Presentation on theme: "Rent, Interest, and Profit"— Presentation transcript:
1Rent, Interest, and Profit Land & RentCapital & InterestEntrepreneurship & Profit
2Land & Rent Land is defined as raw earth Also includes Minerals and resources buried in the landCrops that can be grown on the landTimberEtc.Does not include what is constructed on the LandHow land is used depends upon a number of factorsLocationFertilityMinerals
3How Land is Utilized Highest and best Use Principle Without some form of regulation, land will migrate to the use that people are willing to pay the mostLocation is a key determinant of what the various demands for land will beLand located at the corner of 57th streets and Fifth avenue in Manhattan is worth considerably more than the same quantity of land located in downtown Tonopah, Nevada
4Supply of & Demand for Land The Supply of land is virtually fixedWhen the supply of a product or factor is fixed, its supply is represented by a vertical lineThe demand for land, like all factors will be determined by a firm’s MRP curveSo, in absence of regulation, land will migrate to the firm willing to pay the most for it
5Determination of Rent 30-8 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 demand30-8Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
6Increase in Demand for Land 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).30-9Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
7Economic RentPayment in excess of what people would be willing to accept is called “Economic Rent”It is a result of a fixed supply and a high demandEthical question – Since land wasn’t created by landlords, does it not properly belong to society?What right do current landlords have to extract rent from something that was always thereRents should be taxed – Henry George (1879)Since God created the earth, only He is entitled to collect rent – Pierre-Joseph ProudhonA strong current in historical economic thought denies the landlord’s claim to rent
8Economic Rent, Continued However; since price guides the use of land, price ensures that land is used for its most productive enterprisesAre prices high because rents are high?Or, are rents high because prices are high?Answer – Rents are high because of the opportunity to generate profits – So, profitable locations bid up rentsTherefore, desirable (profitable) locations bid up rents
9Capital & InterestCapital is the plant, equipment and machinery used in the production processStock verses FlowStock equals a quantity of something at an instant in time, such as the stock of capital -- How much capital we have at a moment in time?Flow is an “over time” concept – How much additional investment in capital takes place over a year?
10The Demand for and Supply of Capital The Demand for Capital is determined by the firm’s MRP for capitalThe supply of loanable funds (the financial source of capital) is not fixed, but will be increased as the price of loanable funds (the interest rate) is increasedThe history of the western world did not condone the making of money on money itself – Usury – Religious thought that collecting of interest was a sinWe still have usury laws on the books in all statesTo the economist, usury laws are price ceilings and cause a shortage of loanable funds & disrupt the price mechanism
11How Is the Interest Rate Determined? 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 rates30-13Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
12The Present Value of Future Income A dollar in my hand today is worth more than a dollar I expect to receive at some point in the future“A bird in the hand is worth two in the bush”Why?Inflation may lower the value of expected incomeRisk that expected income may not be realizedThe opportunity cost of not having expected income nowThese factors are represented as an interest rate (discount rate) which discounts future expected cash flows to a present value
13Present Value of Future Income Present value of a dollar received n years from now= 1/(1+r) to the nth powerIf the discount rate = 8%, how much is the Present value of $100 expected two years from now?Answer = 1/1.08 squared = 1/ x $100= x $100 = $85.73This is the basis of all “return on investment” calculations in financial investment decisions
14Entrepreneurship and Profits Unlike other factors of production, profit is not determined by the supply of and demand for entrepreneurshipProfits are considered a residual from Total Revenue after the payment of rent, interest, and wagesOne could argue that since all other factors are determined by supply and demand, profits are indirectly determined by these forcesYour author estimates profit to be about 18.5% of the Nation’s National Income
15Theories of ProfitEconomic profit is the reward for recognizing a profit opportunity and taking advantage of itTheories overlap, but see the entrepreneur as one who sees an advantage and grabs itTheoriesThe entrepreneur as a risk takerThe entrepreneur as an innovatorThe entrepreneur as a monopolistThe entrepreneur as an exploiter of labor
16The Entrepreneur as a Risk Taker The only way to get someone to risk money is to offer a high reward (economic profit) as an incentiveEconomic profit is associated with uncertainty; nothing ventured, nothing gainedEntrepreneurs are willing to take the risk in return for the opportunity of a large rewardProfit is the reward for risk bearing
17The Entrepreneur as an Innovator An invention is not the same as an innovationInnovation includes invention but also carries the business process from production to marketing to profit generation; that is, it is the commercialization of the inventionIt is the effort to carry an invention through to its logical conclusion – the generation of a profitJoseph Schumpeter, noted Harvard economist, even stated that innovation and financial risk are two separate components – Financial risk is interest
18The Entrepreneur as a Monopolist The entrepreneur takes advantage of the idea of exclusivity to monopolize a product or serviceNatural scarcity – to do it first and thereby lock out potential competitorsContrived scarcity – to corner a market on a vital resource or gain economic power to limit competition and generate profit by reducing production and raising pricesDeBeers (diamonds)Early RailroadsNational Football League
19The Entrepreneur as an Exploiter of Labor Karl Marx – The Capitalist exploits the value of LaborIf the worker could produce enough value to sustain life by working six hours/day, but is forced by the capitalist to work 12 hours a day for six hours of value, the capitalist expropriates 6 hours of labor’s value for himselfThe capitalist uses the value of those six hours to purchase even more capital to exploit even more laborThe surplus value of labor is the capitalist’s profit
20ProfitWe call profits as the income of the entrepreneur or say that profit is the reward for the services of the entrepreneur.We can simply define profits as the reward received by the entrepreneur for his contribution to the production process.The excess of income from the sale of production over his costs of production is that we generally call profit.Profit = Total Revenue – Rent – Wages -Interest
21Definition of Entrepreneur Here, Entrepreneur is one who takes the initiative of starting a business, organises it and employs other factor of production. He bears risks and takes all types of decisions regarding production.
22Definition of profitAccording to Marshall, Taussig, Robertson and Bober have defined profits as ‘the residual payment, what is left to the producer’s income after all the other payments have been met.”According to Drucker, “ The surplus of current income over past cost is profit.”
24Gross profitWhat is commonly called ‘Profit’ is gross profit. Generally by profit we mean that part of income of firms which is available to them after all the payments to the three factors of production.In other words, Gross profit is the excess of revenue over total explicit costs (direct).
25Net ProfitNet profits are the profits which accrue to an entrepreneur for his functions as an entrepreneur. These functions include risk bearing ability, innovating spirit etc.According to Snider, “The economist defines profits as the excess of sales receipt over explicit plus implicit expenses of production.”
26Theories of Profit Wage theory of profits Marginal productivity theory of profit.Clark’s dynamic theory of profits.Schumpeter’s Innovation Theory of profit