16-1Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

Chapter 16

Rent, interest and profits

16-2Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

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

16-3Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

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

16-4Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

Determination of land rent

Lan

d r

ent

(do

llar

s)

Acres of land0 Q

S

S

D1

R1

R2

D2

D3

R3

D4

16-5Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

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

16-6Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

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

16-7Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

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

16-8Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

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

16-9Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

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

16-10Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

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

16-11Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

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 determinesthe equilibrium interest rate

16-12Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

Interest rate determination (cont.)

0

10

8

6

4

2

50 100 150 200 250 300

Rat

e o

f in

tere

st (

per

cen

t)

Amount of money demanded and supplied ($billion)

Dm

Sm

Ie

16-13Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

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

16-14Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

The interest rate and investment

66

88

1010

00 $125$125 $150$150 $175$175

66

88

1010

00$15$15 $20$20 $25$25

Rea

l ra

te o

f in

tere

st (

%)

Sm1

Dm

Sm2 Sm3

Amount of money demandAmount of money demandand suppliedand supplied

Amount of Investment, Amount of Investment, IIR

eal

Rat

e o

f in

tere

st (

%)

(a) The money market(a) The money market (b) Investment demand(b) Investment demand

16-15Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

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

16-16Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

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

16-17Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

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

16-18Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

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

16-19Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

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

16-20Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

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

16-21Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

Functions of profits• Energise the economy• Stimulate innovation and output• Encourage investment• Allocate resources among alternatives

16-22Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

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

16-23Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

Relative share of GDP at factor cost: Australia

16-24Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

Income sharesHistorical 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

16-25Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

Next chapter:

Market failure and resource allocation