Chapter 29
Rent, Interest and
Profit
Economic Rent
To the business executive “rent” is a
payment made for the use of a building,
machine, or warehouse facility.
Economists use “rent” in a narrower
sense. Economic rent is the price paid
for the use of land and other natural
resources that are completely fixed and
in total supply.
Economic Rent
Perfectly Inelastic Supply – For all
practical purposes the supply of land is
perfectly inelastic, as reflected in
supply curve S. Land has no
production cost.
Changes in Demand – because the
supply of land is fixed, demand is the
only active determinant of land rent.
Economic Rent
Changes in Demand
What determines the demand for land?
1 – the price of the product grown on the land
2 – the productivity of the land
3 – the prices of the other resources which are
combined with land
Figure 29-1 show different demand options. If the
demand were D4, land rent would be zero. Land would
be a free good. This situation was approximated in the
free-land era of U.S. history
Economic Rent
Land Rent: A Surplus Payment
The perfectly inelastic supply of land must be contrasted with
the relatively elastic supply of capital, such as apartment
buildings, machinery, and warehouses.
In the long run, capital is not fixed in total supply. The supply
curves of these nonland resources are upsloping, meaning the
prices paid to such resources provide an incentive function. A
higher price provides an incentive to offer more of the
resource; a low price, an incentive to offer less.
This is not so with land. Rent serves no incentive function
because the total supply is fixed. This is why economists
consider rent a surplus payment not necessary to ensure that
land is available to the economy as a whole.
Economic Rent
A Single Tax on Land
Henry George’s Proposal
The single-tax movement gained much
support in the late 19th century.
This reform movement maintained that
economic rent could be taxed away without
impairing the available supply of land or,
therefore, the productive potential of the
economy as a whole.
Economic Rent
A Single Tax on Land
George observed the increasing demand for
a resource whose supply was perfectly
inelastic. Landlords were receiving
fabulously high incomes solely from
holding advantageously located land.
George believed these land rents should be
heavily taxed and the revenue spent for
public uses.
Economic Rent
Productivity Differences and Rent Difference
Different pieces of land vary greatly in productivity, depending
on soil fertility and such climatic factors as rainfall and
temperature.
Such productivity differences are reflected in resource demand
and prices.
Location may be equally important in explaining differences in
land rent.
Other things equal, rents will pay more for a unit of land which
is strategically located than for a unit of land whose location is
remote.
Example: the enormously high land rents of large metropolitan
areas and at the bases of major alpine ski areas.
Economic Rent
Alternative Uses of Land
We know that land has alternative uses. An acre of
farmland maybe useful in raising not only corn but
also wheat, oats, barley, and cattle; or it may be used
for a house, highway or factory
This tells us that a particular use of land involves an
opportunity cost – the forgone production from the
next best use of the resource.
Where there are alternative uses, individual firms must
pay rent to cover these opportunity costs if they are to
secure the use of land for their particular purpose
Interest
Interest is the price paid for the use of
money
Interest is stated as a percentage
Money is not a resource
Businesses “buy” the use of money
because it can be used to acquire capital
goods – factories, machinery, warehouse
Loanable Funds Theory of Interest
Explains the interest rate in terms of the
supply and demand for funds available for
lending (and borrowing).
Supply is an upward slope because
households will make available a larger
quantity of funds at high interest rates than
at low interest rates
Loanable Funds Theory of Interest
For people to delay consumption –
increase their saving – they must be
“bribed” or compensated by an interest
payment.
Most economists view saving as being
relatively insensitive to changes in the
interest rate. The supply curve of loanable
funds may therefore be more inelastic than
implied in figure 29-2
Loanable Funds Theory of Interest
Demand is a downward slope because at
higher interest rates fewer investment
projects will be profitable to businesses
and hence a smaller quantity of loanable
funds will be demanded
At lower interest rates, more investment
projects will be profitable and therefore
more loanable funds will be demanded
Extending the Model
Financial Institutions – Profit by charging
borrowers higher interest rates than the
interest rates they pay saver
Changes in Supply – anything which
causes households to be more thrifty will
prompt them to save more at each interest
rate, shifting the supply curve rightward
Extending the Model
Changes in Supply – conversely, a decline
in thriftiness would shift the supply-ofloanable-funds curve to the left
Changes in Demand – anything which
increases the rate of return on potential
investments will increase the demand for
loanable funds. This shift in the demand
curve to the right and thus increasing the
equilibrium interest rate
Extending the Model
Changes in Demand – anything which
reduces the rate of return on potential
investments would shift the demand curve
for loanable funds to the left, reducing the
equilibrium interest rate.
Other Participants – households can
participate on both the supply and demand
side of the loanable funds market
Extending the Model
Other Participants – Like households,
businesses operate on both the supply
and demand sides of the market.
Range of Interest Rates
See Table 29-1 on page 609. Here there
are several of the interest rates referred to.
The differences are based on the
following:
Risk
Maturity
Loan size
Taxability
Market Imperfections
Pure Rate of Interest
The pure rate is best approximated by the
interest paid on long-term, virtually riskless
securities such as long-term bonds of the
U.S. government (30-year Treasury
bonds).
Role of the Interest Rate
The interest rate is a critical price; it affects
both the level and the composition of
investment goods production, as well as
the amount of R&D spending
Interest and Total Output – A lower
equilibrium interest rate encourages more
borrowing by businesses for investment.
Total spending in the economy therefore
rises.
Role of the Interest Rate
Interest and Total Output – Conversely, a
higher equilibrium interest rate
discourages business borrowing for
investment, reducing investment and total
spending. Such a decrease in spending
may be desirable if an economy is
experiencing inflation
Role of the Interest Rate
Interest and the Allocation of Capital
Prices are rationing devices. The interest rate
is no exception; it rations the available supply
of loanable funds to investment projects whose
rate of return or expected profitability is
sufficiently high to allow payment of the going
interest rate.
Role of the Interest Rate
Interest and the Allocation of Capital
The interest rate allocates money, and
ultimately physical capital, to those industries in
which it will be most productive and therefore
most profitable. Such an allocation of capital
goods is in the interest of society as a whole.
Interest and the Level and Composition of
R&D Spending
The lower the interest rate – that is, the
less the cost of borrowing funds for R&D –
the greater the amount of R&D is the
greatest
The interest rate allocates R&D funds to
those firms and industries for which the
expected rate of return on R&D is the
greatest.
Nominal and Real Interest Rates
The nominal interest rate is the rate of
interest expressed in dollars of current
value.
The real interest rate is the rate of interest
expressed in purchasing power – dollars
of inflation-adjusted value.
Usury Laws
Usury laws specify a maximum interest
rate at which loans can be made. The
purpose is to hold down the interest cost
of borrowing, particularly for low-income
borrower.
If an usury law sets the rate below
equilibrium what will be the effect?
Usury Laws
1. Nonmarket rationing – quantity of
loanable funds demanded exceeds the
quantity supplied: there is a shortage.
Loans will be made to the most
creditworthy borrowers.
2. Gainers and losers – Creditworthy
borrowers gain and Lenders lose.
3. Inefficiency – usury laws may ration
funds to less-productive investments