© 2005 Thomson C hapter 17 Interest, Rent, and Profit

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CChapter 17hapter 17

Interest, Rent, and Interest, Rent, and ProfitProfit

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Gottheil - Principles of Economics, 4e

Economic PrinciplesEconomic PrinciplesMarginal physical product of capital

Marginal revenue product of capital

Loanable funds and equipment capital

Interest rate determination

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Economic PrinciplesEconomic Principles

The ethics of earning interest-based income

The present value of a property

Pure rent, differential rent, and location rent

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Economic PrinciplesEconomic Principles

Wage-related rents

Profit-related income

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• 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.

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Marginal revenue product (MRP) of capital• The change in total revenue that results from adding one more dollar of loanable funds to production.

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Loanable funds

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

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• 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.

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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.

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EXHIBIT 1A EDWARDS’S DEMAND FOR LOANABLE FUNDS

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EXHIBIT 1B EDWARDS’S DEMAND FOR LOANABLE FUNDS

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Exhibit 1: Edwards’s Exhibit 1: Edwards’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.

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Exhibit 1: Edwards’s Exhibit 1: Edwards’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.

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Converting Loanable Converting Loanable Funds to Capital Funds to Capital

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

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EquipmentEquipment• 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.

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EquipmentEquipmentCapital equipment

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

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EquipmentEquipmentFor 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.

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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.

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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.

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The MRP = MFC rule

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

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

SupplySupplyThe 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.

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

SupplySupplyLoanable funds market

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

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

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

of Loanable Fundsof Loanable FundsWhy 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.

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The Equilibrium Rate of The Equilibrium Rate of InterestInterest

• 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.

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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.

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

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EXHIBIT 3 CHANGES IN THE RATE OF INTEREST

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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.

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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.”

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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.

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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.

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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?

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• 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.

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• 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.

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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.

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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.

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Price floors artificially inflate the value of property.

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EXHIBIT 4 PRICE AND OUTPUT IN THE TOBACCO MARKET

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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.

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

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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).

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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.

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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.

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EXHIBIT 5 DERIVING LAND RENT AND DIFFERENTIAL LAND RENT

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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.

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Land RentLand Rent

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

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

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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.

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Land RentLand Rent

• 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 5?

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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.

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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.

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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.

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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.

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Differential land rent

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

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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.

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

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Location rent

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

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• 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.

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

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EXHIBIT 6 A NEW SET OF RENT-YIELDING ACRES

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

• 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.

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?

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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.

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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.

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Wage-related rent

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

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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.

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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.

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EXHIBIT 7 THE RENT COMPONENT IN COAL MINERS’ WAGES

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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.

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Income from ProfitsIncome from Profits

Profit

• Income earned by entrepreneurs.

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Profit

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

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

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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.

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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.

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

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© 2005 Thomson C hapter 17 Interest, Rent, and Profit