Factor markets and income distribution

1. Factor markets and income distribution

2. Capital and land • Physical capital • the stock of produced goods which contributes to the production of goods and services. • Land • the factor of production which nature supplies. • Together capital and land make up the tangible wealth of a country.

3. Investment • Capital depreciates over time • becoming less productive and less valuable. • Gross investment • the production of new capital goods and the improvement of existing capital goods. • Net investment • gross investment minus the depreciation of the existing capital stock.

4. Stocks and flows • A stock • the quantity of an asset at a point in time • the asset price is the sum for which the stock can be bought outright. • A flow • the stream of services that an asset provides during a period • the rental rate is the cost of using capital services.

5. Interest and present value • The present value of £1 at some future date is the sum that, if lent out today, would accumulate to £1 by that future date. • It depends upon how far into the future the sum accumulates • and on the rate of interest. • The price of a capital asset should be related to the stream of future payments that will be earned from the services it provides • discounted back to give the present value.

6. Real and nominal interest rates • The nominal interest rate • tells us how many actual pounds will be earned in interest by lending £1 for one year. • The real rate of interest • measures the return on a loan as the increase in goods that can be purchased rather than as the increase in the nominal value of the loan fund. • The real rate of interest is the nominal rate minus the inflation rate.

7. The equilibrium real interest rate AA' shows the production possibility frontier between current and future consumption: A' by devoting resources to investment, future consumption can be increased. Future consumption The slope of the frontier has magnitude –(1 + i) where i is the rate of return on investment. A Current consumption

8. Given society's preferences between present and future consumption, the optimal position is at E, where the indifference curve UU is at a tangent to the PPF. U E The slope of the red line represents –(1 + r), where r is the real interest rate that balances the productivity of investment and the thriftiness of consumers. U The equilibrium real interest rate A' Future consumption A Current consumption

9. The markets for capital and land • The derived demand curve for capital (and for land) services closely parallels the earlier analysis of labour demand. • But land is in fixed supply to the economy as a whole. • Rental rates tend to become equalised across alternative uses.

10. Changes in capital intensity • Over time, the UK economy is becoming more capital-intensive • the wage-rental ratio has increased, leading industries to substitute capital for labour • in the long run the supply of labour is less elastic than the supply of capital • new capital embodies latest technology.

11. The functional distribution of income in the UK The distribution of income between the factors of production changed little between 1981-89 and 1998.