Rent, Interest, and Profit

Land & Rent Capital & Interest Entrepreneurship & Profit

Land & Rent

Land is defined as raw earth Also includes

• Minerals and resources buried in the land• Crops that can be grown on the land• Timber• Etc.

Does not include what is constructed on the Land How land is used depends upon a number of

factors• Location• Fertility• Minerals

How Land is Utilized

Highest and best Use Principle

Without some form of regulation, land will migrate to the use that people are willing to pay the most

Location is a key determinant of what the various demands for land will be

• Land located at the corner of 57th streets and Fifth avenue in Manhattan is worth considerably more than the same quantity of land located in downtown Tonopah, Nevada

Supply of & Demand for Land

The Supply of land is virtually fixed When the supply of a product or factor is fixed,

its supply is represented by a vertical line The demand for land, like all factors will be

determined by a firm’s MRP curve So, in absence of regulation, land will migrate

to the firm willing to pay the most for it

Determination of Rent

30-8Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

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

30-9Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

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

Payment in excess of what people would be willing to accept is called “Economic Rent”

It is a result of a fixed supply and a high demand Ethical question – Since land wasn’t created by

landlords, does it not properly belong to society? What right do current landlords have to extract rent

from something that was always there• Rents should be taxed – Henry George (1879)• Since God created the earth, only He is entitled to collect

rent – Pierre-Joseph Proudhon• A strong current in historical economic thought denies the

landlord’s claim to rent

Economic Rent, Continued

However; since price guides the use of land, price ensures that land is used for its most productive enterprises

Are prices high because rents are high? Or, are rents high because prices are high? Answer – Rents are high because of the

opportunity to generate profits – So, profitable locations bid up rents

Therefore, desirable (profitable) locations bid up rents

Capital & Interest

Capital is the plant, equipment and machinery used in the production process

Stock verses Flow• Stock equals a quantity of something at an instant in

time, such as the stock of capital -- How much capital we have at a moment in time?

• Flow is an “over time” concept – How much additional investment in capital takes place over a year?

The Demand for and Supply of Capital

The Demand for Capital is determined by the firm’s MRP for capital

The supply of loanable funds (the financial source of capital) is not fixed, but will be increased as the price of loanable funds (the interest rate) is increased

The history of the western world did not condone the making of money on money itself – Usury – Religious thought that collecting of interest was a sin

We still have usury laws on the books in all states To the economist, usury laws are price ceilings and

cause a shortage of loanable funds & disrupt the price mechanism

How Is the Interest Rate Determined?

30-13Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

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

The Present Value of Future Income

A dollar in my hand today is worth more than a dollar I expect to receive at some point in the future

“A bird in the hand is worth two in the bush”

Why?• Inflation may lower the value of expected income• Risk that expected income may not be realized• The opportunity cost of not having expected income now• These factors are represented as an interest rate (discount

rate) which discounts future expected cash flows to a present value

Present Value of Future Income

Present value of a dollar received n years from now = 1/(1+r) to the nth power

If the discount rate = 8%, how much is the Present value of $100 expected two years from now?

Answer = 1/1.08 squared = 1/1.1664 x $100 = .8573388 x $100 = $85.73

This is the basis of all “return on investment” calculations in financial investment decisions

Entrepreneurship and Profits

Unlike other factors of production, profit is not determined by the supply of and demand for entrepreneurship

Profits are considered a residual from Total Revenue after the payment of rent, interest, and wages

One could argue that since all other factors are determined by supply and demand, profits are indirectly determined by these forces

Your author estimates profit to be about 18.5% of the Nation’s National Income

Theories of Profit

Economic profit is the reward for recognizing a profit opportunity and taking advantage of it

Theories overlap, but see the entrepreneur as one who sees an advantage and grabs it

Theories• 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 only way to get someone to risk money is to offer a high reward (economic profit) as an incentive

Economic profit is associated with uncertainty; nothing ventured, nothing gained

Entrepreneurs are willing to take the risk in return for the opportunity of a large reward

Profit is the reward for risk bearing

The Entrepreneur as an Innovator

An invention is not the same as an innovation Innovation includes invention but also carries the

business process from production to marketing to profit generation; that is, it is the commercialization of the invention

It is the effort to carry an invention through to its logical conclusion – the generation of a profit

Joseph Schumpeter, noted Harvard economist, even stated that innovation and financial risk are two separate components – Financial risk is interest

The Entrepreneur as a Monopolist

The entrepreneur takes advantage of the idea of exclusivity to monopolize a product or service

Natural scarcity – to do it first and thereby lock out potential competitors

Contrived scarcity – to corner a market on a vital resource or gain economic power to limit competition and generate profit by reducing production and raising prices

• DeBeers (diamonds)• Early Railroads• National Football League

The Entrepreneur as an Exploiter of Labor

Karl Marx – The Capitalist exploits the value of Labor

If the worker could produce enough value to sustain life by working six hours/day, but is forced by the capitalist to work 12 hours a day for six hours of value, the capitalist expropriates 6 hours of labor’s value for himself

The capitalist uses the value of those six hours to purchase even more capital to exploit even more labor

The surplus value of labor is the capitalist’s profit

Profit We call profits as the income of the

entrepreneur or say that profit is the reward for the services of the entrepreneur.

We can simply define profits as the reward received by the entrepreneur for his contribution to the production process.

The excess of income from the sale of production over his costs of production is that we generally call profit.

Profit = Total Revenue – Rent – Wages -Interest

Definition of Entrepreneur

Here, Entrepreneur is one who takes the initiative of starting a business, organises it and employs other factor of production. He bears risks and takes all types of decisions regarding production.

Definition of profit

According to Marshall, Taussig, Robertson and Bober have defined profits as ‘the residual payment, what is left to the producer’s income after all the other payments have been met.”

According to Drucker, “ The surplus of current income over past cost is profit.”

Types of Profit

ProfitGross Profit Net Profit

Gross profit

What is commonly called ‘Profit’ is gross profit. Generally by profit we mean that part of income of firms which is available to them after all the payments to the three factors of production.

In other words, Gross profit is the excess of revenue over total explicit costs (direct).

Net Profit Net profits are the profits which accrue

to an entrepreneur for his functions as an entrepreneur. These functions include risk bearing ability, innovating spirit etc.

According to Snider, “The economist defines profits as the excess of sales receipt over explicit plus implicit expenses of production.”

Theories of Profit

Wage theory of profits Marginal productivity theory of

profit. Clark’s dynamic theory of profits. Schumpeter’s Innovation Theory of

profit