Transcript Exhibit 5 - Choose your book for Principles of Economics, by Fred

Chapter 17
Interest, Rent, and Profit
© 2002 South-Western
Economic Principles
• Marginal physical product of
capital and marginal revenue
product of capital
• Loanable funds and equipment
capital
• Interest rate determination
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Economic Principles
• The ethics of earning interestbased income
• The present value of a property
• Pure rent, differential rent, and
location rent
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Economic Principles
• Wage-related rents
• Profit-related income
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Interest, Rent, and Profit
• 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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Interest, Rent, and Profit
Loanable funds
Money that a firm employs to
purchase the physical plant,
equipment, and raw materials
used in production.
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Interest, Rent, and Profit
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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Interest, Rent, and Profit
• 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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Interest, Rent, and Profit
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: Edward’s Demand
for Loanable Funds
1. 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: Edward’s Demand
for Loanable Funds
2. 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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From Loanable Funds to
Equipment Capital
Adding an additional dollar of
loanable funds is different than
adding another laborer to a firm.
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From Loanable Funds to
Equipment Capital
• 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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From Loanable Funds to
Equipment Capital
Capital equipment
The machinery a firm uses in
production. Capital equipment is
unalterable in the short run.
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From Loanable Funds to
Equipment Capital
For 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 cannot 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 for
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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Edwards’s Demand for
Loanable Funds
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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Edwards’s Demand for
Loanable Funds
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
Economy: Demand
and Supply
The 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
Economy: Demand
and Supply
Loanable 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
Demand for and Supply of
Loanable Funds
Why 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 Interest
• 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 Equilibrium Rate
of Interest
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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The Equilibrium Rate
of Interest
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 the 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
from 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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The Ethics of Income
from Interest
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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The Ethics of Income
from Interest
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 Income
from Interest
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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The Ethics of Income
from Interest
• 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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The Ethics of Income
from Interest
• 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 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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Present Value
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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Present Value
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 Output in
the Tobacco Market
Where 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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Present Value
Property, in the world of
economics, need not be physical.
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Present Value
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 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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Income from Rent
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 Rent
and Differential Land Rent
1. 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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Exhibit 5: Deriving Land Rent
and Differential Land Rent
1. How does the value of land rent
change in panel a of Exhibit 5 as
demand shifts to the right?
• At D1, the price per acre increases to
$50, creating a $50-per-acre land rent.
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Exhibit 5: Deriving Land Rent
and Differential Land Rent
1. 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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Exhibit 5: Deriving Land Rent
and Differential Land Rent
2. How is the supply curve for
land in panel b different than in
panel a of Exhibit 5?
• In panel a, there are 120,000 acres of
land available for cultivation, whatever
the price, so the supply curve is vertical.
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Exhibit 5: Deriving Land Rent
and Differential Land Rent
2. 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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Exhibit 5: Deriving Land Rent
and Differential Land Rent
3. 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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Exhibit 5: Deriving Land Rent
and Differential Land Rent
3. 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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Exhibit 5: Deriving Land Rent
and Differential Land Rent
4. 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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Income from Rent
Differential land rent
Rent arising from differences in
the cost of providing land.
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Income from Rent
In the Netherlands a system of
dikes have been constructed in
order to wrest land form the sea.
There is a cost associated with
securing this land.
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Income from Rent
The market price of the land is
determined by the intersection of
demand and supply.
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Income from Rent
Location rent
Rent arising from differences in
land distances from the
marketplace.
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Income from Rent
• 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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Income from Rent
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 RentYielding Acres
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?
• 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.
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Exhibit 6: A New Set of RentYielding Acres
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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Exhibit 6: A New Set of RentYielding Acres
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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Income from Rent
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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Income from Rent
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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Income from Rent
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
Component in Coal
Miners’ Wages
How 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 Profits
Profit
Income earned by entrepreneurs.
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Income from Profits
Profit
It is the reward for undertaking the
uncertainties of enterprise.
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Income from Profits
Profit for the entrepreneur is
income adjusted for the implicit
costs of that entrepreneur’s labor
and money capital.
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Income from Profits
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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Income from Profits
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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Income from Profits
In a corporation it is the
stockholders 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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