1. Rent, Interest, and Profit Chapter 29 McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

2. 29-2 Learning Objectives 1. Define land and how rent is determined. 2. Define and illustrate economic rent. 3. Demonstrate whether prices are high because rents are high, or whether rents are high because prices are high. 4. Define capital and how the interest rate is determined. 5. Explain and calculate the present value of future income. 6. List and discuss how are profits determined. 7. Name and discuss the theories of profit. 8. Discuss usury and payday and fringe lenders.  After this chapter, you should be able to:

3. 29-3 Rent  What Is Land? Land is a resource or a factor of production. The owner of land is paid rent for allowing its use in the production process. The amount of rent paid for a piece of land is based on the supply of and the demand for land.

4. 29-4 Exactly What Is Land?  Land is land.  How land is used depends on its location, its fertility, and whether it possesses any valuable minerals.  Sometimes we confuse land with what is built on it: Land with an apartment building on it will rent for more than a vacant lot. However, in economic terms we pay rent on the land itself.

5. 29-5 How Does One Piece of Land Differ from Another?  A plot of land may have alternative uses.  If it is used at all, it will be used by the highest bidder— the one willing to pay the most for it.  The basic way one piece of land differs from another is location. An acre of land in the middle of a desert is worth a lot less than an acre of land in a metropolitan area.

6. 29-6 How Is the Supply of Land Derived?  The supply of land is fixed (perfectly inelastic). At any given location there is a fixed amount of land.  We can make more efficient use of land.  We represent the supply of land as a vertical line.

7. 29-7 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 curve.  The land will go to the highest bidder.  The 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.

8. 29-8 How Is Rent Determined? The demand for land is the MRP schedule of the highest bidder for a specific piece of land. The rent, like the price of anything else, is set by the intersection of S & D.

9. 29-9 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).

10. 29-10 Question for Thought and Discussion  Think of an example of land that is not “turf” or acreage or space.  Draw the S and D curves for that land.  Now draw what happens when the supply of that land goes down: what is the effect on rent?  Can you think of an instance in which the supply of that land would increase?

11. 29-11 Economic Rent  Economic rent is payment in excess of what people would be willing to accept.  Rent paid to landlords (exclusive of any payment for buildings and property improvement ) is, by definition, economic rent.

12. 29-12 Are Prices High Because Rents Are High, or Are Rents High Because Prices Are High?  High rents don’t cause high prices.  Desirable locations attract many prosperous renters, who bid up rents because they believe they will get a lot of business.  Rents are high because the demand for the final product(s)—and consequently the derived demand—is high.  If low rents lead to low prices, the mom and pop stores would have lower prices, but they have higher prices.

13. 29-13 Interest  What Is Capital? Capital consists of office buildings, factories, stores, machinery and equipment, computer systems, and other synthetic goods used in the production process. When we invest, we are spending money on new capital. The stock of capital increases by means of a flow of investment.  Say you have a capital stock of 4 machines. You buy 2 more. That’s your investment for the year. Now you have a capital stock of 6 machines.

14. 29-14 How Is the Interest Rate Determined? The interest rate is determined by the supply and demand for 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.

15. 29-15 Interest Rates and Consumer Loans  High interest rates deter borrowing for consumer loans.  Banks probably charge too much on credit card loans.  Should this justify a legal ceiling (usury laws) on the interest that may be charged on these and other loans?

16. 29-16 Usury Laws  Usury laws place limits on how much interest may be charged.  They are price ceilings; they prevent interest rates from rising to their equilibrium level.  How do these laws hurt borrowers? Since they create a shortage of loanable funds, the available credit go to the most creditworthy borrowers. Borrowers with poor credit ratings must seek out companies not subject to usury laws, and they charge even higher interest rates!

17. 29-17 Interest Rate Ceiling Shortage of ($550 - $200) = $350B

18. 29-18 The Present Value of Future Income  A dollar today is worth more than a dollar in the future. Because of inflation. Because the dollar can be lent out to earn interest.

19. 29-19 The Present Value (PV) of Future Income PV of $1 received n years from now where r = the interest rate; n = the number of years = 1 (1 + r) n

20. 29-20 The Present Value (PV) of Future Income PV of $1 received n years from now = 1 (1 + r) n If the interest rate were 5%, how much would a dollar received one year from now be worth today? r = 5% 1 (1 +.05) n = Answer: 1/1.05 = 95.24 cents

21. 29-21 The Present Value (PV) of Future Income PV of a $1 received n years from now = ---------------------- 1 (1 + r) n where r = the interest rate; n = the number of years = $1,000 x --------------------- 1 (1.05) 3 = $1,000 x ---------------------------- 1 1.157625 PV = $1,000 x.863838 = $863.84 What is the PV of $1,000 that will be paid to you in 3 years if the interest rate is 5 percent? Work out to the nearest cent. PV

22. 29-22 Profits  What Is Profit? Profits are a residual left over after payment of wages, rent, and interest.

23. 29-23 How Large Are Profits?  Economists subtract both explicit costs and implicit costs from sales to get economic profit. Accountants subtract only explicit cost. So economic profit is lower than accounting profit. Large corporations have no implicit cost, but the majority of the nation’s corporations are very small businesses with substantial implicit costs.

24. 29-24 The Top Corporate Winners and Losers of 2008

25. 29-25 The Great Recession: Declining Fortunes, 2004-2008

26. 29-26 Theories of Profit  The Entrepreneur as a Risk Taker  The Entrepreneur as an Innovator  The Entrepreneur as a Monopolist  The Entrepreneur as an Exploiter of Labor

27. 29-27 The Entrepreneur as a Risk Taker  Starting a business is a risky endeavor.  Most new businesses fail in the first 5 years.  Why then do people start a new business?  If they succeed, they may get a high rate of return.

28. 29-28 The Entrepreneur as an Innovator  An innovation is not an invention.  An invention is a new idea, a new product, or a new way of producing things.  An innovation is the act of putting the invention to practical use.  Innovation is what entrepreneurs do.

29. 29-29 The Entrepreneur as a Monopolist  Monopolists and oligopolists earn profits (economic) because of a shortage of competition.  If this shortage of competition is due to hard work, foresight, and innovation, one could hardly complain of the evils of big business. The 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. 29-30 The Entrepreneur as an Exploiter of Labor  Karl 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 workers.  Marx sees the capitalist’s role as that of exploiting the employees. Have you ever worked for an organization that fit this model?

31. 29-31 Conclusion  Which theory of profits is correct?  There is a lot of truth in each of the four theories.  Conclusion: Everyone has a bit of the truth.

32. 29-32 Current Issue: Subprime, Fringe, and Payday Lending  The poorer you are, the harder it is to borrow money. Poor people are forced to pay high and sometimes exorbitant interest rates on “subprime” loans.  Tax refund loans, mainly to the working poor, usually equate to annual interest rates of more than 100% and sometimes more than 1,500%, plus flat fees.  Fringe lending from so-called “payday stores” charge interest rates as high as 800%. Payday lending is permitted in 35 states; roughly 22,000 payday lenders in U.S. today. Congress, like the fifty states, has been unwilling to clamp down on these lenders, except for military personnel. In 2007, Congress effectively closed down payday operations around U.S. military bases.