Transcript Income from Rent - Cengage Learning

Chapter 17
INTEREST, RENT,
AND PROFIT
© 2013 Cengage Learning
Gottheil — Principles of Economics, 7e
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Economic Principles
Marginal physical product of capital
Marginal revenue product of capital
Loanable funds and equipment
capital
Interest rate determination
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Gottheil — Principles of Economics, 7e
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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
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
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
• 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: Edwards’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: Edwards’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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Converting Loanable Funds to
Capital Equipment
Adding an additional dollar of loanable
funds is different than adding another
laborer to a firm.
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Converting Loanable Funds to
Capital Equipment
• 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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Converting Loanable Funds to
Capital Equipment
Capital equipment
• The machinery a firm uses in production.
Capital equipment is unalterable in the
short run.
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Converting Loanable Funds to
Capital Equipment
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 can’t 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
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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
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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
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 4
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DERIVING LAND RENT AND DIFFERENTIAL
LAND RENT
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Exhibit 4: Deriving Land Rent
and Differential Land Rent
1. How does the value of land rent
change in panel a of Exhibit 4 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 4: Deriving Land Rent
and Differential Land Rent
1. How does the value of land rent
change in panel a of Exhibit 4 as
demand shifts to the right?
• At D , the price per acre increases to $50,
creating a $50-per-acre land rent.
1
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Exhibit 4: Deriving Land Rent
and Differential Land Rent
1. How does the value of land rent
change in panel a of Exhibit 4 as
demand shifts to the right?
• At D , the land rent increases again to $75
per acre.
2
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Exhibit 4: 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 4?
• 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 4: 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 4?
• 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 4: 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 4: 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 4: 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 from 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 5
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A NEW SET OF RENT-YIELDING ACRES
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Exhibit 5: 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 5?
• 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 5: 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 5?
• 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 5: 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 5?
• 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 6
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THE RENT COMPONENT IN COAL MINERS’
WAGES
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Exhibit 6: The Rent Component
in Coal Miners’ Wages
How is the combined rent determined
in Exhibit 6?
• 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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