AP Microeconomics – Chapter 14 Outline I. Learning Objectives–In this chapter students should learn: A. The nature of economic rent and how it is determined. B. The loanable funds theory of interest rates. C. How interest rates relate to the time‐value of money and vary based on risk, maturity, loan size, and taxability. D. Why economic profits occur, and how profits, along with losses, allocate resources among alternative uses. E. The share of U.S. earnings received by each of the factors of production. II. Economic Rent A. Economic rent is the price paid for the use of land and other natural resources that are fixed in supply. (Note that this definition differs from the everyday use of the term.) B. The model for the determination of land rent assumes: 1. Land has a single use (growing wheat, but not also drilling oil beneath the land or putting a windmill atop the land). 2. All land is of equal quality. 3. Land is rented in a purely competitive market, with demand and supply coming from many sources. C. The Land Rent Determination Model (Figure 14.1) 1. The demand for land is downward sloping because of diminishing returns and the fact that producers must lower the price of the product to sell additional units of output. AP Microeconomics – Chapter 14 Outline 2. Perfectly inelastic supply of land is one unique feature of the market. Land has no production cost; it is a “free and nonreproducible gift of nature” whose quantity does not change with price (with a few exceptions). 3. Changes in demand therefore determine the amount of rent. Demand is determined by: a. The price of the products grown on the land b. The productivity of the land c. The prices of other resources that are combined with the land D. In reality, each parcel of land is not equally productive. More productive land will be in great demand and therefore will receive higher rent. These different rent payments allocate land to its most productive use. E. Land rent is viewed as a surplus payment because it performs no incentive function to provide more supply; it is not necessary to ensure the availability of land. F. In reality, land has alternative uses and costs. From society’s perspective, rent is a surplus, but an individual firm must pay rent to attract the land away from alternative uses. Without rent to allocate land among its various uses, there would be no market mechanism to make sure each piece of land was being utilized in its most valuable fashion. Therefore, rent does provide an important function to our economic system. G. Some argue that rent should be taxed away because it is unearned, or that land should be nationalized and owned by the state. 1. Henry George’s Single Tax on Land a. Economic rent could be heavily taxed without reducing the supply of land or reducing the efficiency of allocation. b. Increases in rent are only due to ownership, not productivity on the part of landowners; therefore, the increases in rent belong to society. c. As a result, rent should be heavily taxed, with the income used for the public good. George asserted that this tax could eliminate the need for other taxes. d. Allocative and productive efficiency would still be achieved under a tax on land rent. Unlike the effect of a tax on other resources, the tax on land would not have a negative incentive effect. 2. Criticisms of the Single‐Tax Idea a. Current levels of government spending are too great to be supported solely by land taxes. b. It is difficult to separate the rent component from other income resulting from the combined use of land with other resources. c. Unearned income goes beyond land ownership; capital gains and interest income might also be considered unearned. AP Microeconomics – Chapter 14 Outline d. It is unfair to tax current owners, who may have paid a steep market price for the land and therefore find that the rent return is not high relative to that price. III. Interest A. Interest is the price paid for the use of money, generally expressed as a percentage rate. B. Money itself is not an economic resource, but it is used to acquire capital goods. So in hiring money capital, businesses are ultimately buying the use of real capital goods. C. The interest rate on money loans determines the interest income earned by households for providing capital to firms. D. Interest rates for different types of loans vary for many reasons (Table 14.1). 1. Risk—riskier loans carry higher rates 2. Maturity—longer‐term loans usually carry higher rates 3. Loan size—smaller loans have higher rates 4. Taxability—interest on some local and state bonds is tax‐free, so the interest rate is lower, because lenders don’t have to pay federal taxes on that interest income AP Microeconomics – Chapter 14 Outline E. The “pure rate of interest” is the hypothetical interest rate that would completely compensate lenders to forgo other consumption and investment opportunities until their money is repaid. It is best approximated by the interest paid on long‐term, risk‐
free bonds, such as 20‐year U.S. Treasury bonds. E. Loanable Funds Theory of Interest Rates (Figure 14.2) 1. The supply of loanable funds is an upward sloping curve. Households will make a larger quantity of funds available at high interest rates than at low interest rates, because most individuals prefer present consumption and must be paid to defer consumption by saving. 2. The demand for loanable funds is a downward sloping curve, inversely related to the rate of interest. At higher interest rates, fewer investment projects will be profitable because fewer projects yield the high rate of return needed to compensate for the high interest cost. At lower interest rates, more projects yield the rate of return required to cover the interest cost, so more loanable funds are demanded by firms. 3. The equilibrium interest rate is at the point where the quantity of loanable funds supplied equals the quantity demanded. 4. Changes in the supply of funds may occur as a result of changes in tax policy or social insurance benefits. 5. Changes in the demand of funds result from changes in the rates of return on potential investments, such as improvements in technology or a change in the demand for the final product. AP Microeconomics – Chapter 14 Outline 6. Households rarely lend savings directly to businesses. Households place their savings in financial institutions and receive an interest payment. Businesses borrow funds from financial institutions and pay an interest payment. 7. Both households and businesses operate on both the supply and demand sides of the market for loanable funds. While households supply loanable funds, they may also borrow to finance large purchases and education. Similarly, businesses may save in the market for loanable funds, and governments may borrow to finance deficits. G. Banks and other financial institutions not only gather and make available the savings of households, but also create funds through the lending process. Federal Reserve policy influences how much money financial institutions can create. H. Time‐Value of Money 1. A specific amount of money is more valuable to a person the sooner it is obtained. A sum of money received today is equivalent to a larger amount of money in the future, because today’s sum can be placed in an interest‐bearing account or a financial investment. This concept also relates to present value, future value, and compound interest principles (Table 14.2). 2. CONSIDER THIS … That is Interest – because those accepting payment later must give up present investment opportunities, they demand interest to compensate them for the opportunity cost of that choice. I. The role of the interest rate is important because it affects both the level and composition of investment and R&D spending. 1. The level of investment varies inversely with the interest rate; as interest rates fall, capital investment increases. The Federal Reserve System changes the money supply to influence interest rates. Changes in investment affect the level of GDP, causing changes in output and employment. 2. Interest rates also affect borrowing for R&D, because the cost of borrowing money is compared to the expected rate of return on the R&D project. 3. Nominal interest rates are those stated in terms of current dollars; the “real” interest rate is the rate of interest expressed in terms of dollars of inflation‐
adjusted value. The real interest rate is the nominal rate minus the rate of inflation. 4. It is the real interest rate, not the nominal rate, which businesses should consider in making their investment and R&D decisions. J. Application: Usury Laws AP Microeconomics – Chapter 14 Outline 1. Usury laws specify the maximum interest rate that can be charged on loans, in order to make borrowing more accessible to low‐income borrowers. 2. Effects of setting usury rates lower than the equilibrium interest rate: a. A shortage of loanable funds—riskier borrowers may be excluded from borrowing from established financial institutions, defeating the purpose of the law. b. Gainers and losers—creditworthy borrowers are able to borrow at below‐
market interest rates, while lenders receive less than market rates of return on the funds loaned. c. Inefficiency—funds may not be allocated to their most efficient use. IV. Economic Profit A. Economic profit is what remains of a firm’s total revenue after it has paid for materials, capital, and labor supplied to the firm (the explicit costs) and allowed for payment to self‐employed resources (the implicit costs). B. The role of the entrepreneur is most important in a capitalist economy. Profits are the reward paid for entrepreneurial ability, which includes deciding the firm’s strategy for combining resources for production, deciding whether and how to develop new products and production processes, and taking risks associated with the success or failure of the business. 1. A normal profit is the minimum required to retain the entrepreneur in some specific line of production, because the entrepreneur has an opportunity cost in giving up other entrepreneurial pursuits. 2. An economic profit is any profit above the normal profit. This residual profit, which also goes to the entrepreneur, does not exist under pure competition in a static economy; it occurs because of the dynamic nature of real‐world capitalism and the presence of monopoly power. 3. Sources of Uninsurable Risks a. Changes in the general economic environment (recessions) b. Changes in the structure of the economy (consumer tastes, technology, resource costs) c. Changes in government policy (regulations, taxes) d. New products or production processes 4. Entrepreneurs are rewarded with profit to compensate them for personally taking on the uninsurable risks of running a business. C. Sources of Economic Profit 1. Create popular new products—increases allocative efficiency, benefiting society. 2. Reduce production costs below rivals’ costs—increases productive efficiency, benefiting society. AP Microeconomics – Chapter 14 Outline 3. Create and maintain a profitable monopoly—stems from a misallocation of resources, which does not benefit society. 4. CONSIDER THIS … Apple CEO Steve Jobs a. Jobs created a profit by creating very popular versions of existing products. b. He defied conventional wisdom by deciding Apple should produce both its own hardware and software, to fully integrate them so they would work together flawlessly. c. Rival firms could not duplicate Apple’s products, because they produced hardware or software, but not both; therefore, Apple achieved monopoly power. D. Functions of Profit 1. The expectation of profit encourages firms to innovate, which stimulates new investment, leading to expansion in output and employment. 2. Profits allocate resources among alternative lines of production. Resources leave
unprofitable ventures and flow to profitable ones, which is where society signals
it wants these resources to be allocated.
V. Income Shares
A. Labor income is the dominant type of income, with wages and salaries constituting about 70 percent of all income earned by Americans. If one adds in a part of proprietors’ income, which is probably largely labor income, the share rises to about 80 percent. B. Therefore, the share of income for corporate profits, interest, and rent is only about 20 percent. C. These percentages have remained remarkably stable in the United States since 1900. VI. LAST WORD: Determining the Price of Credit A. To determine the interest rate, compare the interest paid with the amount borrowed. If you borrow $10,000 and agree to repay that amount plus $1,000 at the end of the year, the interest rate is 10 percent. B. In some cases, a lender will discount the interest payment at the time the loan is made, so the borrower would pay the $1,000 and receive the remaining $9,000 for an 11 percent rate of interest. C. In many cases, the financial institution uses a 360‐day year (instead of 365 days) to calculate the interest rate, because it is simpler to calculate monthly rates (twelve 30‐
day months), but this does increase the interest rate. D. If the loan is paid back in installments, the process becomes more complicated because on average, the borrower had only half the loan for the full year. AP Microeconomics – Chapter 14 Outline r = $1,000/$5,000 = 20% on an annual basis E. Another factor that influences the effective interest rate is whether or not it is compounded. If it is, then interest is added onto the deposit as it is earned, and the new amount earns interest. Compound interest on deposits is effectively more than simple interest. The more often it is compounded, the higher the effective rate will be. F. Two pieces of legislation have been enacted to protect financial market customers. 1. The 1968 Truth in Lending Act requires uniform disclosure of lending terms (including annual interest rates). 2. The 1991 Truth in Savings Act requires that banks disclose fees and interest rates on deposit accounts. G. Despite these laws, financial institutions have creative ways to extract more revenue from their customers. “Payday” check‐cashing firms lend people money at hundreds of percent interest per year. Banks have implemented “bounce (overdraft) protection” fees. These fees, ranging as high as $35, amount to interest on a loan for the overdraft. Late‐payment fees on credit card accounts effectively increase the actual rate paid on credit card balances, and “teaser” rates bump up the interest rate in the event of a late payment. H. “Let the buyer beware” is a fitting motto in the world of credit.