The Markets for Land and Capital Micro: Econ: 34 70 Module The Markets for Land and Capital KRUGMAN'S MICROECONOMICS for AP* Margaret Ray and David Anderson

What you will learn in this Module: How can we determine demand and supply in the markets for land and capital? How can we find equilibrium in the capital and land markets? How does the demand for factors leads to the marginal productivity theory of income distribution? The purpose of this module is to show how we can use supply and demand to model the markets for the land and capital inputs.

Demand in the Markets for Capital and Land The price (marginal cost) of capital or land is the rental rate (R) Explicit cost? Implicit cost? How does the owner of the firm determine how much land and capital to employ? In the same way the firm hires labor.   If the return on the next unit of land or capital is greater than or equal to the marginal cost of employing that unit of capital, that unit is employed. Economists use “rental rate” to refer to the marginal cost (or price) of hiring the next unit of land or capital. To maximize profit from the hiring of land, employ units of land up to the point where: VMPLand = RLand Likewise, to maximize profit from the hiring of capital, employ units of capital up to the point where: VMPCapital = RCapital What exactly is this rental rate? We can think about the rental rate in two ways: as an explicit cost or an implicit cost. Explicit cost: the firm is renting the use of a machine, a building, or a parcel of land from another person who owns the capital or land. This might represent a monthly payment in the explicit costs of the firm. Implicit cost: the firm already owns the machine, building or parcel of land but there are other people out there who might like to rent it themselves. If the firm uses the capital or land itself, it forgoes the rental income, and this is an implicit, or opportunity, cost for the firm.

Demand in the Markets for Capital and Land Firms hire capital or land up to the point where VMP = R Example: VMPk=Rk, or VMPland=Rland How does the owner of the firm determine how much land and capital to employ? In the same way the firm hires labor.   If the return on the next unit of land or capital is greater than or equal to the marginal cost of employing that unit of capital, that unit is employed. Economists use “rental rate” to refer to the marginal cost (or price) of hiring the next unit of land or capital. To maximize profit from the hiring of land, employ units of land up to the point where: VMPLand = RLand Likewise, to maximize profit from the hiring of capital, employ units of capital up to the point where: VMPCapital = RCapital What exactly is this rental rate? We can think about the rental rate in two ways: as an explicit cost or an implicit cost. Explicit cost: the firm is renting the use of a machine, a building, or a parcel of land from another person who owns the capital or land. This might represent a monthly payment in the explicit costs of the firm. Implicit cost: the firm already owns the machine, building or parcel of land but there are other people out there who might like to rent it themselves. If the firm uses the capital or land itself, it forgoes the rental income, and this is an implicit, or opportunity, cost for the firm.

Supply in the Markets for Capital and Land The supply curve for capital and land is upward sloping. The supply of land is inelastic (very steep) Why? Macro: Where does the funds for new investment in capital [or in general] come from in the private sector? Savings What happens if the rate of return on this investment rises? More investment! [Unless you get the paradox of thrift.] The supply of land is upward sloping, but nearly vertical, or very inelastic. After all, there are only so many square miles (or kilometers) of usable land in a nation. If the rental rate of farmland were to increase, it is possible to convert land from one non-farm use to farm use, but it’s costly to do.   The supply of capital is also upward sloping, but much less steep, or very elastic. If the rental rate on capital rises, firms that supply capital will simply operate their factories longer and create more capital machines. Note: in a macro course, students learn that the funds for new investment in capital machinery and new construction come from savers. If the rate of return on savings rises, households will save more money, thus greasing the wheels of new investment spending.

Equilibrium in the Markets for Capital and Land Supply and demand in factor markets work very much like supply and demand in product markets. Equilibrium in the market for capital or land is where the supply curve intersects the demand curve. The equilibrium rental rate and quantity of land/capital are found on the axes of the graph. The graph shown here is for the market for farm land. Suppose that, over the course of many years, farm land is converted to housing developments, golf courses and Chuck-E-Cheeses. The supply curve shifts to the left, decreasing the equilibrium quantity of land and increasing the price, or rental rate, of each acre of farm land.

Marginal Productivity Theory If we are at equilibrium, what is the relationship between the wage paid for the last worker and the product for the last worker? How about land, or capital? If labor’s factor income is 71%, then what is the relationship between VMP labor and VMP k or land? If all factor markets are in equilibrium, the last unit employed is paid a wage (or rental rate) equal to the value of the marginal product. These equilibrium factor prices determine the distribution of factor income shown in Module 69.   Because labor’s share of factor income is about 70%, it must be the case that labor’s value of the marginal product is greater than the other factors land and capital.

Marginal Productivity Theory Looking at VMP labor, does this mean that each worker is equally useful [ignore diminishing returns]? Why are there differences in wages? Why do wages rise and fall – both by market and by individual? If all factor markets are in equilibrium, the last unit employed is paid a wage (or rental rate) equal to the value of the marginal product. These equilibrium factor prices determine the distribution of factor income shown in Module 69.   Because labor’s share of factor income is about 70%, it must be the case that labor’s value of the marginal product is greater than the other factors land and capital.