1. Rent, Interest, and Profit
Chapter 29
Rent, Interest, and Profit
29-1
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

2. Objectives What is land? Economic rent
Are prices high because rents are high, or are rents high because prices are high?
What is capital?
How is the interest rate determined?
The net productivity of capital
The capitalization of assets
The present value of future income
How are profits determined?
Theories of profit
29-2
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

3. Rent What Is Land? Land is a resource or a factor of production
The owner of land is paid rent for allowing its use in the production process
The amount of rent paid for a piece of land is based on the supply of and the demand for land
29-3
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

4. Exactly What Is Land? Land is land
How land is used depends on its location, its fertility, and whether it possesses any valuable minerals
Sometimes we confuse land with what is built on it
Land with an apartment building on it will rent for more than a vacant lot
However in economic terms we pay rent on the land itself
29-4
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

5. How Does One Piece of Land Differ From Another?
A plot of land may have alternative uses
If it is used at all, it will be used by the highest bidder – the one willing to pay the most for it
The basic way one piece of land differs from another is location
An acre of land in the middle of a desert is worth a lot less than an acre of land in a metropolitan area
29-5
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

6. How Is the Supply of Land Derived?
In economics we say the supply of land is fixed
At any given location there is a fixed amount of land
We can make more efficient use of land
We represent the supply of land as a vertical line
29-6
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

7. How Is the Demand for Land Derived?
The demand for land, like the demand for labor and capital, is derived from a firm’s MRP curve
The land will go to the highest bidder
The demand curve for land slopes downward to the right because its marginal physical product declines with output (due to diminishing returns)
If the firm is an imperfect competitor, it must lower price to increase sales, thereby further depressing MRP as output expands
29-7
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

8. Determination of Rent 29-8
The demand for rent is the MRP schedule of the highest bidder for a specific piece of land. The supply of land is fixed, so its supply curve is perfectly inelastic. The rent, like the price of anything else, is set by supply and demand
29-8
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

9. Increase in Demand for Land
Since the supply of land is perfectly inelastic, an increase in demand is reflected entirely in an increase in price (and not an increase in the quantity of land).
29-9
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

10. Economic Rent
Economic rent is payment in excess of what people would be willing to accept
Rent paid to landlords (exclusive of any payment for buildings and property improvement ) is, by definition, economic rent
29-10
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

11. Are Prices High Because Rents Are High, or Are Rents High Because Prices Are High?
High rents don’t cause high prices
Desirable locations attract many prosperous renters, who bid up rents because they believe they will get a lot of business
Rents are high because the demand for the final product(s) – and consequently the derived demand – is high
If low rents lead to low prices, the mom and pop stores would have lower prices, but they have higher prices
29-11
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

12. Capital What Is capital
Capital consists of office buildings, factories, stores, machinery and equipment, computer systems, and other synthetic goods used in the production process
When we invest we are spending money on new capital
The stock of capital increases by means of a flow of investment
Say you have a capital stock of four machines. You buy two more. That’s your investment for the year. Now you have a capital stock of six machines
29-12
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

13. How Is the Interest Rate Determined?
The interest rate is determined by the demand for loanable funds and the supply of loanable funds
The supply of loanable funds (or savings) slopes upward to the right because the amount of money people save is somewhat responsive to interest rates
29-13
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

14. Interest Rates and Consumer Loans
High interest rates deter borrowing for consumer loans
Banks probably charge too much on credit card loans
Should this justify a legal ceiling (usury laws) on the interest that may be charged on these and other loans?
29-14
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

15. Usury Laws Usury laws place limits on how much interest may be charged
Usury laws are price ceilings because they prevent the interest rates from rising to their equilibrium level
This creates a shortage of loanable funds
29-15
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

16. Usury Laws How do usury laws hurt borrowers?
Since usury laws create a shortage of loanable funds, the funds that are available go to the most creditworthy individuals and businesses first
Borrowers with poor credit ratings are completely left out
These borrowers are left with consumer finance companies that may not be subject to usury laws
This means that if they can find money to borrow they will end up paying much higher interest rates than without usury laws
29-16
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

17. Interest Rate Ceiling Shortage of $350 billion 29-17
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

18. The Present Value of Future Income
A dollar today is worth more than a dollar in the future
Because of inflation
Because the dollar can be lent out to earn interest
29-18
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

19. The Present Value of Future Income
r = the interest rate; n = the number of years 1
Present value of a dollar received n years from now = n
(1 + r)
29-19
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

20. The Present Value of Future Income
If the interest rate were 5 percent, how much would a dollar received one year from now be worth today? 1
Present value of a dollar received n years from now = n
(1 + r) 1 = 1
( )
r = the interest rate; n = the number of years
29-20
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

21. The Present Value of Future Income
If the interest rate were 5 percent, how much would a dollar deceived one year from now be worth today? 1
Present value of a dollar received n years from now = n
(1 + r) 1 = 1
( ) 1 =
1.05
= cents
r = the interest rate; n = the number of years
29-21
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

22. The Present Value of Future Income
What is the present value of $1,000 that will be paid to you in three years if the interest rate is 5 percent. Work out to the nearest cent 1
Present value of a dollar received n years from now = n
(1 + r)
r = the interest rate; n = the number of years
29-22
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

23. The Present Value of Future Income
What is the present value of $1,000 that will be paid to you in three years if the interest rate is 5 percent. Work out to the nearest cent 1
Present value of a dollar received n years from now = n
(1 + r) 1
= $1,000 X 3
(1.05)
r = the interest rate; n = the number of years
29-23
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

24. The Present Value of Future Income
What is the present value of $1,000 that will be paid to you in three years if the interest rate is 5 percent. Work out to the nearest cent 1
Present value of a dollar received n years from now = n
(1 + r) 1
= $1,000 X
(1.05) 3 1
= $1,000 X
r = the interest rate; n = the number of years
29-24
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

25. The Present Value of Future Income
What is the present value of $1,000 that will be paid to you in three years if the interest rate is 5 percent. Work out to the nearest cent 1
Present value of a dollar received n years from now = n
(1 + r) 1
= $1,000 X
(1.05) 3 1
= $,1000 X
= $1,000 X = $863.84
r = the interest rate; n = the number of years
29-25
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

26. How Large Are Profits?
Economist subtract both explicit cost and implicit cost from sales to get economic profits
Accountants subtract only explicit cost
This means economics profits are lower than accounting profits
Large corporations have no implicit cost, but the majority of the nation’s 4 million corporations are very small businesses with substantial implicit costs
29-26
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

27. Theories of Profit The Entrepreneur as a Risk Taker
The Entrepreneur as an Innovator
The Entrepreneur as a Monopolist
The Entrepreneur as an Exploiter of Labor
29-27
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

28. The Entrepreneur As a Risk Taker
The entrepreneur is a risk taker
Starting a business is a risky endeavor
Most new businesses fail in the first five years
Why then do people start a new business?
If they succeed they will get a high rate of return
29-28
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

29. The Entrepreneur As an Innovator
An innovation is not an invention
An invention is a new idea, a new product, or a new way of producing things
An innovation is the act of putting the invention to practical use
Innovate is what entrepreneurs do
29-29
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

30. The Entrepreneur As a Monopolist
Monopolist and oligopolist make profits (economic) because of a shortage of competition
If this shortage of competition is due to hard work, foresight, and innovation one could hardly complain of the evils of big business
The shortage of competition is due to ‘natural scarcities”
If this shortage of competition is due to “contrived scarcities” and the business restricts output so it can make monopoly profits, that is another story
29-30
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

31. The Entrepreneur As an Exploiter of Labor
Karl Marx based his theory of profits on the supposition that the capitalist exploits the worker by taking the surplus value of the worker’s labor (profits) and using this to buy more capital to be able to exploit even more workers
Marx sees the capitalist’s role as that of exploiting the employees
Have you ever worked for an organization that fit this model?
29-31
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

32. Conclusion Which theory of profits is correct?
Whichever theory you choose is correct
There is a lot of truth in each of the four theories
We may conclude , then, that everybody’s right and that nobody has a monopoly on the truth
29-32
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.