© The McGraw-Hill Companies, 2002 Factor markets and income distribution

© The McGraw-Hill Companies, Capital and land Physical capital –the stock of produced goods which contributes to the production of goods and services. Land –the factor of production which nature supplies. Together capital and land make up the tangible wealth of a country.

© The McGraw-Hill Companies, Investment Capital depreciates over time –becoming less productive and less valuable. Gross investment –the production of new capital goods and the improvement of existing capital goods. Net investment –gross investment minus the depreciation of the existing capital stock.

© The McGraw-Hill Companies, Stocks and flows A stock –the quantity of an asset at a point in time –the asset price is the sum for which the stock can be bought outright. A flow –the stream of services that an asset provides during a period –the rental rate is the cost of using capital services.

© The McGraw-Hill Companies, Interest and present value The present value of £1 at some future date is the sum that, if lent out today, would accumulate to £1 by that future date. –It depends upon how far into the future the sum accumulates –and on the rate of interest. The price of a capital asset should be related to the stream of future payments that will be earned from the services it provides –discounted back to give the present value.

© The McGraw-Hill Companies, Real and nominal interest rates The nominal interest rate –tells us how many actual pounds will be earned in interest by lending £1 for one year. The real rate of interest –measures the return on a loan as the increase in goods that can be purchased rather than as the increase in the nominal value of the loan fund. The real rate of interest is the nominal rate minus the inflation rate.

© The McGraw-Hill Companies, The equilibrium real interest rate Current consumption Future consumption A A' AA' shows the production possibility frontier between current and future consumption: by devoting resources to investment, future consumption can be increased. The slope of the frontier has magnitude –(1 + i) where i is the rate of return on investment.

© The McGraw-Hill Companies, The equilibrium real interest rate Current consumption Future consumption A A' The slope of the red line represents –(1 + r), where r is the real interest rate that balances the productivity of investment and the thriftiness of consumers. U U Given society's preferences between present and future consumption, the optimal position is at E, where the indifference curve UU is at a tangent to the PPF. E

© The McGraw-Hill Companies, The markets for capital and land The derived demand curve for capital (and for land) services closely parallels the earlier analysis of labour demand. But land is in fixed supply to the economy as a whole. Rental rates tend to become equalised across alternative uses.

© The McGraw-Hill Companies, Changes in capital intensity Over time, the UK economy is becoming more capital-intensive –the wage-rental ratio has increased, leading industries to substitute capital for labour –in the long run the supply of labour is less elastic than the supply of capital –new capital embodies latest technology.

© The McGraw-Hill Companies, The functional distribution of income in the UK The distribution of income between the factors of production changed little between and 1998.