INDUSTRIETECHNIK

SRI LANKA INSTITUTE of ADVANCED TECHNOLOGICAL

EDUCATION

Electrical and Electronic

Engineering
Instructor Manual

Training Unit

Economics 3
Theory

No: AS 054

Training Unit
Economics 3
Theoretical Part
No.: AS 054

Edition:

2009
All Rights Reserved

Editor:

MCE Industrietechnik Linz GmbH & Co

Education and Training Systems, DM-1
Lunzerstrasse 64 P.O.Box 36, A 4031 Linz / Austria
Tel. (+ 43 / 732) 6987 3475
Fax (+ 43 / 732) 6980 4271
Website: www.mcelinz.com

List of Content

CONTENTS
1

Labor, Land, and Capital ..............................................................................................4

1.1

Income and Wealth ..............................................................................................4

1.2

Income .................................................................................................................4

1.2.1

Wealth..................................................................................................................5

1.4

The Theory of Income Distribution .......................................................................6

1.4.1

The Nature of Factor Demands........................................................................6

1.4.2

Marginal Revenue Product...............................................................................9

Factor Demands for Profit-Maximizing Firms.................................................11

1.5.2

Marginal Revenue Product and the Demand for Factors...............................12

1.6.1

Determining Marginal Benefit by the Marginal Revenue Product ......................13

Factors shifting the Derived Demand for an Input..........................................15

1.7

The Supply of Factors of Production..................................................................16

1.8

Determination of Factor Prices by Supply and Demand ....................................19

1.9

Marginal-Productivity Theory with Various Inputs ..............................................19

Wages and Labor Markets .........................................................................................22

2.1

Workers Alike, Jobs Alike ..................................................................................22

2.2

Workers Alike, Jobs Different.............................................................................27

2.3

Other Models of Differences in Wages ..............................................................29

2.3.1

Human Capital ...............................................................................................29

2.3.2

Special Skills ..................................................................................................29

2.3.3

Non-competing Groups ..................................................................................30

2.3.4

Efficiency Wages............................................................................................30

2.4

Discrimination ....................................................................................................30

2.5

Summary of Competitive Wage Determination ..................................................31

2.6

Unions in Price-Taking Firms.............................................................................31

Land and Capital ........................................................................................................32

3.1
3.1.1

The Demand for Factors of Production ..............................................................10

1.5.1
1.6

Factor Incomes and Personal Incomes............................................................4

1.3

1.5

Page

Land and Rent ...................................................................................................32

Taxing Land ...................................................................................................34

Capital and Interest ....................................................................................................36

4.1
4.1.1

Basic Concepts ..................................................................................................36

Prices and Rentals on Capital Goods ............................................................36
2

4.1.2

Rate of Return on Capital Goods ...................................................................36

4.1.3

Financial Assets and Tangible Assets ...........................................................37

4.1.4

Financial Assets and Interest Rates...............................................................38

4.1.5

Real and Nominal Interest Rates ...................................................................38

4.2

Present Value of Assets.....................................................................................39

4.2.1

General Formula for Present Value ...............................................................39

4.2.2

Maximize Present Value ................................................................................41

4.3

Profits.................................................................................................................41

4.3.1

Reported Profit Statistics................................................................................41

4.3.2

Determinants of Profits...................................................................................41

4.4

The Theory of Capital and Interest ....................................................................42

4.4.1

Diminishing Returns and the Demand for Capital ..........................................42

4.4.2

Determination of Interest and the Return on Capital......................................42

4.4.3

Graphical Analysis of the Return on Capital ..................................................44

4.5

Applications of Classical Capital Theory ............................................................49

4.5.1

Taxes and Inflation.........................................................................................49

4.5.2

Uncertainty and Expectations ........................................................................49

4.5.3

Technological Disturbances ...........................................................................50

Labor, Land, and Capital

1.1

Income and Wealth

Questions about the distribution of income are among the most controversial in
economics. The time has come to understand the determination of factor prices along with
the forces that affect the distribution of income among the population. The majority of
opinion has been that incomes should be determined by the market rewards.

1.2

Income

In measuring the economic status of a nation or an individual, income and wealth are
used as a reference. By definition, income is the amount an individual can spend in a
period of time while leaving his capital unchanged.
Income refers to the flow of wages, dividends, interest payments, and other things of
value collected during a period of time. The sum of all incomes is the national income. The
biggest part of national income is from the labor, as wages, salaries etc. Other parts of
national income are property income, such as rent, cooperate profits, or net interests, and
proprietors income.

1.2.1

Factor Incomes and Personal Incomes

There is a difference between factor incomes and personal incomes. Factor incomes are
distributed between labor and property incomes. An individual can own different factors of
production, such as receiving salary, collecting rent from a real-estate investment etc. An
individuals market income is the quantity of factors of production sold by that individual
times the price of each factor. The income distribution in the United States for example
has not really changed since 1960, as seen on figure 1. The share of national income
mainly goes to labor.

Personal income equals market income plus transfer payments. Most of the market
income comes from wages and salaries.

(Figure 1)

The share of labor income increased during the 1960s. Since then, it has been stable at
between 70 and 75 percent of national income.

1.3

Wealth

Wealth consists of the net dollar value of assets owned at a given point in time. Wealth is
a stock while income is a flow per unit of time. A households wealth includes its tangible
items, such as houses, cars etc, and its financial holdings, such as cash, saving accounts,
bonds etc. Items that have a value are called assets. The ones that are owed are called
liabilities. The difference between total assets and total liabilities is called wealth or net
worth.

1.4

The Theory of Income Distribution

The distribution theory studies how incomes are determined in an economy. The
differences in incomes of different families are obvious. Economics help explain those
differences, such as greater incomes in America compared to other countries in the world,
or the different salaries between women and men etc.
The distribution theory is a special case of the theory of prices. Salaries are only the price
of labor; rents are similarly the price for using land. The prices of factors of production are
set by the interaction between supply and demand for different factors (just as the prices
of goods are determined by the supply and demand for goods).
By applying the production theory, we will see that the demands for factors of production
can be expressed in terms of the revenues earned on their marginal products. The
marginal productivity theory is the key to reveal what lies behind supply and demand. This
key finding on demand, and supply factors, will determine the prices and quantities of
factors and thereby market incomes.
The fundamental point is that the demands for the different factors of production, such as
input factors, are derived from the revenues that each factor yields on its marginal
product.

1.4.1

The Nature of Factor Demands

The demand for factors is different from consumption goods in two aspects:
-

Factor demands are derived demands

Factor demands are interdependent demands

1.4.1.1 Demands for Factors are Derived Demands

There is an essential difference between ordinary demands by consumers and the
demand by firms for inputs. Consumers demand final goods because of the direct utility
these consumption goods provide. Businesses, in contrast, do not pay for inputs, such as
office space, because they draw direct satisfaction. They rather purchase inputs because
of the production and revenue that it can gain from employment of those factors.
An accurate analysis of the demand for inputs must, therefore, recognize that consumer
demands determine business demands.
The firms demand for inputs is derived indirectly from the consumer demand for its final
product.
Economists, therefore, speak of the demand for productive factors as a derived demand.
This means, when firms demand an input, they do so because that input permits them to
produce a good which consumers desire now or in near future.
Figure 2 and 3 show how the demand for a given input, such as corn land, must be
regarded as being derived from the consumer demand curve for corn.
(Figure 2)

Commodity Demand

(Figure 3)

Derived Factor Demand

In these two figures, it is illustrated how the demand for factors is derived from demand for
goods they produce. The blue curve (figure 3) of derived demand for corn land comes
from the curve (figure2) of commodity demand for corn. The more inelastic the black
commodity curve becomes, the more inelastic the blue input demand curve becomes.

1.4.1.2 Demands for Factors are Independent

The productivity of one factor depends upon the amount of other factors available to work
with. For example, a hammer alone, without the labor, does not build a house.
It is impossible to determine the output by knowing the input taken alone. The different
input interacts with one another.
The distribution of income is a very complex topic because of this interdependence of
productivities of land, labor, and capital goods. Different factors of input contribute to the
resulting output. But to figure how much each and single input alone has contributed to
the resulting output, we must look to the interaction of marginal productivities, which affect
demand, and factor supplies. Both determine the competitive price and quantity.

1.4.2

Marginal Revenue Product

The marginal revenue product is a tool to measure productivity. If a firm wants to

maximize profits measured in dollars, it needs a concept that measures the additional
dollars each additional unit of input produces. The MRP is a name given to the money
value of the additional output generated by an extra unit of input.
The marginal revenue product of input A is the additional revenue produced by an
additional unit of input A.
It is easy to calculate the MPR when the product markets are perfectly competitive. In this
case, each unit of the workers marginal product (MPL) can be sold at the competitive
output price (P). In perfect competition the output price is unaffected by the firms output,
and price therefore equals the marginal revenue (MR).
Under perfect competition, each worker is worth to the firm the dollar value of the last
workers marginal product. This goes for each factor.
The individual firms demand curve is downward-sloping in the case of imperfect
competition. The marginal revenue received from each extra unit of output sold is less
than the price because the firm must lower its price on previous units in order to sell an
additional unit. Hence, each unit of marginal product will be worth MR < P to the firm.
The marginal revenue product represents the addition to total revenue when one
additional unit of an input (such as capital or labor) is employed.

1.4.2.1 How to calculate the Marginal Revenue Product

It is calculated as the marginal product of the input multiplied by the marginal revenue
obtained from selling an extra unit of output.
Formally we have:
Marginal revenue product of labor:

(MRPL) = MR x MPL
Marginal revenue product of land:

(MRPA) = MR x MPA
In perfect competition P = MR, and therefore:

(MRPi) = P x MPi

1.5

The Demand for Factors of Production

Profit-maximizing firms decide upon the optimal combination of inputs, which will allow
deriving the demand for inputs.

10

1.5.1

Factor Demands for Profit-Maximizing Firms

The demand for any factor of production can be determined by analyzing how a profitoriented firm chooses its optimal combination of inputs.
The optimal combinations of inputs:
To maximize profits, firms should add inputs up to the point where the marginal revenue
product of the input equals the price of the input.
The optimal combinations of inputs to maximize profits for a perfectly competitive firm are
achieved when the marginal product times the output price equals the price of the input:

Marginal product of labor x output price = price of labor

Marginal product of land x output price = price of land

Example:
Each kind of input is worth 1 $; packages of 1 $ worth of labor, land and so on. To
maximize profit, firms will buy inputs up to that point where each 1 $ dollar package
produces output which is also worth 1 $. Each 1 $ input package will produce MP units so
that the MP x P equals 1. The MRP of the 1 $ units is then exactly 1 $ under profit
maximization.

11

In general, this profit-maximization rule applies to perfect and imperfect competition in

product markets:
Marginal Product of Labor = Marginal Product of land =
Price of labor

Price of land

1
Marginal Revenue

Costs are minimized when the marginal product per dollar of input is equalized for each
input. This holds for perfect and imperfect competitors in product markets.

1.5.2

Marginal Revenue Product and the Demand for Factors

The relationship between the price of the input and the quantity demanded of that input is
called the demand curve. This relationship can be determined from the MRP schedule.
The MRP schedule for each input gives the demand schedule of the firm for that input.
The substitution rule states that if the prices of one factor rises while other factor prices
remain the same, a firm will profit from substituting more of the other inputs for the more
expensive factor. An increase in the price of labor, PL, will reduce MPL/PL. As a result to
this, firms will reduce employment and increase land use until equality of marginal
products per dollar of input is restored. This will lower the amount of needed labor and
increase the demand for land. An increase in the lands price, PA, will cause labor to be
substituted for more expensive land.

12

1.6

Determining Marginal Benefit by the Marginal Revenue Product

A perfectly competitive firm can increase output and still sell it at the same price.
Formally, we have

Marginal Revenue Product = Price x Marginal Physical Product

Or: MRP = Price x MPP
Example:
If P = 10 $ and a worker adds four units to total output, the worker adds 40 $ to the firms
total revenue. This is the workers MRP.
MPP is the marginal physical product of the input. It determines how much the added
input increases the total physical output.
The table below shows the MRP for a perfectly competitive firm whose price is 4 $. The
MPP schedule shows the diminishing marginal return.

Units of Input

Output

15

21

26

30

33

35

MPP

MRP = P x MPP

32 $

28 $

24 $

20 $

16 $

12 $

8$

The third input, for example, adds 6 units to the total output. Each unit sells for 4 $, so the
third unit adds 24 $ to the total revenue. Using marginal analysis, if the marginal factor
cost is 20 $, the firm will hire 5 units. As a consequence, the MRP schedule is the derived
demand curve for the input. Figure 4 shows the derived demand for labor when the price
equals 4 $.

13

(Figure 4)

Figure 4 shows the derived demand curve for a perfectly competitive firm. The derived
demand curve is negatively sloped because of the law of diminishing marginal returns.
Therefore, other inputs are being held constant when the firm calculates the marginal
worth of an added worker.

14

1.6.1

Factors shifting the Derived Demand for an Input

The table below shows how various factors change the demand for an input.

Factor

Shift in Factor

Shift in Derived Demand

1. Demand for output

Increase

Increase (to right)

(change in P and MR)

Decrease

Decrease (to left)

MPP Up

Increase

MPP Down

Decrease

Industry- wide

Up if elastic demand;

increase

down if inelastic

Price Up

Uncertain

Price Down

Uncertain

4. Price of complementary

Price Up

Decrease

input

Price Down

Increase

2. Change in productivity

3. Price of substitute input

15

1.7

The Supply of Factors of Production

The determination of factor prices and of incomes must combine the demand for inputs
and the supplies of different factors. The general principles of supply vary from input to
input.
Labor supply is determined by many economic but also non-economic factors. The
important determinants of labor supply are the price of labor, for example salaries, and
other factors, such as gender, age, education and so on.
The quantity of land and other natural resources is determined by geology. The quality of
land is affected by conservation, improvements etc.
The supply of capital depends on the past investments made by businesses,
governments, and households. In the long run, the supply of capital reacts to economic
factors such as risks, rates of return, and taxes.
The total supply of land is usually unaffected by price, and in this case the total supply of
land will be perfectly inelastic, with a vertical supply curve. In some cases, when the return
to the factor increases, owners my supply less of the factor to the market. The supply
curve for labor may bend backwards, when, for example, people work fewer hours
because of higher wages.
The different possible elasticities for the supply of factors are illustrated by the SS supply
curve shown in figure 5.

16

(Figure 5)

Figure 5 shows a supply curve for factors of production. Supplies of factors of production
depend upon characteristics of the factors and owners preferences. In the region below
A, it is shown how supplies respond positively to price.
For factors that are fixed in supply, such as land, the supply curve is perfectly inelastic, as
from A to B.
A higher price of the factor increases the income of its owner making the supply curve
bend backward as seen in the region above B.

17

(Figure 6)

Figure 6 shows how the factor supply and the derived demand interact to determine factor
prices and income distribution. Factor prices and quantities are determined by the
interaction of factor supply and demand.

18

1.8

Determination of Factor Prices by Supply and Demand

A full analysis of the distribution of income must combine the supply and demand for
factors of production. By adding together the individual demands of each of the firms, the
market demand for inputs (whether land, labor etc) can be obtained. Thus at a given price
of an input, all the demands for that input must be added together at that price. By adding
horizontally the demand curves for that input of all the individual firms, the market demand
curve for that input can be obtained. This procedure can be done for any input, summing
up all the derived demands of all the businesses to get the market demand for each input.
The derived demand for the input is based on the marginal revenue product of the input.
Figure 6 shows a general demand curve for a factor of production as the DD curve. It also
shows the equilibrium price of the input in a competitive market, which comes at a level
where the quantities supplied and demanded are equal. At point E the derived demand
curve for a factor intersects its supply curve. At this price (point E) will the amount that
owners of the factor supply just balance the amount that the buyers purchase.

1.9

Marginal-Productivity Theory with Various Inputs

The marginal-productivity theory is a tool to understand the pricing of different inputs. The
positions of land and labor could be reversed to get a complete theory of distribution. To
reverse the position of land and labor, we hold labor constant and add successive units of
variable land to fixed labor. Then we calculate each successive acres marginal product.
We then draw a demand curve showing how many acres labor owners will demand of
land at each rent rate.
In figure 7, E is the new point of equilibrium. Rent times the quantity of land equals the
lands rectangle of rent. The labors residual wage triangle can be identified.
By the complete symmetry of the factors, we can see how the distributive shares of each
and every factor of production are being simultaneously determined by their
interdependent marginal product.

19

(Figure 7)

This figure shows how the marginal product principles determine factor distribution of
income. Each vertical slice represents the marginal product of that unit of labor. The total
national output 0DES is determined by adding all vertical slices of MP up to the total
supply of labor at S.
The distribution of output is determined by marginal product principles. The lower
rectangle represents the total wages. The upper triangle NDE represents the land rents.

20

In competitive markets, the demand for inputs is determined by the marginal products of
factors.
Where factors are paid in terms of single output, we formally have:

Wage = Marginal Product of Labor

Rent = Marginal Product of Land

Among all the factors of production, this distributes one hundred percent of output.
The theory of distribution of income is compatible with the competitive pricing of any
amount of goods produced by and amount of factors. It shows how the distribution of
income is related to productivity in a competitive market economy.

21

Wages and Labor Markets

This chapter will answer questions such as why some workers of the same ability earn
different wages, or why a doctor earns more than a teacher etc.
We will examine two different scenarios in this chapter. First a scenario where all the
workers are alike with jobs exactly alike. And secondly, we will examine a scenario, where
all the workers are also alike but with different jobs.

2.1

Workers Alike, Jobs Alike

In this scenario assumptions are that

all workers are equally skilled.
all jobs are exactly alike in terms of amenities, benefits etc.
competition exists among employers and workers.
workers are well informed about what other jobs pay.
workers can change jobs easily and the employers can replace their workers easily.
The results are that
the wage level will be set so the labor market clears.
all firms pay the same wage.
Figure 8 shows the demand and supply for workers in a given labor market. The
equilibrium wage is 8 $, where the demand for workers (70 jobs) equals the supply (70
workers).

22

(Figure 8)

If wages are too low, there will be a shortage of workers. For example, at a wage of 6 $
there is a shortage of 20 workers making employers, who cannot get enough workers, bid
up wages.
If wages are too high, there will be a surplus of workers. For example, at a wage of 10 $
there is a surplus of 20 workers making this surplus of workers bid down wages.
If one firm, for example, pays a wage below the market, all its workers will resign and no
others will apply. The firm must then either raise its wage or go out of business.
If one firm, for example, pays a wage above the market, it will have a surplus of workers.
This surplus is a sign for employers that the firm pays too much. This firm can be put out
of business by under-pricing it in the output market. The firm must lower its wage.

23

If all workers are equally skilled, employers value all workers the same and pay each the
same wage. All jobs are non-monetary aspects, which mean that workers accept the job
that pays the highest wage. If workers demand wages that exceed the market level, they
can easily be replaced.
Implications:
-

A firm can determine how its wages compare to what other firms are paying by
simply regarding its resignation rate and application rate. The firm is paying too
little when the resignation rates are high and the application rates are low.

Wages for workers are forced down by competition among the workers.
Competition among the employers forces wages up. This is an example of the
invisible hand. It moves people by self-interest to outcomes that are actually in
the economys interest.

Any factor that increases the demand for workers will increase wages:

Wage = Price of Output x Marginal Physical Product

Any factor that increases demand for output and thus its price or MPP will increase
labor demand and thus wages. Wages will be higher when:
1. The nation has more capital per worker
2. The nation has abundant natural resources. When workers in one industry
become more productive because of more capital, for example, other
industries benefit from it. As the industry expands, it will draw workers from
other areas of the economy, making wages elsewhere rise. Workers benefit
from the higher productivity and wages of others.
3. The nation has better technology, know-how, and better managerial skills.

24

Any factor that decreases the supply of workers will increase wages. Wars, for
example, reduces a nations population, but may leave the capital, land and
technical know-how intact. It affects the supply of labor. Other factors that affect
the supply of labor are population, the labor-force participation rate (fraction of the
population that wants to work and is working), and the hours of work per worker.

An increase in the real wages has two effects:

1. The Substitution Effect

The time of workers is divided in work and leisure. Work is any activity for which the
worker gets paid and leisure time includes the remaining hours for which the worker does
not get paid. A higher real wage increases the reward for working and thereby increases
the opportunity cost of leisure time. This higher relative cost of work time will cause
workers to substitute some leisure time in order to work longer hours.

2. The Income Effect

Leisure is a normal good. So, when income increases, people usually want to have more
leisure time and work less.
Figure 9 illustrates these two effects.

25

(Figure 9)

Figure 9 shows the backward-bending supply curve of labor for a worker. In this figure, the
worker works only if wages exceed 4 $. From 4 $ to 8 $ the substitution effect dominates
the income effect as higher wages elicit more hours of work. For 8 $ to 10 $ the two
effects offsets each-other. In this range of wage, the supply of hours for this worker is
perfectly inelastic. From 10 $ up, the income effect dominates the substitution effect as
higher wages result in fewer work hours.

26

2.2

Workers Alike, Jobs Different

In this scenario assumptions are that

...all workers are equally skilled.
jobs are different in their working conditions.
competition exists among employers and workers.
workers are well informed about what other jobs pay.
workers place the same value on amenities and disagreeable working conditions.
Jobs differ in their working condition. This means that workers compare not only wages
but working conditions as well. Some jobs are pleasant and some are better paid etc.
The results are that
the full wage of all jobs will be equal. The wages vary to compensate workers for nonmonetary differences between jobs.

27

Full wages are the full monetary value that workers place on working in a given job. Any
job whose full wage is too high will have a surplus of job applicants. Any job whose full
wage is too low will have a shortage of workers. The labor market will only be in
equilibrium when all jobs pay the same full wage.
The compensating wage differentials compensate workers for differences in working
conditions. Those jobs with disagreeable aspects will have to pay higher wage. Those
jobs with positive non-monetary aspects will be able to pay a lower wage.
Implications:
-

An incentive for employers to provide better working conditions is that employers

have to pay lower wages if the working conditions are better. They will do that as
long as the dollar savings from lower wages will cover the employers cost of
providing better working conditions.

An economic rent is any payment in excess of opportunity cost. Its the excess in full
wages over what the worker can get elsewhere. In both scenarios, all the jobs paid the
same full wage in equilibrium so that no worker received any economic rent.

28

2.3

Other Models of Differences in Wages

In the two scenarios from before, workers were equally skilled and they were considered
replaceable by their employers.

2.3.1

Human Capital

Human capital is the set of skills that a worker acquires through schooling and experience
that improve the workers productivity and income. It may be acquired through explicit
training, or on-the-job experience. Like physical capital, it is liable to obsolescence
through changes in technology or tastes. In the long run, the costs for extra schooling or
training will be compensated by higher wages.

2.3.2

Special Skills

Some workers often have unique skills that make them special, such as actors,
professional athletes, top managers etc. They earn salaries far more than what they could
earn elsewhere. Their high salaries are mostly economic rents. For example, a unique
skilled worker earns 500,000 $ a year who elsewhere would have earned 60,000 $ a year,
as a salesperson for example, earning an economic rent of 440,000 $.

29

2.3.3

Non-competing Groups

Non-competing groups are groups of workers with certain skills and attributes who earn
economic rents and are high in demand.

2.3.4

Efficiency Wages

In efficiency-wage models, paying a higher wage itself makes workers more efficient. In
this model, the firm can only sporadically monitor what workers are producing. To keep
productivity up, firms have to motivate workers not to shirk on their jobs. One way to do
this is, if the firm pays higher wages than what workers can get elsewhere. Another way is
to unexpectedly monitor workers if they shirk on their jobs.

2.4

Discrimination

Discrimination occurs when workers with the same ability as others are denied well-paid
jobs or receive less pay because of their gender, race or other characteristics not related
to productivity. In common usage it means simply treating unfairly. Discrimination occurs
in forms of informal, pre-market, criminal-justice, and statistical discrimination.

30

2.5

Summary of Competitive Wage Determination

The table of the market wage structure below shows a great variety of patterns under
competition.

Labor Situation

Wage Result

Workers alike, jobs alike

No wage differentials

Workers alike, jobs different

Compensating wage differentials

Workers different, but each type of job is in

unchangeable supply (non-competing
groups)

Wage differentials that reflect supply and

demand for segment markets

Workers different, but there is some

General-equilibrium pattern of wage

mobility among groups (partially competing

differentials as determined by general

groups)

demand and supply

2.6

Unions in Price-Taking Firms

A union has a monopoly on the supply of labor to the firms it has organized. If the union
wants the most member

31

Land and Capital

Land, capital and assets are mostly privately owned. Under capitalism, individuals and
private firms do most of the saving, own most of the wealth and get most of the profits on
investments. The ability to generate large flows of savings and invest in high-return capital
makes the difference between a rich and a poor country.

3.1

Land and Rent

Rent as Return to Fixed Factors:

Land is an important and essential factor of production for any business. The quantity of
land is fixed and unresponsive to price. The price of using a piece of land for a period of
time is called its rent (or economic rent). The rent is calculated as dollars per unit of time.
The notion of paying rent applies not only to land but to any factor that is fixed in supply.
Rent is the payment for the use of factors of production that are fixed in supply.
Market Equilibrium:
The supply curve for land is completely inelastic. It is vertical because the supply of the
land is fixed as seen in figure 10. The demand and supply curves intersect at the
equilibrium point E. Towards this factor price the rent of land must tend. If rent were above
the equilibrium, the amount of land demanded by all firms would be less than the fixed
supply. Only at a competitive price where the total amount of land demanded equals the
fixed supply will the market be in equilibrium.
The value of the land derives entirely from the value of the product and not the other way
around.

32

(Figure 10)

Figure 10 shows the perfectly inelastic supply curve. It characterizes the case of rent. To
determine rent we need to run up the supply curve to the factor demand curve. Aside from
land, this rent considerations applies to anything else in fixed supply.

33

3.1.1

Taxing Land

The fact that the supply of land is fixed has a very important consequence. In figure 11 we
assume that the government introduces a 50 percent tax on all land rents. All that is being
taxed is the rent on the fixed supply of agricultural and urban land sites.
In figure 11, at a price of 200 $, including tax, people will continue to demand the entire
fixed supply of land. With fixed land in supply, the market rent on land services will be
unchanged and must be at the market equilibrium at point E.
The rent received by the landowner:
Demand and quantity supplied are unchanged. The market price will be unaffected by the
tax. The tax must have been completely paid out of the landowners income.
In figure 11 this situation is illustrated. Once the government takes 50 percent share, the
effect is just the same as would be if the net demand to the owners had shifted from DD to
DD. Landowners equilibrium return after taxes is now only E (half as E).
All of the tax has been shifted backward onto the owners of the factor in perfectly inelastic
supply.
Tax on pure economic rent does not change anyones economic behavior. Demanders
are unaffected because their price is unchanged. The behavior of suppliers is unaffected
because the supply of land is fixed and can not react. A tax on pure rent will lead to no
distortions or inefficiencies.

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(Figure 11)

Figure 11 shows how tax on fixed land is shifted back to landowners with government tax
on pure economic rent. A tax on fixed land leaves prices paid by users unchanged at E
but reduces rent retained by landowners to E.

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Capital and Interest

4.1

Basic Concepts

Factors of production are commonly provided into three categories: land, labor, and
capital. Capital is also known as the produced factor of production.
Capital, or capital goods, consists of those durable produced goods. They are used as
productive inputs for further production. Capital goods are input and output.
There are three categories of capital goods: structures, inventories of inputs and outputs.

4.1.1

Prices and Rentals on Capital Goods

Capital goods are bought and sold in capital-goods markets. When sales occur, we
observe the prices of capital goods. Most capital goods are owned by the firm that uses
them. Some capital goods are rented out by their owners. These payments for the rental
of capital goods are called rentals. We distinguish rent on fixed factors (land) from rentals
on durable factors (capital).

4.1.2

Rate of Return on Capital Goods

In deciding upon the best investment, we need a measure for that return on capital. One
important measure is the rate of return on capital. It denotes the next dollar return per year
for every dollar of invested capital.
Example:
A car company buys a car for 15,000 $ and rents it out for 4000 $ a year to a private
consumer. After considering all payments, such as maintenance, insurance, etc, the car
company earns a net rental of 2200 $ a year. In this case, the rate of return is 14,6 % a
year (= 2200 $ / 15,000 $ x 100). The rate of return is a pure number per unit of time.

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4.1.3

Financial Assets and Tangible Assets

A balance sheet contains a mixture of financial assets and tangible assets.

Financial Assets:
Financial assets are claims, as distinct from physical assets such as land, buildings or
equipment. Financial assets include money, securities giving a claim to receive money,
and shares giving indirect ownership of the physical and financial assets of companies.
The claims held as financial assets include the obligations of individuals, companies and
governments.
Tangible Assets:
Tangible assets consist of land and capital goods. They include only physical objects like
plant and equipment, but it is usually also used to include leases and company shares, as
these are mainly titles to tangible assets.

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4.1.4

Financial Assets and Interest Rates

Interest rates are also known as financial return on funds or the annual return on
borrowed funds. It is the yield you get when you deposit money in a bank. There are
many varieties of interest rates, such as long-term and short-term interest rates,
depending on the duration of the loan or the bond; the fixed-interest-rates loans and
variable-interest-rates loans and so on.
The rate of interest represents the price that a borrower pays to a lender for the use of the
money for a certain period of time. They are quoted as a certain percent yield per year.

4.1.5

Real and Nominal Interest Rates

The real yield on funds is called the real interest rates, as opposed to the nominal interest
rates, which is the dollar return on dollars invested.
The real interest rate is the return on funds in terms of goods and services. The real
interest rate is calculated as the nominal interest rate minus the rate of inflation.
If the nominal interest rate is i and the rate of inflation is p, the real rate of interest of r is
given by (1+r)=(1+i) / (1+p). For low interest and inflation rates, the
approximation r = ip is fairly accurate.

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4.2

Present Value of Assets

Capital goods are durable assets. They produce a stream of rentals over time.
The present value is the dollar value today of a stream of income over time. It is measured
by calculating how much money invested would be needed to generate the assets future
stream of rentals.

4.2.1

General Formula for Present Value

The income stream of the present value of an asset varies over time. Future payments are
worth less than current payments and therefore they are discounted relative to the
present. The interest rate produces a similar shrinking of time perspective.
Formally, we have:
N1
V=
(1+i)

N2

Nt

(1+i)

(1+t)

In this equation, i is the market interest rate (held constant). N1 is the net rentals (receipts)
in period 1. N2 is the net rentals (receipts) in period 2. Nt is the net rental in period t. The
stream of payments will have the present value V given by the formula.

39

Figure 12 shows the graphical calculation of the present value for a machine that earns a
net rental of 100 $ per year over a 20 year period of time. Its present value is not 2000 $
but 1157 $. The dollar earning has discounted because of the time perspective. The total
area remaining after discounting (blue shaded area) represents the machines total
present value.

(Figure 12)

The blue area shows the present value of a machine giving net annual rentals of 100 $ for
20 years with an interest rate of 6 % a year. The upper area has been discounted away.

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4.2.2

Maximize Present Value

The present value should always be maximized in order to have more wealth.

4.3

Profits

Profits are in addition to wages, interest, and rent another category of income.

4.3.1

Reported Profit Statistics

In accounting profits are defined as the difference between total revenues and total costs.
Total revenues from sales minus all expenses, such as wages, rents, materials, interests,
etc, equals profits.

4.3.2

Determinants of Profits

Profits are in a combination of different elements, including the reward for risk bearing,
innovational profits, and the implicit returns on owners capital. This is what determines
the corporate profits in a market economy.

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4.4

The Theory of Capital and Interest

This chapter is about the classical theory of demand.

4.4.1

Diminishing Returns and the Demand for Capital

The law of diminishing returns would set in when a nation sacrifices more of its
consumption for capital accumulation and production becomes more and more indirect.
Example:
Computers decades ago were expensive. As computer technology innovates the marginal
product of computer power (value of the last calculation) had diminished greatly as
computer inputs increased relative to labor, land, and other capital. As capital
accumulates, diminishing returns set in and the rate of return on the investments tend to
fall.

4.4.2

Determination of Interest and the Return on Capital

The classical theory of capital can be used to understand the determination of the rate of
interest. Households supply funds for investments by abstaining from consumption and
accumulating saving over time. Businesses demand capital goods to combine with labor,
land, and other inputs. In the end, a firms demand for capital is driven by its desire to
make profits by producing goods.

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In a closed economy with perfect competition and without risk or inflation, deciding
whether to invest, a profit-maximizing firm will always compare its cost of borrowing funds
with the rate of return on capital. If the rate of return is higher than the market interest rate
at which the firm can borrow funds, it will invest. If the interest rate is higher than the rate
of return on investment, the firm will not invest.
Eventually firms will invest there where the rates of return is higher than the market
interest rate. Equilibrium is then reached when the amount of investment that firms are
willing to undertake at a given interest rate equals the saving which that interest rate calls
forth.
In a competitive economy without inflation, the competitive rate of return on capital would
be equal to the market interest rate.
The market interest rate serves two functions:
-

The market interest rate rations out societys scarce supply of capital goods for the
uses that have the highest rates of return.

The market interest rate induces people to sacrifice current consumption in order
to increase the stock of capital.

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4.4.3

Graphical Analysis of the Return on Capital

The capital theory can be illustrated by concentrating on a case in which all capital goods
are alike. Figure 13 shows the short-run determination of interest and returns. DD shows
the demand curve for the stock of capital. It plots the relationship between the quantity of
capital demanded and the rate of return on capital.
The demand for a factor like capital is a derived demand. This means that the demand
comes from the marginal product of capital. It is the extra output yielded by additions to
the capital stock.
The law of diminishing returns is illustrated by the downward-sloping of the demand for
capital curve in figure 13. A project has a very high rate of return when the capital is a
scarce.
Short-Run Equilibrium:
In Figure 13, past investments have produced a given stock of capital, shown as the
vertical short-run supply curve SS. Firms will demand capital goods in a manner shown by
the downward-sloping demand curve, DD. At the intersection of supply and demand, at
point E, the amount of capital is just rationed out to the demanding firms.
At this short-run equilibrium, firms are willing to pay-10 percent a year to borrow funds to
buy capital goods. At that point the lenders of funds are satisfied to receive exactly 10
percent a year on their supplies of capital.

44

(Figure 13)

In the short run, the economy has inherited a given stock of capital from the past, shown
as the vertical SS supply-of-capital schedule. Intersection of the short-run supply curve
with the demand-for-capital schedule determines the short-run return on capital and the
short-run real interest rate, at 10 percent per year.
The rate of return on capital exactly equals the market interest rate. Any higher interest
rate would find firms unwilling to borrow for their investment; any lower-interest would find
firms clamoring for the too scarce capital. Only at the equilibrium interest rate of 10
percent are supply and demand equilibrated.

45

But the equilibrium at E is sustained only for the short run:

At this interest rate, people desire to accumulate more wealth, for example to continue
saving. This means that the capital stock increases. However, because of the law of
diminishing returns, the rate of return and the interest rate move downward. As capital
increases, while other things such as labor, land, and technical knowledge remain
unchanged, the rate of return on the increased stock of capital goods falls to ever-lower
levels.
This process is shown graphically in Figure 14. Note that capital formation is taking place
at point E. So each year, the capital stock is a little higher as net investment occurs. As
time passes, the community moves slowly down the DD curve as shown by the black
arrows in Figure 14. You can actually see a series of very thin short-run supply-of-capital
curves in the figure S, S, S", S etc. These curves show how the short-run supply of
capital increases with capital accumulation.

46

(Figure 14)

In the long run, society accumulates capital, so the supply curve is no longer vertical. The
supply of capital is responsive to higher interest rates.
Long run equilibrium comes at E. At this point the net savings ceases.

47

Long-Run Equilibrium:
The eventual equilibrium is shown at point E in Figure 14; this is where the long-run
supply of capital (shown as SLSL) intersects with the demand for capital. In long-run
equilibrium, the interest rate is at that level where the desired capital stock held by firms
just matches the desired wealth that people want to own.
At the long-run equilibrium, net saving stops, net capital accumulation is zero, and the
capital stock is no longer growing.
The long-run equilibrium stock of capital comes at that real interest rate where the value of
assets that people want to hold exactly matches the amount of capital that firms want for
production.

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4.5

Applications of Classical Capital Theory

Capital theory needs amplifications and qualifications to account for important realistic
features of economic life.

4.5.1

Taxes and Inflation

Investors always keep a sharp eye out for inflation and taxes. Recall that inflation tends to
reduce the quantity of goods you can buy with your dollars. Therefore, we want to
calculate the real interest rate or the real return to our investments, removing the effect of
the changing yardstick of money. Another important feature is taxes. Part of our incomes
goes to the government to pay for public goods and other government programs.
Therefore, investors will want to focus on the post tax return on investments.

4.5.2

Uncertainty and Expectations

The final qualification concerns the risks that exist in investment decisions: In real life no
one has a crystal ball to read the future. All investments, resting as they do on estimates
of future earnings, must necessarily involve guesses about future costs and pay-offs. In
fact almost any loan or investment has an element of risk. Investments differ in their
degree of risk, but no investment is completely risk-free.
Investors are generally averse to holding risky assets. They would rather hold an asset
that is sure to yield them 10 percent than an asset that is equally likely to yield 0 or 20
percent. Investors must therefore receive an extra return, or risk premium, to induce them
to hold investments with high systematic or uninsurable risk.

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4.5.3

Technological Disturbances

A deeper complexity involves technological change. Historical studies show that

inventions and discoveries raise the return on capital and thereby affect the equilibrium
interest rates. The tendency towards falling interest rates via diminishing returns has been
just about canceled out by inventions and technological progress.

50

AS 054

Economics 3
Theoretical Test

51

Economics 3
TEST
1. What is the exact definition of income in reference to an individual?
2. What is the difference between consumer demands and demands by firms and
businesses?
3. What does the marginal revenue product measure?
4. How is the demand for inputs determined in competitive markets?
5. In a labor situation where workers and jobs are alike, what happens when wages
are too high?
6. Explain the substitution effect.
7. In which three categories are factors of production commonly provided?
8. What are tangible assets?
9. What is the present value of an asset?
10. When would the law of diminishing returns set in?

52

Economics 3
TEST
(Solutions)

1. Income is the amount an individual can spend in a period of time while leaving his
capital unchanged.
2. Consumer demands provide direct utility whereas demand from firms and
businesses draw direct satisfaction without having to pay for inputs such as office
space.
3. It measures the productivity.
4. It is determined by the marginal products of factors.
5. In this scenario, there will be a surplus of workers.
6. It occurs when workers substitute their free time for longer working hours. The
resulting higher real wage increases the opportunity cost of leisure time.
7. They are provided into land, labor, and capital.
8. They consist of land and capital goods and include only physical objects such as
equipments.
9. It is the dollar value today of a stream of income over time.
10. It would set in when a nation sacrifices more of its consumption for capital
accumulation and production becomes more and more indirect.

53