Interest, Rent, and Profit
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Transcript of Interest, Rent, and Profit
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Interest, Rent, and Profit
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Interest
• It is the price for credit or loanable funds.• It is also called the return earned by capital as
an input in the production process.
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Demand and Supply of Credit
• The equilibrium interest rate is determined by the demand for and supply of credit (loanable funds).
• The Demand for loanable funds is composed of the demand for consumption loans, the demand for investment loans, and government’s demand for loanable funds.
• The supply of loanable funds comes through people’s saving and newly created money.
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Credit Market
• Supply: The higher the interest rate, the greater the quantity supplied of loanable funds, and vice versa.
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Demand For Loanable Funds
• Roundabout Method of Production: When firm directs its efforts to produce capital goods (i.e. R&D), then uses those goods to produce consumer goods.
• To finance the roundabout method of production, firm demands capital (credit). This is known as investment credit.
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Credit Market
• The sum of the demand for consumer credit and investment credit represents the credit demand.
• The interest rate and quantity demanded of credit are inversely related
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The Credit Market
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Credit Market Vs. Investment Market
• The price of credit (interest) and the return on investment (capital goods) tend to equalize.
• Assume: the return on capital is 10% and the price for credit is 8%.
• Firm behavior: Firms will borrow in the credit market and invest in capital goods.
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Potential Problems on Credit Market
• Risk
• Length of the term of the loan
• Transaction and Administrative
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Effect of Problems on the Price of the Credit
• Higher risk Higher Interest Rate, vice-versa.
• Long term loan Higher the interest rate; vice versa.
• Higher administrative and Transaction Costs Higher interest rates; vice-versa.
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Nominal Vs. Real Interest Rates
• Nominal interest rate is the current interest rate (determined by the forces of supply and demand in the credit market).
• Nominal Interest rate changes whenever there is disequilibrium in the credit market.
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Effect of Expected Inflation in the Credit Market
• Individuals’ expectations of inflation are one of the factors that can change both the demand for and supply of loanable funds.
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Expected Inflation and Interest Rates
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Nominal Vs.Real Interest Rate
• The Real Interest Rate is the nominal interest rate adjusted for the expected inflation rate.
• Real interest rate=nominal interest rate – expected inflation rate
• The real interest rate, not the nominal interest rate, matters to borrowers and lenders.
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Present Value
• Present Value refers to the current worth of some future dollar amount.
• PV=An/(1+i)n
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Deciding Whether to Purchase A Capital Good
• Business firms often compute present values when trying to decide whether or not to buy a capital good.
• As the interest rate decrease, present values increase and firms will buy more capital goods; as interest rates increase, present values decrease and firms will buy fewer capital goods, all other things held constant.
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Q & A
• What is the present value of $1,000 two years from today if the interest rate is 5%?
• A business firm is thinking of buying a capital good. The capital good will earn $2,000 a year for the next four years and will cost $7,000. The interest rate is 8%. Should the firm buy the machine? Explain your answer.
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Rent
• Economic Rent is a payment in excess of opportunity costs.
• Pure Economic Rent is a payment in excess of opportunity costs, when opportunity costs are zero
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Land
. The total supply of land is fixed.
. The payment for the services of this land is determined by the forces of supply and demand.
. The payment is for a factor in fixed supply so it is refereed to as pure economic rent.
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Pure Economic Rent and the Total Supply of Land
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Economic Rent and Other Factors
• The concept of economic rent applies to economic factors besides land. An example is labor.
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Economic Rent and the Supply of Land (Competing Uses)
. A particular parcel of land, as opposed to the total supply of land has competing uses, or positive opportunity costs. (i.e. to obtain land to build a shopping mall, the developers must bid high enough to attract existing land away from competing uses.)
. Thus, the supply curve of land is upward sloping.
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Economic Rent and the Supply of Land (Competing Uses)
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Artificial and Real Rents
• Individuals and firms will compete for both artificial rents and real rents.
• An artificial rent is an economic rent that is artificially contrived by government; it would not exist without a government.
• Competing for real rents is different: if the rent is real and there are no barriers to competing for it, resources are used in a way that is socially productive.
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Profit
• For a layperson “profits” are accounting profits, not economic profits.
• Because, Economic profit is the difference between total revenue and total cost, where both explicit and implicit costs are included in total cost.
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Theories of Profit
1. Profit and Uncertainty.
2. Profit and Arbitrage Opportunities.
3. Profit and Innovation.
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Profit and Uncertainty
• Risk exists when the probability of a given event can be estimated.
• Uncertainty exists when a potential occurrence is so unpredictable that a probability cannot be estimated.
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Profit and Uncertainty
• Risks can be insured against, while uncertainties cannot. Anything that can be insured against can be considered “a cost of doing business.”
• The investor-decision maker who is adept at making business decisions under conditions of uncertainty makes a profit.
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Profit and Arbitrage Opportunities
• Buy factors in one set of markets at the lowest possible prices,( may combine the factors into a finished product), then sell the factors (product) for the highest possible price
• To make profit, investor (firm) must buy low, and sell high.
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Profit and Innovation
• Profit is the return to the entrepreneur as innovator.
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Profit Vs. Loss Signals• Profit and loss signal how a market may be
changing:1. Resources follow profit.2. Resources turn away from losses.