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Preceding chapters have outlined how input prices are determined, with special emphasis on the wages paid to
labor. It is now time to extend the analysis to include the determination of the economic rents and the return to
capital.
Economic rent, strictly interpreted, is the return paid to an input which is available in fixed supply and
which has only one possible occupation. Economic rent is, as a result, perhaps the simplest input price to
analyze because it emerges immediately from markets characterized by perfectly inelastic supply. Rents are,
nonetheless, critical to the accurate calculation of the economic and social costs of production. They also
provide a convenient benchmark against which to measure the relative (in)efficiency of various taxation
schemes.
Market determination of the return to capital is, by way of contrast, an extremely complicated process. The
return to capital depends upon many factors, economic and psychological, that lie well beyond the
straightforward intersection of a derived demand curve and a simple supply curve. It depends upon the
willingness of people to forgo present consumption to finance increased consumption in the future. It depends
upon the uncertainties inherent in forecasting the future, and the aversion of people to the risks that those
uncertainties create. It even depends upon policies enacted on a macroeconomic and sometimes international
level. For present purposes, however, only the simplest of theories will be explored. Brief mention of the
many possible complications will be made, but the focus of the chapter will be a simple but appropriate
description of the workings of the capital market. This rather extreme caveat notwithstanding, your work in
Chapter 14 will produce substantial insight into one of the most critical topics of contemporary research.
After you have read Chapter 14 in your text and completed the exercises in this Study Guide chapter, you
should be able to:
1. Explain the concept of economic rent, the circumstances under which it applies, and the inferences
which can be drawn from those circumstances regarding the theory of efficient taxation.
2. Define precisely what economists mean when they speak of physical capital, and understand why
capital is not a primary factor of production.
3. Define the rate of return on capital and describe how it relates to an interest rate.
4. Explain present value and its importance in evaluating the potential profitability of a capital project.
Record a formula for the present value of a perpetual asset which generates a constant return and of a more
general asset which generates an arbitrary stream of returns into the future. Trace the sensitivity of the
present value in either circumstance to changes in the interest rate.
5. Define profit in a statistical sense, and explain the roles of (a) implicit rents, interest payments, and
wages; (b) rewards for risk taking; and (c) monopoly rents in determining profit.
6. Explain the major factors that determine (a) the derived demand for capital and (b) the supply of capital
in the classical theory. Relate the theory to some of its major qualifications: (a) technological change, (b)
uncertainty and risk, (c) present and future inflation, and (d) macroeconomic shocks and policies.
7. State the relationship between the real rate of interest, the nominal rate of interest, and the rate of
inflation. Explain why the classical theory of capital investment uses the real rate of interest as its price
variable.
Match the following terms from column A with their definitions in column B.
A B
__ Rent 1. Measures the increase in output when the firm hires an additional unit of capital,
all else fixed.
__ Henry George 2. The value today of an asset that yields a stream of income over time.
__ Capital 3. The difference between total revenues and total costs.
__ Rentals 4. The opportunity costs of factors owned by firms.
__ Rate of return 5. Interest rates that measure the quantity of goods we get tomorrow for
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N1 N2 Nt
V= + 2 + ... +
(1 + i) (1+ i) (1 + i) t
For example, consider an investment opportunity with a two-year life. In the first year the investment will
bring in $30,000, and in the second year, $40,000. The relevant market interest rate is 10 percent. If the
investment costs $50,000 today, what is its present value?
Given this information, Nl = $30,000, N 2 = $40,000, and i = 10 percent, the present value can be found as
follows:
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$30,000 $40,000
V= + − $50,000 = $10,330.55
(1 + .1) (1 + .1)2
If an asset has perpetual life, and if Nt = N = permanent annual receipts, then the equation simplifies to:
$N
V=
i
The higher the interest rate i, the lower the present value V in any case.
5. Very simply put, profits are revenues less costs. They accrue to many owned, nonlabor factors of
production in the form of implicit rents. They can also represent rewards for risk taking and monopoly rents
derived from continued scarcity. Empirical studies show that over the past 30 years, U.S. corporations have
earned a modest rate of return on their investments—only about 6 percent after taxes.
6. Investment in capital goods involves indirect roundaboutness. This means that forgoing consumption
today in order to increase investment leads indirectly to even greater consumption in the future.
7. The derived demand for capital comes from its marginal product. Remember that the law of diminishing
returns applies to capital too. That is, as a firm continues to invest in capital, the rate of return on marginal
dollars will eventually fall. This causes the demand for capital to be downward-sloping. High interest rates
reduce the number of capital investment projects with positive present values and thus the demand for (new)
capital. Low interest rates do the opposite, thereby encouraging capital-intensive investment.
8. In short-run equilibrium, a fixed amount of capital is rationed such that the rate of return on capital exactly
equals the market interest rate. In the short run, the supply of capital is fixed, based on past investments; thus,
its price is determined by the position of the demand curve.
9. In long-run equilibrium, the supply of capital is upward-sloping, which means that as interest rates rise,
savers are willing to supply more funds to the market. Thus, in the long run, the equilibrium is found where
the demand for capital crosses the supply of capital.
10. Acceptance of the supply-and-demand structure of classical capital theory is subject to qualifications which
relate to technological change, uncertainty and risk, inflation, and macroeconomic fluctuations. Taxes and
inflation can alter the behavior of investors because they lower the real return on investments. Technological
changes usually increase the return on investments by increasing the productivity of resources. Finally, we
must remember that all investments carry risk and uncertainty. Any decision is based upon best estimates of
the future. Since the future is rarely certain, there are few absolute guarantees that the return for a given
investment will be as predicted.
V. HELPFUL HINTS
1. The perfectly inelastic supply curve, applicable in the case of land, should be familiar to you. It was
introduced in Chapter 4, with elasticities, reviewed in Chapter 8, and applied to the general case of factors of
production in Chapter 12. Look back to those sources if you need a review.
2. Economists’ interest in the case of the single-occupation input with perfectly inelastic supply led them to
ask another question: Does the payment made to such an input constitute a cost of production? At first, this
may seem to be an odd question. Each separate user of that input must pay the price, high or low, for the
quantity of that input which he or she employs, and that outlay certainly is a cost of production.
On the other hand, production costs are supposed to reflect social costs. Chapter 2 used the production-
possibilities frontier to point out that the way to get more of some good A is to transfer some of the inputs
used in the production of some other good B into the production of A, i.e., to sacrifice some consumption of B
for the potential of increasing the production of A. This sort of substitution is possible, of course, only for
inputs which can be used to produce either A or B.
Economic rents are, by definition, paid only to inputs which have just one possible occupation; they
apply, therefore, only to inputs whose employment cannot be transferred from the production of one good to
the production of another. Their employment does not entail a cost to society. When these inputs are put to
work, their employment does not impose any sacrifice of any other commodity.
3. There are several different ways to define and measure profits. Footnote 8 from your text reviews these,
but the concept is important and bears repeating here. Remember that accountants measure profits as revenues
less explicit costs. If profits are positive, a firm pays all its bills and has something left over. Economists
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measure profits as revenues less explicit costs less implicit costs. Implicit costs are the opportunity costs of
doing business, or what the firm could earn if it put resources to their next-best alternative use. If economic
profits are positive, then a firm is not only earning something after paying bills, but also its earnings are greater
than they would be if resources were put to their next-best alternative use. This is a very important distinction.
4. The present-value formula can be run in reverse to yield future value. Suppose we have $10 to put in an
investment that is expected to yield 10 percent per year for three years. How much money will we have at the
end of the life of the investment? Note that each year, the interest will become part of the new principal that is
carried into the following year. So:
At the end of each year we have what we started with plus interest on what we started with.
5. Capital is one of those terms that economists use in a very specific way. Physical capital includes
structures, like factories and warehouses; equipment, like drills and hammers; and inventories of inputs and
outputs, like finished automobiles and shirts. People sometimes use the term to refer to financial capital, or
money used to save or to invest. Beware! This is not what an economist means by the term capital.
These questions are organized by topic from the chapter outline. Choose the best answer from the options
available.
c. the rent payment in question is really a payment for buildings or improvements to the land, not for the
use of the land itself.
d. when this factor is used for the production of good A, its employment does not entail any sacrifice of
any other good B.
e. competition among the suppliers will continually tend to push the price of this factor toward zero.
6. Economic analysis suggests that:
a. society’s resources cannot be allocated properly into employment unless competitive rent payments are
made.
b. rental payments to factors with relatively price elastic supply should be taxed more heavily.
c. economic rent does not enter into the cost of production.
d. the allocation of resources can be distorted if certain input supplies are inelastic with respect to price.
e. rental payments to factors with relatively price-elastic supply should be taxed more heavily.
7. Suppose Figure 14-l represents the market for land in Connecticut. A tax of $100 per acre will:
Figure 14-1
c. $263.
d. $545.
e. none of the above.
19. Implicit in any discussion of capital and interest is a rule for the proper method of determining the worth,
or value, of any asset. This rule instructs us to:
a. value assets according to the original cost of construction or purchase, deducting from this cost figure
an appropriate depreciation figure to arrive at present value.
b. value assets according to the net revenue they are expected to yield in the future.
c. value assets according to the discounted sum of the net revenue that they are expected to yield in the
future.
d. determine the dollar figure which represents the net productivity of the asset and then discount that net
productivity figure by means of the interest rate.
e. do none of the above.
20. If market interest rates generally fall, then the present value of any capital asset should:
a. fall, since lower interest rates indicate that revenue amounts accruing at any future date are now given a
higher present value.
b. fall, since lower interest rates indicate that revenue amounts accruing at any future date are now given a
lower present value.
c. remain unchanged, unless relevant cost or revenue factors thereby changed.
d. rise, because lower interest rates indicate that revenue amounts accruing at any future date are now
given a lower present value.
e. rise, because lower interest rates indicate that revenue amounts accruing at any future date are now
given a higher present value.
21. Which alternative in question 19 would be correct had the question referred to the asset’s rate of return
instead of its present value?
a. value assets according to the original cost of construction or purchase, deducting from this cost figure
an appropriate depreciation figure to arrive at present value.
b. value assets according to the net revenue they are expected to yield in the future.
c. value assets according to the discounted sum of the net revenue that they are expected to yield in the
future.
d. determine the dollar figure which represents the net productivity of the asset and then discount that net
productivity figure by means of the interest rate.
e. do none of the above.
22. In a period of deflation (i.e., of generally falling prices), the “real” rate of interest obtained by any lender
will:
a. exceed the nominal rate.
b. become a negative figure.
c. fall below the stated rate, although not to the extent of becoming a negative figure.
d. become a meaningless, incalculable figure.
e. exceed the rate of unemployment.
23. The rate of return to any capital good could reasonably be described as the:
a. rate of interest at which the capital good could just be worth buying or building, i.e., the rate of
interest for which the present value of anticipated revenues would exactly match the present value of
anticipated costs.
b. dollar amount of profit that would accrue if that capital good were bought or built.
c. same thing as the market rate of interest.
d. physical increase in output (as distinct from the money value) that would accrue if that capital good
were bought or built.
e. percentage figure obtained by adding up all net revenues that would accrue from the capital good and
dividing this total by its cost.
24. If business firms generally became more optimistic regarding the revenues that should accrue from the
investment projects that they are planning, then the computed rate of return to that capital:
a. would increase, since revenues enter into the computation of the rate of return.
b. would decrease, since the rate of return is an interest rate, and the interest rate varies inversely with the
value of the investment project.
c. would not change, since the rate of return is governed by technical considerations, not by expected
revenues.
d. would probably fall, although there is a special case in which it would rise.
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e. may do any of the above since the effect of a change in expected revenues upon the rate of return is
unpredictable.
25. Profits are defined as the:
a. difference between total revenues and total costs.
b. difference between marginal revenue and marginal cost at equilibrium.
c. total revenues a firm earns from the sale of its product.
d. amount of money that is distributed to shareholders as dividends.
e. amount of money that the firm reinvests in its plant and equipment.
26. A firm’s rate of profit is determined by:
a. implicit returns on factors of production that the firm owns.
b. the level of risk in which the firm is engaged.
c. the level of innovation that the firm is able to undertake.
d. all of the above.
e. none of the above.
27. If an investment returns $800 a year and the annual rate of interest is 10%, then its present value is:
a. $10,000.
b. $8,000.
c. $720.
d. $none of the above.
The following problems are designed to help you apply the concepts that you learned in this chapter.
the tax would, meanwhile, equal $___. Note that the relative inelasticity of demand in panel (b) has
allowed more revenue to be generated by the same per unit tax with a smaller loss in consumer surplus.
Figure 14-2
3. Consult Figure 14-3; DD there represents a demand curve for rental housing, while SS represents a short-
run supply curve. The equilibrium rent for housing would be $___.
Figure 14-3
a. Suppose the rent-control authorities have determined that rents should be lowered and have imposed
upon it a (ceiling / floor) equal to 80 percent of the equilibrium price. The quantity of rental housing
provided would, in the short run illustrated in Figure 14-3 (increase / remain the same / decline), while
the quantity demanded would (increase / remain the same / decline) . Additionally, the ceiling would
(provide incentives for / remove incentives for) landlords to increase the supply.
b. Now consider a 20 percent tax on rents collected by landlords. This policy would produce (the same /
a different) equilibrium in the rental market in terms of quantity supplied in the short run. The rent paid
would, meanwhile (climb / remain the same / fall), and a shortage of rental housing (would / would not)
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materialize. In the long run, though, the quantity supplied could fall along a sloped supply curve, and a
shortage could thereby materialize.
7. You must decide whether asset A or asset B has the higher present value. Asset A promises to make four
income payments of $1225 each at the end of years 1, 2, 3, and 4. Asset B promises to make five payments of
$1000 each at the end of years 1, 2, 3, 4, and 5. The confidence with which payments can be expected is the
same for both. The market interest rate is 10%.
Calculate the present values of A and B: Asset A = ___ and asset B = ___. You decide to invest in (asset
A / asset B).
8. The panels of Figure 14-4 show demand and supply curves for capital. The demand curves describe the
behavior of business firms in the economy, who are borrowing money in order to pursue investment projects.
The supply curves describe the stock of capital that is available to these business firms at alternative interest
rates. Panel (a) describes these relationships in the short run and panel (b) describes these relationships in the
long run.
a. The demand curves in both these panels are downward-sloping. What accounts for this?
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b. Given the stock of capital indicated in panel (a) of Figure 14-4, the equilibrium short-run interest rate
in this economy is ____.
c. As time goes by, the stock of capital goods will (fall / remain constant / increase) because the short-
term interest rate is (high / low) compared to long run equilibrium. In terms of panel (a), the vertical SS
curve will (shift to the left / remain constant / shift to the right) and the market interest rate will (rise /
remain constant / fall) . Show this shift in panel (a) of Figure 14-4.
d. The supply curve in panel (b) is upward-sloping. What accounts for this? What is the difference
between the short-run and the long-run supply of capital?
e. The short-run supply of capital curve will adjust until the short-run interest rate is equal to (0 / the
inflation rate / the long run equilibrium interest rate). Show this in the panels of Figure 14-4.
Figure 14-4
Answer the following questions, making sure that you can explain the work you did to arrive at the answers.
1. Explain, in your own words, why a tax on land is efficient. Would you agree with Henry George that
government operations might be financed through land taxation only? Do you think this would be equitable?
2. True or false: “The real interest rate is the sum of the nominal interest rate and the inflation rate.”
3. As interest rates rise, the present value of any stream of income will fall. Explain this in your own words,
using the present value equation for illustration.
4. What does “roundaboutness” mean? Why is it important to consider when making investment decisions?
5. Why is the short-run capital supply curve perfectly inelastic, while the long-run capital supply curve is
upward-sloping?
6. Suppose that you run a roadside fruit and vegetable stand, situated on your own land. You would,
typically, describe your net income as “profit.” Would this be correct? What role might implicit rents and
wages play in your definition of profits?
7. Three important sources of profits have been identified in this chapter. What are these?
8. If there are some parts of profit which cannot be converted into implicit wages, implicit rent, or implicit
interest in situations other than perfect competition, then it is necessary to answer another question: What
useful function is performed or undertaken by the individual who receives a profit? Profit is the reward for
doing what? How should you answer these questions?
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9. Innovation, in the Schumpeterian view, is a risky and uncertain business. The majority of would-be
innovators fail. Why does Schumpeter describe market dynamics as “the process of creative destruction”?
Explain.
10. Explain the difference between real and nominal interest rates.