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Chapter 16 Rent, interest and profits Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIver By Muni Perumal, University of Canberra, Australia 16-1 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 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIver By Muni Perumal, University of Canberra, Australia 16-2 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 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIver By Muni Perumal, University of Canberra, Australia 16-3 Determination of land rent Land rent (dollars) S R1 R2 D1 R3 D2 D4 0 D3 S Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIver By Muni Perumal, University of Canberra, Australia Acres of land Q 16-4 Land rent • Supply of land is perfectly inelastic • Changes in 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 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIver By Muni Perumal, University of Canberra, Australia 16-5 Perfectly inelastic supply of land • Why? – No production costs associated with land – Economy has a finite supply of land – Variability in the useability of land affects a very small fraction of the total amount of land Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIver By Muni Perumal, University of Canberra, Australia 16-6 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 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIver By Muni Perumal, University of Canberra, Australia 16-7 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 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIver By Muni Perumal, University of Canberra, Australia 16-8 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 Two important aspects of interest: 1. Measured as a percentage 2. Money is not a resource – Money is not in itself useful Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIver By Muni Perumal, University of Canberra, Australia 16-9 Determining interest rate • Demand and the supply of money determine interest rate Demand for money • Total demand for money is made of: – Transaction demand for money — the demand for money as a medium of exchange – Asset demand — money acts as a financial asset and store of wealth Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIver By Muni Perumal, University of Canberra, Australia 16-10 Determining interest rate (cont.) • Money supply – The money supply curve is a vertical line and is independent of the interest rate • The intersection of the demand-for-money curve and the money supply curve determines the equilibrium interest rate Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIver By Muni Perumal, University of Canberra, Australia 16-11 Rate of interest (per cent) Interest rate determination (cont.) Sm 10 8 6 Ie 4 2 Dm 0 50 100 150 200 250 300 Amount of money demanded and supplied ($billion) Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIver By Muni Perumal, University of Canberra, Australia 16-12 Determining interest rate (cont.) Investment decision • The investment demand curve shows the amount of investment the business sector will undertake at various real rate of interest • Nominal interest rate is the rate of interest expressed in terms of dollars of current value • Real interest rate is interest rate adjusted for inflation – Important in making investment decisions Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIver By Muni Perumal, University of Canberra, Australia 16-13 Sm1 Sm2 Sm3 10 8 6 Dm 0 Real Rate of interest (%) Real rate of interest (%) The interest rate and investment $125 $150 $175 Amount of money demand and supplied (a) The money market Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIver By Muni Perumal, University of Canberra, Australia 10 8 6 0 $15 $20 $25 Amount of Investment, I (b) Investment demand 16-14 Range 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 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIver By Muni Perumal, University of Canberra, Australia 16-15 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 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIver By Muni Perumal, University of Canberra, Australia 16-16 Economic profits • Economists define profit more narrowly than accountants • Profit from the viewpoint of accountants only considers explicit cost – Payment by firms to outsiders • They ignore implicit costs – Payments for similar resources that are owned and self-employed by a firm Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIver By Muni Perumal, University of Canberra, Australia 16-17 Economic profits (cont.) • Economic or pure profits are what remain after all opportunity costs — explicit and implicit wage, rent, and interest costs and a normal profit — have been subtracted from a firm’s total revenue • Economic profit can be either positive or negative Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIver By Muni Perumal, University of Canberra, Australia 16-18 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 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIver By Muni Perumal, University of Canberra, Australia 16-19 Sources of economic profits • Economic profits – Are not a cost – Accrue to the entrepreneur Sources of economic profits • Uncertainty, risk and profits – Bearing of uninsurable risk • Uncertainty, innovation and profits • Monopoly profits Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIver By Muni Perumal, University of Canberra, Australia 16-20 Functions of profits • • • • Energise the economy Stimulate innovation and output Encourage investment Allocate resources among alternatives Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIver By Muni Perumal, University of Canberra, Australia 16-21 Income shares • Largest share of national income accrues to labour. It receives currently about 54 per cent of the national income • Labour’s relative share has declined in Australia since the 1980s • Capitalist share less than 25 per cent of national income Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIver By Muni Perumal, University of Canberra, Australia 16-22 Relative share of GDP at factor cost: Australia Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIver By Muni Perumal, University of Canberra, Australia 16-23 Income shares Historical trends • Defining labour’s share as ‘wages and salaries’, it increased from around 50 per cent in the post-war period to a high of around 61 per cent in the 1970s • Changing output mix and industry mix have contributed to the rise in labour’s share Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIver By Muni Perumal, University of Canberra, Australia 16-24 Next chapter: Market failure and resource allocation Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIver By Muni Perumal, University of Canberra, Australia 16-25