Interest, Rent, and Profit
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.
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.
Credit Market
• Supply: The higher the interest rate, the
greater the quantity supplied of loanable
funds, and vice versa.
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.
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
The Credit Market
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.
Potential Problems on Credit
Market
• Risk
• Length of the term of the loan
• Transaction and Administrative
Effect of Problems on the Price
of the Credit
• Higher risk  Higher Interest Rate, viceversa.
• Long term loan Higher the interest rate;
vice versa.
• Higher administrative and Transaction
Costs  Higher interest rates; vice-versa.
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.
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.
Expected Inflation and Interest
Rates
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.
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
• 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
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.
Pure Economic Rent and the
Total Supply of Land
Economic Rent and Other
Factors
• The concept of economic rent applies to
economic factors besides land. An example is
labor.
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.
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.
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.
Theories of Profit
1. Profit and Uncertainty.
2. Profit and Arbitrage Opportunities.
3. Profit and Innovation.
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.
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.
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.
Profit and Innovation
•
Profit is the return to the entrepreneur as
innovator.
Profit Vs. Loss Signals
•
Profit and loss signal how a market may be
changing:
1. Resources follow profit.
2. Resources turn away from losses.