Ch 29: Interest, Rent, and Profit
Del Mar College
John Daly
©2003 South-Western Publishing, A Division of Thomson Learning
Interest
• Sometimes refers to
the price for credit or
loanable funds.
• Interest can also refer
to the return earned by
capital as an input in
the production
process.
Loanable Funds: Demand and Supply
• The equilibrium interest rate is determined by the
demand for and supply of 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.
Demand and Supply for Loanable
Funds
• Supply: The higher the interest rate, the greater the
quantity supplied of loanable funds; The lower the
interest rate, the lower the quantity supplied of
loanable funds.
• Consumption Loans: Loanable funds are
demanded by consumers because they have a
positive rate of time preference – consumers
prefer earlier availability of goods to later
availability.
Demand For Loanable Funds
• Investors demand loanable funds so they can
invest in roundabout methods of production. A
firm using a roundabout method of production
first directs its efforts to producing capital goods
and then uses those goods to produce consumer
goods.
• The capital-investive roundabout method of
production is highly productive, which makes the
production worthwhile. This makes firms
prepared to borrow now to enter into the
roundabout method of production.
The Loanable Funds Market
The sum of the
demand for
consumption loans
and the demand for
investment loans is
the total demand for
loanable funds. The
interest rate and
quantity demanded of
of loanable funds are
inversely related.
The Price for Loanable Funds
and the Return on Capital Goods
Tend to Equality
• Given: the return on capital is 10% and the
price for loanable funds is 8%
• Therefore: Firms will borrow in the
loanable funds market and invest in capital
goods.
• The return on capital and the price for
loanable funds approach each other
Risk, Loan Terms, and Making
the Loan
• The more risk associated with a loan, the higher
the interest rate; the less risk associated with a
loan, the lower the interest rate.
• The longer the term of the loan, the higher the
interest rate; the shorter the term of the loan, the
shorter the interest rate.
• Loans that cost more to process and administer
will have higher interest rates than loans that cost
less.
Nominal and Real Interest Rates
• Nominal interest rate is the interest rate
determined by the forces of supply and demand in
the loanable funds market.
• Nominal Interest rate will change if the demand
for or supply of loanable funds changes.
• Individuals’ expectations of inflation are one of
the factors that can change both the demand for
and supply of loanable funds.
Expected Inflation and Interest Rates
We start at an 8% interest rate and
an actual and expected inflation
rate of 0%. Later, both borrowers
and lenders expect an inflation rate
of 4%. Borrowers are willing to
pay a higher interest rate because
they will be paying off their loans
with cheaper dollars. Lenders
require a higher interest rate
because they will be paid back
with cheaper dollars. The demand
and supply curves shift such that
Q1 borrowers are willing to pay
and lenders require a 4%higher
interest rate. The nominal interest
rate is now 12%. The real interest
rate is 8%.
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.
Present Value
• Present Value refers to
the current worth of
some future dollar
amount.
• PV=An/(1+i)n
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.
Q&A
• Why does the price for loanable funds tend to
equal the return on capital goods?
• Why does the real interest rate, and not the
nominal interest, matter to borrowers and lenders?
• 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.
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
Pure Economic Rent and the
Total Supply of Land
The total supply of land is
fixed at Q1. The payment
for the services of this land
is determined by the forces
of supply and demand.
Because the payment is for
a factor in fixed supply it is
refereed to as pure
economic rent.
This depicts the supply of
land as fixed. This is the
case when the total supply
of land is in question.
Economic Rent and Other
Factors
• The concept of
economic rent applies
to economic factors
besides land. An
example is labor.
• Economic rent differs
depending on the
perspective from
which the factor is
being viewed.
A particular parcel of
land, as opposed to the
total supply of land has
competing uses, or
positive opportunity costs.
For example, to obtain
land to build a shopping
mall, the developers must
bid high enough to attract
existing land away from
competing uses. The
supply curve is upward
sloping. At a payment of
R1, economic rent is
identified as the payment
in excess of (positive)
opportunity costs.
Economic Rent and
the Supply of Land
(Competing Uses)
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.
Q&A
• Give an example that illustrates that land rents are
price determined, not price determining.
• Nick’s salary is pure economic rent. What does
this imply about Nick’s “next best alternative
salary”?
• What are the social consequences of firms
competing for artificial rents as opposed to
competing for real rents (where there are no
barriers to real rents)?
Profit
• The “profits” that appear
in newspaper headlines
are accounting profits, not
economic profits.
• Economic profit is the
difference between total
revenue and total cost,
where both explicit and
implicit costs are included
in total cost.
Theories of Profit
1. Profit and Uncertainty: Uncertainty exists
when a potential occurrence is so unpredictable
that a probability cannot be estimated.
• Risk exists when the probability of a given event
can be estimated.
• 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.
Theories of Profit
2. Profit and Arbitrage Opportunities: “Buy
Low, Sell High”.
• What is usually bought and sold is the same item.
• Sometimes this refers to buying factors in one set
of markets at the lowest possible prices,
combining the factors into a finished product,
then selling the product for the highest possible
price
3. Profit and Innovation: Profit is the return to the
entrepreneur as innovator.
Monopoly Profits
• Monopolies can earn
positive economic profits
owing to the high barriers
to entry.
• Monopoly profits can
exist for a long time.
• Monopoly profits may be
competed for and may
disappear altogether if the
monopoly market is
contestable
Profit and Loss as Signals
• Profit and loss signal how a market may be changing.
• When a firm earns a profit, entrepreneurs in other industries
view this as a signal that the profit earning firm is producing
and selling a good that buyers value more than the factors
that go into making the good. The profit causes
entrepreneurs to move resources into the production of the
particular good to which the profit is linked.
• Resources follow profit.
• If a firm is taking a loss, this is a signal that the firm is
producing a good buyers value less than the factors that
make up the good. Thus, entrepreneurs turn away from
making that particular good.
• Resources turn away from losses.
Q&A
• What is the difference
between risk and
uncertainty?
• Why does profit exist?
• “Profit is not simply a
dollar amount, it is a
signal.” Comment.