Chapter 30: Rent, Interest, and Profit

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

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Chapter 30Rent, Interest, and Profit30-1Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Chapter ObjectivesWhat is land?Economic rentAre 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 capitalThe capitalization of assets The present value of future incomeHow are profits determined?Theories of profit30-2Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.What Is Rent?What is land?Land is a resource or a factor of productionThe owner of land is paid rent for allowing its use in the production processThe amount of rent paid for a piece of land is based on the supply of and the demand for land 30-3Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.What Is Land?Land is landHow land is used depends on its location, its fertility, and whether it possesses any valuable mineralsSometimes we confuse land with what is built on itLand with an apartment building on it will rent for more than a vacant lotHowever in economic terms we pay rent on the land itself30-4Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.How Does One Piece of Land Differ From Another?A plot of land may have a few alternative usesIf it is used at all, it will be used by the highest bidder – the one willing to pay the most for itThe basic way one piece of land differs from another is locationAn acre of land in the middle of a desert is worth a lot less than an acre of land in a metropolitan area30-5Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.How Is the Supply of Land Arrived at?In economics we say the supply of land is fixedWe can make more efficient use of landWe represent the supply of land as a vertical line30-6Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.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 curveThe land will go to the highest bidderThe 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 30-7Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Determination of Rent30-8Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.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 Land30-9Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.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 RentEconomic rent is payment in excess of what people would be willing to acceptRent paid to landlords (exclusive of any payment for buildings and property improvement ) is, by definition, economic rent 30-10Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Are Prices High Because Rents Are High, or Are Rents High Because Prices Are High?High rents don’t cause high pricesDesirable locations attract many prosperous renters, who bid up rents because they believe they will get a lot of businessRents are high because the demand for the final product(s) – and consequently the derived demand – is highIf low rents lead to low prices mom and pop stores would have lower prices, but they have higher prices 30-11Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.CapitalWhat is capitalCapital consists of office buildings, factories, stores, machinery and equipment, computer systems, and other synthetic goods used in the production processWhen we invest we are spending money on new capitalThe stock of capital increases by means of a flow of investmentSay you have a capital stock of four machines. You buy two more. That’s your investment for the year. Now you have a capital stock of six machines30-12Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.How Is the Interest Rate Determined?30-13Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The interest rate is determined by the demand for loanable funds and the supply of loanable fundsThe supply of loanable funds (or savings) slopes upward to the right because the amount of money people save is somewhat responsive to interest rates Interest Rates and Consumer LoansHigh interest rates deter borrowing for consumer loansBanks arguably charge too much on credit card loansShould this justify a legal ceiling (usury laws) on the interest that may be charged on these and other loans?30-14Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Usury LawsUsury laws place limits on how much interest may be chargedUsury laws are price ceilings because they prevent the interest rates from rising to their equilibrium levelThis creates a shortage of loanable funds30-15Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Usury LawsHow do usury laws hurt borrowers?Since usury laws create a shortage of loanable funds, the funds that are available go to the most creditworthy individuals and businesses firstBorrowers with poor credit ratings are completely left outThese borrowers are left with consumer finance companies that may not be subject to usury lawsThis means that if they can find money to borrow they will end up paying much higher interest rates than without usury laws30-16Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Interest Rate Ceiling30-17Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Shortage of $350 billion Determination of the Level of Investment30-18Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Net Productivity of CapitalThe net productivity of capital is, in effect, a firm’s MRP schedule. In this case, given this firm’s net productivity of capital, it would borrow $40 million if the interest rate were 10 percent. The lower the interest rate, the more that would be borrowed and investedThe Net Productivity of CapitalEconomist have developed the concept of net productivity of capital, which translates into the expected profit rateSubtract all cost (including an allowance for a normal profit) from sales. This give us the dollar value of net productivityAssuming this value is positive, we divide it by capital cost to give us the net productivity of capital, which we express as a percentage 30-19Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.30-20Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Net Productivity of CapitalFind the net productivity of capital if sales = $150,000; labor cost = $30,000; raw materials = $10,000; fuel and maintenance = $5,000; normal profit = $5,000; and capital cost = $80,000 Sales $ 150,000 - Total Cost ________ x Dollar value of net productivity Labor cost $30,000 Raw materials 10,000 Fuel and Maintenance 5,000 Normal Profit 5,000 Capital cost 80,000 Total Cost $130,000 $130,000$ 20,00030-21Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Net Productivity of CapitalFind the net productivity of capital is sales = $150,000; labor cost = $30,000; Raw materials = $10,000; Fuel and maintenance = $5,000; Normal profit = $5,000; and Capital Cost = $80,000 ( are included in Total Cost) Sales $ 150,000 - Total Cost ________ x Dollar value of net productivity $ 130,000$ 20,000----------------------------------------------------- = Net productivity of capital (25 percent)Dollar value of net productivity ($20,000) Capital cost ($80,000)You would invest right up the point (or just short of the point) at which the interest rate equals the net productivity of capitalThe Capitalization of AssetsThe capitalization of assets is just an alternate way of dealing with capital investmentThis concept enables a business firm to make a decision about purchasing a capital assetTo make this decision a firm needs to know what is the value of that assetTo do this the firm must also know what the current interest rate is30-22Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Value of Asset30-23Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.How much is the value of a building that provides an annual income of $200 when the going rate of interest is 8%?Value of Asset30-24Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.How much is the value of a building that provides an annual income of $200 when the going rate of interest is 8%?Value of asset = ---------------------------------------------Annual income from assetInterest rateValue of Asset30-25Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.How much is the value of a building that provides an annual income of $200 when the going rate of interest is 8%?Value of asset = --------------------------------------------- = ----------------- = $2,500Annual income from assetInterest rate$200.08If the interest rate rises, the value of an asset falls. If the interest rate falls, the value of an asset rises.The Present Value of Future IncomeA dollar today is worth more than a dollar in the futureBecause of inflationBecause the dollar can be lent out to earn interest30-26Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Present Value of Future Income30-27Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Present value of a dollar received n years from now = -------------------------------------1(1 + r)nr = the interest rate; n = the number of yearsThe Present Value of Future Income30-28Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Present value of a dollar received n years from now = -------------------------------------1(1 + r)nr = the interest rate; n = the number of yearsIf the interest rate were 5%, how much would a dollar received one year from now be worth today?= --------------------------------1(1 + .05)1The Present Value of Future Income30-29Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Present value of a dollar received n years from now = -------------------------------------1(1 + r)nr = the interest rate; n = the number of yearsIf the interest rate were 5%, how much would a dollar deceived one year from now be worth today?= --------------------------------1(1 + .05)1= ----------------------------------11.05= 95.24 centsThe Present Value of Future Income30-30Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Present value of a dollar received n years from now = -------------------------------------1(1 + r)nr = the interest rate; n = the number of yearsWhat 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 centThe Present Value of Future Income30-31Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Present value of a dollar received n years from now = -------------------------------------1(1 + r)nr = the interest rate; n = the number of years= $1,000 X --------------------------------1(1.05)3What 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 centThe Present Value of Future Income30-32Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Present value of a dollar received n years from now = -------------------------------------1(1 + r)nr = the interest rate; n = the number of years= $1,000 X -------------------------------1(1.05)3= $1,000 X ---------------------------------- 11.157625What 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 centThe Present Value of Future Income30-33Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Present value of a dollar received n years from now = -------------------------------------1(1 + r)nr = the interest rate; n = the number of years= $1,000 X -------------------------------1(1.05)3= $,1000 X ---------------------------------- 11.157625= $1,000 X .863838 = $863.84What 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 centHow Are Profits Determined?Economist treat profits as a residual left to the entrepreneur after rent, interest, and wages have been paidOne 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 demand30-34Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Theories of ProfitingThe Entrepreneur as a Risk TakerThe Entrepreneur as an InnovatorThe Entrepreneur as a MonopolistThe Entrepreneur as an Exploiter of Labor 30-35Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Entrepreneur as a Risk TakerThe entrepreneur is indeed a risk takerStarting a business is a risky endeavorMost new businesses fail in the first five yearsWhy then do people start a new business?If they succeed they will get a high rate of return30-36Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Entrepreneur ss an InnovatorAn innovation is not an inventionAn invention is a new idea, a new product, or a new way of producing thingsAn innovation is the act of putting the invention to practical useInnovation is what entrepreneurs do30-37Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Entrepreneur as a MonopolistMonopolist and oligopolist make profits (economic) because of a shortage of competitionIf this shortage of competition is due to hard work, foresight, and innovation, one could hardly complain of the evils of big businessThe 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 30-38Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Entrepreneur as an Exploiter of LaborKarl 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 workersMarx sees the capitalist’s role as that of exploiting the employeesHave you ever worked for an organization that fit this model?30-39Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.ConclusionWhich theory of profits is correct?Whichever theory you choose as correctThere is a lot of truth in each of the four theoriesWe may conclude, then, that everybody’s right and that nobody has a monopoly on the truth30-40Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.