinciplesEconomic Principles

• The ethics of earning interest-based income

• The present value of a property

• Pure rent, differential rent, and location rent

4

Economic PrinciplesEconomic Principles

• Wage-related rents

• Profit-related income

5

Interest, Rent, and Interest, Rent, and ProfitProfit

• 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.

6

Interest, Rent, and Interest, Rent, and ProfitProfit

Loanable funds

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

7

Interest, Rent, and Interest, Rent, and ProfitProfit

Marginal revenue product (MRP) of capital

The change in total revenue that results from adding one more dollar of loanable funds to production.

8

Interest, Rent, and Interest, Rent, and ProfitProfit

• 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.

9

Interest, Rent, and Interest, Rent, and ProfitProfit

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.

10

EXHIBIT 1A EDWARDS’S DEMAND FOR LOANABLE FUNDS

11

EXHIBIT 1B EDWARDS’S DEMAND FOR LOANABLE FUNDS

12

Exhibit 1: Edward’s Exhibit 1: Edward’s Demand for Loanable Demand for Loanable

FundsFunds1. 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.

13

Exhibit 1: Edward’s Exhibit 1: Edward’s Demand for Loanable Demand for Loanable

FundsFunds2. 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.

14

From Loanable Funds From Loanable Funds to Equipment Capitalto Equipment Capital

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

15

From Loanable Funds From Loanable Funds to Equipment Capitalto Equipment Capital

• 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.

16

From Loanable Funds From Loanable Funds to Equipment Capitalto Equipment Capital

Capital equipment

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

17

From Loanable Funds From Loanable Funds to Equipment Capitalto Equipment Capital

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 cannot add $1,000 to the $1,000 already invested in picks and shovels and end up with a new drill.

18

Edwards’s Demand Edwards’s Demand for Loanable Fundsfor Loanable Funds

Interest rate

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

19

Edwards’s Demand Edwards’s Demand for Loanable Fundsfor 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.

20

Edwards’s Demand Edwards’s Demand for Loanable Fundsfor Loanable Funds

The MRP = MFC rule:

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

21

Loanable Funds in the Loanable Funds in the Economy: Demand Economy: Demand

and Supplyand 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.

22

Loanable Funds in the Loanable Funds in the Economy: Demand Economy: Demand

and Supplyand Supply

Loanable funds market

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

23

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

24

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

FundsFundsWhy 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.

25

The Equilibrium Rate The Equilibrium Rate of Interestof 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.

26

The Equilibrium Rate The Equilibrium Rate of Interestof Interest

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.

27

The Equilibrium Rate The Equilibrium Rate of Interestof Interest

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

28

EXHIBIT 3 CHANGES IN THE RATE OF INTEREST

29

Exhibit 3: Changes in Exhibit 3: Changes in the Rate of Interestthe Rate of 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.

30

The Ethics of Income The Ethics of Income from Interestfrom Interest

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

31

The Ethics of Income The Ethics of Income from Interestfrom Interest

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.

32

The Ethics of Income The Ethics of Income from Interestfrom Interest

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.

33

The Ethics of Income The Ethics of Income from Interestfrom Interest

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?

34

The Ethics of Income The Ethics of Income from Interestfrom 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.

35

The Ethics of Income The Ethics of Income from Interestfrom 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.

36

Present ValuePresent ValuePresent 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.

37

Present ValuePresent Value 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.

38

Present ValuePresent Value

Price floors artificially inflate the value of property.

39

EXHIBIT 4 PRICE AND OUTPUT IN THE TOBACCO MARKET

40

Exhibit 4: Price and Exhibit 4: Price and Output in the Tobacco Output in the Tobacco

MarketMarketWhere do the market demand and supply curves intersect in Exhibit 4?

• The demand and supply curves intersect at P = $3.00 and Q = 800,000. The market equilibrium price is $0.80 less than the price floor of $3.80.

41

Present ValuePresent Value

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

42

Present ValuePresent Value

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).

43

Income from RentIncome from RentRent

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

44

Income from RentIncome from RentLand 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.

45

EXHIBIT 5 DERIVING LAND RENT AND DIFFERENTIAL LAND RENT

46

Exhibit 5: Deriving Land Exhibit 5: Deriving Land Rent and Differential Rent and Differential

Land RentLand Rent1. How does the value of land rent change in panel a of Exhibit 5 as demand shifts to the right?

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

47

Exhibit 5: Deriving Land Exhibit 5: Deriving Land Rent and Differential Rent and Differential

Land RentLand Rent1. How does the value of land rent change in panel a of Exhibit 5 as demand shifts to the right?

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

48

Exhibit 5: Deriving Land Exhibit 5: Deriving Land Rent and Differential Rent and Differential

Land RentLand Rent1. How does the value of land rent change in panel a of Exhibit 5 as demand shifts to the right?

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

49

Exhibit 5: Deriving Land Exhibit 5: Deriving Land Rent and Differential Rent and Differential

Land RentLand Rent2. How is the supply curve for land in panel b different than in panel a of Exhibit 5?

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

50

Exhibit 5: Deriving Land Exhibit 5: Deriving Land Rent and Differential Rent and Differential

Land RentLand Rent2. How is the supply curve for land in panel b different than in panel a of Exhibit 5?

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

51

Exhibit 5: Deriving Land Exhibit 5: Deriving Land Rent and Differential Rent and Differential

Land RentLand Rent3. 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.

52

Exhibit 5: Deriving Land Exhibit 5: Deriving Land Rent and Differential Rent and Differential

Land RentLand Rent3. 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.

53

Exhibit 5: Deriving Land Exhibit 5: Deriving Land Rent and Differential Rent and Differential

Land RentLand Rent4. 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.

54

Income from RentIncome from Rent

Differential land rent

Rent arising from differences in the cost of providing land.

55

Income from RentIncome from Rent

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

56

Income from RentIncome from Rent

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

57

Income from RentIncome from Rent

Location rent

Rent arising from differences in land distances from the marketplace.

58

Income from RentIncome from Rent

• 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.

59

Income from RentIncome from Rent

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

60

EXHIBIT 6 A NEW SET OF RENT-YIELDING ACRES

61

Exhibit 6: A New Set of Exhibit 6: A New Set of Rent-Yielding AcresRent-Yielding Acres

What is the location rent for acres a, b and c when the demand for food requires bringing acre c under cultivation in Exhibit 6?• Because acre c is the furthest from the market, people there must pay the highest transportation cost to market. It becomes no-rent land at $0.

62

Exhibit 6: A New Set of Exhibit 6: A New Set of Rent-Yielding AcresRent-Yielding Acres

What is the location rent for acres a, b and c when the demand for food requires bringing acre c under cultivation in Exhibit 6?• 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.

63

Exhibit 6: A New Set of Exhibit 6: A New Set of Rent-Yielding AcresRent-Yielding Acres

What is the location rent for acres a, b and c when the demand for food requires bringing acre c under cultivation in Exhibit 6?• Acre a is at the market. As such, people there have no transportation cost. The location rent is $20.

64

Income from RentIncome from Rent

Wage-related rent

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

65

Income from RentIncome from Rent

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.

66

Income from RentIncome from Rent

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.

67

EXHIBIT 7 THE RENT COMPONENT IN COAL MINERS’ WAGES

68

Exhibit 7: The Rent Exhibit 7: The Rent Component in Coal Component in Coal

Miners’ WagesMiners’ WagesHow is the combined rent determined in Exhibit 7?

• The combined rent is the sum of the differences between the $13 equilibrium wage rate and the specific supply prices of each miner.

69

Income from ProfitsIncome from Profits

Profit

Income earned by entrepreneurs.

70

Income from ProfitsIncome from Profits

Profit

It is the reward for undertaking the uncertainties of enterprise.

71

Income from ProfitsIncome from Profits

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

72

Income from ProfitsIncome from Profits

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.

73

Income from ProfitsIncome from Profits

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.

74

Income from ProfitsIncome from Profits

In a corporation it is the stockholders who are the entrepreneurs. They are the ones who have invested their money and who alone assume the uncertainties of the business.