Rent, Interest, & Profit Chapter 16 1/2/2019

Economic Rent (16.1) Price paid for the use of land & other natural resources that are completely fixed in total supply Assumptions All land is of the same grade or quality All land has a single use Land is rented or leased in a competitive market in which many producers are demanding land and many landowners are offering land in the market 1/2/2019

Perfectly inelastic supply Land has no production cost; it is a “free & nonreproducible gift of nature” Economy has only so much land Any parcel of land can be made more usable by clearing, drainage, & irrigation but these are capital improvements 1/2/2019

Changes in demand Because the supply of land is fixed, demand is the only active determinant Determinants of land demand Price of the product produced on the land Productivity of land (which depends in part on the quantity & quality of resources with which land is combine) Prices of the other resources that are combined with land Changes in economic rent have no effect on the amount of land available because the supply is fixed 1/2/2019

Incentive Function A high price provides an incentive to offer more of other non-land resources Land serves no incentive function because the total supply is fixed 1/2/2019

Productivity differences & rent differences Different pieces of land vary greatly in productivity, depending on soil fertility & on such climatic factors as rainfall & temperature Such productivity differences are reflected in resource demand & prices Location itself may be just as important in explaining differences in land rent Renters will pay more for a unit of land that is strategically located with respect to materials, transportation, labor, & customers 1/2/2019

Alternatives uses of land Individual firms must pay rent to cover opportunity costs in order to secure the use of land for their particular purposes To the individual firm, rent is a cost of production 1/2/2019

Interest (16.2) Price paid for the use of money Price that borrowers need to pay lenders for transferring purchasing power from the present to the future Stated as a percentage of the money borrowed rather than as a dollar amount Money is not a resource Businesses can “buy” the use of money because it can be used to acquire capital goods (factories, machinery, & warehouses) 1/2/2019

Loanable funds theory of interest Refers to supply of and demand for funds available for lending Supply of loanable funds Households will make available a larger quantity of funds at higher interest rates Most people prefer to use their incomes to purchase things today For people to delay consumption & increase their saving, they must be compensated by an interest payment. 1/2/2019

Demand for loanable funds Businesses primarily borrow loanable funds to add to their stocks of capital goods (plants/warehouses/machinery) To determine whether the investment would be profitable… Firm must compare the interest rate with the expected rate of return If the investment is profitable, it should be made 1/2/2019

Extending the model Financial institutions Households place their savings in banks who pay interest to savers in order to attract loanable funds Those funds are then lent to businesses Businesses borrow the funds from the banks, paying them interest for the use of the money Financial institutions profit by charging borrowers higher interest rates than the interest rates they pay their savers 1/2/2019

Changes in supply Anything that causes households to be thriftier will prompt them to save more at each interest rate Changes in demand- anything that increases the rate of return on potential investments will increase the demand for loanable funds 1/2/2019

Other participants Both households as well as the government are participants on both the demand & supply side of the loanable funds market 1/2/2019

Range of interest rates Why do interest rates vary? Risk The greater the chance that the borrower will not repay the loan, the higher the interest rate the lender will charge to compensate for that risk. Maturity – length of loan affects interest rate Loan size – interest rate on smaller loans will be higher Taxability – interest on certain state & municipal bonds is exempt from Federal income taxation Market imperfections – ex. Small town banks monopolize local lending may charge high interest rates on loans because it’s inconvenient & costly to “shop around” 1/2/2019

Role of the interest rate Lower interest rate encourages businesses to borrow more for investment As a result, total spending in the economy rises Sometimes higher interest rates are desirable if an economy is experiencing inflation because spending will decrease The Federal Reserve often manipulates the interest rate to try to expand investment & output 1/2/2019

Role of the interest rate (cont) Interest & the allocation of capital The interest rate rations the available supply of loanable funds to investment projects that have expected rates of return at or above the interest rate cost of the borrowed funds 1/2/2019

Role of Interest Rates (cont) Interest & R&D spending The lower the interest rate & thus the lower the cost of borrowing funds for R&D, the greater the amount of R&d spending that is profitable 1/2/2019

Nominal & real interest rates Rate of interest expressed in dollars of current value Real Rate of interest expressed in purchasing power 1/2/2019

Usury Laws Specifies a maximum interest rate at which loans can be made (price ceiling) Purpose: hold down the interest cost of borrowing, particularly for low-income borrowers 1/2/2019

Economic Profit (16.3) According to economists, “accounting” profit is overstated. Accounting profit only considers explicit costs (payments made by the firm to outsiders) Implicit costs are ignored under “accounting profit” (monetary income that the firm sacrifices when it uses resources that it owns). Economic (pure) profit – amount remaining after both costs have been subtracted from revenue 1/2/2019

Risk & profit Insurable risks – annual fee paid to insurance company. Entrepreneur does not bear the risk. Uninsurable risks – uncontrollable & unpredictable changes in the demand & supply conditions facing the firm 1/2/2019