1. 15 Pricing the Factors of Production Rent is that portion of the produce of the earth which is paid to the landlord for use of the original and indestructible powers of the soil. DAVID RICARDO (1772–1823) Pricing the Factors of Production Rent is that portion of the produce of the earth which is paid to the landlord for use of the original and indestructible powers of the soil. DAVID RICARDO (1772–1823)

2. ●The Principle of Marginal Productivity ●Inputs and Their Derived Demand Curves ●Investment, Capital, and Interest ●The Determination of Rent ●Payments to Entrepreneurship: Are Profits Too High or Too Low? ●Criticisms of Marginal Productivity Theory ●Appendix: Discounting and Present Value ●The Principle of Marginal Productivity ●Inputs and Their Derived Demand Curves ●Investment, Capital, and Interest ●The Determination of Rent ●Payments to Entrepreneurship: Are Profits Too High or Too Low? ●Criticisms of Marginal Productivity Theory ●Appendix: Discounting and Present Value Contents Copyright© 2003 South-Western/Thomson Learning. All rights reserved.

3. ●Marginal productivity  demand for a factor of production ●Hire inputs up to the point where the marginal revenue product = price of the input (MRP = P) ●Marginal productivity  demand for a factor of production ●Hire inputs up to the point where the marginal revenue product = price of the input (MRP = P) The Principle of Marginal Productivity

4. TABLE 15-1 Naomi’s Natural Farm Schedules Copyright© 2003 South-Western/Thomson Learning. All rights reserved.

5. Inputs and Their Derived Demand Curves ●The demand curve for an input is the downward-sloping portion of its marginal revenue product curve. ●The demand for an input is called a derived demand because it is derived from the underlying demand for the final product. ●The demand curve for an input is the downward-sloping portion of its marginal revenue product curve. ●The demand for an input is called a derived demand because it is derived from the underlying demand for the final product.

6. FIGURE 15-1 MRP Schedule for Naomi’s Natural Farm Copyright© 2003 South-Western/Thomson Learning. All rights reserved. 1211 C B A MRP per Bag of Corn per Week Bags of Corn per Week 010987654321 –10 –14 –12 –8 –6 –16 –4 –2 0 2 4 6 8 10 12 14 16 18 20 22 24 $26 D

7. Copyright© 2003 South-Western/Thomson Learning. All rights reserved. ●A shift in the demand curve for a commodity causes a similar shift in the demand curve for the factors used in producing that commodity. Inputs and Their Derived Demand Curves

8. FIGURE 15-2 A Shift in the Demand Curve for Corn Copyright© 2003 South-Western/Thomson Learning. All rights reserved. D 0 D 0 MRP per Bag of Corn Bags of Corn per Week $50 40 30 20 10 9876543210 D 1 D 1

9. Copyright© 2003 South-Western/Thomson Learning. All rights reserved. Investment, Capital, and Interest ●Investment (a flow) = increase in capital (a stock) ●Rate of interest = price at which funds can be rented (borrowed) ●Investment (a flow) = increase in capital (a stock) ●Rate of interest = price at which funds can be rented (borrowed)

10. FIGURE 15-3 The Investment Production Process Copyright© 2003 South-Western/Thomson Learning. All rights reserved. Investment flow: Buy inputs, use them to build up capital stock 3

11. Copyright© 2003 South-Western/Thomson Learning. All rights reserved. Investment, Capital, and Interest ●The Demand for Funds ♦How does the firm decide how much to borrow? ♦Sets marginal revenue product of the investment financed by the funds = the interest payment charged for borrowing ●The Demand for Funds ♦How does the firm decide how much to borrow? ♦Sets marginal revenue product of the investment financed by the funds = the interest payment charged for borrowing

12. Copyright© 2003 South-Western/Thomson Learning. All rights reserved. Investment, Capital, and Interest ●The Demand for Funds ♦The productivity of today's investment will occur in the future; its present value is found by discounting. ♦In the discounting process, the higher the interest rate, the lower the value of future income. ●The Demand for Funds ♦The productivity of today's investment will occur in the future; its present value is found by discounting. ♦In the discounting process, the higher the interest rate, the lower the value of future income.

13. Copyright© 2003 South-Western/Thomson Learning. All rights reserved. Investment, Capital, and Interest ●The Downward-Sloping Demand Curve for Funds ♦The marginal revenue product curve for an investment is negatively related to the interest rate. ♦Consequently, the higher the interest rate, the less people and firms will want to borrow to finance their investments. ●The Downward-Sloping Demand Curve for Funds ♦The marginal revenue product curve for an investment is negatively related to the interest rate. ♦Consequently, the higher the interest rate, the less people and firms will want to borrow to finance their investments.

14. FIGURE 15-4 The Derived Demand Curve for Loans Copyright© 2003 South-Western/Thomson Learning. All rights reserved. 0 Rate of Interest in Percent per Year Dollars Demanded per Year D D

15. Copyright© 2003 South-Western/Thomson Learning. All rights reserved. Investment, Capital, and Interest ●The Supply of Funds ♦Interest = reward to people for saving, i.e., for foregoing present consumption ♦Normally,  interest   savings ●The Supply of Funds ♦Interest = reward to people for saving, i.e., for foregoing present consumption ♦Normally,  interest   savings

16. Copyright© 2003 South-Western/Thomson Learning. All rights reserved. Investment, Capital, and Interest ●The Supply of Funds ♦However, people who have specific target goals for accumulated savings may lower their current rate of saving when interest rates rise. ♦Typically, therefore, the supply curve of savings is positively sloped, but fairly steep. ●The Supply of Funds ♦However, people who have specific target goals for accumulated savings may lower their current rate of saving when interest rates rise. ♦Typically, therefore, the supply curve of savings is positively sloped, but fairly steep.

17. FIGURE 15-5 Equilibrium in the Market for Loans Copyright© 2003 South-Western/Thomson Learning. All rights reserved. S S 7.5% 5.5 0 Rate of Interest in Percent per Year Dollars Lent per Year D D E BA

18. Copyright© 2003 South-Western/Thomson Learning. All rights reserved. Investment, Capital, and Interest ●The Issue of Usury Laws: Are Interest Rates Too High? ♦Governments may attempt to limit interest rates by imposing usury laws. ♦When they do so, they benefit the people who are able to borrow funds, but they harm the lenders and the people who would like to borrow but cannot find funds. ●The Issue of Usury Laws: Are Interest Rates Too High? ♦Governments may attempt to limit interest rates by imposing usury laws. ♦When they do so, they benefit the people who are able to borrow funds, but they harm the lenders and the people who would like to borrow but cannot find funds.

19. Copyright© 2003 South-Western/Thomson Learning. All rights reserved. ●Fixed supply of land  determination of the market level of land rent by the demand side ●Economic rent = an "extra" payment for a factor of production (such as land) that does not change the amount of the factor that is supplied ●Fixed supply of land  determination of the market level of land rent by the demand side ●Economic rent = an "extra" payment for a factor of production (such as land) that does not change the amount of the factor that is supplied The Determination of Rent

20. Copyright© 2003 South-Western/Thomson Learning. All rights reserved. The Determination of Rent ●Economic rent is, thus, that portion of the factor payment that exceeds the minimum payment necessary to induce any of that factor to be supplied.

21. Copyright© 2003 South-Western/Thomson Learning. All rights reserved. The Determination of Rent ●Land Rents: Complicated Version ♦Capital invested on any piece of land must yield the same return as capital invested on any other piece of land that is actually in use. ♦Any land that is exactly on the borderline between being used and not being used is called marginal land. ●Land Rents: Complicated Version ♦Capital invested on any piece of land must yield the same return as capital invested on any other piece of land that is actually in use. ♦Any land that is exactly on the borderline between being used and not being used is called marginal land.

22. Copyright© 2003 South-Western/Thomson Learning. All rights reserved. The Determination of Rent ●Land Rents: Complicated Version ♦Rent on a piece of land = cost of producing the output on that land minus the cost of producing it on marginal land ●Land Rents: Complicated Version ♦Rent on a piece of land = cost of producing the output on that land minus the cost of producing it on marginal land

23. TABLE 15-2 Nonrent Costs and Rent on Three Pieces of Land Copyright© 2003 South-Western/Thomson Learning. All rights reserved.

24. The Determination of Rent ●Land Rents: Complicated Version ♦  demand  ■community uses land previously thought to be submarginal ■more intensive exploitation of already used land ●Land Rents: Complicated Version ♦  demand  ■community uses land previously thought to be submarginal ■more intensive exploitation of already used land

25. FIGURE 15-6 Determination of Land Rent in Littleville Copyright© 2003 South-Western/Thomson Learning. All rights reserved. $2,000 Annual Rent per Acre Acres of Land 1,000 D D S S E

26. Copyright© 2003 South-Western/Thomson Learning. All rights reserved. The Determination of Rent ●Land Rents: Complicated Version ♦This increases the differential between other plots of land and marginal land and, therefore, increases rent. ●Land Rents: Complicated Version ♦This increases the differential between other plots of land and marginal land and, therefore, increases rent.

27. Copyright© 2003 South-Western/Thomson Learning. All rights reserved. The Determination of Rent ●Generalization: Economic Rent Seeking ♦Economic rent is any payment made to a factor above the amount necessary to induce any of that factor to be supplied to its present employment. ♦Some portion of every factor’s income will consist of economic rent in this sense, unless the factor’s supply curve is horizontal. ●Generalization: Economic Rent Seeking ♦Economic rent is any payment made to a factor above the amount necessary to induce any of that factor to be supplied to its present employment. ♦Some portion of every factor’s income will consist of economic rent in this sense, unless the factor’s supply curve is horizontal.

28. ●When athletes would be willing to play for quite a bit less than their salary, the “excess” salary is economic rent. ♦This same analysis applies to any factor of production whose supply curve is not horizontal. ♦Only those factors that can be reproduced by a number of producers at constant cost earn no rents. ●When athletes would be willing to play for quite a bit less than their salary, the “excess” salary is economic rent. ♦This same analysis applies to any factor of production whose supply curve is not horizontal. ♦Only those factors that can be reproduced by a number of producers at constant cost earn no rents. Application of Rent Theory: Salaries of Professional Athletes Copyright© 2003 South-Western/Thomson Learning. All rights reserved.

29. “A-ROD”: Earning Lots of Rent ●Alex Rodriquez, Texas Rangers, recently signed a 10-year, $252 million contract ●This makes him the highest paid athlete in history. ●Assuming he would play baseball for significantly less, much of his contract represents economic rent ●Alex Rodriquez, Texas Rangers, recently signed a 10-year, $252 million contract ●This makes him the highest paid athlete in history. ●Assuming he would play baseball for significantly less, much of his contract represents economic rent

30. ●People sometimes think that rents on housing are economic rents. ♦They could then be lowered without reducing the quantity supplied. ●This may be true in the short run. ●People sometimes think that rents on housing are economic rents. ♦They could then be lowered without reducing the quantity supplied. ●This may be true in the short run. Rent Controls: The Misplaced Analogy Copyright© 2003 South-Western/Thomson Learning. All rights reserved.

31. ●But in the long run, the housing market is quite competitive. ♦An effective rent control law is, therefore, likely to lead to a reduction in housing and consequent shortages. ●But in the long run, the housing market is quite competitive. ♦An effective rent control law is, therefore, likely to lead to a reduction in housing and consequent shortages. Rent Controls: The Misplaced Analogy Copyright© 2003 South-Western/Thomson Learning. All rights reserved.

32. FIGURE 15-7 A Shift in Demand with a Vertical Supply Curve Copyright© 2003 South-Western/Thomson Learning. All rights reserved. $2,000 Annual Rent per Acre Acres of Land 1,000 D D S S E

33. Copyright© 2003 South-Western/Thomson Learning. All rights reserved. Payments to Entrepreneurship ●Profits are a small portion of GDP. ●They are the residual: what remains from revenue after all other factors have been paid ●Profits are a small portion of GDP. ●They are the residual: what remains from revenue after all other factors have been paid

34. Copyright© 2003 South-Western/Thomson Learning. All rights reserved. Payments to Entrepreneurship ●What Accounts for Profits? ♦In pure competition, economic profits disappear in the long run. ♦In the real world, however, they persist for different reasons: ■Monopoly power ■Risk bearing ■Returns to innovation ●What Accounts for Profits? ♦In pure competition, economic profits disappear in the long run. ♦In the real world, however, they persist for different reasons: ■Monopoly power ■Risk bearing ■Returns to innovation

35. Copyright© 2003 South-Western/Thomson Learning. All rights reserved. Payments to Entrepreneurship ●Taxing Profits ♦We do not know whether the observed profit rate provides more than the minimum reward necessary to attract entrepreneurial talent into the market. ●Taxing Profits ♦We do not know whether the observed profit rate provides more than the minimum reward necessary to attract entrepreneurial talent into the market.

36. Copyright© 2003 South-Western/Thomson Learning. All rights reserved. Payments to Entrepreneurship ●Taxing Profits ♦This relationship between observed profit rates and minimum necessary rewards is crucial when we start to consider the policy ramifications of taxes on profits. ●Taxing Profits ♦This relationship between observed profit rates and minimum necessary rewards is crucial when we start to consider the policy ramifications of taxes on profits.

37. Copyright© 2003 South-Western/Thomson Learning. All rights reserved. Payments to Entrepreneurship ●Taxing Profits ♦If an industry earns profit rates well above the minimum required to attract entrepreneurial talent, those profits contain a large element of economic rent. ♦In that case, we could tax away these excess profits (rents) without fear of reducing the industry’s production. ●Taxing Profits ♦If an industry earns profit rates well above the minimum required to attract entrepreneurial talent, those profits contain a large element of economic rent. ♦In that case, we could tax away these excess profits (rents) without fear of reducing the industry’s production.

38. Copyright© 2003 South-Western/Thomson Learning. All rights reserved. ●Taxing Profits ♦On the other hand, if the profits being earned by the industry do not include economic rents, then a windfall profits tax can seriously curtail research and development and production. ●Taxing Profits ♦On the other hand, if the profits being earned by the industry do not include economic rents, then a windfall profits tax can seriously curtail research and development and production. Payments to Entrepreneurship

39. Public Opinion on Profits Copyright© 2003 South-Western/Thomson Learning. All rights reserved. Profit per Dollar of Sales 32% What people estimate 26% What people think is a “reasonable” profit 3.8% Actual profit

40. Copyright© 2003 South-Western/Thomson Learning. All rights reserved. Criticism of Marginal Productivity Theory ●Some people criticize the theory for providing what is seen as a moral justification for the status quo in income distribution. ●Marginal productivity theory, however, has no moral content. ●Some people criticize the theory for providing what is seen as a moral justification for the status quo in income distribution. ●Marginal productivity theory, however, has no moral content.

41. Copyright© 2003 South-Western/Thomson Learning. All rights reserved. Criticism of Marginal Productivity Theory ●A better criticism is that the theory gives only incomplete insight into many current, pressing problems of income distribution, including poverty and underdevelopment.

42. Copyright© 2003 South-Western/Thomson Learning. All rights reserved. ●The present value of a future income stream depends inversely upon the interest rate used in discounting. ●The general formula for the present value of $1.00 to be received N years from today when the rate of interest is i = $1.00  (1 + I)N ●The present value of a future income stream depends inversely upon the interest rate used in discounting. ●The general formula for the present value of $1.00 to be received N years from today when the rate of interest is i = $1.00  (1 + I)N Appendix: Discounting and Present Value