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Rent, Interest, and Profit

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1 Rent, Interest, and Profit
Land & Rent Capital & Interest Entrepreneurship & Profit

2 Land & Rent Land is defined as raw earth Also includes
Minerals and resources buried in the land Crops that can be grown on the land Timber Etc. Does not include what is constructed on the Land How land is used depends upon a number of factors Location Fertility Minerals

3 How 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 most Location is a key determinant of what the various demands for land will be Land 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

4 Supply of & Demand for Land
The Supply of land is virtually fixed When the supply of a product or factor is fixed, its supply is represented by a vertical line The demand for land, like all factors will be determined by a firm’s MRP curve So, in absence of regulation, land will migrate to the firm willing to pay the most for it

5 Determination 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 demand 30-8 Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

6 Increase 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). 30-9 Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

7 Economic Rent Payment 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 demand Ethical 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 there Rents should be taxed – Henry George (1879) Since God created the earth, only He is entitled to collect rent – Pierre-Joseph Proudhon A strong current in historical economic thought denies the landlord’s claim to rent

8 Economic Rent, Continued
However; since price guides the use of land, price ensures that land is used for its most productive enterprises Are 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 rents Therefore, desirable (profitable) locations bid up rents

9 Capital & Interest Capital is the plant, equipment and machinery used in the production process Stock verses Flow Stock 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?

10 The Demand for and Supply of Capital
The Demand for Capital is determined by the firm’s MRP for capital The 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 increased The history of the western world did not condone the making of money on money itself – Usury – Religious thought that collecting of interest was a sin We still have usury laws on the books in all states To the economist, usury laws are price ceilings and cause a shortage of loanable funds & disrupt the price mechanism

11 How Is the Interest Rate Determined?
The interest rate is determined by the demand for loanable funds and the supply of loanable funds The supply of loanable funds (or savings) slopes upward to the right because the amount of money people save is somewhat responsive to interest rates 30-13 Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

12 The 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 income Risk that expected income may not be realized The opportunity cost of not having expected income now These factors are represented as an interest rate (discount rate) which discounts future expected cash flows to a present value

13 Present Value of Future Income
Present value of a dollar received n years from now = 1/(1+r) to the nth power If 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 = $85.73 This is the basis of all “return on investment” calculations in financial investment decisions

14 Entrepreneurship and Profits
Unlike other factors of production, profit is not determined by the supply of and demand for entrepreneurship Profits are considered a residual from Total Revenue after the payment of rent, interest, and wages One could argue that since all other factors are determined by supply and demand, profits are indirectly determined by these forces Your author estimates profit to be about 18.5% of the Nation’s National Income

15 Theories of Profit Economic profit is the reward for recognizing a profit opportunity and taking advantage of it Theories overlap, but see the entrepreneur as one who sees an advantage and grabs it Theories The entrepreneur as a risk taker The entrepreneur as an innovator The entrepreneur as a monopolist The entrepreneur as an exploiter of labor

16 The Entrepreneur as a Risk Taker
The only way to get someone to risk money is to offer a high reward (economic profit) as an incentive Economic profit is associated with uncertainty; nothing ventured, nothing gained Entrepreneurs are willing to take the risk in return for the opportunity of a large reward Profit is the reward for risk bearing

17 The Entrepreneur as an Innovator
An invention is not the same as an innovation Innovation includes invention but also carries the business process from production to marketing to profit generation; that is, it is the commercialization of the invention It is the effort to carry an invention through to its logical conclusion – the generation of a profit Joseph Schumpeter, noted Harvard economist, even stated that innovation and financial risk are two separate components – Financial risk is interest

18 The Entrepreneur as a Monopolist
The entrepreneur takes advantage of the idea of exclusivity to monopolize a product or service Natural scarcity – to do it first and thereby lock out potential competitors Contrived scarcity – to corner a market on a vital resource or gain economic power to limit competition and generate profit by reducing production and raising prices DeBeers (diamonds) Early Railroads National Football League

19 The Entrepreneur as an Exploiter of Labor
Karl Marx – The Capitalist exploits the value of Labor If 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 himself The capitalist uses the value of those six hours to purchase even more capital to exploit even more labor The surplus value of labor is the capitalist’s profit

20 Profit We 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

21 Definition 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.

22 Definition of profit According 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.”

23 Types of Profit

24 Gross profit What 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).

25 Net Profit Net 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.”

26 Theories of Profit Wage theory of profits
Marginal productivity theory of profit. Clark’s dynamic theory of profits. Schumpeter’s Innovation Theory of profit

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