ECON 201 Macroeconomics

1. ECON 201Macroeconomics Chapter 27 Rent, Interest, & Profit

2. Ch 27 Objectives The nature of economic rent and how it is determined. About the loanable funds theory of interest rates. How interest rates vary based on risk, maturity, loan size, and taxability. Why economic profits occur, and how profits, along with losses, allocate resources among alternative uses. The share of U.S. earnings received by each of the factors of production.

3. Economic Rent price paid for use of land and other natural resources that are fixed in supply. demand for land is downward sloping b/c of diminishing returns and the fact that producers must lower the price of the product to sell additional units of output.

4. Economic Rent Land has no production cost; it is a “free and nonreproducible gift of nature.” Perfectly inelastic supply of the resource. Its quantity does not change with price.

5. Assumptions All land is the same grade (each arable acre is equally productive). All land has a single use. Land is rented in a competitive market (many producers are demanding land & many landowners are offering land in the market).

6. I’ll have the rent for you tomorrow.the next day I don't know • Changes in demand determine amount of rent • The price of the product produced on the land. • The productivity of the land. • The prices of other resources combined with the land for production.

7. The Determination of Land Rent S R1 D1 Land Rent (Dollars) R2 D2 R3 D3 b a 0 L0 Acres of Land D4

8. Surplus Payment 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.

9. Key Question 2 Explain why economic rent is a surplus payment when viewed by the economy as a whole, but a cost of production from the standpoint of individual firms and industries. Explain: “Land rent performs no ‘incentive function’ for the overall economy.”

10. Answer Land is completely fixed in total supply. As population expands, and the demand for land increases, rent first appears and then grows. From society’s perspective, rent is a surplus payment unnecessary for ensuring that the land is available to the economy as a whole. If rent disappeared, the same amount of land would be available. If it increased, no more land would be forthcoming. Thus, rent does not function as an incentive for adding land to the economy.

11. But land does have alternative uses. To get it to its most productive use, individuals and firms compete and the winners are those who pay the highest rent. To the high bidders, rent is a cost of production that must be covered by the revenue gained through the sale of the commodities produced on that land.

12. Some argue that rent should be taxed away, since it is unearned, or that land should be nationalized and owned by the state. Socialists – feel that land should be nationalized (owned by the state) so that any payments can be used by the gov for all instead of just land-owners.

13. The Summer of George Political Economist – Henry George Author– Progress and Poverty (1879) “Single Tax” on land aka land value tax Tax land rents heavily & spend $ for public use. Georgism, that holds that everyone owns what they create, but that everything found in nature, (land), belongs equally to all humanity.

14. 99 % Henry George’s proposal for a single tax of up to 99 percent of land rent asserted that this tax could eliminate other taxes.

15. Critics of the single-tax idea (H. George) • levels of government spending are too great to be supported by land taxes. • difficult to separate the rent from other income resulting from the combined use of land with other resources. • Unearned income goes beyond land and land ownership; capital gains and interest income might also be considered unearned. • unfair to tax current owners, who may have paid a steep price for the land and therefore find that the rent return is not high relative to that price.

16. 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, 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.

17. Allocation Each parcel of land is not equally productive. More productive land will be in great demand and therefore will receive different rents. These different rent payments allocate land to its most productive use.

18. Interest • price paid for the use of money. • usually viewed as the money that must be paid for the use of one dollar for one year.

19. Two aspects of interest are important. • stated as a percentage. • The Truth in Lending Act of 1968 requires lenders to state the costs and terms of consumer credit in terms of an annualized interest rate. • Money itself is not an economic resource, but it is used to acquire capital goods.

20. The loanable funds theory of interest • Explains the interest rate in terms of the supply of & demand for funds available for lending (and borrowing). • 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.

21. The loanable funds theory of interest interest rates are determined by the supply and demand of loanable funds in the capital markets. 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.

22. The loanable funds theory of interest • Economists • disagree about the responsiveness of the quantity of investment funds supplied to changes in interest rates. • believe that saving is relatively insensitive to interest rate changes and believe the supply of funds is inelastic.

23. Supply of loanable funds Upward slope Households will make available a larger quantity of funds at high interest rates than low interest rates. Spend $ today To delay spending, people must be “bribed by interest payments”

24. The supply of loanable funds may change because • of a change in households’ attitudes about saving (tax policies, economic conditions) or changes in Federal Reserve policies relative to the money supply.

25. The demand for loanable funds could change as a result of • a change in technology or a change in the demand for the final product. • If there is either a change in supply of or demand for loanable funds, the interest rate will change.

26. Demand for loanable funds Downsloping. At higher interest rates, fewer investment projects. If funds can be borrowed at an interest rate less than the rate of return, then the investment is profitable.

27. Range of Interest rates • Why the differences in % rates? • Risk (do you look like you need a loan?) • Maturity (when it will be paid back) • Loan size • Taxability (is interest exempt from taxation?)

28. Pure Rate of Interest • Interest paid on long-term, riskless securities. • Example: • Long-term U.S. government bonds (20-year treasury bonds)

29. Role of the Interest Rate • Interest rate • critical price that affects the level & composition of investment goods production, as well as the amount of R & D spending (research & development).

30. Nominal & Real Interest Rates • Nominal Interest Rate • Rate of interest expressed in dollars of current value. • Real Interest Rate • Rate of interest expressed in purchasing power – dollars of inflation-adjusted value. • Affects investment and R&D decisions.

31. Usury Laws • Specify a maximum interest rate at which loans can be made. • Rates are a special case of price ceilings • Purpose is to hold down the interest cost of borrowing for low-income borrowers. • “Usury” – means exorbitant interest

32. Efects of Usury Laws • May • Deny credit to low-income people. • Subsidize high-income borrowers & penalize lenders. • Diminish the efficiency with which loanable funds are allocated to investment & R&D projects.

33. Usury laws specify maximum interest rate that can be charged on loans • Several problems with usury laws. • 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. • Credit-worthy borrowers will be able to borrow at below-market “prices.” • Lenders will receive less than market rates of return on the funds loaned. • Funds will not be allocated to their most efficient use.

34. Economic (or Pure) Profit • What remains after all costs (both explicit and implicit) have been subtracted from a firm’s total revenue. • May be positive or negative. • 3 Sources • Bearing of uninsurable risk • Uncertainty of innovation • Monopoly power

35. Risk and Profit • The Entrepreneur must assume risks • Some or all economic profit may be a reward for assuming risks. • Insurable risks • Fire, floods, theft. Etc. • Uninsurable risks • Uncontrollable & unpredictable changes in the demand & supply conditions facing the firm

36. Uninsurable Risks • Stem from 3 general sources • Changes in the general economic environment • Changes in the structure of the economy • Changes in Government policy

37. What are the major economic functions of the interest rate? Interest rates affect the level of domestic output as the monetary authorities deliberately vary them by changing the money supply. (2) Interest rates allocate capital to its most productive uses

38. Explain the Equilibrium rate The equilibrium interest rate is determined where the interest rate (cost of borrowing the funds) is equal to the expected rate of return. The supply of loanable funds may change because of a change in households’ attitudes about saving (tax policies, macroeconomic conditions) or changes in Federal Reserve policies relative to the money supply.

39. The supply of loanable funds may change because • of a change in households’ attitudes about saving (tax policies, economic conditions) or changes in Federal Reserve policies relative to the money supply.

40. End chapter 27