1. © 2005 Thomson C hapter 17 Interest, Rent, and Profit

2. © 2005 Thomson 2 Gottheil - Principles of Economics, 4e Economic Principles Marginal physical product of capital Marginal revenue product of capital Loanable funds and equipment capital Interest rate determination

3. © 2005 Thomson 3 Gottheil - Principles of Economics, 4e Economic Principles The ethics of earning interest- based income The present value of a property Pure rent, differential rent, and location rent

4. © 2005 Thomson 4 Gottheil - Principles of Economics, 4e Economic Principles Wage-related rents Profit-related income

5. © 2005 Thomson 5 Gottheil - Principles of Economics, 4e Interest, Rent, and Profit Economists believe that capital is productive in precisely the same way that people are. We calculate the productivity of capital the same way we calculate the productivity of people.

6. © 2005 Thomson 6 Gottheil - Principles of Economics, 4e Interest, Rent, and Profit Marginal revenue product (MRP) of capital The change in total revenue that results from adding one more dollar of loanable funds to production.

7. © 2005 Thomson 7 Gottheil - Principles of Economics, 4e Interest, Rent, and Profit Loanable funds Money that a firm employs to purchase the physical plant, equipment, and raw materials used in production.

8. © 2005 Thomson 8 Gottheil - Principles of Economics, 4e Interest, Rent, and Profit The demand curve for loanable funds is identical to the firm’s MRP of capital curve. Each borrowed dollar must produce revenue for the firm that is greater than or equal to the rate of interest charged on the loan.

9. © 2005 Thomson 9 Gottheil - Principles of Economics, 4e Interest, Rent, and Profit For example, suppose the rate of interest is 15 percent and the quantity of loans demanded by the firm is $8,000. Then each of the first $7,999 produces more than $0.15 in revenue. The $8,000th produces exactly $0.15.

10. © 2005 Thomson 10 Gottheil - Principles of Economics, 4e EXHIBIT 1AEDWARDS’S DEMAND FOR LOANABLE FUNDS

11. © 2005 Thomson 11 EXHIBIT 1BEDWARDS’S DEMAND FOR LOANABLE FUNDS

12. © 2005 Thomson 12 Gottheil - Principles of Economics, 4e Exhibit 1: Edwards’s Demand for Loanable Funds 1. What will be the quantity of loanable funds demanded by the firm when the interest rate is 20 percent? At an interest rate of 20 percent, $7,000 of loanable funds will be demanded.

13. © 2005 Thomson 13 Gottheil - Principles of Economics, 4e Exhibit 1: Edwards’s Demand for Loanable Funds 2. What is the marginal revenue product if the firm decides to use $2,000 of loanable funds and the price per ton of coal is $2? Marginal revenue product of capital = price per unit × marginal physical product = $2 × 225 = $450.

14. © 2005 Thomson 14 Gottheil - Principles of Economics, 4e Converting Loanable Funds to Capital Equipment Adding an additional dollar of loanable funds is different than adding another laborer to a firm.

15. © 2005 Thomson 15 Gottheil - Principles of Economics, 4e Converting Loanable Funds to Capital Equipment A firm can hire, lay off, and rehire miners without affecting their individual physical characteristics. Unlike adding labor, however, adding loanable funds used in production may require changing the physical character of the first loanable funds employed.

16. © 2005 Thomson 16 Gottheil - Principles of Economics, 4e Converting Loanable Funds to Capital Equipment Capital equipment The machinery a firm uses in production. Capital equipment is unalterable in the short run.

17. © 2005 Thomson 17 Gottheil - Principles of Economics, 4e Converting Loanable Funds to Capital Equipment For example, suppose a mining firm has $1,000 invested in picks and shovels and would like to purchase a $2,000 drill. Obviously the firm can’t add $1,000 to the $1,000 already invested in picks and shovels and end up with a new drill.

18. © 2005 Thomson 18 Gottheil - Principles of Economics, 4e Edwards’s Demand for Loanable Funds Interest rate The price of loanable funds, expressed as an annual percentage return on a dollar of loanable funds.

19. © 2005 Thomson 19 Gottheil - Principles of Economics, 4e Edwards’s Demand for Loanable Funds Marginal factor cost The change in a firm’s total cost that results from adding one more unit of a factor (labor, capital or land) to production.

20. © 2005 Thomson 20 Gottheil - Principles of Economics, 4e Edwards’s Demand for Loanable Funds The MRP = MFC rule A firm will continue adding loanable funds to production as long as MRP is greater than or equal to MFC.

21. © 2005 Thomson 21 Gottheil - Principles of Economics, 4e Loanable Funds in the Economy: Demand and Supply The economy’s demand for loanable funds at the prevailing interest rate is the sum of each firm’s demand for loanable funds at that interest rate.

22. © 2005 Thomson 22 Gottheil - Principles of Economics, 4e Loanable Funds in the Economy: Demand and Supply Loanable funds market The market in which the demand for and supply of loanable funds determines the rate of interest.

23. © 2005 Thomson 23 EXHIBIT 2THE ECONOMY’S DEMAND FOR AND SUPPLY OF LOANABLE FUNDS

24. © 2005 Thomson 24 Gottheil - Principles of Economics, 4e Exhibit 2: The Economy’s Demand for and Supply of Loanable Funds Why is the supply curve of loanable funds upward sloping? The supply curve reflects the willingness of people to supply quantities of loanable funds at varying interest rates. At a higher interest rate, more people are willing to supply loanable funds.

25. © 2005 Thomson 25 Gottheil - Principles of Economics, 4e The Equilibrium Rate of Interest Supply and demand determine the equilibrium rate of interest. If conditions change, affecting either demand or supply, then the equilibrium interest rate will change as well.

26. © 2005 Thomson 26 Gottheil - Principles of Economics, 4e The Equilibrium Rate of Interest The demand curve can change as a result of changes in capital’s MRP. Changes in MRP may be caused by: Change in the marginal physical product of capital. Change in the price of the product produced by that capital. New firms entering the market.

27. © 2005 Thomson 27 Gottheil - Principles of Economics, 4e The Equilibrium Rate of Interest Changes in the supply curve are generally a reflection of people’s preferences for more present and less deferred consumption.

28. © 2005 Thomson 28 EXHIBIT 3CHANGES IN THE RATE OF INTEREST

29. © 2005 Thomson 29 Gottheil - Principles of Economics, 4e Exhibit 3: Changes in the Rate of Interest What is the equilibrium rate of interest when the demand curve for loanable funds increases and the supply curve for loanable funds decreases in Exhibit 3? The interest rate increases from r = 0.15 to r = 0.25.

30. © 2005 Thomson 30 Gottheil - Principles of Economics, 4e The Ethics of Income from Interest Some would argue that those who receive income from interest are “unproductive” or “living off the sweat of the working class.”

31. © 2005 Thomson 31 Gottheil - Principles of Economics, 4e The Ethics of Income from Interest Others would argue that loanable funds are a person’s property, just as a worker’s labor is their property. The loanable funds, or capital, are working for the person.

32. © 2005 Thomson 32 Gottheil - Principles of Economics, 4e The Ethics of Income from Interest It may be the case that an individual worked and saved for many years in order to have funds to loan, while others spent their income on consumption items.

33. © 2005 Thomson 33 Gottheil - Principles of Economics, 4e The Ethics of Income from Interest The ethics of earning income from interest brings up questions of property and property rights. What is property? Who has claims to its productive capacity?

34. © 2005 Thomson 34 Gottheil - Principles of Economics, 4e The Ethics of Income from Interest Many people possess particular sets of physical or mental properties that work for him or her. Examples include athletic ability, musical talent and an exceptional mind. All of these are considered forms of property.

35. © 2005 Thomson 35 Gottheil - Principles of Economics, 4e The Ethics of Income from Interest Marxists understand how supply and demand for loanable funds determine the interest rate, but question how the supply of loanable funds got into the hands of the suppliers in the first place. They believe all private property originates in theft.

36. © 2005 Thomson 36 Gottheil - Principles of Economics, 4e Present Value Present value The value today of the stream of expected future annual income a property generates. The method of computing present value is to divide the annual income, R, by the rate of interest, r. That is, PV = R/r.

37. © 2005 Thomson 37 Gottheil - Principles of Economics, 4e Present Value There is an inverse relationship between interest rates and present value. As interest rates fall, present value increases. As interest rates climb, present value decreases.

38. © 2005 Thomson 38 Gottheil - Principles of Economics, 4e Present Value Price floors artificially inflate the value of property.

39. © 2005 Thomson 39 EXHIBIT 4PRICE AND OUTPUT IN THE TOBACCO MARKET

40. © 2005 Thomson 40 Gottheil - Principles of Economics, 4e Exhibit 4: Price and Output in the Tobacco Market Where do the market demand and supply curves intersect in Exhibit 4? The demand and supply curves intersect at P = $3.00 and Q = 800,000. The market equilibrium price is $0.80 less than the price floor of $3.80.

41. © 2005 Thomson 41 Gottheil - Principles of Economics, 4e Present Value Property, in the world of economics, need not be physical.

42. © 2005 Thomson 42 Gottheil - Principles of Economics, 4e Present Value For example, suppose you have a bubbling brook running through your property that you can sell access to for $10 per year. If 1,000 people buy access, the value of the brook is ($10 × 1,000)/(rate of interest).

43. © 2005 Thomson 43 Gottheil - Principles of Economics, 4e Income from Rent Rent The difference between what a productive resource receives as payment for its use in production and the cost of bringing that resource into production.

44. © 2005 Thomson 44 Gottheil - Principles of Economics, 4e Income from Rent Land rent A payment to landowners for the use of land. It is the difference between the payment the resource receives and its supply price. In general land costs nothing to bring into being, so its supply price is $0.

45. © 2005 Thomson 45 Gottheil - Principles of Economics, 4e EXHIBIT 5DERIVING LAND RENT AND DIFFERENTIAL LAND RENT

46. © 2005 Thomson 46 Gottheil - Principles of Economics, 4e Exhibit 5: Deriving Land Rent and Differential Land Rent 1. How does the value of land rent change in panel a of Exhibit 5 as demand shifts to the right? At demand curve D, the price per acre is $0, creating no land rent.

47. © 2005 Thomson 47 Gottheil - Principles of Economics, 4e Exhibit 5: Deriving Land Rent and Differential Land Rent At D 1, the price per acre increases to $50, creating a $50-per-acre land rent. 1. How does the value of land rent change in panel a of Exhibit 5 as demand shifts to the right?

48. © 2005 Thomson 48 Gottheil - Principles of Economics, 4e Exhibit 5: Deriving Land Rent and Differential Land Rent 1. How does the value of land rent change in panel a of Exhibit 5 as demand shifts to the right? At D 2, the land rent increases again to $75 per acre.

49. © 2005 Thomson 49 Gottheil - Principles of Economics, 4e Exhibit 5: Deriving Land Rent and Differential Land Rent In panel a, there are 120,000 acres of land available for cultivation, whatever the price, so the supply curve is vertical. 2. How is the supply curve for land in panel b different than in panel a of Exhibit 5?

50. © 2005 Thomson 50 Gottheil - Principles of Economics, 4e Exhibit 5: Deriving Land Rent and Differential Land Rent 2. How is the supply curve for land in panel b different than in panel a of Exhibit 5? In panel b, there are different supply prices for the 120,000 acres. The supply curve is upward sloping in a steplike fashion.

51. © 2005 Thomson 51 Gottheil - Principles of Economics, 4e Exhibit 5: Deriving Land Rent and Differential Land Rent 3. What is the supply price per acre for the first, second, and third 40,000 acre units of land in panel b? The first 40,000 acres have a $0 supply price—no improvement is needed in order to utilize the land.

52. © 2005 Thomson 52 Gottheil - Principles of Economics, 4e Exhibit 5: Deriving Land Rent and Differential Land Rent 3. What is the supply price per acre for the first, second, and third 40,000 acre units of land in panel b? The second 40,000 acres have a supply price of $50 and the third 40,000 acres have a supply price of $75.

53. © 2005 Thomson 53 Gottheil - Principles of Economics, 4e Exhibit 5: Deriving Land Rent and Differential Land Rent 4. What is the total land rent in Panel b when demand is D 1 ? Total land rent = (land rent per acre) × (number of acres). Land rent per acre = (market price per acre) - (supply price). Total land rent = [$50-$0]×40,000 = $2,000,000.

54. © 2005 Thomson 54 Gottheil - Principles of Economics, 4e Income from Rent Differential land rent Rent arising from differences in the cost of providing land.

55. © 2005 Thomson 55 Gottheil - Principles of Economics, 4e Income from Rent In the Netherlands a system of dikes have been constructed in order to wrest land from the sea. There is a cost associated with securing this land.

56. © 2005 Thomson 56 Gottheil - Principles of Economics, 4e Income from Rent The market price of the land is determined by the intersection of demand and supply.

57. © 2005 Thomson 57 Gottheil - Principles of Economics, 4e Income from Rent Location rent Rent arising from differences in land distances from the marketplace.

58. © 2005 Thomson 58 Gottheil - Principles of Economics, 4e Income from Rent The closer a parcel of land is to the marketplace, the greater the land rent. If the location of the market changes, the fortune of the landowner changes.

59. © 2005 Thomson 59 Gottheil - Principles of Economics, 4e Income from Rent For example, when shopping malls open in suburban areas, urban downtown property loses a great deal of value and suburban property increases in value.

60. © 2005 Thomson 60 Gottheil - Principles of Economics, 4e EXHIBIT 6A NEW SET OF RENT-YIELDING ACRES

61. © 2005 Thomson 61 Gottheil - Principles of Economics, 4e Exhibit 6: A New Set of Rent- Yielding Acres Because acre c is the furthest from the market, people there must pay the highest transportation cost to market. It becomes no-rent land at $0. What is the location rent for acres a, b and c when the demand for food requires bringing acre c under cultivation in Exhibit 6?

62. © 2005 Thomson 62 Gottheil - Principles of Economics, 4e Exhibit 6: A New Set of Rent- Yielding Acres What is the location rent for acres a, b and c when the demand for food requires bringing acre c under cultivation in Exhibit 6? Acre b is only 25 miles from market, and people there pay some transportation cost, but not as much as acre c. It’s location rent is $10.

63. © 2005 Thomson 63 Gottheil - Principles of Economics, 4e Exhibit 6: A New Set of Rent- Yielding Acres What is the location rent for acres a, b and c when the demand for food requires bringing acre c under cultivation in Exhibit 6? Acre a is at the market. As such, people there have no transportation cost. The location rent is $20.

64. © 2005 Thomson 64 Gottheil - Principles of Economics, 4e Income from Rent Wage-related rent The difference between what a resource receives and what it takes to bring the supply of that resource to market.

65. © 2005 Thomson 65 Gottheil - Principles of Economics, 4e Income from Rent Wage-related rent It is the difference between what a person is paid and what they would be paid if they took their next best offer.

66. © 2005 Thomson 66 Gottheil - Principles of Economics, 4e Income from Rent For example, suppose a baseball player is paid $2 million to play baseball. If the next best offer for the baseball player is to sell insurance for $30,000, then the wage-related rent = ($2 million - $30,000) = $1,970,000.

67. © 2005 Thomson 67 EXHIBIT 7THE RENT COMPONENT IN COAL MINERS’ WAGES

68. © 2005 Thomson 68 Gottheil - Principles of Economics, 4e Exhibit 7: The Rent Component in Coal Miners’ Wages How is the combined rent determined in Exhibit 7? The combined rent is the sum of the differences between the $13 equilibrium wage rate and the specific supply prices of each miner.

69. © 2005 Thomson 69 Gottheil - Principles of Economics, 4e Income from Profits Profit Income earned by entrepreneurs.

70. © 2005 Thomson 70 Gottheil - Principles of Economics, 4e Income from Profits Profit It is the reward for undertaking the uncertainties of enterprise.

71. © 2005 Thomson 71 Gottheil - Principles of Economics, 4e Income from Profits Profit for the entrepreneur is income adjusted for the implicit costs of that entrepreneur’s labor and money capital.

72. © 2005 Thomson 72 Gottheil - Principles of Economics, 4e Income from Profits For example, an entrepreneur with a new income-earning store must subtract from her income the opportunity cost of spending her time running the new store instead of working somewhere else.

73. © 2005 Thomson 73 Gottheil - Principles of Economics, 4e Income from Profits She must also subtract the interest she would have received had she invested her money in the loanable funds market, rather than as capital in her store.

74. © 2005 Thomson 74 Gottheil - Principles of Economics, 4e Income from Profits In a corporation it is the stock- holders who are the entrepreneurs. They are the ones who have invested their money and who alone assume the uncertainties of the business.