Chapter 29 Rent, Interest and

Profit

Economic Rent

To the business executive “rent” is a payment made for the use of a building, machine, or warehouse facility.

Economists use “rent” in a narrower sense. Economic rent is the price paid for the use of land and other natural resources that are completely fixed and in total supply.

Economic Rent

Perfectly Inelastic Supply – For all practical purposes the supply of land is perfectly inelastic, as reflected in supply curve S. Land has no production cost.

Changes in Demand – because the supply of land is fixed, demand is the only active determinant of land rent.

Economic RentChanges in Demand

What determines the demand for land?

1 – the price of the product grown on the land

2 – the productivity of the land

3 – the prices of the other resources which are combined with land

Figure 29-1 show different demand options. If the demand were D4, land rent would be zero. Land would be a free good. This situation was approximated in the free-land era of U.S. history

Economic RentLand Rent: A Surplus Payment

The perfectly inelastic supply of land must be contrasted with the relatively elastic supply of capital, such as apartment buildings, machinery, and warehouses.

In the long run, capital is not fixed in total supply. The supply curves of these nonland resources are upsloping, meaning the prices paid to such resources provide an incentive function. A higher price provides an incentive to offer more of the resource; a low price, an incentive to offer less.

This is not so with land. Rent serves no incentive function because the total supply is fixed. This is why economists consider rent a surplus payment not necessary to ensure that land is available to the economy as a whole.

Economic RentA Single Tax on Land

Henry George’s Proposal

The single-tax movement gained much support in the late 19th century.

This reform movement maintained that economic rent could be taxed away without

impairing the available supply of land or, therefore, the productive potential of the

economy as a whole.

Economic RentA Single Tax on Land

George observed the increasing demand for a resource whose supply was perfectly

inelastic. Landlords were receiving fabulously high incomes solely from

holding advantageously located land. George believed these land rents should be

heavily taxed and the revenue spent for public uses.

Economic RentProductivity Differences and Rent Difference

Different pieces of land vary greatly in productivity, depending on soil fertility and such climatic factors as rainfall and temperature.

Such productivity differences are reflected in resource demand and prices.

Location may be equally important in explaining differences in land rent.

Other things equal, rents will pay more for a unit of land which is strategically located than for a unit of land whose location is remote.

Example: the enormously high land rents of large metropolitan areas and at the bases of major alpine ski areas.

Economic RentAlternative Uses of Land

We know that land has alternative uses. An acre of farmland maybe useful in raising not only corn but also wheat, oats, barley, and cattle; or it may be used for a house, highway or factory

This tells us that a particular use of land involves an opportunity cost – the forgone production from the next best use of the resource.

Where there are alternative uses, individual firms must pay rent to cover these opportunity costs if they are to secure the use of land for their particular purpose

Interest

Interest is the price paid for the use of money

Interest is stated as a percentageMoney is not a resourceBusinesses “buy” the use of money

because it can be used to acquire capital goods – factories, machinery, warehouse

Loanable Funds Theory of Interest

Explains the interest rate in terms of the supply and demand for funds available for lending (and borrowing).

Supply is an upward slope because households will make available a larger quantity of funds at high interest rates than at low interest rates

Loanable Funds Theory of Interest

For people to delay consumption – increase their saving – they must be “bribed” or compensated by an interest payment.

Most economists view saving as being relatively insensitive to changes in the interest rate. The supply curve of loanable funds may therefore be more inelastic than implied in figure 29-2

Loanable Funds Theory of Interest

Demand is a downward slope because at higher interest rates fewer investment projects will be profitable to businesses and hence a smaller quantity of loanable funds will be demanded

At lower interest rates, more investment projects will be profitable and therefore more loanable funds will be demanded

Extending the Model

Financial Institutions – Profit by charging borrowers higher interest rates than the interest rates they pay saver

Changes in Supply – anything which causes households to be more thrifty will prompt them to save more at each interest rate, shifting the supply curve rightward

Extending the Model

Changes in Supply – conversely, a decline in thriftiness would shift the supply-of-loanable-funds curve to the left

Changes in Demand – anything which increases the rate of return on potential investments will increase the demand for loanable funds. This shift in the demand curve to the right and thus increasing the equilibrium interest rate

Extending the Model

Changes in Demand – anything which reduces the rate of return on potential investments would shift the demand curve for loanable funds to the left, reducing the equilibrium interest rate.

Other Participants – households can participate on both the supply and demand side of the loanable funds market

Extending the Model

Other Participants – Like households, businesses operate on both the supply and demand sides of the market.

Range of Interest Rates

See Table 29-1 on page 609. Here there are several of the interest rates referred to.

The differences are based on the following: Risk Maturity Loan size Taxability Market Imperfections

Pure Rate of Interest

The pure rate is best approximated by the interest paid on long-term, virtually riskless securities such as long-term bonds of the U.S. government (30-year Treasury bonds).

Role of the Interest Rate

The interest rate is a critical price; it affects both the level and the composition of investment goods production, as well as the amount of R&D spending

Interest and Total Output – A lower equilibrium interest rate encourages more borrowing by businesses for investment. Total spending in the economy therefore rises.

Role of the Interest Rate

Interest and Total Output – Conversely, a higher equilibrium interest rate discourages business borrowing for investment, reducing investment and total spending. Such a decrease in spending may be desirable if an economy is experiencing inflation

Role of the Interest Rate

Interest and the Allocation of Capital Prices are rationing devices. The interest rate

is no exception; it rations the available supply of loanable funds to investment projects whose rate of return or expected profitability is sufficiently high to allow payment of the going interest rate.

Role of the Interest Rate

Interest and the Allocation of Capital The interest rate allocates money, and

ultimately physical capital, to those industries in which it will be most productive and therefore most profitable. Such an allocation of capital goods is in the interest of society as a whole.

Interest and the Level and Composition of R&D Spending

The lower the interest rate – that is, the less the cost of borrowing funds for R&D – the greater the amount of R&D is the greatest

The interest rate allocates R&D funds to those firms and industries for which the expected rate of return on R&D is the greatest.

Nominal and Real Interest Rates

The nominal interest rate is the rate of interest expressed in dollars of current value.

The real interest rate is the rate of interest expressed in purchasing power – dollars of inflation-adjusted value.

Usury Laws

Usury laws specify a maximum interest rate at which loans can be made. The purpose is to hold down the interest cost of borrowing, particularly for low-income borrower.

If an usury law sets the rate below equilibrium what will be the effect?

Usury Laws

1. Nonmarket rationing – quantity of loanable funds demanded exceeds the quantity supplied: there is a shortage. Loans will be made to the most creditworthy borrowers.

2. Gainers and losers – Creditworthy borrowers gain and Lenders lose.

3. Inefficiency – usury laws may ration funds to less-productive investments