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Chapter 16 Rent, Interest and Profits Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia. 1 Learning Objectives • Extend our analysis of resource pricing to include each of the non-wage income sources: rent, interest and profits. • Develop an understanding of the pattern of all income shares in Australia, including wages, and their current and historical significance. Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia. 2 Economic Rent • Economic rent is a term used by economists • Narrower than the common meaning of the term ‘rent’ • Economic rent is the price paid for the use of land and other natural resources that are completely fixed in total supply Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia. 3 Determination of Land Rent Land Rent (dollars) S R1 R2 D1 R3 D2 D4 0 D3 S Acres of Land Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia. Q 4 Land Rent • Supply of land is perfectly inelastic • Demand – sole active determinant of land rent – ‘derived demand’ – down-sloping Law of diminishing returns Product price must be decreased to sell additional units Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia. 5 Perfectly Inelastic Supply • Why? – No production costs associated with land – Economy has a finite supply of land – Variability in the usability of land affects a very small fraction of the total amount of land Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia. 6 Land Rent is a Surplus • Does not serve as an incentive • A payment that is not necessary to ensure that land will be available to the economy as a whole • The case against land rent – Henry George’s proposal: single tax on land – Advantages and disadvantages Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia. 7 Productivity of Land • Different properties will differ in their productivities Soil fertility Mineral wealth Climatic factors Environmental degradation • Different grades of land can be represented by differing demand curves Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia. 8 Interest • The price paid for the use of money. Typically the amount that must be paid for the use of one dollar for one year • Measured as a percentage • Money is not a resource • Money is not in itself useful Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia. 9 Determining Interest Rate • Money demand – transactions demand + assets demand • Money supply • Nominal interest rate: current dollars • Real interest rate: adjusted for inflation – important in making investment decisions Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia. 10 Rate of interest (per cent) Interest Rate Determination (cont.) 10 Sm 8 6 Ie 4 2 Dm 0 50 100 150 200 250 300 Amount of money demanded and supplied ($billion) Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia. 11 Types of Interest Rates • Commercial rates, mortgage rates, etc. • Reasons for interest rate differentials – Risk – Maturity or length of loan – Size of loan • Pure rate of interest – Overall interest rate in the economy – Best approximated by interest paid on long-term Federal Government bonds Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia. 12 Role of Interest Rates • Affect level of production of investment goods – Change in interest rates results in change in investment demand • Affect composition of production of investment goods – Interest rates allocate the available supply of money to those projects which are expected to result in the highest levels of profit Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia. 13 Economic Profits • Various terms – Economic profits or pure profits – Accounting profits – Explicit costs – Implicit costs Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia. 14 Role of the Entrepreneur • Recall from Chapter 2 – entrepreneurs take initiative to combine other resources in production – entrepreneurs make non-routine decisions – entrepreneurs introduce innovation – entrepreneurs take economic risks • Normal profit – the minimum return necessary to retain the entrepreneur in a production line Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia. 15 Sources of Economic Profits • Economic profits – are not a cost – accrue to the entrepreneur • Potential sources – uninsured risks (dynamic and uncertain) – innovations – monopoly power and profits Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia. 16 Functions of Profits • Energise the economy • Stimulate innovation and output • Encourage investment • Allocate resources amongst alternatives Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia. 17 Income Shares • Largest share of national income accrues to labour • Labour’s relative share has declined in Australia since the 1980s • Capitalist share less than 25 per cent of national income Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia. 18 Next Chapter: Market Failure and Resource Allocation Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia. 19