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Factor markets and income distribution

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Capital and land

• Physical capital– the stock of produced goods which

contributes to the production of goods and services.

• Land– the factor of production which nature

supplies.

• Together capital and land make up the tangible wealth of a country.

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Investment• Capital depreciates over time

– becoming less productive and less valuable.

• Gross investment– the production of new capital goods and the

improvement of existing capital goods.

• Net investment– gross investment minus the depreciation of

the existing capital stock.

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Stocks and flows

• A stock– the quantity of an asset at a point in time– the asset price is the sum for which the

stock can be bought outright.

• A flow– the stream of services that an asset

provides during a period– the rental rate is the cost of using capital

services.

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Interest and present value

• The present value of £1 at some future date is the

sum that, if lent out today, would accumulate to £1

by that future date.

– It depends upon how far into the future the sum

accumulates

– and on the rate of interest.

• The price of a capital asset should be related to the

stream of future payments that will be earned from

the services it provides

– discounted back to give the present value.

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Real and nominal interest rates

• The nominal interest rate– tells us how many actual pounds will be earned

in interest by lending £1 for one year.

• The real rate of interest– measures the return on a loan as the increase

in goods that can be purchased rather than as the increase in the nominal value of the loan fund.

• The real rate of interest is the nominal rate minus the inflation rate.

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The equilibrium real interest rate

Current consumption

Fut

ure

cons

umpt

ion

A

A'

AA' shows the production possibility frontier betweencurrent and futureconsumption:

by devoting resources toinvestment, future consumption can be increased.

The slope of the frontierhas magnitude –(1 + i)where i is the rate of return on investment.

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The equilibrium real interest rate

Current consumption

Fut

ure

cons

umpt

ion

A

A'

The slope of the red linerepresents –(1 + r), where r is the real interest rate that balances theproductivity of investmentand the thriftiness ofconsumers.

U

U

Given society's preferencesbetween present and futureconsumption, the optimalposition is at E, where theindifference curve UU is ata tangent to the PPF.

E

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The markets for capital and land

• The derived demand curve for capital (and for land) services closely parallels the earlier analysis of labour demand.

• But land is in fixed supply to the economy as a whole.

• Rental rates tend to become equalised across alternative uses.

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Changes in capital intensity

• Over time, the UK economy is becoming more capital-intensive– the wage-rental ratio has increased, leading

industries to substitute capital for labour– in the long run the supply of labour is less

elastic than the supply of capital– new capital embodies latest technology.

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The functional distribution of income in the UK

0%

20%

40%

60%

80%

100%

1981-89 1999

Employment Self-employment Profits & rents

The distribution of income between the factors of production changed little between 1981-89 and 1998.