MIC ECON Lec 10 – Rent, Interest and Profits

CHAPTER 10:

RENT, INTEREST AND PROFITS

LEARNING OBJECTIVE The purpose of this topic is to apply the principles of resource pricing to rent, interest and profit. For rent, the concept of economic surplus is shown to have lead some to recommend a single tax on rent. Interest differentials are explained by its determinants. Profits are shown to play an important role in permitting economic change.

RENT Economic rent is a payment exclusively for the use of land. Difficulties in measurement and analysis result from the fact that the use of land is enhanced by improvements (such as a building) and payment for these improvements is made an integral part of rent.

 It is difficult to visualize that the rent paid for an apartment has anything to do with land: it covers so many different expenses such as maintenance, repairs and interest on a mortgage. Very little seems to go for the ownership of land itself. These expenses should not be part of rent in an economist point of view.

RENT DETERMINANTS Rent is entirely determined by the alternative uses which can be made of land. Such determination is therefore void of cost consideration. Indeed, land is a free gift of nature and is costless. Any subsequent payment is rent, but the original cost of land is zero. The fact that demand is the only determinant of rent can also be observed graphically by noting that the supply of land is fixed and therefore vertical.

 A parcel of land on Manhattan fetches a very high price. That price, as well as all successive selling prices for a parcel of land come from the potential rent the owner could earn. Indeed, a land value is often calculated as the present value of future possible rent payments. But the initial owner of the land (the Indian tribe) did not have to pay anything, just take possession.

ECONOMIC SURPLUS An economic surplus is a payment made or received only because a market exists and not through any action of the individual. Thus, a land owner may receive a high rent because his/her land is in high demand without having done anything him/herself or having incurred any cost. Such payment, and rent in general, is considered an economic surplus.

 Two individuals purchased houses for the same price 10 years ago, one in Texas, the other in Massachusetts. New England homes have doubled (or more) because a local booming economy. The Texas homes have not fared as well. The home owner of the Massachusetts house has derived a windfall gain from the increase in price: that is a surplus.

ECONOMIC RENT Since rent is a surplus (or windfall gain), by extension, economists call all payments where an economic surplus is present, economic rent. Note that economic rent differs from economic profit, in that no risk is being taken by the owner, which is not true in the case of profit.

 The windfall gain of the Massachusetts home owner can be combined with the notion that the initial owner of the land had no cost. Then, the entire price increase is surplus, and that is what economist call economic rent.

SINGLE TAX ON LAND Because rent is a surplus (or windfall gain), proposals to tax rent have been often made but only partially implemented in the present real property tax. Henry George lead a movement to change taxation in the United States to a single tax on land.

SINGLE TAX ON LAND In addition to the argument that rent is a surplus, a tax on land is seen as – equitable because the increase in value of land is most often attributable to government expenditure (such as roads), and – efficient because the allocation of resources would not change as a result of tax on land (which is not true of any other tax).

SINGLE TAX ON LAND Major difficulties exist in implementing a single tax on land or even most real property taxes. The criticism is tied to difficulties to separate pure rent from payment for improvements and payment for other resources, which are made part of rent. Real estate taxes have been, in part, blamed for urban decay.

 Real estate taxes are based on the market value of a property. The market value of the property depends a great deal on the improvements and construction on the property and on neighboring properties. The land component cannot be separated from the other components. That is a major difficulty of real estate taxes.

INTEREST Interest is a payment for the immediate use of a sum of money. But since money is not itself productive, the payment is made in effect for the capital (or means of production) which can be acquired with it.

 If is obviously unwise to borrow if one is unable to pay back. Borrowers usually expect income streams. Businesses expect revenues from sales generated from the machinery, plants and equipment (i.e. investment) purchased with a loan. Interest is the payment for the ability to have this investment.

REAL INTEREST The interest paid for a sum of money compensates the lender for the non-use of that sum of money, as well as for the loss of purchasing power of the sum of money. Interest adjusted for that loss of purchasing power (or inflation) is known as real interest. All investment decisions are made on the basis of real interest rates, not nominal interest rates.

 Since the episode of high inflation in the early 1980’s, variable or indexed rates have become common. The interest rate is tied to some indicator of inflation. As inflation goes up, so does the interest rate. That implies that a component of interest is due to inflation and another does not change; that second component is real interest.

PURE RATE OF INTEREST Real interest rates include a payment for the risk present in lending to a specific borrower. The interest rate from which all risk is taken out is referred to as the pure rate of interest. Government securities are generally considered as having very low level of risk.

 Real interest is void of inflation, but is varies with the risk present in a particular borrower. If the risk premium is also excluded, what is left is called the pure rate of interest. It is only paid for the non use of what the sum of money could buy at a given point in time.

INTEREST RATE DETERMINANTS Demand and supply of money determine interest rates. Supply of money is controlled by monetary policy. Demand for money results from transaction demand and asset demand for money (further subdivided in precautionary and speculative demands). Other elements which may affect the interest charged and result in a wide range of values, are: risk level, length of maturity, administrative costs, market imperfections, and inflation rate.

 Usually, interest rates are higher on longer maturities because lenders are asked to accept more uncertainty about the future, and not to have access to their money. Occasionally the relationship is not observed; in particular when changes in inflation rates are expected.

INTEREST ECONOMIC EFFECT Interest affects the level of economic activity since it influences consumer purchases and investment decisions. For investment decisions, interest plays a key function in assuring that capital will go where it is most needed.

 In socialist countries, allocation of funds is not relying on the market mechanism of interest rates. As a result, consumer items, which would in other countries generate large revenues, are not given the priority over other desirable production.

ECONOMIC PROFIT Economic or pure profit is the excess of revenues over all explicit and implicit cost (including normal profit, that is the opportunity of the owner of the business to derive income from some other activity).

 Economic profit is also viewed as the long term change of income streams (or wealth). What the concept focuses on is the uncertainty of future values.

ECONOMIC PROFIT DETERMINANTS Economic profit stem from – uncertainty about economic conditions, tastes of consumers, and other forms of uninsurable risk,

– innovations, inventions, and other entrepreneurial decisions, – monopoly power of the firm.

 Each year, close to half a million businesses are formed. The majority will fail in the first few years. This shows that business owners take on risk. If it is desirable to have businesses which can produce the items society needs, then it is necessary for business owners to be given the incentive of a profit to start and own a business.

PROFITS ECONOMIC EFFECT Economic profit would not exist in a riskless and stable economy. Profits are necessary for technological and economic progress. Without profits risk would not be assumed: new products would not be offered to society.

 Tastes of society change. High definition television is now being demanded. To assure that the productive structure of the society keeps adjusting to the needs and tastes of society, the reward of a profit has to be present.

INCOME SHARES The shares of the various resources in national income have been relatively stable over the past century: about 80% has been derived in salaries and proprietor’s income, the remaining 20% going to property income. The decrease of proprietor’s income reflects the decrease in farms, small stores and artisanal businesses.

 In light of the significant changes in our society (e.g. family composition, urbanization), it is almost surprising that the income shares of the different forms of income have been quite stable over times. Only small variations in rent, interest and profit are noticeable in the 20% of total income to which these three income sources have summed to over the past century.

GENERAL EQUILIBRIUM A general equilibrium exists if all markets (goods, services and resources) are in equilibrium. If conditions of efficiency are also met (allocative, productive, maximum consumer satisfaction), Pareto optimality is achieved.

 If just one market is out of equilibrium, for instance there are too many automobiles produced, then, that implies that all markets are also out of equilibrium, for instance there are too many workers in the automobile industry. All markets will tend to a simultaneous equilibrium.

INPUT-OUTPUT TABLES Input-output tables are a major application of the concept of general equilibrium. The tables are constructed to show all the flows from each sector of the economy to all others. The tables are useful for forecasting and they are essential for national income accounting.

 A timely calculation of the GNP of the United States would not be possible without input-output tables: it is just not possible to add the production of every single firm in the country every year. What is done instead is to establish relationships between different sectors, and use these relationships to determine quickly the activity of numerous sectors on the basis of key sectors, such as steel output.

 

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