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Understanding Interest, Rent, and Profit in Economics

Explore principles of economics like loanable funds, interest rate determination, pure rent, differential rent, and ethical considerations. Learn about capital productivity and factors affecting demand for loanable funds.

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Understanding Interest, Rent, and Profit in Economics

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  1. Chapter 17 Interest, Rent, and Profit Gottheil — Principles of Economics, 7e

  2. Economic Principles • Marginal physical product of capital • Marginal revenue product of capital • Loanable funds and equipment capital • Interest rate determination Gottheil — Principles of Economics, 7e

  3. Economic Principles • The ethics of earning interest-based income • The present value of a property • Pure rent, differential rent, and location rent Gottheil — Principles of Economics, 7e

  4. Economic Principles • Wage-related rents • Profit-related income Gottheil — Principles of Economics, 7e

  5. 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. Gottheil — Principles of Economics, 7e

  6. 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. Gottheil — Principles of Economics, 7e

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

  8. 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. Gottheil — Principles of Economics, 7e

  9. 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. Gottheil — Principles of Economics, 7e

  10. EXHIBIT 1A EDWARDS’S DEMAND FOR LOANABLE FUNDS Gottheil — Principles of Economics, 7e

  11. EXHIBIT 1B EDWARDS’S DEMAND FOR LOANABLE FUNDS Gottheil — Principles of Economics, 7e

  12. 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. Gottheil — Principles of Economics, 7e

  13. 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. Gottheil — Principles of Economics, 7e

  14. Converting Loanable Funds to Capital Equipment Adding an additional dollar of loanable funds is different than adding another laborer to a firm. Gottheil — Principles of Economics, 7e

  15. 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. Gottheil — Principles of Economics, 7e

  16. Converting Loanable Funds to Capital Equipment Capital equipment • The machinery a firm uses in production. Capital equipment is unalterable in the short run. Gottheil — Principles of Economics, 7e

  17. 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. Gottheil — Principles of Economics, 7e

  18. 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. Gottheil — Principles of Economics, 7e

  19. 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. Gottheil — Principles of Economics, 7e

  20. 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. Gottheil — Principles of Economics, 7e

  21. 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. Gottheil — Principles of Economics, 7e

  22. 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. Gottheil — Principles of Economics, 7e

  23. EXHIBIT 2 THE ECONOMY’S DEMAND FOR AND SUPPLY OF LOANABLE FUNDS Gottheil — Principles of Economics, 7e

  24. 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. Gottheil — Principles of Economics, 7e

  25. 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. Gottheil — Principles of Economics, 7e

  26. 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. Gottheil — Principles of Economics, 7e

  27. 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. Gottheil — Principles of Economics, 7e

  28. EXHIBIT 3 CHANGES IN THE RATE OF INTEREST Gottheil — Principles of Economics, 7e

  29. 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. Gottheil — Principles of Economics, 7e

  30. 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.” Gottheil — Principles of Economics, 7e

  31. 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. Gottheil — Principles of Economics, 7e

  32. 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. Gottheil — Principles of Economics, 7e

  33. 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? Gottheil — Principles of Economics, 7e

  34. 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. Gottheil — Principles of Economics, 7e

  35. 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. Gottheil — Principles of Economics, 7e

  36. 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. Gottheil — Principles of Economics, 7e

  37. 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. Gottheil — Principles of Economics, 7e

  38. Present Value Property, in the world of economics, need not be physical. Gottheil — Principles of Economics, 7e

  39. 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). Gottheil — Principles of Economics, 7e

  40. 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. Gottheil — Principles of Economics, 7e

  41. 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. Gottheil — Principles of Economics, 7e

  42. EXHIBIT 4 DERIVING LAND RENT AND DIFFERENTIAL LAND RENT Gottheil — Principles of Economics, 7e

  43. Exhibit 4: Deriving Land Rent and Differential Land Rent 1. How does the value of land rent change in panel a of Exhibit 4 as demand shifts to the right? • At demand curve D, the price per acre is $0, creating no land rent. Gottheil — Principles of Economics, 7e

  44. Exhibit 4: Deriving Land Rent and Differential Land Rent 1. How does the value of land rent change in panel a of Exhibit 4 as demand shifts to the right? • At D1, the price per acre increases to $50, creating a $50-per-acre land rent. Gottheil — Principles of Economics, 7e

  45. Exhibit 4: Deriving Land Rent and Differential Land Rent 1. How does the value of land rent change in panel a of Exhibit 4 as demand shifts to the right? • At D2, the land rent increases again to $75 per acre. Gottheil — Principles of Economics, 7e

  46. Exhibit 4: 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 4? • In panel a, there are 120,000 acres of land available for cultivation, whatever the price, so the supply curve is vertical. Gottheil — Principles of Economics, 7e

  47. Exhibit 4: 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 4? • In panel b, there are different supply prices for the 120,000 acres. The supply curve is upward sloping in a steplike fashion. Gottheil — Principles of Economics, 7e

  48. Exhibit 4: 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. Gottheil — Principles of Economics, 7e

  49. Exhibit 4: 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. Gottheil — Principles of Economics, 7e

  50. Exhibit 4: Deriving Land Rent and Differential Land Rent 4. What is the total land rent in panel b when demand is D1? • 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 Gottheil — Principles of Economics, 7e

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