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Chapter 17
Interest, Rent, and Profit
© 2005 Thomson
Economic Principles
Marginal physical product of
capital
Marginal revenue product of
capital
Loanable funds and equipment
capital
Interest rate determination
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Economic Principles
The ethics of earning interestbased income
The present value of a property
Pure rent, differential rent, and
location rent
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Economic Principles
Wage-related rents
Profit-related income
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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.
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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.
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Interest, Rent, and Profit
Loanable funds
• Money that a firm employs to purchase
the physical plant, equipment, and raw
materials used in production.
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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.
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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.
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EXHIBIT 1A EDWARDS’S DEMAND FOR LOANABLE
FUNDS
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EXHIBIT 1B EDWARDS’S DEMAND FOR LOANABLE
FUNDS
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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.
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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.
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Converting Loanable Funds
to Capital Equipment
Adding an additional dollar of
loanable funds is different than
adding another laborer to a firm.
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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.
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Converting Loanable Funds
to Capital Equipment
Capital equipment
• The machinery a firm uses in production.
Capital equipment is unalterable in the
short run.
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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.
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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.
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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.
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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.
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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.
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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.
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EXHIBIT 2
THE ECONOMY’S DEMAND FOR AND
SUPPLY OF LOANABLE FUNDS
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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.
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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.
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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.
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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.
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EXHIBIT 3
CHANGES IN THE RATE OF INTEREST
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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.
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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.”
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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.
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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.
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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?
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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.
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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.
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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.
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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.
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Present Value
Price floors artificially inflate the
value of property.
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EXHIBIT 4
PRICE AND OUTPUT IN THE TOBACCO
MARKET
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Exhibit 4: Price and Output in
the Tobacco Market
Where do the market demand and
supply curves intersect in Exhibit 4?
• The demand and supply curves intersect
at P = $3.00 and Q = 800,000. The market
equilibrium price is $0.80 less than the
price floor of $3.80.
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Present Value
Property, in the world of
economics, need not be physical.
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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).
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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.
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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.
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EXHIBIT 5
DERIVING LAND RENT AND DIFFERENTIAL
LAND RENT
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Exhibit 5: Deriving Land Rent and
Differential Land Rent
1. How does the value of land rent
change in panel a of Exhibit 5 as
demand shifts to the right?
• At demand curve D, the price per acre
is $0, creating no land rent.
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Exhibit 5: Deriving Land Rent and
Differential Land Rent
1. How does the value of land rent
change in panel a of Exhibit 5 as
demand shifts to the right?
• At D , the price per acre increases to
$50, creating a $50-per-acre land rent.
1
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Exhibit 5: Deriving Land Rent and
Differential Land Rent
1. How does the value of land rent
change in panel a of Exhibit 5 as
demand shifts to the right?
• At D , the land rent increases again to
$75 per acre.
2
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Exhibit 5: 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 5?
• In panel a, there are 120,000 acres of
land available for cultivation, whatever
the price, so the supply curve is vertical.
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Exhibit 5: 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 5?
• In panel b, there are different supply prices
for the 120,000 acres. The supply curve is
upward sloping in a steplike fashion.
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Exhibit 5: 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.
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Exhibit 5: 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.
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Exhibit 5: 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.
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Income from Rent
Differential land rent
• Rent arising from differences in the cost of
providing land.
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Income from Rent
In the Netherlands a system of
dikes have been constructed in
order to wrest land from the sea.
There is a cost associated with
securing this land.
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Income from Rent
The market price of the land is
determined by the intersection of
demand and supply.
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Income from Rent
Location rent
• Rent arising from differences in land
distances from the marketplace.
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Income from Rent
• The closer a parcel of land is to
the marketplace, the greater the
land rent.
• If the location of the market
changes, the fortune of the
landowner changes.
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Income from Rent
For example, when shopping
malls open in suburban areas,
urban downtown property loses a
great deal of value and suburban
property increases in value.
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EXHIBIT 6
A NEW SET OF RENT-YIELDING ACRES
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Exhibit 6: A New Set of RentYielding Acres
What is the location rent for acres
a, b and c when the demand for
food requires bringing acre c
under cultivation in Exhibit 6?
• Because acre c is the furthest from the
market, people there must pay the highest
transportation cost to market. It becomes
no-rent land at $0.
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Exhibit 6: A New Set of RentYielding Acres
What is the location rent for acres
a, b and c when the demand for
food requires bringing acre c
under cultivation in Exhibit 6?
• Acre b is only 25 miles from market, and
people there pay some transportation
cost, but not as much as acre c. It’s
location rent is $10.
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Exhibit 6: A New Set of RentYielding Acres
What is the location rent for acres
a, b and c when the demand for
food requires bringing acre c under
cultivation in Exhibit 6?
• Acre a is at the market. As such, people
there have no transportation cost. The
location rent is $20.
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Income from Rent
Wage-related rent
• The difference between what a resource
receives and what it takes to bring the
supply of that resource to market.
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Income from Rent
Wage-related rent
• It is the difference between what a
person is paid and what they would be
paid if they took their next best offer.
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Income from Rent
For example, suppose a baseball
player is paid $2 million to play
baseball. If the next best offer for
the baseball player is to sell
insurance for $30,000, then the
wage-related rent = ($2 million
- $30,000) = $1,970,000.
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EXHIBIT 7
THE RENT COMPONENT IN COAL MINERS’
WAGES
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Exhibit 7: The Rent Component in
Coal Miners’ Wages
How is the combined rent
determined in Exhibit 7?
• The combined rent is the sum of the
differences between the $13 equilibrium
wage rate and the specific supply prices of
each miner.
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Income from Profits
Profit
• Income earned by entrepreneurs.
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Income from Profits
Profit
• It is the reward for undertaking the
uncertainties of enterprise.
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Income from Profits
Profit for the entrepreneur is
income adjusted for the implicit
costs of that entrepreneur’s labor
and money capital.
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Income from Profits
For example, an entrepreneur with
a new income-earning store must
subtract from her income the
opportunity cost of spending her
time running the new store instead
of working somewhere else.
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Income from Profits
She must also subtract the interest
she would have received had she
invested her money in the loanable
funds market, rather than as
capital in her store.
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Income from Profits
In a corporation it is the stockholders who are the entrepreneurs.
They are the ones who have
invested their money and who
alone assume the uncertainties of
the business.
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