AP MICROECONOMICS UNIT #6 FACTOR MARKETS Lecture #5 Economic Rent, Profit, and Interest

ECONOMIC RENT BASICS Rent: price paid for use land (natural resource) that is a fixed supply Fixed supply makes it inelastic in the short run and long run Supply and Demand Analysis assumes All land is of the same quality All land has a single use

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

ECONOMIC RENT DEMAND Demand is the ONLY active determinant of rent since supply is fixed Based on price of the product produced on the land Land’s productivity/quality – location, what it can be used for, etc. Prices of other resources used with the land

RENT DETERMINATION Land Rent (Dollars) D4 is a “free good” b L0 Acres of Land D4

ECONOMIC RENT Rent can have no “Incentive Function” other resources do because they allow you to make more available at a higher price Some argue that rent shouldn’t have to be paid because it costs nothing to produce Why should rent be paid to those who got it by inheritance or some other advantage?

HENRY GEORGE AND THE “SINGLE TAX” MOVEMENT Land should be taxed heavily and shared with the public & should be the only tax Most efficient tax: Taxing other goods or income could cause reallocation of that resource Taxing land heavily would not lead to reallocation because it can’t be used for anything else

INTEREST Stated as a percentage: it’s the money paid for the loan of money MONEY IS NOT A RESOURCE! BUSINESSES “buy” the use of money because it can be used to acquire other capital goods

ECONOMIC PROFIT Review Economic Profit is what remains after both explicit and implicit costs are subtracted from total revenue Normal Profits are the payments necessary to have the use of the entrepreneur

ENTREPRENEUR’S PROFIT Entrepreneur gets normal profits plus any economics profits that may occur Why? The economy is not static (constant, unchanging, predictable), but dynamic In dynamic economies there are risks Profit is reward for taking risks

MANAGING RISK Insurable risks: buying insurance shields the firm from some risks (fire, etc.) Uninsurable risks: cannot be controlled or predicted

SOURCES OF RISK Changes in the Overall Economy (recession, unemployment, etc.) Changes in the Economic Structure (consumer tastes, availability of resources, etc.) Changes in Government Policy (taxes, regulations, etc.)

PROFIT IN MONOPOLIES Different from risk-taking profit Monopoly power can Reduce risk and or negative effects Allow room for innovation in oder to sustain profits

PROFIT AND CAPITALISM Motivates innovation that leads to growth Leads to most productive means of allocating resources Away from unsuccessful firms To profitable firms

ECONOMIC PROFIT 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.

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

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

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

The Determination of Rent Land Rents: Complicated Version This increases the differential between other plots of land and marginal land and, therefore, increases rent.

ECONOMIC RENT AS IT RELATES TO SALARIES The payment for labor has two parts The minimum amount needed to acquire the input The bonus to inputs of higher quality (workers with exceptional skills) Rent is not a consideration in whether to work or not, but rather it is “gravy” Almost all inputs receive some rent Inputs provided by a large number of suppliers at constant cost with equal quality will not

RENT SEEKING The search and battle for opportunities to charge or collect payments above and beyond the amount necessary to create the source of the income (trying to make more money without producing more for customers) One example is a monopoly license Ex. A monopoly license for cable broadcasting is expected to generate $900 million rent over its lifetime Companies will spend close to that amount in lobbying for the license For example, if 10 companies are competing for the license, they would be willing to spend $90 million for a 1 in 10 chance of winning the license

RENT SEEKING (continued) Forms of rent-seeking Protection racket Gangs taking a cut from shopkeeper’s pocket A cartel of firms agreeing to raise prices A union demanding higher wages without offering an increase in productivity Lobbying the government for tax, spending, or regulatory policies that benefit the lobbyists at the expense of taxpayers or consumers or some other rivals

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.

Application of Rent Theory: Salaries of Professional Athletes 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. Copyright© 2003 South-Western/Thomson Learning. All rights reserved.

“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

Rent Controls: The Misplaced Analogy 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. Copyright© 2003 South-Western/Thomson Learning. All rights reserved.

Rent Controls: The Misplaced Analogy 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. Copyright© 2003 South-Western/Thomson Learning. All rights reserved.