1. Rent, Interest, and Profit
Chapter 16
In this chapter, we will define economic rent and explore the factors that impact its value. Then we will look at the price of money, or interest rates, and how the interest rates are determined using the loanable funds theory. Along with interest rates, we will investigate present and future values of money. Lastly, we will examine the role of profits in the allocation of resources.
Rent, Interest, and Profit
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2. Economic Rent Price paid for land and other natural resources
Perfectly inelasticity supply
Changes in demand
A surplus payment
Economists use the term “rent” to mean economic rent. Economic rent is the price paid for the use of land and other natural resources that are completely fixed in total supply. This fixed overall supply distinguishes rental payments from wage, interest, and profit payments. For all practical purposes, the supply of land is perfectly inelastic, resulting in a vertical supply curve. Because the supply of land is fixed, demand is the only active determinant of land rent. The demand for land is driven by the productivity of the land, the demand for the products produced on the land and the prices of other resources that are combined with the land. Given the fact that land has a perfectly inelastic supply, there are no incentive payments associated with land. Economists therefore consider land rents to be surplus payments that are not necessary to ensure that land is made available for economic use. No matter what rent is paid, the land will always be there.
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3. Economic Rent Land Rent (Dollars) Acres of Land S R1 D1 R2 D2 R3 D3 a
Because the supply of land is perfectly inelastic, demand is the sole determinant of land rent. An increase in demand from D2 to D1 or a decrease in demand from D2 to D3 will cause a considerable change in rent. The amount of land will always stay the same. If demand is very weak (D4) relative to supply, land will be a “free good,” commanding no rent. D3 a b L0
Acres of Land D4
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4. Economic Rent Land ownership: fairness vs. allocative efficiency
Application: a single tax on land
Henry George’s proposal
Single-tax movement
Criticisms
Socialists have often argued that land rents are unearned incomes because the owners of land who rent it out produce nothing. However, supporters of private land ownership have argued that private ownership forces owners to consider their opportunity costs and use the land for its best use. Markets are used to reflect changes in value of land based on new technologies and economic growth. If land were owned by the government, it would be very difficult for the government to identify the best use of the land with a lack of market signals.
In the United States, criticism of rental payments produced what was referred to as the single-tax movement in the late 19th century. Supporters of this movement held that economic rent could be heavily taxed without diminishing the available supply of land or reducing the efficiency with which it is allocated. The concept was created in response to the idea that private ownership of land results in unfair allocations. Henry George spearheaded the movement, which was based upon allowing land to remain in private hands but then to tax the land based upon the rent it earns. This would allow private landowners to allocate their land to its best possible use. Society would benefit because the land would be used for its highest and best purpose, but a portion of the rent would be redirected from the private landowner to society as a whole. The single tax idea had many critics who argued that it would not produce enough revenue for government to operate and it would be difficult to isolate exactly what the rent was for the land. They also argued that other individuals are also the recipients of unearned income and since land is frequently sold at higher and higher prices, it would not be fair to impose a heavy tax on the recent buyers only.
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5. Interest Price paid for use of money Stated as a percentage
Money is not a resource
Interest rates and interest income
Range of interest rates
Risk
Maturity
Loan size
Taxability
Interest is the price paid for the use of money, typically stated as an annual percentage. It is important to remember that money is not itself an economic resource, meaning you cannot directly produce any goods and services with it. Borrowers value money for what it can purchase. The interest rate itself is determined by several factors. First and foremost, interest rates reflect the risk that the money will not be repaid. The greater the chance of default, the higher the interest rate that will be charged. The time length of the loan, or its maturity, also affects the interest rate. Longer-term loans usually command higher interest rates due to the likelihood that other factors may change during the term of the loan. The loan amount will also have an impact in that interest rates on a smaller amount will usually be smaller as well. Finally, the taxability of the interest income may be a factor. If the interest is tax-exempt, the borrower will receive a lower rate.
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6. Loanable Funds Theory Extending the model Financial institutions
Changes in supply
Household thrift
Changes in demand
Rate of return on investment
Other participants
The loanable funds theory of interest explains the interest rate on any particular type of loan in terms of the supply of and demand for funds available for lending in the loanable funds market that exists for that particular type of loan. There is a loanable funds market for nearly every type of loan. Most loans will be obtained through some form of financial institution such as a bank. Banks will pay interest to savers to attract loanable funds and, in turn, will lend those funds to businesses. The institution profits by charging a higher rate to the borrower than they pay to the saver. Anything that causes households to save more will shift the supply curve rightward. A decline in savings will shift the supply curve leftward. Changes in demand come about when the rate of return on potential investments increases or decreases. There are many participants besides just households and businesses involved in this process. The Federal Reserve controls the amount of bank activity and thus influences a wide variety of interest rates. The government also has an impact on the lending process by granting special tax treatment for different types of interest.
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7. Loanable Funds Theory The equilibrium interest rate
Interest Rate (Percent)
i = 8%
The upsloping supply curve for loanable funds in a specific lending market reflects the idea that at higher interest rates, households will defer more of their present consumption (save more), making more funds available for lending. The downsloping demand curve for loanable funds in such a market indicates that businesses will borrow more at lower interest rates than at higher interest rates. At the equilibrium interest rate, the quantities of loanable funds lent and borrowed will be equal. D F0
Quantity of Loanable Funds
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8. Time-Value of Money Money is more valuable the sooner it is obtained
Ability to earn interest
Compound interest
Future value
Present value
Interest is central to understanding the time-value of money or the concept that a specific amount of money is more valuable to a person the sooner it is obtained. Compound interest is the total interest that accumulates over time on money that is placed into an interest-bearing account. Future value is the amount to which some current amount of money will grow as interest compounds over time. Present value is today’s value of some amount of money to be received in the future.
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9. Time-Value of Money
This table illustrates the power of compound interest. As each period goes by, the interest earned is added to the value and the interest for the next period is calculated on the beginning value plus the interest earned to date.
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10. Role of Interest Rates Relationship to: Total output
Allocation of capital
R&D spending
Nominal and real rates
Application: Usury Laws
Nonmarket rationing
Gainers and losers
Inefficiency
Lower equilibrium interest rates encourage businesses to borrow more for investment, resulting in total spending in the economy rising. Since interest rates are prices, they allow for the allocation of the available supply of loanable investment funds to investment projects that have expected returns at or above the interest rate of the borrowed funds. Decisions to spend on R & D will also be influenced by the interest rate. It is important to distinguish between nominal and real interest rates. The nominal interest rate is the rate of interest expressed in dollars of current value. The real interest rate is the rate of interest expressed in purchasing power, adjusted for inflation. It is the real interest rate that affects investment and R & D decisions. Many states have passed what are referred to as usury laws, which specify a maximum interest rate at which loans can be made. By specifying a maximum rate, the government is interfering with the equilibrium rate. This can cause nonmarket rationing in which there is a shortage of loanable funds since the rate is below the equilibrium rate. Creditworthy borrowers gain from usury laws because they pay below-market interest rates and the below-market rates will promote inefficiency in the marketplace since less productive projects may receive financing.
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11. Global Perspective
This data shows the short-term nominal interest rates in various countries in Because these are nominal rates, much of the variation reflects differences in rates of inflation. Differences in central bank policies and default risk also influence the variation.
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12. Economic Profit Explicit costs Implicit costs Pure profit
Total revenue less explicit and implicit costs
Role of the entrepreneur
Normal profit
It is important to remember that economists define profit very narrowly. Accountants define profit as what is left over after all of the bills are paid. The economist defines profit as what is left after both the explicit costs (expenses) and implicit costs have been covered. The implicit costs are the monetary income the firm sacrifices when it uses resources that it owns, rather than supplying those resources to the market, and includes a normal profit. Economic profits are sometimes referred to as pure profits. The economic profits flow to individuals to motivate them to provide the economic resource known as entrepreneurship.
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13. Economic Profit Insurable risks Uninsurable risks
Changes in economic environment
Structure of economy
Government policy
New products of production methods
Entrepreneurs face significant financial risk which fall into two different categories. Insurable risks are those risks for which it is possible to buy insurance from an insurance company. Uninsurable risks are those risks for which it is not possible to buy insurance. Uninsurable risks fall into four main categories. The first includes changes in the general economic environment such as a recession. The second is changes in the structure of the economy. Consumer tastes, technology, and price changes occur unpredictably in the real world. Changes in government policy such as a newly instituted regulation are another source of uninsurable risk. Finally, new products or production methods pioneered by rivals can result in a firm suddenly losing sales and revenue.
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14. Economic Profit Profit is compensation for bearing uninsurable risks
Sources of economic profit
Create new products
Reduce production costs
Create and maintain a profitable monopoly
Profits serve as compensation to the entrepreneur for personally taking on the uninsurable risks of running a business. Basically, in exchange for making sure that everyone else gets paid if things go wrong, the entrepreneur gets to keep the firm’s profits when things go right. There are three main ways in which entrepreneurs can generate economic profits. They can create a popular new product that people desire, they can implement more-efficient production methods for existing products or they can create and maintain a monopoly for their product.
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15. Economic Profit Profit rations entrepreneurship
Profit aids in resource allocation
Profit and corporate stockholders
Profit can be thought of as the price that allocates the scarce resource of entrepreneurship toward different possible economic activities. Economic profits are distributed widely beyond the entrepreneurs who first start new businesses. The corporate structure of business enterprise has allowed millions of individuals to participate and therefore share the risks and rewards of ownership. By sharing the profits with these individuals, society is able to indicate which businesses it desires to continue.
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16. Income Shares
Labor by far holds the dominant role in the U.S. economy. Even narrowly defining labor as just wages and salaries, labor receives about 70% of all income earned by Americans in a typical year. Adding proprietor’s income brings the total up to nearly 80%. The remaining 20% goes to “capitalists” in the form of rents, interest, and corporate profits.
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17. The Price of Credit Effective interest rates Discounting a loan
Repaying a loan in installments
Effects of compounding
Truth in Lending Act 1968
Truth in Savings Act 1991
Fees and teaser rates
Let the borrower beware
There are many different forms of borrowing and the interest paid on those loans can sometimes be deceiving. It is important for an individual to pay attention to exactly how the interest is being calculated. Two pieces of legislation, the Truth in Lending Act of 1968 and the Truth in Savings Act of 1991, have attempted to clarify interest charges and payments for consumers. The old adage “let the borrower beware” is still a fitting motto in the world of credit.