Survey
* Your assessment is very important for improving the workof artificial intelligence, which forms the content of this project
* Your assessment is very important for improving the workof artificial intelligence, which forms the content of this project
Heckscher–Ohlin model wikipedia , lookup
Economic calculation problem wikipedia , lookup
History of macroeconomic thought wikipedia , lookup
Resource curse wikipedia , lookup
Fei–Ranis model of economic growth wikipedia , lookup
Brander–Spencer model wikipedia , lookup
Icarus paradox wikipedia , lookup
Criticisms of the labour theory of value wikipedia , lookup
Microeconomics wikipedia , lookup
Labour economics wikipedia , lookup
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.