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Chapter 14 - Rent, Interest, and Profit

CHAPTER FOURTEEN

RENT, INTEREST, AND PROFIT

CHAPTER OVERVIEW

In the preceding chapter, wages were accorded a lengthy discussion. In contrast, the discussions of the income shares—rent, interest, and profits—found in the present chapter are relatively brief. Because the theories of rent, interest, and profits are quite unsettled, and because together they constitute only about 30 percent of income paid to American resource suppliers, only the basic features of these income shares are covered.

The complete inelasticity of the supply of land and certain other natural resources is the foundation for the analysis of economic rent. Related topics, such as differential rents and the single-tax movement are presented.

The determination of the interest rate and its role in allocating loanable funds are briefly surveyed. In the discussion of profit, economic and accounting profits are differentiated. There is also an analysis of the sources and functions of profits. The chapter concludes with an overview of the relative shares of national income.

INSTRUCTIONAL OBJECTIVES

After completing this chapter, you should be able to:

1.Explain what determines economic rent.

2.Explain what determines rent differentials.

3.Describe why economic rent is a surplus payment.

4.Distinguish between nationalized land and private ownership of land and how each affects allocative efficiency.

5.Explain the single-tax theory and its criticisms.

6.Explain how rent functions as a cost to the individual firm.

7.Analyze how the interest rate is determined using the loanable funds theory of interest.

8.Explain how business firms make investment decisions.

9.State four factors that may cause interest rates to differ.

10.Analyze the idea of the time-value of money and how that relates to compound interest, present value, and future value.

11.Describe the role of interest in the economy.

12.Distinguish between nominal and real interest rates.

13.Distinguish between economic, normal, and accounting profits.

14.Analyze the relationship between entrepreneurs, profits, and risk.

15.State four sources of uninsurable risk.

16.List three sources of economic profits.

17.Describe the general function of profits.

18.Summarize the current relative shares of national income.

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Chapter 14 - Rent, Interest, and Profit

19.Define and identify terms and concepts listed at the end of the chapter.

LECTURE NOTES

I.Introduction

A.Learning objectives – After reading this chapter, students should be able to:

1.Explain the nature of economic rent and how it is determined.

2.Describe the loanable funds theory of interest rates.

3.Demonstrate how interest rates relate to the time value of money and vary based on risk, maturity, loan size, and taxability.

4.Relate why economic profits occur, and how profits, along with losses, allocate resources among alternative uses.

5.List the share of U.S. earnings received by each of the factors of production.

B.Emphasis in previous two chapters was on labor markets, because wages and salaries account for about 70 percent of all income paid to American resource suppliers.

C.This chapter focuses on the other three sources of income—rent, interest, and profits—which compose the remaining 30 percent of our national income.

D.This chapter will answer each of the following questions:

1.Why do different parcels of land in different locations receive different rent payments?

2.What factors determine interest rates and cause interest rates to change?

3.What are the sources of profits and losses and why do profits and losses change over time?

II.Economic rent is the price paid for use of land and other natural resources that are fixed in supply. (Note that this definition differs from the everyday use of the term.)

A.As presented in Chapter 12, the demand for land is downward sloping because of diminishing returns and the fact that producers must lower the price of the product to sell additional units of output.

B.Perfectly inelastic supply of the resource is one unique feature of the supply side of the market that determines rent. Land has no production cost; it is a “free and nonreproducible gift of nature.” Its quantity does not change with price (with a few exceptions).

C.Changes in demand therefore determine the amount of rent. This will be determined by several factors (Figure 14.1).

1.The price of the product grown on the land,

2.The productivity of the land, and

3.The prices of other resources combined with the land for production.

D.Each parcel of land is not equally productive. More productive land will be in greater demand and therefore will receive higher rents. The different rent payments cause land to be allocated to

its most productive use. (Figure 14.1 represents this situation where D1 reflects the most productive land)

E.Land rent is viewed as a surplus payment because it performs no incentive function to provide more supply; it is not necessary to ensure the availability of land.

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Chapter 14 - Rent, Interest, and Profit

F.In reality, land has alternative uses and costs. From society’s perspective, rent is a surplus; but an individual firm must pay rent to attract the land away from alternative uses. Without rent to allocate land among its various uses, there would be no market mechanism to make sure each piece of land was being utilized in its most valuable fashion. Therefore, rent does provide an important function to our economic system.

1.Some argue that rent should be taxed away, since it is unearned, or that land should be nationalized and owned by the state, but government would have problems properly assigning the correct value to the land.

2.Opponents argue that privately owned land with market determined prices leads to an allocatively efficient use of land and contributes to economic growth.

3.Henry George’s proposal for a single tax on land rent asserted that this tax could eliminate other taxes. Unlike the effect of a tax on other resources, the tax on land would not have a negative incentive effect.

4.Critics of the single-tax idea make several points.

a.Current levels of government spending are too great to be supported only by land taxes.

b.It is difficult to separate the rent component from other income resulting from the combined use of land with other resources.

c.Unearned income goes beyond land and land ownership; capital gains and interest income might also be considered unearned.

d.It is unfair to tax current owners, who may have paid a steep market price for the land and therefore find that the rent return is not high relative to that price.

III.Interest is the price paid for the use of money. It is usually viewed as the money that must be paid for the use of one dollar for one year.

A.Two aspects of interest are important.

1.It is stated as a percentage.

2.Interest expressed as a percentage simplifies the comparison of interest paid on various loans.

B.Money itself is not an economic resource, but it is used to acquire capital goods, so in borrowing money, businesses are ultimately buying the use of real capital goods which can expand their businesses and increase profits.

C.Households cannot charge businesses more for the use of their capital than the amount that businesses would pay in interest payments to borrow the money and buy their own capital.

D.There are many different interest rates with different names and they vary for many reasons. (See Table 14.1)

1.Varying degrees of risk (riskier loans carry higher rates),

2.Differing maturities on the loan (higher rates usually on longer-term loans),

3.The size of the loan (larger loans have lower rates),

4.Taxability (interest on some local and state bonds is tax-free; the interest would be lower, since lenders don’t have to pay federal taxes on that interest income).

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Chapter 14 - Rent, Interest, and Profit

E.Economists usually refer to what is called the “pure rate of interest,” which is best approximated by the interest paid on long-term, riskless bonds such as 20-year Treasury Bonds.

F.The loanable funds theory of interest.

1.The supply of loanable funds is an upward-sloping curve—a larger quantity of funds will be made available at high interest rates than at low interest rates. Most individuals prefer present consumption and must be paid to defer consumption by saving.

2.The demand for loanable funds is inversely related to the rate of interest. At higher interest rates fewer investment projects will be profitable since fewer projects yield the high rate of return needed to compensate for the high interest cost.

3.The equilibrium interest rate equates the quantities of loanable funds supplied and demanded. (See Figure 14.2)

G.Extending the Model

1.Households rarely lend savings directly to businesses. Households place their savings in financial institutions and receive an interest payment. Businesses borrow funds from financial institutions and pay an interest payment.

2.Changes in the supply of funds may occur as a result of changes in tax policy or social insurance benefits.

3.Anything that changes the rates of return on potential investments, such as improvements in technology or a decrease in the demand of the final product, will change the demand for funds.

4.Both households and businesses operate on both the supply and demand sides of the market for loanable funds. While households supply loanable funds, they may also borrow to finance large purchases and education. Similarly, businesses may save in the market for loanable funds, and governments may borrow to finance deficits.

5.Banks and other financial institutions not only gather and make available the savings of households, but also create funds through the lending process. Federal Reserve policy influences how much money financial institutions can create.

H.The time value of money is the idea that a specific amount of money is more valuable to a person the sooner it is obtained. It also determines a way in which a given amount of money today can be thought of as being equivalent to a larger amount of money in the future. (Table 14.2)

1.Compound interest is interest that cumulates over time.

2.Future value is the amount to which some current amount of money will grow as interest compounds over time.

3.Present value is today’s value of some amount of money to be received in the future.

I.CONSIDER THIS…That is Interest

J.The role of the interest rate is important because it affects both the level and composition of investment and R&D spending.

1.The level of investment varies inversely with the interest rate. The Federal Reserve System will increase and decrease the money supply and thus influence interest rates. Changes in investment will affect the level of GDP.

2.Interest rates will also have an effect on borrowing for R&D. Again, R&D depends upon the cost of borrowing money as compared to the expected rate of return on the R&D

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Chapter 14 - Rent, Interest, and Profit

project. Interest rates allocate loanable-funds to industries that are most productive and profitable.

3.Interest rates allocate funds for research and development to those with the greatest expected rates of return.

4.Nominal interest rates are those stated in terms of current dollars; the “real” interest rate is the rate of interest expressed in terms of dollars of constant or inflation-adjusted value. The real interest rate is the nominal rate minus the rate of inflation.

5.It is the real interest rate, not the nominal rate, that businesses should consider when making their investment and R&D decisions.

K.Application: Usury laws specify maximum interest rate that can be charged on loans. The purpose is to make borrowing more accessible to low-income borrowers. However, Figure 14.2 demonstrates several problems with usury laws.

1.There will be a shortage of credit if the usury rate is below the market rate. Riskier borrowers may be excluded from borrowing from established financial institutions.

2.Credit-worthy borrowers will be able to borrow at below-market “prices.”

3.Lenders will receive less than market rates of return on the funds loaned.

4.Funds will not be allocated to their most efficient use.

IV.

Economic profits are what remains of a firm’s total revenue after it has paid individuals

 

and other firms for materials, capital and labor supplied to the firm (the explicit costs) and

 

allowed for payment to self-employed resources (the implicit costs).

 

A.

The role of the entrepreneur is most important in a capitalist economy. Profits are the reward

 

 

paid for entrepreneurial ability, which includes taking initiative in combining resources for

 

 

production, making nonroutine policy decisions, introducing innovations in products and

 

 

production processes, and taking financial risks associated with the uncertainty of all of the

 

 

above functions.

 

 

1.

Entrepreneurs are residual claimants.

 

 

2.

Entrepreneurs lose their own money if the firm makes a loss.

 

B.

Being residual claimants, entrepreneurs have two kinds of risk.

 

 

1.

With insurable risks insurance policies can be purchased from an insurance company and

 

 

 

financial losses are reimbursed.

 

 

2.

In a dynamic economy, the future is uncertain and some risks cannot be insured against.

 

C.

Uninsurable risks stem from three general sources:

 

 

1.

Changes in the general economic environment

 

 

2.

Changes in the structure of the economy; and

 

 

3.

Changes in government policy.

 

 

4.

New products or production methods introduced by rivals.

 

D. Some or all of the economic profit in a real, dynamic economy may be compensation for risk

 

 

taking. Economic profit is compensation for dealing with the uninsurable risks.

 

E.

There are three main sources for generating an economic profit (greater than a normal profit).

 

 

1.

Create popular new products.

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Chapter 14 - Rent, Interest, and Profit

2.Reduce production costs below rivals’ costs.

3.Create and maintain a profitable monopoly.

F.In an effort to increase profits, the firm gets closer to achieving productive and allocative efficiency except when the additional profits are generated by the development of a monopoly.

G.A normal profit is the minimum payment required to retain the entrepreneur in some specific line of production.

H.People other than entrepreneurs can share in risk taking and therefore firms’ profits by either directly or indirectly buying stock in the firms.

1.The expectation of profits encourages firms to innovate, which stimulates new investment. This will expand output and employment.

2.Profits allocate resources among alternative lines of production. Resources leave unprofitable ventures and flow to profitable ones, which is where society is signaling it wants these resources to be allocated.

I.CONSIDER THIS…Apple CEO Steve Jobs

V.Labor income is the dominant type of income, with wages and salaries constituting about 70 percent of all income earned by Americans. If one adds in a part of proprietors’ income, which is probably largely labor income, the share rises to about 80 percent. Therefore, the “capitalists’” share of income is only about 20 percent. These percentages have remained remarkably stable in the U.S. since 1900.

VI. LAST WORD: Determining the Price of Credit

A.To determine the interest rate, one compares the interest paid with the amount borrowed: If you borrow $10,000 and agree to repay that amount plus $1,000 at the end of the year, the interest rate is 10 percent.

r$1,000/$10,000 10%

B.In some cases a lender will discount the interest payment at the time the loan is made, so the borrower would pay the $1,000 and receive the remaining $9,000 for an 11 percent rate of interest.

r$1,000/$9,000 11%

C.In other cases the financial institution uses a 360-day year instead of 365 days to calculate the interest rate, because it is simpler to calculate monthly rates (twelve 30-day months), but this does reduce interest paid.

D.If the loan is paid back in installments, the process becomes more complicated because on average the borrower had only half the loan for the full year, so r = $1,000/$5,000 = 20 percent on an annual basis.

E.Another fact that influences the effective interest rate is whether or not it is compounded. If it is, then interest is added on to the deposit as it is earned and the new amount earns interest. Compound interest on deposits is effectively more than simple interest. The more often it is compounded, the more the effective rate will be.

F.Two pieces of legislation have been enacted to protect financial market customers. The 1968 Truth in Lending Act requires uniform disclosure of lending terms (including annual interest rates), while the 1991 Truth in Savings Act requires that banks disclose fees and interest rates on deposit accounts. Despite these laws, financial institutions have creative ways to

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Chapter 14 - Rent, Interest, and Profit

extract more revenue from their customers. Recently, for example, banks have implemented “bounce (overdraft) protection” fees. These fees, ranging as high as $20 to $35, amount to interest on a loan for the overdraft. Late-payment fees on credit card accounts effectively increase the actual rate paid on credit card balances, and “teaser” rates bump up the interest rate in the event of a late payment.

G. “Let the buyer beware” is a fitting motto in the world of credit.

Practice Questions

1.Interest rates are the payments needed to entice individuals to:

A.Accept insurable risk

B.Accept uninsurable risk

C.Sacrifice their present consumption

D.Sacrifice their future consumption

2.The rent paid for the pasture land used to graze cattle would increase if:

A.the productivity of the land increased.

B.people decided to consume more beef.

C.oil deposits were discovered on the land.

D.any of the above occurred.

3.Suppose that interest payments are $140 per year on a $1,000 loan and $1,188 per year on an $8,485 loan. The interest rates on the two loans are:

A.14 percent and 20 percent, respectively.

B.14 percent on both loans.

C.18.8 percent on both loans.

D.1.4 percent and 11.8 percent, respectively.

4.Which of the following is not a source of loanable funds?

A.the saving of households

B.business saving

C.commercial bank lending

D.government budget deficits

5.If the interest rate is 15%, what is the future of value of $10,000 two years from now?

A.$13,225

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Chapter 14 - Rent, Interest, and Profit

B.$225

C.$13,000

D.$7,576

6.Entrepreneurs normally do all of the following except:

A.Take the initiative in combining other resources to produce goods or services

B.Make the basic, nonroutine policy decisions for their organization

C.Bear the risks involved in introducing new product or production innovations

D.Avoid accepting risks associated with a business

7.Economic profits are not payments received for:

A.Taking uninsurable risks

B.Making product or production innovations

C.Ownership of large stocks of capital resources

D.Exercising monopoly power

8.Since 1900, the relative share of income paid to American resource suppliers as corporate profits, interest, and rent has been about:

A.10 percent

B.20 percent

C.50 percent

D.80 percent

9.The largest single share of all income earned by Americans consists of:

A.wages and salaries.

B.interest.

C.rents.

D.corporate profits.

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