Rent as return to fixed factors Unless you are planning to run your company from a balloon, land is an essential

factor of production for any business. The unusual feature of land is that its quantity is fixed and completely unresponsive to price. The price of using land or other inputs in fixed supply is called its rent (or pure economic rent) Economists apply the term rent not only to land but also to any factor that is fixed in supply Rent (or pure economic 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 that is, vertical because the supply of land is fixed. Suppose the land can be used only to grow corn. If the demand for corn rises, the demand curve for cornland will shift up and to the right, and rent will rise. This leads to an important point about land: The price of land is high because the price of corn is high. This is fine example of derived demand which signifies that the demand for the factor is derived from the demand for the product produced by the factor Because the supply of land is inelastic, land will always work whatever it can earn. Thus the value of the land derives entirely from the value of the product, and not vice versa

After taxing the land, the total demand for the land s services will not have changed. At a price (including tax) of $200 in slide 7, people will continue to demand the entire fixed supply of land. Hence, with land fixed in supply, the market rent on land services (including the tax) will be unchanged and must be at the original market equilibrium at point E. What will happen to the rent received by the landowners? Demand and quantity supplied are unchanged, so the market price will be unaffected by the tax. Therefore, the tax must have been completely paid out of the landowner s income

Landowners will surely complain. But under perfect competition there is nothing they can do about it, since they cannot alter the total supply and the land must work whatever it can get. Half a loaf is better than none You might at this point wonder about the effects of such a tax on economic efficiency. The striking result is that tax on rent will lead to no distortions (deformation) or economic inefficiencies. This surprising result comes because a tax on pure economic rent does not change anyone s economic behavior. Demanders are unaffected because their price is unchanged. The behavior of suppliers is unaffected because the supply of land is fixed and cannot react. Hence, the economy operates after the tax exactly as it did before the tax with no distortions or inefficiencies arising as a result of the land tax.

Economic analysis traditionally divides factors of production into three categories: land, labor, and capital. The first two of these are called primary or original factors of production, whose suppliers are determined largely outside of the marketplace. To them we add a produced factor of production, capital Capital (or capital goods) consists of those durable produced goods that are in turn used as productive inputs for further production.

Some capital goods might last a few years, while others might last for a century or more. But the essential property of a capital good is that it is both an input and an output There are three major categories of capital goods: structures (such as factories and homes), equipment (consumer durable goods like automobiles and producer durable equipment like machine tools and computers), and inventories of inputs and outputs (such as cars in dealers lots).

Capital goods are bought ad sold in capitalgoods markets. For example, Dell sells computers to businesses; these computers are used by firms to help improve the efficiency of their payroll systems or production management. When sales occur, we observe the prices of capital goods Payments for the temporary use of capital goods are called rentals

One of the most important tasks of any economy, business, or household is to allocate its capital across different possible investments. Should a country devote its investment resources to heavy manufacturing like steel or information technologies like the internet? In deciding upon the best investment, we need a measure that yield or return to capital. One important measure is the rate of return on capital, which denotes the net dollar return per year for every dollar of invested capital

You might be considering different investments: rental cars, oil wells, apartments, education, and so forth. Your financial advisers tell you that you do not have sufficient cash to invest in everything, so how can you decide which investments to make? One useful approach is to compare the rates of return on capital of the different investments. For each one, you first calculate the dollar cost of the capital good. Then estimate the net annual dollar receipts or rentals yielded by the asset. The ratio of the annual net rental to the dollar cost is the rate of return on capital: it tells you the amount of money you get back for every dollar invested, measured as dollars per year per dollar of investment

I buy a grape for $10 and sell it a year later as wine for $11. If there are no other expenses, the rate of return on investment is 10% per year. ($11 - $10)/$10 = 10% I plant a tree with labor cost of $100. At the end of 25 years the grown tree sells for $430. The rate of return on this capital project is then 330 percent per quarter-century, which a calculator will show, is equivalent to a return of 6% per year. That is, $100 x (1.06) to the power of 25 = 430

Tangible assets consist of land and capital goods like computers, buildings, and automobiles that are used to produce further goods and services Financial assets are monetary claims by one party against another party. An important example is a mortgage, which is a claim by a bank against a homeowner for monthly payments of interest and principal; these payments will repay the original loan that helped finance the house purchase (essentially pieces of paper)

When people save, they expect a return. This is the interest rate, or the financial return on funds, or the annual return on borrowed funds Households and other savers provide financial resources or funds to those who want to invest in tangible or intangible capital. The rate of interest represents the price that a borrower pays to a lender for the use of the money for a period of time; interest rates are quoted as a certain percent yield per year

The difference between real and nominal interest rates is particularly dramatic during periods of high inflation We call the real yield of funds the real interest rate, as opposed to the nominal interest rate, which is the dollar return on dollar invested. For low rates of interest and inflation, the real interest rate is very close to the nominal interest rate minus the rate of inflation The real interest rate is the return on funds in terms of goods and services; we generally calculate the real interest rate as the nominal interest rate minus the rate of inflation

Capital goods are durable assets that produce a stream (flow) of rental or receipts over time Suppose you become weary of tending the building and decide to sell it. To set a fair price for the building, you would need to determine the value today of the entire stream of future income. The value of that stream is called the present value of the capital asset The present value is the dollar value today of a stream of income over time. It is measured by calculating how much money invested today would be needed, at the going interest rate, to generate the asset s future stream of receipts

We present the first way of calculating present value by examining the case of perpetuity, which is an asset like land that lasts forever and pays $N each year from now to eternity V = $N/I Where V = present value of the land $N = perpetual annual receipts ($ per year) i = interest rate I decimal terms (e.g., 0.05, or 5/100 per year)

This says that if the interest rate is always 5 percent per year, an asset yielding a constant stream of income will sell for exactly 20 1 / (5/10) times its annual income. In this case, what would be the present value of a perpetuity yielding $100 every year? At a 5 percent interest rate its present value would be $ 2,000 ( = 100 / 0.05)

Having seen the simple case of the perpetuity, we move to the general case of the present value of an asset with an income stream that varies over time V = N1/(1+i) + N2/(1+i) to the power of two + Nt/(1+i) to the power of time For example, assume that the interest rate is 10 percent per year ad that I am to receive $ 1,100 ext year and $ 2,662 in 3 years. The present value of this stream is: V = 1,100/(1.10) + 2,662/(1.10) = 3,000

There is one rule that gives correct answers to all investment decisions. Calculate the present value resulting from each possible decision. Then always act so as to maximize present value. In this way you will have more wealth to spend whenever and however you like

The lower, rust area shows the present value of a machine giving net annual rentals of $100 for 20 years with an interest rate of 6 percent per year. The upper, gray area has been discounted away. Explain why raising the interest rate increases the gray area and therefore depresses the market price of an asset

In addition to wages, interest, ad rent, economies often talk about a fourth category of income called profits. What are profits? How do they differ from interest and the returns on capital more generally? Accountants define profits as the difference between total revenues and total costs To the economist, business profits are a hodgepodge (mixture) of different elements , including returns on owner s capital, reward for risk bearing, and innovational profits

Much of reported business profits is primarily the return to the owners of the firm for the capital and labor provided by the owners of the firm such as the doctor or lawyer who works in a small professional corporation. Part is the ret return on land owned by the firm. In large corporations, most profits are the opportunity costs invested capital. These returns are called implicit returns (or costs) which is the name given to the opportunity costs of factors owed by firms

Profits also include a reward for the riskiness of the investments. Most businesses must incur (earn) a risk of default, which occurs when a loan or investment cannot be paid, say when the borrower went bankrupt In addition, there are may insurable risks, such as those for fires or hurricanes, analyzed in Chapter 11, which can be covered through purchase of insurance

A third kind of risk is the uninsurable or systematic risk of investments. A company may have a high degree of sensitivity to business cycles, which means that its earnings fluctuate a great deal when aggregate output goes up or down. Yet a fourth category is sovereign risk, which occurs when a nation defaults on its obligations and (because the government is sovereign (ruler) and exercises ultimate legal authority) there is no recourse in the legal systems Because they contain elements of these four kinds of risk, corporate profits are the most volatile (unstable) component of national income. The rights to earn corporate profits corporate stocks or equities must therefore provide a significant premium (payment) to attract risk-averse investors.

A third kind of profits consists of the returns to innovation and invention. A growing economy is constantly producing new products from telephones in the nineteenth century to automobiles early in the twentieth century to the computerrelated goods ad services in the present era. These new products are the result of research, development, and marketing. We call the person who brings a new product or process to market a innovator or entrepreneur Every successful innovation creates a temporary pool of monopoly. We can identify innovational profits (sometimes called Schumpeterian profits) as the temporary excess return to investors or entrepreneurs

A modern industrial economy has accumulated large stocks of capital, or capital goods. These are the machines, buildings, and inventories that are so vital to an economy s productivity The annual dollar earnings on capital are called rental. When we divide the net earrings (rentals less costs) by the dollar value of the capital generating the rentals, we obtain the rate of return on capital (measured in percent per year) Capital is financed by savers who lend funds and hold financial assets. The dollar yield on these financial assets is the interest rate , measured in percent per year

Capital goods and financial assets generate a stream of income over time. This stream can be converted into a present value, that is, the value that the stream of income would be worth today. This conversion is made by asking what quantity of dollars today would be sufficient to generate the asset s stream of income at going market interest rates Profits are residual income item, equal to total revenues minus total costs. Profits contain elements of implicit returns (such as return on owner s capital), return for risk bearing, and innovational profits

Roundaboutness investment in capital goods involves indirect or roundabout production. Instead of catching fish with our hands, we find it ultimately more worthwhile first to build boats and nets to catch many more fish than we could by hand Put differently, investments in capital goods involves forgoing present consumption to increase future consumption. Consuming less today frees labor for making nets to catch many more fish tomorrow. In the most general sense, capital is productive because by forgoing consumption today we get more consumption in the future By sacrificing current consumption and building capital goods today, societies ca increase their consumption in the future

The graph shows two islands begin with equal endowments (natural quality or ability) of labor and natural resources. Lazy island A invests nothing and shows a modest growth in per capita consumption. Thrifty Island B devotes an initial period to investment, forgoing consumption, and then enjoys the harvest of much higher consumption in the future

Let s take the example of computers. The first computers were expensive and used intensively. Three decades ago, scientists would eke every last hour of time from an expensive mainframe computer that had less power than today s personal computer The marginal product of computer power the value of the last calculation or the last byte of storage had diminished greatly as computer inputs increased relative to labor, land, and other capital. More generally, as capital accumulates, diminishing returns set in ad the rate of return on the investments tends to fall

Short-run equilibrium The rate of return on capital exactly equals the market interest rate. Any higher interest rate would find firms unwilling to borrow for their investments; any lower interest rate would find firms clamoring (shouting) for the too scarce capital. Only at the equilibrium interest rate of 10 percent are supply and demand equilibrated Long-run equilibrium In the long-run equilibrium, the interest rate is at the level where the desired capital stock held by the firms matches the desired wealth that people want to own. At the long-run equilibrium, et savings stops, net capital accumulation is zero, and the capital stock is no longer growing

Taxes and inflation 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 (standard) of money. Another important feature is taxes. Part of our incomes goes to the government programs. Therefore, investors will want to focus on the postax return on investments Technological disturbances Historical studies show that inventions and discoveries raise the return on capital and thereby affect equilibrium interest rates. Indeed, the tendency toward falling interest rates via diminishing returns has been just about cancelled out by inventions and technological progress

Almost any loan or investment has an element of risk. Machines break down; a oil well may turn out to be a dry hole; you favorite internet company may go belly up. 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 to 20 percent. Investors must therefore receive an extra return, or risk premium, to induce (bring) them to hold investments with high systematic or uninsurable risk

Economists emphasize that a free market in capital and land will promote high rates of saving and investment, rapid economic growth, and healthy productivity growth. Three final thoughts a. Competitive factor markets promote efficiency. People s market incomes are determined by rents, interest, and wages. We may or may not like the competitive distribution of income, but we must recognize that competitive pricing helps solve the question of how goods are to be produced in an efficient manner

B. Capital markets balance saving and investment. When people look at profits, they usually think about the dollars that corporations are paying to management and stockholders. These perceptions overlook the basic point about the role of capital in a market economy. The accumulation of capital and its return are drive by two fundamental forces. On the one hand, the demand for capital results from the fact that indirect or roundabout production processes are productive; by abstaining from consumption today, society can raise consumption in the future. On the other hand, people must be willing to abstain from consumption in order to accumulate financial assets, lending funds to firms that will make the productive investments in roundabout productive processes.

C. Governments can reduce inequality without impairing (spoiling) efficiency. Finally, we must remember that incomes are not carved in granite. Factor prices are affected by government policies, and incomes can be modified by transfer payments. If society dislikes the inequality brought about by high land rents or fabulous wages of unique individuals, taxes on these factors can reduce inequality without inducing great inefficiencies. Well-designed taxes on high incomes and inheritances, efficient wage subsidies to low-wage workers, and transfer programs to help the truly needy ca reduce the worst inequalities of a market economy without impairing the ability of factor prices to guide markets to efficient allocations