Download Section 1.6 Factor Markets

SECTION 1.6 FACTOR MARKETS
Section 1.6 Factor Markets
Firms are sellers in the product market and buyers in the
factor (resource) market. Households are buyers in the product
market and sellers in the factor (resource) market.
1. Present four major reasons for studying resource
pricing.
Firms demand resources (inputs)
Factors of production, resources, or inputs are what is used in
the production process to produce output—that is, finished
goods and services.
The amounts of the various inputs used determine the quantity
of output according to a relationship called the production
function. There are three basic resources or factors of
production: land, labor, and capital.
Resource prices are important because of:
1. Money-income determination
2. Cost minimization
3. Resource allocation
4. Policy issues
2. Explain the concept of derived demand as it
applies to resource demand.
Demand for factors of production is
a derived demand.
It is derived from and directly
related to the demand for the
product that the resources go to
produce.
If the demand for the product rises,
the demand for the factors used to
produce the product rises.
Resource demand depends upon
the:
 price of the good or service
that the resource produces and
upon
 the resource’s productivity in
producing the good or service.
3. Determine the marginal-revenue-product schedule for
an input when given appropriate data.
Marginal Revenue Product (MRP) is the additional
revenue generated by employing an additional factor
unit.
There are two ways of figuring out MRP:

MRP= Total Revenue/  Quantity of the Factor

MRP= Product Price x Marginal Product of Factor
3. Determine the marginal-revenue-product schedule
for an input when given appropriate data.
Marginal Revenue Product
The strength of demand of any resource will depend on:

productivity of the resource in helping to create a good or service


market value or price of the good or service it helps produce



resource that is highly productive in turning out a highly valued commodity will
be in high demand, but a resource that is capable of only producing a minimally
valued commodity and that is relatively unproductive will be little demand
no demand at all for a highly efficient resource that is producing a good or
service that nobody wants
MRP = Δ TR / Δ resource quantity
Price of other resources

substitute resources: a firm will use more resource A when A is relatively
cheaper than resource B, assuming they can produce the same good/service


There is a direct relationship between substitute resources
complimentary resources: assuming resource A must be used along with
resource B, when price of resource A decrease, demand for resource B increase

There is an indirect relationship between complimentary resources
Calculating the Marginal Revenue
Product (MRP)
There are two
methods for
calculating
MRP.
Part a shows one
method
(MRP=  TR/ 
quantity of
factor)
and part b shows
the other
(MRP = Product
Price x MPL)
Marginal Resource (Factor) Cost
Marginal factor cost (MFC) sometime referred to as
Marginal Resource Cost (MRC) is the additional cost
incurred by employing an additional factor unit. For
labor it is their wage.

MFC =  TC/  Quantity of the factor
For a Perfectly Competitive firm in the Factor Market
they are a Factor Price Taker: a firm can buy all it
wants of a factor at the equilibrium price.
Calculating the MFC and Deriving the
MFC Curve
In (a), MFC is calculated in column 4.
Notice that the firm is a factor price taker because it can buy any
given quantity of factor X at a given price.
In (b), the data from columns (1) and (4) are plotted to derive the
MFC curve, which is the firm’s factor supply curve.
4. State the principle employed by a profit maximizing firm in
determining how much of a resource it will employ.
A firm will continue to hire factors of production as long as its
marginal revenue product (MRP) exceeds its marginal Factor
Cost (MFC). A firm will NOT hire resources once their MFC
exceeds their MRP.
A firm maximizes profits where a factor’s marginal revenue
product equals a factor’s marginal factor cost. A firm
maximized profit where MRP=MFC.
In a perfectly competitive labor market, a firm will hire
workers until the last worker’s wage (MFC) equals the
marginal revenue product (MRP) of the last worker hired.
The MRP = MFC principle
To maximize profit the firm should increase usage of the
input "up to the point where the input's marginal revenue
product equals its marginal costs".
So mathematically the profit maximizing rule is MRPL =
MCL, where the subscript L refers to the commonly assumed
variable input, labor.
The marginal revenue product is the change in total
revenue per unit change in the variable input.
That is MRPL = ∆TR/∆L. MRPL is the product of marginal
revenue and the marginal product of labor or
MRPL = MR x MPL.
5. Apply the MRP = MRC principle to find the quantity of a
resource a firm will employ when given the necessary data.
If MFC = $12 and price is $3, then $3 x MPL (4) = $12, so you would hire
4 workers at $12 wages. This is because at 4 workers MRP = MFC
Short-Run Factor Demand of a Firm
The firm maximizes its profit by hiring workers until the
marginal revenue product (MRP) of the last worker
exactly equals the marginal Factor cost (MFC) of
employing that worker, which is the wage:
(MRPL = MFCL)
Remember: MFCL=wage
Short-Run Factor Demand of a Firm
A perfectly competitive firm faces an perfectly elastic
demand for its output at the market price, p,
so:
In a Perfectly Competitive Product Market:
MR = price
And in the Factor Market:
MRPL = (p x MPL )
Short-Run Factor Demand of a Firm
15
The perfectly competitive firm hires labor to the point at
which:
MRPL = (p . MPL) = wage
The wage line is the supply of labor the firm faces.
The marginal revenue product of labor curve, MRPL, is the
firm’s demand curve for labor
The Relationship Between Labor Market and
Output Market Equilibrium
(a) Labor Profit-Maximizing Condition
(b) Output Profit-Maximizing Condition
w, VMPL, $ per unit
MC, p, $ per unit
16
18
15
Labor supply
curve
w = 12
9
MRPL, Labor
demand curve
2
3
4
5
6
L, Workers per hour
MC
4
3
6
0
6
p
2.4
2
0
13
18
22 25 27
q, Units of output per hour
Equating MRP and MFC
The firm continues to
purchase a factor as
long as the factor’s
MRP exceeds its MFC.
In the exhibit, the firm
purchases Q1.
6. Explain why the MRP schedule of a resource is the firm’s demand
schedule for the resource in a purely competitive product market.
The marginal revenue product of labor curve,
MRPL, is the firm’s demand curve for labor.
 The MRP schedule constitutes the firm’s demand
for labor, because each point on this schedule (or
curve) indicates the number of workers the firm
would hire at each possible wage rate.
 Each firm only hires a small fraction of the
market supply making it not able to affect the
market wage rate (i.e. each firm is a wage
taker)
The MRP Curve is the Firm’s Factor
Demand Curve
The data from columns
1 and 5 in the
previous chart are
plotted to derive the
MRP curve.
The MRP curve shows
the various quantities
of the factor the firm
is willing to buy at
different prices which
is what a demand
curve shows.
The MRP curve is the
firm’s factor demand
curve.
Value Marginal Product


Value Marginal Product (VMP) is equal to the price of the
product times the marginal physical product of the factor.
MRP=VMP for a perfectly competitive firm.
7. Explain why the resource demand curve is downward sloping when a firm is
selling output in a purely competitive product market; an imperfectly
competitive product market.
Under pure competition, product price is constant; therefore,
the downward slope of the D=MRP curve is due solely to
the decline in the resource’s marginal product (law of
diminishing marginal returns).
But the MRP of the imperfectly competitive seller falls for
two reasons: marginal product diminishes and product
price falls as output increases.
The imperfectly competitive producer is less responsive to
resource price cuts than the purely competitive producer.
Other things equal, the imperfectly competitive seller
produces less of a product than a purely competitive seller.
In producing this smaller output, it demands fewer resources.
MRP as Resource Demand
(1)
(2)
Units of Total Product
Resource
(Output)
0
1
2
3
4
5
6
7
(3)
Marginal
Product (MP)
(4)
Product
Price
7
6
5
4
3
2
1
$2
2
2
2
2
2
2
2
0]
7]
13 ]
18 ]
22 ]
25 ]
27
]
28
(5)
Total Revenue,
(2) X (4)
$0
14
26
36
44
50
54
56
]
]
]
]
]
]
]
(6)
Marginal Revenue
Product (MRP)
$14
12
10
8
6
4
2
$18
Purely
Competitive
Firm’s
Demand for
A Resource
Resource Wage
(Wage Rate)
16
14
12
10
8
6
D=MRP
4
2
0
-2
1
2
3
4
5
6
7
Quantity of Resource Demanded
LO1
12-22
MRP as Resource Demand
(1)
(2)
Units of Total Product
Resource
(Output)
0
1
2
3
4
5
6
7
(3)
Marginal
Product (MP)
0]
7]
13 ]
18 ]
22 ]
25 ]
27
]
28
(4)
Product
Price
(5)
Total Revenue,
(2) X (4)
$2.80
2.60
2.40
2.20
2.00
1.87
1.75
1.65
7
6
5
4
3
2
1
$ 0.00
18.20
31.20
39.60
44.00
46.25
47.25
46.20
]
]
]
]
]
]
]
(6)
Marginal Revenue
Product (MRP)
$18.20
13.00
8.40
4.40
2.25
1.00
-1.05
$18
Imperfectly
Competitive
Firm’s
Demand for
A Resource
Resource Wage
(Wage Rate)
16
14
D=MRP
(Pure Competition)
12
10
8
6
4
2
0
D=MRP
(Imperfect
Competition)
1
2
3
4
5
6
7
-2
Quantity of Resource Demanded
LO1
12-23
8. List the three determinants of demand for a resource and explain how a
change in each of the determinants would affect the demand for the resource.
Determinants of Resource Demand:
A. Changes in product demand will shift the demand for the resources that produce it (in the same
direction).
B. Productivity (output per resource unit) changes will shift the demand in same direction. The
productivity of any resource can be altered in several ways:
1.
Quantities of other resources
2.
Technical progress
3.
Quality of variable resource.
C. Prices of other resources will affect resource demand.
1. A change in price of a substitute resource has two opposite effects.
a. Substitution effect example: Lower machine prices decrease demand for labor.
b. Output effect example: Lower machine prices lower output costs, raise equilibrium output,
and increase demand for labor.
c. These two effects work in opposite directions—the net effect depends on magnitude of
each effect.
2. Change in the price of complementary resource (e.g., where a machine is not a
substitute for a worker, but machine and worker work together) causes a change in the demand for the
current resource in the opposite direction. (Rise in price of a complement leads to a decrease in the
demand for the related resource; a fall in price of a complement leads to an increase in the demand
for related resource).
Shifts in the Firm’s MRP, or Factor
Demand, Curve
It is always the case that
MRP = MR x MPP.
For a perfectly competitive firm,
where P = MR, it follows that
MRP = P x MPP.
If P changes, MRP will change. For
example, if product price rises,
MRP rises, and the firms MRP curve
(factor demand curve) shifts
rightward.
If product price falls, MRP falls, and
the firm’s MRP curve (factor
demand curve) shifts leftward.
If MPP rises (reflected in a shift in the
MPP curve), MRP rises and the
firm’s MRP curve shifts rightward.
If MPP falls, MRP falls and the firm’s
MRP curve shifts leftward.
9. Explain what demand factors have influenced the growth and
decline of the occupations listed by the Bureau of Labor Statistics
Occupational employment projections to 2022
Total employment in the U.S. economy is projected to grow by 15.6 million during
the 2012–2022 decade to reach 161 million; this represents a 10.8-percent
employment increase.
Some of the fastest projected growth will occur in the healthcare, healthcare
support, construction, and personal care fields. Together, these four occupational
groups are expected to account for about one-third—more than 5.3 million—of
all new jobs during this period.
Drivers of occupational growth and decline
Occupational growth and decline stem from two different factors: growth or
decline of the industries in which occupations are employed, and changes in
the mix of occupations employed in those industries.
Reasons occupational mixes change: Technology, Changes in business practices or
production methods, Outsourcing, Replacement of one product or service for
another, & Organizational restructuring of work.
9. Explain what demand factors have influenced the growth and
decline of the occupations listed by the Bureau of Labor Statistics
10. List three determinants of the price elasticity of demand for a
resource, and state how changes in each would affect the elasticity
of demand for a resource.
Elasticity of resource demand is affected by several factors.
Formula of elasticity of resource demand:
Erd measures the sensitivity of producers to changes in resource prices.
If Erd > 1, the demand is elastic; if Erd < 1, the demand is inelastic; and
if Erd = 1, demand is unit-elastic.
Determinants of elasticity of demand:
1.
Ease of resource substitutability: The easier it is to substitute, the
more elastic the demand for a specific resource
2.
Elasticity of product demand: The more elastic the product
demand, the more elastic the demand for its productive resources.
3.
Resource-cost/total-cost ratio: The greater the proportion of total
cost determined by a resource, the more elastic its demand, because any
change in resource cost will be more noticeable.
11. State the rule for determining the least cost
combination of resources.
Optimal Combination of Resources:
What is the least-cost combination of resources to use in
producing any given output?
The least-cost rule states that costs are minimized where the
marginal product per dollar’s worth of each resource used is
the same.
Example: MP of labor/labor price = MP of capital/capital
price.
 Long-run cost curves assume that each level of output is
being produced with the least-cost combination of inputs.
 The least-cost production rule is similar to the utilitymaximizing combination of goods.
When There is More than One Factor, How Much
of Each Factor Should the Firm Buy?
MP Labor/Price Labor = MP Capital/Price
Capital
The firm purchases the
two factors until the ratio
of MPP to price for one
factor equals the ratio of
MPP to price for the
other factor
This is called the:
“Least Cost Rule”
12. Find the least cost combination of resources
when given appropriate data.
Data for finding the least-cost and profitmaximizing combination of labor and capital
13. State the rule used by a profit maximizing firm to determine
how much of each of several resources to employ.
What combination of resources (and output) will maximize a
firm’s profits?
The profit-maximizing rule states that in a competitive market, the
price of the resource must equal its marginal revenue product. This
rule determines level of employment
MRP(labor) / Price(labor) = MRP(capital) / Price(capital) = 1
In competitive markets, a firm will achieve its profit-maximizing
combination of resources when each resource is employed to the
point at which its marginal revenue product equals its resource
price.
MRPL/PL = MRPC/PC = 1 (*ratios must equal 1)
* The profit maximizing equation hold the premise that the firm is
also using the least cost combination. However, a firm operating
at least cost combination may not be operating at the output that
maximizes its profits.
14. When given necessary data, find the quantities of two
or more resources a profit maximizing firm will hire.
Data for finding the least-cost and profit-maximizing combination of labor and
capital
15. Explain the marginal productivity theory of income
distribution and present two criticisms of it.
Marginal Productivity Theory of Income Distribution
“To each according to what he or she creates” is the rule.
Labor and other resources are paid according to their contribution to
society’s output. Therefore, if you are willing to accept this ethical
proposition, the payment of resources (wages) is based on MRP seem to
provide a fair and equitable distribution of society’s income.
There are criticisms of the theory.
1.
It leads to much inequality, and many resources
are distributed unequally in the first place.
2.
Monopsony and monopoly interfere with
competitive market results with regard to prices of
products and resources.
16. Differentiate between nominal and real wages.
A nominal wage is the amount of money received per
hour, per day, and so on.
A real wage is the quantity of goods and services a
person can obtain with nominal wages; real wages are
the “purchasing power” of nominal wages.
Your real wages depends on your nominal wage and
the prices of the goods and services you purchase.
17. List those factors that have led to an increasing level
of real wages in the U.S. historically.
In developed economies such as the United States, demand
for labor is quite large relative to the supply of labor. Also,
the greater the productivity of labor, the greater the
demand for it.
There are several reasons for higher productivity in
developed countries:
 Plentiful capital
 Access to abundant natural resources
 Advanced technology
 Labor quality
 Other factors as flexibility, positive environment to
productivity and the vast size of the domestic market.
Real Wages and Productivity Wages and
Productivity
Long-run trend of average real wages in the U.S.
18. Determine the equilibrium wage rate and employment level when given appropriate data for a firm operating in
a purely competitive product and labor market; a firm operating in a monopolistically competitive product market
and a purely competitive labor market; and a firm operating in a purely competitive product market and a
monopolistic labor market.
MR=MC rule: A purely competitive firm
seeking to maximize total profit they will
produce at the point where MR = MC.
Profit maximizing price:
Find MC= MR however, the market demand
curve sets the price that the firm must take.
Labor Market Equilibrium wage
rate and level of employment in PC
labor market equals the intersection
of market labor D curve and market
S curve each individual firm finds it
profitable to hire this type of labor
up to point at which MRP = MRC
The area under the demand curve
represents the total costs.
18. Determine the equilibrium wage rate and employment level when given appropriate data for a firm operating in
a purely competitive product and labor market; a firm operating in a monopolistically competitive product market
and a purely competitive labor market; and a firm operating in a purely competitive product market and a
monopolistic labor market.
MR=MC rule:
A monopolist seeking to maximize total profit will
employ the same rationale as a profit-seeking firm in a
competitive industry; they will produce at the point where
MR = MC.
Profit maximizing price: Find MC= MR and draw a
vertical line up to the demand curve.
18. Determine the equilibrium wage rate and employment level when given appropriate data for a firm operating in
a purely competitive product and labor market; a firm operating in a monopolistically competitive product market
and a purely competitive labor market; and a firm operating in a purely competitive product market and a
monopolistic labor market.
A purely competitive firm seeking to
maximize total profit they will produce
at the point where MR = MC.
Profit maximizing price:
Find MC= MR however, the market
demand curve sets the price that the
firm must take.
Monopsony is a market in which a single employer
of labor has substantial buying (hiring) power
Characteristics:
• only a single buyer of a particular type of labor
• relatively immobile type of labor, e.g.
geographically or b/c workers would have to
acquire new skills
• firm is a 'wage maker' b/c the wage rate it must
pay varies indirectly w/ the # of workers it employs
19. Illustrate graphically how wage rates are determined
in purely competitive and monopolistic labor markets.



Labor Market Equilibrium wage rate and level of employment
in PC labor market = intersection of market labor D curve and
market S curve
each individual firm finds it profitable to hire this type of labor
up to point at which MRP = MRC
The area under the demand curve represents the total costs
19. Illustrate graphically how wage rates are determined
in purely competitive and monopolistic labor markets.
The MRC is higher than the
Wage Rate (We)
MRC > wage rate
(graphically, MRC line is
above average-cost-of labor
curve or labor S curve)
The monopsony hires fewer
workers and pays them less.
19. Illustrate graphically how wage rates are determined in
purely competitive and monopolistic labor markets.
20. List the methods used by labor organizations to increase wages
and the impact each has on employment. Give specific examples.
Union models illustrate a different kind of imperfect completion
in the labor market where the workers are organized so that
employers do not deal with individual workers, but with their
unions, who try to raise wage rates in several ways.
1.
In the Demand-Enhancement Union Model, a union increases
the wage rate by increasing labor demand through actions
which increase product demand, raise labor productivity, or
alter the price of related inputs.
2.
In the Exclusive (Craft) Union Model, a union increases wage
rates by artificially restricting labor supply, say, through long
apprenticeships or occupational licensing.
3.
In the Inclusive (Industrial) Union Model, a union raises the
wage rate by gaining control over a firm’s labor supply and
threatening to withhold labor via a strike unless a negotiated
wage is obtained.
21. Illustrate graphically how an Demand-Enhancement Union Model, inclusive
(industrial) union and an exclusive (craft) union would affect wages and
employment in a previously competitive labor market.
21. Illustrate graphically how an Demand-Enhancement Union Model, inclusive
(industrial) union and an exclusive (craft) union would affect wages and
employment in a previously competitive labor market.
21. Illustrate graphically how an Demand-Enhancement Union Model, inclusive
(industrial) union and an exclusive (craft) union would affect wages and
employment in a previously competitive labor market.
22. Explain and illustrate graphically wage determination
in the bilateral monopoly model.
Bilateral monopoly model
occurs when there is a
monopsonistic industry
facing a unionized labor
force; in other words, both
the employer and employees
have market power.
Wages and employment
outcomes are determined by
collective bargaining in this
situation.
23. Present the major points in the cases for and
against the minimum wage.
The case against the minimum wage contains two major
criticisms.
1.
Employers will just hire fewer workers.
2.
Those who lose jobs because of the higher wage are not better
off. It is poorly targeted as an antipoverty device since most on
minimum wage are teenager workers not the working poor.
The case for the minimum wage argues includes other
arguments.
1.
A higher minimum wage may produce more jobs by eliminating
the monopsonistic employer’s motive for restricting employment.
2.
May increase labor productivity that would offset the loss of
jobs from higher wages.
23. Present the major points in the cases for and
against the minimum wage.
24. Explain the demand factors that create wage
differentials.
The strength of labor demand differs greatly among
occupations due to differences in how much various
occupations groups contribute to their employer’s
revenue.
This revenue contribution, in turn, depends on the workers
productivity and the products demand.
Example: High labor productivity and high product
demand would lead to high wages generally.
25. Explain the supply factors that create wage
differentials.
To discover why supply and demand conditions differ in various labor
markets, We must probe the factors underlying the supply of and
demand for particular types of labor.
Wage rates do differ because:
1.
Workers are not homogeneous. They differ in abilities and in
education and training and as a result, fit into a number of distinct
occupational groups.
2.
Jobs vary in attractiveness; the nonmonetary aspects of various
jobs are not the same. An example would be where Jobs with
higher risk would generally pay a higher wage than a job with low
risk.
3.
Labor markets do not work perfectly. Examples; lack of job
information, geographic immobility, union and government
restraints, discrimination.
26. Describe briefly salary systems in which pay is
linked to performance rather than to time.
Many occupations pay a wage rate that is commensurate
with performance, such as sales or managerial occupations.
The purpose of performance pay is to attract the most highly
qualified and productive workers, or as economists like to
say, workers with highest marginal revenue productivity.
Performance pay is also used to motivate workers to work.
Performance pay helps to solve this principal-agent problem
by aligning the interests of the employees with that of the
owners of the firm — both want to make more money.
There are various types of performance pay: Piece rates,
Commissions, Royalties, Bonuses, Stock options, Profitsharing plans & efficiency wages.
27. Describe the negative side effects of poorly
planned incentive pay plans.
Drawbacks to Pay Incentives:
• Piece rates may result in sloppy work as workers rush to make
more money.
• Commissioned salespeople often exaggerate claims, or even
lie, to make a sale, and oftentimes, the product is not in the best
interest of the customer.
• Bonuses may disrupt teamwork and cause envy among
coworkers.
• Because profit sharing plans apply to all workers at a firm, less
productive employees will receive the same pay incentive as
more productive ones, which may cause resentment by the
productive workers and anger that they are not making as
much money as they could be, since how much they are
ultimately paid depends on how hard the others work.
28. Understand the concept of economic rent.
Economic rent is the revenue that can be earned from
the land or other natural resource for which there is a
fixed supply — as economists like to say, the supply is
perfectly inelastic.
Because the supply is perfectly inelastic, the amount of
its supply does not depend on any income that the
resource can produce.
Increased demand does not increase the supply because
it is a natural product that was always available.
Hence, it is a free gift to society.
Economic Rent = Price of Resource in its Native State
29. Graphically demonstrate how land rent is
determined
30. Explain the effects of changes in demand on
economic rent
Because the supply of land is fixed, demand is the
only active determinate of land rent; supply is
passive.
And what determines the demand for land?
 The price of the products grown on the land,
 the productivity of land (which depends in part on
the quantity and quality of the resources with which
land is combined),
 and the price of the other resources which are
combined with land.
31. Explain how land rent is a surplus payment
Among the factors of production, land is
fundamentally different from labor and capital,
because the supply of labor and capital depends on
its price in the marketplace while the supply of land
does not.
Land rent has no incentive function because the supply
of land is not dependent on the rent paid.
Land rent is considered a surplus payment, because
even if no rent was paid, land would still be
available.
32. Explain what determines rent differentials.
Rent differentials:
Different pieces of land vary greatly in productivity
of the land itself.
Location may be equally important in explaining
differences in land rent.
The rent differentials arising from quality differences
in land also play a part.
33. Explain how rent functions as a cost to the
individual firm.
Where there are alternative uses, individual firms
must pay rent to cover these opportunity costs if they
are to secure the use of land for their particular
purposes.
To individual firms rent is a cost of production, just like
wages and interest.
As a result, individual firms do need to pay rent to
attract land resources away from alternative uses; for
firms, rental payments are a cost.
34. Describe how the interest rate is determined.
Interest is the price paid for the use of money. Borrowers exchange the
ability to purchase today in exchange for purchasing in the future —
some of the money they receive in the future will be used to pay back
the loan.
Interest is almost always stated as a percentage of the amount
borrowed, simplifying the comparison of different borrowing
opportunities.
Although businesses borrow money, money itself is not a resource since
it is not a factor of production that can be used as an input to produce
an actual product or service.
Rather, businesses use money to purchase real capital, such as
equipment or supplies, or to hire labor.
Interest rates is set by the equilibrium between the supply and demand
of money. However, since most money is not available for lending, it
makes more sense to talk about the supply and demand for loanable
funds, which is the amount of money available for borrowing.
35. Explain how business firms make investment
decisions.
Because firms are the main borrowers of loanable
funds, they will only borrow if they can make an
investment in real capital to produce a product or
service that will have a higher return on investment than
the interest rate being paid on loanable funds.
For instance, if a firm can borrow money at 6% to invest
in a project that will yield a 10% rate of return, then it
would be prudent for the business to borrow the money.
But if the interest rate on loanable funds is 12%, then it
makes no sense to borrow the money, especially since
there is always some risk in business enterprises.
36. Distinguish between nominal and real interest rates--Explain
why profits are received by some firms and not by others.
Nominal Interest Rate
The nominal interest rate is simply the stated interest rate given bond or loan. The nominal
interest rate is in essence the actual monetary price that borrowers pay to lenders to use
their money. If the nominal rate on a loan is 5%, then borrowers can expect to pay $5 of
interest for every $100 loaned to them.
Real Interest Rate
The real interest rate is so named because it states the “real” rate that the lender or investor
receives after inflation is factored in; that is, the interest rate that exceeds the inflation rate.
If a bond that compounds annually has a 6% nominal yield and the inflation rate is 4%, then
the real rate of interest is only 2%.
The real rate of interest could be said to be the actual mathematical rate at which investors
and lenders are increasing their purchasing power with their bonds and loans. It is actually
possible for real interest rates to be negative if the inflation rate exceeds the nominal rate
of an investment.
For example, a bond with a 3% nominal rate will have a real interest rate of -1% if the
inflation rate is 4%. A comparison of real and nominal interest rates can therefore be
summed up in this equation:
Nominal interest rate – Inflation = Real interest rate
37. List three sources of economic profits.
The source for economic profit are: Market control, Innovation & Risk
 Market control is one of the most common reasons and source of economic
profit, by which a firm makes the profit. A firm with market control can
influence the market price of a product. Market control, principally in the
oligopoly or monopoly firm the profit is generally generated by the inefficient
allocation of resources. When a firm controls the price it is able to make more
revenue which adds to the profit.
 Innovation is another source of economic profit. Firms who are involved in
innovative activities like introducing new product or adding technological
innovation are generally rewarded with economic profits. The economic
innovations made by entrepreneurs or business houses are rewarded with the
economic profit. This reward is to encourage the risk these entrepreneurs have
taken by bring improved good or service into the market.
 The last source of economic profit is the risk that a company goes through
during the process of production. The riskier the project the more profit an
entrepreneur will make. This risk profit is basically a reward for the risk taken
by a company. It is a very good type of profit for the economy.
38. Describe the general function of profits.
High profit Enables
1. Investment in Research & Development. This leads to better technology and dynamic efficiency. This profit is
particularly important for some industries such as oil exploration and car manufacture. Without this investment the
economy will stagnate and lose international competitiveness, leading to job losses in some sectors.
2. Reward for Shareholders
Shareholders are given dividends. Higher profit leads to higher dividends and encourages people to buy shares.
Shareholders are an important source of finance for firms. Profit is important to be able to remunerate shareholders.
3. High Profit should attract new firms into the industry
For example, the high price of oil and hence profits for oil companies should encourage firms to develop new oil
fields. This assumes the market is contestable and new firms can actually enter.
4. Risk Bearing Economies
Profit can be saved and provide insurance for an unexpected downturn, such as recession or rapid appreciation in
the exchange rate.
5. Tax Revenues
Governments charge corporation tax on company profits and this provides billions of dollars of tax revenue per
year.
6. Acts as Incentive
Higher profit acts as an incentive for entrepreneurs to set up a business. Without the reward of profit, there would be
less investment and less people willing to take risks. For example, it is argued higher corporation tax, which reduces
a firms post tax income may deter inward investment.