Chapter 30 Rent, Interest, and Profit 30-1 Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

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 30-2 Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

What Is 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 30-3 Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

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 30-4 Copyright 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 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 30-5 Copyright 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 fixed We can make more efficient use of land We represent the supply of land as a vertical line 30-6 Copyright 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 firms 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 30-7 Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Determination of Rent 30-8 Copyright 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 Land 30-9 Copyright 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 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 Copyright 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 dont 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 mom and pop stores would have lower prices, but they have higher prices Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Capital 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 four machines. You buy two more. Thats your investment for the year. Now you have a capital stock of six machines Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

How Is the Interest Rate Determined? Copyright 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 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

Interest Rates and Consumer Loans High interest rates deter borrowing for consumer loans Banks arguably 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? Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Usury Laws Usury laws place limits on how much interest may be charged Usury laws are price ceilings because they prevent the interest rates from rising to their equilibrium level –This creates a shortage of loanable funds Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Usury Laws How 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 first –Borrowers with poor credit ratings are completely left out These borrowers are left with consumer finance companies that may not be subject to usury laws This means that if they can find money to borrow they will end up paying much higher interest rates than without usury laws Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Interest Rate Ceiling Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Shortage of $350 billion

Determination of the Level of Investment Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Net Productivity of Capital The net productivity of capital is, in effect, a firms MRP schedule. In this case, given this firms 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 invested

The Net Productivity of Capital Economist have developed the concept of net productivity of capital, which translates into the expected profit rate –Subtract all cost (including an allowance for a normal profit) from sales. This give us the dollar value of net productivity –Assuming this value is positive, we divide it by capital cost to give us the net productivity of capital, which we express as a percentage Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

30-20 Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. The Net Productivity of Capital Find 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 $ 20,000

30-21 Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. The Net Productivity of Capital Find 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, = 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 capital

The Capitalization of Assets The capitalization of assets is just an alternate way of dealing with capital investment This concept enables a business firm to make a decision about purchasing a capital asset To make this decision a firm needs to know what is the value of that asset –To do this the firm must also know what the current interest rate is Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Value of Asset Copyright 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 Copyright 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 asset Interest rate

Value of Asset Copyright 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 = = = $2,500 Annual income from asset Inter e st rate $ If 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 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 Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

The Present Value of Future Income Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Present value of a dollar received n years from now = (1 + r) n r = the interest rate; n = the number of years

The Present Value of Future Income Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Present value of a dollar received n years from now = (1 + r) n r = the interest rate; n = the number of years If the interest rate were 5%, how much would a dollar received one year from now be worth today? = (1 +.05) 1

The Present Value of Future Income Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Present value of a dollar received n years from now = (1 + r) n r = the interest rate; n = the number of years If the interest rate were 5%, how much would a dollar deceived one year from now be worth today? = (1 +.05) 1 = = cents

The Present Value of Future Income Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Present value of a dollar received n years from now = (1 + r) n r = the interest rate; n = the number of years What 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 cent

The Present Value of Future Income Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Present value of a dollar received n years from now = (1 + r) n r = the interest rate; n = the number of years = $1,000 X (1.05) 3 What 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 cent

The Present Value of Future Income Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Present value of a dollar received n years from now = (1 + r) n r = the interest rate; n = the number of years = $1,000 X (1.05) 3 = $1,000 X What 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 cent

The Present Value of Future Income Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Present value of a dollar received n years from now = (1 + r) n r = the interest rate; n = the number of years = $1,000 X (1.05) 3 = $,1000 X = $1,000 X = $ What 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 cent

How Are Profits Determined? Economist treat profits as a residual left to the entrepreneur after rent, interest, and wages have been paid –One 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 demand Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Theories of Profiting The Entrepreneur as a Risk Taker The Entrepreneur as an Innovator The Entrepreneur as a Monopolist The Entrepreneur as an Exploiter of Labor Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

The Entrepreneur as a Risk Taker The entrepreneur is indeed a risk taker Starting a business is a risky endeavor –Most new businesses fail in the first five years Why then do people start a new business? –If they succeed they will get a high rate of return Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

The Entrepreneur ss 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 Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

The Entrepreneur as a Monopolist Monopolist and oligopolist make 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 – Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

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 workers labor (profits) and using this to buy more capital to be able to exploit even more workers –Marx sees the capitalists role as that of exploiting the employees –Have you ever worked for an organization that fit this model? Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Conclusion Which theory of profits is correct? Whichever theory you choose as correct –There is a lot of truth in each of the four theories We may conclude, then, that everybodys right and that nobody has a monopoly on the truth Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.