Chapter 14 - Rent, interest, and profit. After reading this chapter, you should be able to: Explain the nature of economic rent and how it is determined; describe the loanable funds theory of interest rates; demonstrate how interest rates relate to the time-value of money and vary based on risk, maturity, loan size, and taxability; relate why economic profits occur, and how profits, along with losses, allocate resources among alternative uses; list the share of U.S. earnings received by each of the factors of production.
Chapter 14 Rent, Interest, and Profit McGrawHill/Irwin Copyright © 2009 by The McGrawHill Companies, Inc. All rights reserved Chapter Objectives • • • • • Economic rent The loanable funds theory Interest rate variation Economic profits Distribution of U.S earnings 14-2 Economic Rent • Price paid for land and other natural resources • Perfectly inelasticity supply • Changes in demand • A surplus payment 14-3 Determination of Land Rent Land Rent (Dollars) S R1 D1 R2 D2 R3 D3 a b L0 Acres of Land D4 14-4 Economic Rent • Application: a single tax on land – Henry George’s proposal – Single tax movement – Criticisms • Productivity differences • Alternative uses of land 14-5 Interest • • • • Price paid for use of money Stated as a percentage Money is not a resource Loanable funds theory – Supply of loanable funds – Demand for loanable funds 14-6 Market For Loanable Funds The equilibrium interest rate Interest Rate (Percent) S i= 8% D F0 Quantity of Loanable Funds 14-7 Loanable Funds Theory • Extending the model • Financial institutions • Changes in supply – Household thrift • Changes in demand – Rate of return on investment • Other participants 14-8 Time-Value of Money • Money more valuable the sooner it is obtained – Ability to earn interest – Compound interest • Future value • Present value 14-9 Range of Interest Rates • There are many interest rates • Why interest rates differ? – Risk – Maturity – Loan size – Taxability • Pure rate of interest 14-10 Role of the Interest Rate • Relationship to – Total output – Allocation of capital – R&D spending • Nominal and real rates • Application: Usury Laws – Nonmarket rationing – Gainers and losers – Inefficiency 14-11 Nominal Interest Rates Short-Term Interest Rate, 2007 10 New Zealand Hungary Mexico Australia United Kingdom United States South Korea Canada Sweden Switzerland Japan Source: Organization for Economic Cooperation and Development 14-12 Economic Profit • • • • Explicit costs Implicit costs Pure profit Total revenue less explicit and implicit costs • Role of the entrepreneur – Normal profit 14-13 Sources of Economic Profit • Static economy • Risk and profit – Insurable and uninsurable risks – Changes in economic environment, structure of economy, government policy • Innovations and profit • Monopoly and profit 14-14 Economic Profit • Functions of profit – Profit and total output – Profit and resource allocation • Income shares • Labor receives 70-80% • Rest is rent, interest, profit 14-15 The Price of Credit • • • • • • • • Effective interest rates Discounting a loan Repaying a loan in installments Effects of compounding Truth in Lending Act 1968 Truth in Savings Act 1991 Fees and teaser rates Let the borrower beware 14-16 Key Terms • • • • • • • • • • economic rent incentive function single-tax movement loanable funds theory of interest time-value of money future value present value pure rate of interest nominal interest rate real interest rate • • • • • • • • usury laws explicit costs implicit costs economic or pure profit normal profit static economy insurable risks uninsurable risks 14-17 Next Chapter Preview… Natural Resource and Energy Economics 14-18 ... profit 1 4- 14 Economic Profit • Functions of profit – Profit and total output – Profit and resource allocation • Income shares • Labor receives 7 0-8 0% • Rest is rent, interest, profit 1 4- 15 The... normal profit static economy insurable risks uninsurable risks 1 4- 17 Next Chapter Preview… Natural Resource and Energy Economics 1 4- 18 ... Funds 1 4- 7 Loanable Funds Theory • Extending the model • Financial institutions • Changes in supply – Household thrift • Changes in demand – Rate of return on investment • Other participants 1 4- 8