16-1 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIver By Muni Perumal, University of Canberra, Australia Chapter 16 Rent, interest and profits

16-2 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIver By Muni Perumal, University of Canberra, Australia Learning objectives Extend our analysis of resource pricing to include each of the non-wage income sources: rent, interest and profits Develop an understanding of the pattern of all income shares in Australia, including wages, and their current and historical significance

16-3 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIver By Muni Perumal, University of Canberra, Australia Economic rent ‘Economic rent’ is a term used by economists Narrower than the common meaning of the term ‘rent’ Economic rent is the price paid for the use of land and other natural resources that are completely fixed in total supply

16-4 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIver By Muni Perumal, University of Canberra, Australia Determination of land rent Land rent (dollars) Acres of land 0 Q S S D1D1 R1R1 R2R2 D2D2 D3D3 R3R3 D4D4

16-5 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIver By Muni Perumal, University of Canberra, Australia Land rent Supply of land is perfectly inelastic Changes in demand –Sole active determinant of land rent –‘Derived demand’ –Down-sloping  Law of diminishing returns  Product price must be decreased to sell additional units

16-6 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIver By Muni Perumal, University of Canberra, Australia Perfectly inelastic supply of land Why? –No production costs associated with land –Economy has a finite supply of land –Variability in the useability of land affects a very small fraction of the total amount of land

16-7 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIver By Muni Perumal, University of Canberra, Australia Land rent is a surplus Does not serve as an incentive A payment that is not necessary to ensure that land will be available to the economy as a whole The case against land rent –Henry George’s proposal: single tax on land –Advantages and disadvantages

16-8 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIver By Muni Perumal, University of Canberra, Australia Productivity of land Different properties will differ in their productivities –Soil fertility –Mineral wealth –Climatic factors –Environmental degradation Different grades of land can be represented by differing demand curves

16-9 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIver By Muni Perumal, University of Canberra, Australia Interest The price paid for the use of money. Typically the amount that must be paid for the use of one dollar for one year Two important aspects of interest: 1.Measured as a percentage 2.Money is not a resource –Money is not in itself useful

16-10 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIver By Muni Perumal, University of Canberra, Australia Determining interest rate Demand and the supply of money determine interest rate Demand for money Total demand for money is made of: –Transaction demand for money — the demand for money as a medium of exchange – Asset demand — money acts as a financial asset and store of wealth

16-11 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIver By Muni Perumal, University of Canberra, Australia Determining interest rate (cont.) Money supply –The money supply curve is a vertical line and is independent of the interest rate The intersection of the demand-for-money curve and the money supply curve determines the equilibrium interest rate

16-12 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIver By Muni Perumal, University of Canberra, Australia Interest rate determination (cont.) Rate of interest (per cent) Amount of money demanded and supplied ($billion) DmDm SmSm IeIe

16-13 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIver By Muni Perumal, University of Canberra, Australia Determining interest rate (cont.) Investment decision The investment demand curve shows the amount of investment the business sector will undertake at various real rate of interest Nominal interest rate is the rate of interest expressed in terms of dollars of current value Real interest rate is interest rate adjusted for inflation –Important in making investment decisions

16-14 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIver By Muni Perumal, University of Canberra, Australia The interest rate and investment $125$150$ $15$20$25 Real rate of interest (%) S m1 DmDm S m2 S m3 Amount of money demand and supplied Amount of Investment, I Real Rate of interest (%) (a) The money market (b) Investment demand

16-15 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIver By Muni Perumal, University of Canberra, Australia Range of interest rates Commercial rates, mortgage rates etc. Reasons for interest rate differentials –Risk –Maturity or length of loan –Size of loan Pure rate of interest –Overall interest rate in the economy –Best approximated by interest paid on long-term federal government bonds

16-16 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIver By Muni Perumal, University of Canberra, Australia Role of interest rates Affect level of production of investment goods –Change in interest rates results in change in investment demand Affect composition of production of investment goods –Interest rates allocate the available supply of money to those projects which are expected to result in the highest levels of profit

16-17 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIver By Muni Perumal, University of Canberra, Australia Economic profits Economists define profit more narrowly than accountants Profit from the viewpoint of accountants only considers explicit cost –Payment by firms to outsiders They ignore implicit costs –Payments for similar resources that are owned and self-employed by a firm

16-18 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIver By Muni Perumal, University of Canberra, Australia Economic profits (cont.) Economic or pure profits are what remain after all opportunity costs — explicit and implicit wage, rent, and interest costs and a normal profit — have been subtracted from a firm’s total revenue Economic profit can be either positive or negative

16-19 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIver By Muni Perumal, University of Canberra, Australia Role of the entrepreneur Recall from Chapter 2 –Entrepreneurs take initiative to combine other resources in production –Entrepreneurs make non-routine decisions –Entrepreneurs introduce innovation –Entrepreneurs take economic risks Normal profit –The minimum return necessary to retain the entrepreneur in a production line

16-20 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIver By Muni Perumal, University of Canberra, Australia Sources of economic profits Economic profits –Are not a cost –Accrue to the entrepreneur Sources of economic profits Uncertainty, risk and profits –Bearing of uninsurable risk Uncertainty, innovation and profits Monopoly profits

16-21 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIver By Muni Perumal, University of Canberra, Australia Functions of profits Energise the economy Stimulate innovation and output Encourage investment Allocate resources among alternatives

16-22 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIver By Muni Perumal, University of Canberra, Australia Income shares Largest share of national income accrues to labour. It receives currently about 54 per cent of the national income Labour’s relative share has declined in Australia since the 1980s Capitalist share less than 25 per cent of national income

16-23 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIver By Muni Perumal, University of Canberra, Australia Relative share of GDP at factor cost: Australia

16-24 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIver By Muni Perumal, University of Canberra, Australia Income shares Historical trends Defining labour’s share as ‘wages and salaries’, it increased from around 50 per cent in the post-war period to a high of around 61 per cent in the 1970s Changing output mix and industry mix have contributed to the rise in labour’s share

16-25 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIver By Muni Perumal, University of Canberra, Australia Next chapter: Market failure and resource allocation