Market for Resources other than Labor

1. Market for Resources other than Labor

2. What Resources? You may recall that the basic economic resources in an economy are land, labor, capital and entrepreneurial ability. We have already studied the market for labor. Our concern here will be with land, capital and entrepreneurial ability. On page 66 of our book you can see the functional distribution of income. 71% of income was in form of wage and salary payments to labor, 9% of income was in form of income to proprietors, 14% of income was in the form of corporate profit of stockholders, 5% of income was in the form of interest to bond holders and savers, and 1% of income was in the form of rent to owners of buildings and land. So, 29% of income did not go to labor. This 29% is what we typically say goes to the capitalists. So, in our capitalist system the capitalists are getting 29% of the income. It is probably true that there are relatively few capitalists relative to laborers, so the capitalists make good income, per capita.

3. Market for Land As we have already done in other contexts, here our aim is to learn about the market for land. We will consider the supply and demand for land and how the price and quantity traded are determined. The price of land is called rent in an economics setting such as ours. Please see the book for the more common way the term rent is used. The supply of land, as seen in the graph on the next slide, is vertical at the fixed amount of land available. This supply is called perfectly inelastic because any % change in the rent will not change the amount of land supplied at all because there is no more land than this available amount.

4. Supply of Land r, for rent The point about the supply is that if the rent should change, as shown, there is no change in the land supplied. S r1 r2 L0

5. Demand for Land The demand for land, like the demand for labor, is called a derived demand. The resource is demanded because of what it will then permit the owner to do. For example, for many people in the US the only reason they will want land is so they can have a home they can call their own. This is a huge reason. But, for some, land will be desired as one input among many so that something else can be produced and sold in the market. By the way, real estate developers probably look at land in a way similar to a farmer in that both look at how much “green” they can “grow” per acre. For our work here we will consider the following factors as having an influence on the amount of land folks want: the rent, the productivity of the land, the price of the good they make on the land and the price of other resources used with land.

6. Demand for Land r, for rent Here we see the demand for land is downward sloping from left to right. Here we also see the two curves, but we understand that at any time the demand curve is in only one place. Over time it can bounce around. D1 D2 r1 r2 L0

7. Demand for Land If the rent should change we move along a demand curve and say there has been a change in the quantity demanded. If the other influences listed on slide 5 change the demand shifts (bounces to a new place) and we say there has been a change in demand. So, at a point in time we have prices of output made on land, we have land productivity, and we have prices of other resources used with land. So, if the rent should fall it becomes cheaper to make output given these other factors, and we move along a demand curve. But, if output price should rise, land productivity rise, or the price of other inputs used with land should fall (can there be a substitute for land?) the demand for land will rise and the curve will shift to the right. How can the demand shift to the left?

8. Market for Land What happens to the rent on land when the price of corn rises? Since the demand will shift to the right, the rent will rise as well. But, since the amount of land is fixed the amount of land used will not change. A similar result holds if land becomes more productive or if the price of other inputs or resources used with land becomes cheaper.

9. Caution What happens to the rent of land when the price of the output made on the land falls? It falls because the demand shifts to the left. Here is the caution. Some folks, seeing the price of corn going up may want more land and they pay a premium for the land. Often, they borrow to buy the land. Then, the price of corn falls. The land then has a lower rental value. Maybe the borrower can not make payments and they lose the land. They become sad. Let’s turn next to a loanable funds theory of interest in which the resource capital is a major component.

10. Capital Capital consists of all the man made resources that are then used to make other goods. The classic examples of capital goods are big machines, buildings and equipment. Why use a net to catch fish? Why not! Really though, using a net is not the most direct way to catch fish. Just jump in and grab. But as you can guess, using a net yields way more fish than just jumping in and using your hands. This has become such an ingrained idea in our minds that it almost seems silly to think about. But, businesses use the same logic when they buy new capital goods.

11. Loanable Funds

12. The demand for loanable funds People who want to buy capital goods have to come up with funds from other sources because the amount needed is often more than they have. They have to find others who saved and borrow from them. We will say folks who want to purchase capital goods demand loanable funds. For our purposes in terms of loanable funds, businesses that want investment demand loanable funds and so do people who want to buy homes.

13. The demand for loanable funds will depend on the interest rate, the productivity of capital and the price of the output made with the capital. The interest rate i is the move alonger. Here is the story. The higher i is the more folks have to pay back. The more they have to pay back the less inclined they are to undertake the action. This leads to a demand for loanable funds as we see below. i Firms have many capital goods they would like to have. We can think of each one as like the fish net. It adds to the firms ability to generate revenue. But, since firms borrow, the higher the rate of interest the fewer the capital purchases that will have enough revenue to overcome the cost. i2 D i1 Q Q2 Q1

14. Productivity of capital If capital becomes more productive then more projects have revenues large enough to overcome the interest cost of the project and thus demand shifts to the right. Price of output Similarly, if the output made from capital (and other resources) has an increased price then capital will be more profitable and thus a greater amount will be demanded.

15. Loanable Funds i Demand shifts right with more productive capital or higher output prices i2 Demand shifts left with less productive capital or lower output prices. D i1 Q Q2 Q1

16. The Supply of Loanable Funds What can people do with their income? In a broad sense we say they can consume goods and services, pay taxes, or save. And just as if you look at different people the consumption patterns may be different, different people have different saving patterns. Some people have more cars and less house, some are the opposite. Some have big checking accounts and few bonds, some are the opposite. Whatever the form of saving, here we talk about saving. Saving will be represented by the supply of loanable funds. In general we will have 3 items that influence the amount of loanable funds from a supply perspective. Two of these influences I will informally call shifters – because when they change they shift the supply curve – and the other one I will call a move alonger – because when it changes there is a movement along a supply curve.

17. The move alonger - The Interest Rate I will use i to represent the rate of interest. A few slides ago I mentioned you can use your income to consume or save (or pay taxes). Why save? Just go pig city and consume all the income. Life is good, enjoy. Jimmy, what did you say? Did you say - what about the future, the proverbial rainy day? Good Jimmy, you are catching on. People save for things in the future. Saving is just giving up consumption today so that consumption can occur later. Who would give up a coke today if I pay you a coke next year. Not many of us will give up today for the same amount next year. But if we can get a positive return – what we gave up plus some - then we might give up today. In other words, we would save.

18. In fact, the higher the rate of interest, the more we expect to see a group save. This is summarized in the graph below as an upward sloping supply of loanable funds curve. Here S represents the supply of loanable funds and Q is loanable funds in general. i S i2 i1 Q Q1 Q2

19. Special Language page I didn’t make the following up, but I hope you understand it when you are finished reading this page. On the previous page, the way we look at the graph and talk about it are the following. If the i should rise from i1 to i2 (note I mention i changing first) then Q will change from Q1 to Q2. There is movement along the curve because i has changed and the movement from Q1 to Q2 is called an increase in the quantity supplied. Similarly, there would be a decrease in the quantity supplied if the interest rate fell. Note, at this time I did not say why the interest rate might change.

20. Supply Shifters, or things that can lead to a change in supply. Tax rates on saving in the form of taxes on the interest earned and the level of the government budget are two items that we consider at this time as factors that can lead to shifts in the supply curve. Let’s consider each idea next, shall we? If you save $1 today and i is 10% then next year you will have $1.10 of purchasing power. A certain number of folks will say, dude and dudettes, with this rate we should save the amount X. But now let’s add in the idea that the government places a tax on the interest we earn. If the tax rate is 100% most say, well that is like shoveling shtuff against the tide, so we will save less than X. Now the tax rate on saving is usually not 100%, but we can see the higher the tax rate the more we could expect saving to fall. The converse is also true. The lower this tax rate is the more saving there would be.

21. In this graph, if i is i2 and the tax rate on saving is zero then I tell you the relevant supply is S1. If the tax rate is increased the supply of loanable funds will decrease and this shows up as a shift to the left of the supply curve – here to S2. S2 Note here that the supply curve shifted but the interest rate of record is still i2 at this time. On the Q axis we have a new Q – Q1 not Q2 – but in general we say there has been a decrease in supply. You will notice I did NOT say a decrease in the quantity supplied because we reserve that language for when the interest rate changes i S1 i2 i1 Q Q1 Q2

22. Summary of tax rate impact on supply curve If tax rate on interest earned from saving is made higher the supply shifts to the left. If tax rate on interest earned from saving is made lower the supply shifts to the right. Government budget impact Remember that the supply of loanable funds is really a supply of saving. Saving in the country is private saving and public saving. Hey, public saving is really the concept of looking at the government budget situation. If T – G >0 we say it is a miracle, no, I mean a government surplus. If T – G = 0 we have a balanced budget, and if T – G < 0 we have a budget deficit.

23. In general we talk about the state of public saving as T – G, but when we get specific T – G is positive, negative, or zero. Now let’s consider a change in the budget situation. If the budget starts in surplus and then the surplus becomes even larger the saving level in the economy would go up and the supply of loanable funds would shift to the right. Here is a similar story. Say the budget starts in a deficit and then the deficit shrinks. The supply of loanable funds would increase and the curve would shift to the right. The budget is still in deficit, but a smaller one so the supply of loanable funds becomes larger than what it used to be.

24. T - G deficit balance surplus I have this arrow to show that if the deficit gets smaller or the surplus gets bigger the supply of loanable funds will shift to the right. What would you write if I had an arrow pointing to the left? (“Parker, you lazy bum, why don’t you write something,” is not something you should write here!)

25. Loanable Funds Here we look at the market interaction

26. i S1 i1 D1 Q Q1

27. Some have made the claim that you can teach a parrot economics. Just teach the parrot to say supply and demand. Well, this teaching would be a good start. On the previous screen we have a start. Notice that demand and supply are positioned and with these positions we get the market outcome of i1 and Q1. i1 is the rate of interest and Q1 is the amount of loanable funds traded between the savers and the investors. (Hey, is Q1 the supply amount or the demand amount? It is both at this one i) We know the position of supply or demand could change and we would thus get a new i and Q. Let’s turn to that next. Say capital becomes more productive (due to technological advancement). This will shift the demand for loanable funds to the right.

28. i S1 i2 i1 D2 D1 Q Q1 Q2

29. Here is how I like to look at the graph on the previous screen. 1. Start at the initial equilibrium – when we have D1 and S1, i1 and Q1 result. 2. The increase in capital productivity has the demand shift to D2. D1 is no longer relevant. You will notice I have a dashed line at the height i1 and it shows the amount the demand shifted. This amount also now represents a shortage of loanable funds. Shortages cause prices to rise. Here the price is the interest rate. i rises to i2. 3. Note the supply curve did not change here. But as i rises the quantity supplied rises and the quantity demanded falls from its new higher level to eliminate the shortage. Overall, the Q in the market rose to Q2.

30. Summary: An increase in capital productivity raises the interest rate and raises the amount of loanable funds traded. Now since the demand for loanable funds is really about capital the higher loanable funds traded means more capital is purchased. Next let’s look at the impact on the market when the tax rate on interest from saving is changed – we will do a reduction in the tax rate.

31. i S1 S2 i1 i2 D1 Q Q1 Q2

32. Here is how I like to look at the graph on the previous screen. 1. Start at the initial equilibrium – when we have D1 and S1, i1 and Q1 result. 2. The reduction in the tax rate on the interest from saving has the supply shift to S2. S1 is no longer relevant. You will notice I have a dashed line at the height i1 and it shows the amount the supply shifted. This amount also now represents a surplus of loanable funds. Surpluses cause prices to fall. Here the price is the interest rate. i falls to i2. 3. Note the demand curve did not change here. But as i falls the quantity supplied falls from its new higher level and the quantity demanded rises to eliminate the surplus. Overall, the Q in the market rose to Q2. So, lowering the tax rate on saving will lead to more capital being purchased.

33. Entrepreneurial Ability Entrepreneurial ability is that resource owned by people and people are using the resource when they are deciding how to combine the other resources. We want to understand what entrepreneurs get paid. Remember that the firm will hopefully generate some revenue from the sale of each good or service they provide. We called costs both explicit and implicit. Explicit costs are payments made to folks outside the firm ownership. Implicit costs reflect the idea that the firm owner uses resources they own in the business instead of supplying those resources to the market. We call this implicit cost by another name – normal profit. This is the minimum payment necessary to retain the entrepreneur in the current line of business. It is typically what they would earn elsewhere.

34. Entrepreneurial Ability Before in this class we called economic profit = revenue minus explicit cost minus implicit cost. The implicit cost is the normal profit and the entrepreneur gets it, but they would have made this much if they used their own resources elsewhere. Economic profit is also a payment to the entrepreneur and is that part of revenue left after all explicit and implicit costs are paid. The entrepreneur is the residual claimant of this residual profit that we call economic profit.

35. Profit and Resource Allocation From time to time you hear about people asking what should be made and how much of it should be made. When we talk about private goods, the presence of economic profit is a sign that the good in question is valued by many people. So keep making the good. Plus economic profit existing means more of the good should be produced. Revenue is a measure of how consumers like the way resources are used and make up the good or services being produced. Cost is a measure of how consumers like the way the resources would be used in another good or service. So when revenue > cost consumers like the resources here and not there (other places). So bring more resources here.

36. Monopoly as source of profit From the previous slide you would expect the presence of economic profit for only so long. After a while the profit will act like a magnet and attract more resources to the industry. With a monopoly more resources can not come in from entities other than the monopoly. With this in mind, some claim monopolies are the source of economic profit.