Chapter 30 - rent, interest, and profit. After studying this chapter you will be able to understand: 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.
Chapter 30 Rent, Interest, and Profit Copyright 2002 by The McGrawHill Companies, Inc. All rights reserved 301 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 Copyright 2002 by The McGrawHill Companies, Inc. All rights reserved 302 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 Copyright 2002 by The McGrawHill Companies, Inc. All rights reserved 303 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 Copyright 2002 by The McGrawHill Companies, Inc. All rights reserved 304 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 Copyright 2002 by The McGrawHill Companies, Inc. All rights reserved 305 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 Copyright 2002 by The McGrawHill Companies, Inc. All rights reserved 306 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 Copyright 2002 by The McGrawHill Companies, Inc. All rights reserved 307 Determination of Rent S 10,000 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 8,000 6,000 D 4,000 2,000 Amount of land Copyright 2002 by The McGrawHill Companies, Inc. All rights reserved 308 Increase in Demand for Land S 200,000 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) 160,000 120,000 D2 80,000 D1 40,000 Amount of land Copyright 2002 by The McGrawHill Companies, Inc. All rights reserved 309 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 Copyright 2002 by The McGrawHill Companies, Inc. All rights reserved 3010 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 Copyright 2002 by The McGrawHill Companies, Inc. All rights reserved 3026 The Present Value of Future Income r = the interest rate; n = the number of years Present value of a dollar received n years from now = Copyright 2002 by The McGrawHill Companies, Inc. All rights reserved (1 + r) n 3027 The Present Value of Future Income If the interest rate were 5%, how much would a dollar received one year from now be worth today? Present value of a dollar received n years from now = (1 + r) n = (1 + .05) r = the interest rate; n = the number of years Copyright 2002 by The McGrawHill Companies, Inc. All rights reserved 3028 The Present Value of Future Income If the interest rate were 5%, how much would a dollar deceived one year from now be worth today? Present value of a dollar received n years from now = (1 + r) n = (1 + .05)1 = r = the interest rate; n = the number of years Copyright 2002 by The McGrawHill Companies, Inc. All rights reserved 1.05 = 95.24 cents 3029 The Present Value of Future Income 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 Present value of a dollar received n years from now = (1 + r) n r = the interest rate; n = the number of years Copyright 2002 by The McGrawHill Companies, Inc. All rights reserved 3030 The Present Value of Future Income 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 Present value of a dollar received n years from now = (1 + r) n = $1,000 X (1.05) r = the interest rate; n = the number of years Copyright 2002 by The McGrawHill Companies, Inc. All rights reserved 3031 The Present Value of Future Income 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 Present value of a dollar received n years from now = (1 + r) n = $1,000 X (1.05) = $1,000 X 1.157625 r = the interest rate; n = the number of years Copyright 2002 by The McGrawHill Companies, Inc. All rights reserved 3032 The Present Value of Future Income 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 Present value of a dollar received n years from now = (1 + r) n = $1,000 X (1.05) = $,1000 X 1.157625 = $1,000 X .863838 = $863.84 r = the interest rate; n = the number of years Copyright 2002 by The McGrawHill Companies, Inc. All rights reserved 3033 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 Copyright 2002 by The McGrawHill Companies, Inc. All rights reserved 3034 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 Copyright 2002 by The McGrawHill Companies, Inc. All rights reserved 3035 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 Copyright 2002 by The McGrawHill Companies, Inc. All rights reserved 3036 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 Copyright 2002 by The McGrawHill Companies, Inc. All rights reserved 3037 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 – Copyright 2002 by The McGrawHill Companies, Inc. All rights reserved 3038 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? Copyright 2002 by The McGrawHill Companies, Inc. All rights reserved 3039 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 Copyright 2002 by The McGrawHill Companies, Inc. All rights reserved 3040 ... Copyright 2002 by The McGrawHill Companies, Inc. All rights reserved 30 5 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... 2002 by The McGrawHill Companies, Inc. All rights reserved 30 16 Interest Rate Ceiling S 36 32 28 24 20 Ceiling 16 12 D 100 200 300 400 500 600 700 800 Quantity of loanable funds (in $billions)... productivity of capital 16 14 12 10 10 20 30 40 50 60 Amount of investment (in $millions) Copyright 2002 by The McGrawHill Companies, Inc. All rights reserved 30 18 The Net Productivity of Capital