15 pricing the factors of production rent is that portion of the produce of the earth which is paid...

15Pricing the Factors

of ProductionRent is that portion of the produce of the earth which is paid to

the landlord for use of the original and indestructible

powers of the soil.

DAVID RICARDO (1772–1823)

● The Principle of Marginal Productivity● Inputs and Their Derived Demand Curves● Investment, Capital, and Interest● The Determination of Rent● Payments to Entrepreneurship: Are Profits

Too High or Too Low?● Criticisms of Marginal Productivity Theory● Appendix: Discounting and Present Value

● The Principle of Marginal Productivity● Inputs and Their Derived Demand Curves● Investment, Capital, and Interest● The Determination of Rent● Payments to Entrepreneurship: Are Profits

Too High or Too Low?● Criticisms of Marginal Productivity Theory● Appendix: Discounting and Present Value

ContentsContents

Copyright© 2003 South-Western/Thomson Learning. All rights reserved.


● Marginal productivity demand for a factor of production

● Hire inputs up to the point where the marginal revenue product = price of the input (MRP = P)

● Marginal productivity demand for a factor of production

● Hire inputs up to the point where the marginal revenue product = price of the input (MRP = P)

The Principle of Marginal ProductivityThe Principle of Marginal Productivity

TABLE 15-1 Naomi’s Natural Farm Schedules

TABLE 15-1 Naomi’s Natural Farm Schedules



Inputs and Their Derived Demand CurvesInputs and Their Derived Demand Curves

● The demand curve for an input is the downward-sloping portion of its marginal revenue product curve.

● The demand for an input is called a derived demand because it is derived from the underlying demand for the final product.

● The demand curve for an input is the downward-sloping portion of its marginal revenue product curve.

● The demand for an input is called a derived demand because it is derived from the underlying demand for the final product.

FIGURE 15-1 MRP Schedule for Naomi’s Natural Farm

FIGURE 15-1 MRP Schedule for Naomi’s Natural Farm


12 11

C

B

A

MR

P p

er B

ag o

f C

orn

per

Wee

k

Bags of Corn per Week

0 10 9 8 7 6 5 4 3 2 1

–10

–14 –12

–8 –6

–16

–4 –2

0 2 4 6 8

10 12 14 16 18 20 22 24

$26

D


● A shift in the demand curve for a commodity causes a similar shift in the demand curve for the factors used in producing that commodity.

● A shift in the demand curve for a commodity causes a similar shift in the demand curve for the factors used in producing that commodity.

Inputs and Their Derived Demand CurvesInputs and Their Derived Demand Curves

FIGURE 15-2 A Shift in the Demand Curve for Corn

FIGURE 15-2 A Shift in the Demand Curve for Corn


D0

D0

MR

P p

er B

ag o

f C

orn

Bags of Corn per Week

$50

40

30

20

10

10 9 8 7 6 5 4 3 2 1 0

D1

D1


Investment, Capital, and InterestInvestment, Capital, and Interest

● Investment (a flow) = increase in capital (a stock)

● Rate of interest = price at which funds can be rented (borrowed)

● Investment (a flow) = increase in capital (a stock)

● Rate of interest = price at which funds can be rented (borrowed)

FIGURE 15-3 The Investment Production Process

FIGURE 15-3 The Investment Production Process


Other inputs

Initial capital stock

Added capital stock

4

Production

5

Raise funds

2

Investment flow: Buy inputs, use them to build up capital stock

3

Decide to increase the capital stock

1



● The Demand for Funds ♦ How does the firm decide how much to

borrow?

♦ Sets marginal revenue product of the investment financed by the funds = the interest payment charged for borrowing

● The Demand for Funds ♦ How does the firm decide how much to

borrow?

♦ Sets marginal revenue product of the investment financed by the funds = the interest payment charged for borrowing



● The Demand for Funds♦ The productivity of today's investment will

occur in the future; its present value is found by discounting.

♦ In the discounting process, the higher the interest rate, the lower the value of future income.

● The Demand for Funds♦ The productivity of today's investment will

occur in the future; its present value is found by discounting.

♦ In the discounting process, the higher the interest rate, the lower the value of future income.



● The Downward-Sloping Demand Curve for Funds♦ The marginal revenue product curve for an

investment is negatively related to the interest rate.

♦ Consequently, the higher the interest rate, the less people and firms will want to borrow to finance their investments.

● The Downward-Sloping Demand Curve for Funds♦ The marginal revenue product curve for an

investment is negatively related to the interest rate.

♦ Consequently, the higher the interest rate, the less people and firms will want to borrow to finance their investments.

FIGURE 15-4 The Derived Demand Curve for Loans

FIGURE 15-4 The Derived Demand Curve for Loans


0

Ra

te o

f In

tere

st

in P

erc

en

t p

er

Ye

ar

Dollars Demanded per Year

D

D



● The Supply of Funds♦ Interest = reward to people for saving, i.e., for

foregoing present consumption

♦ Normally, interest savings

● The Supply of Funds♦ Interest = reward to people for saving, i.e., for

foregoing present consumption

♦ Normally, interest savings



● The Supply of Funds♦ However, people who have specific target

goals for accumulated savings may lower their current rate of saving when interest rates rise.

♦ Typically, therefore, the supply curve of savings is positively sloped, but fairly steep.

● The Supply of Funds♦ However, people who have specific target

goals for accumulated savings may lower their current rate of saving when interest rates rise.

♦ Typically, therefore, the supply curve of savings is positively sloped, but fairly steep.

FIGURE 15-5 Equilibrium in the Market for Loans

FIGURE 15-5 Equilibrium in the Market for Loans


S

S

7.5%

5.5

0

Rat

e o

f In

tere

st i

n P

erce

nt

per

Yea

r

Dollars Lent per Year

D

D

E

B A



● The Issue of Usury Laws: Are Interest Rates Too High?♦ Governments may attempt to limit interest

rates by imposing usury laws.

♦ When they do so, they benefit the people who are able to borrow funds, but they harm the lenders and the people who would like to borrow but cannot find funds.

● The Issue of Usury Laws: Are Interest Rates Too High?♦ Governments may attempt to limit interest

rates by imposing usury laws.

♦ When they do so, they benefit the people who are able to borrow funds, but they harm the lenders and the people who would like to borrow but cannot find funds.


● Fixed supply of land determination of the market level of land rent by the demand side

● Economic rent = an "extra" payment for a factor of production (such as land) that does not change the amount of the factor that is supplied

● Fixed supply of land determination of the market level of land rent by the demand side

● Economic rent = an "extra" payment for a factor of production (such as land) that does not change the amount of the factor that is supplied

The Determination of RentThe Determination of Rent



● Economic rent is, thus, that portion of the factor payment that exceeds the minimum payment necessary to induce any of that factor to be supplied.

● Economic rent is, thus, that portion of the factor payment that exceeds the minimum payment necessary to induce any of that factor to be supplied.



● Land Rents: Complicated Version♦ Capital invested on any piece of land must

yield the same return as capital invested on any other piece of land that is actually in use.

♦ Any land that is exactly on the borderline between being used and not being used is called marginal land.

● Land Rents: Complicated Version♦ Capital invested on any piece of land must

yield the same return as capital invested on any other piece of land that is actually in use.

♦ Any land that is exactly on the borderline between being used and not being used is called marginal land.



● Land Rents: Complicated Version♦ Rent on a piece of land = cost of producing

the output on that land minus the cost of producing it on marginal land

● Land Rents: Complicated Version♦ Rent on a piece of land = cost of producing

the output on that land minus the cost of producing it on marginal land

TABLE 15-2 Nonrent Costs and Rent on Three Pieces of Land

TABLE 15-2 Nonrent Costs and Rent on Three Pieces of Land




● Land Rents: Complicated Version demand

■community uses land previously thought to be submarginal

■more intensive exploitation of already used land

● Land Rents: Complicated Version demand

■community uses land previously thought to be submarginal

■more intensive exploitation of already used land

FIGURE 15-6 Determination of Land Rent in Littleville

FIGURE 15-6 Determination of Land Rent in Littleville


$2,000

An

nu

al R

ent

per

Ac

re

Acres of Land

1,000

D

D

S

S

E



● Land Rents: Complicated Version♦ This increases the differential between other

plots of land and marginal land and, therefore, increases rent.

● Land Rents: Complicated Version♦ This increases the differential between other

plots of land and marginal land and, therefore, increases rent.



● Generalization: Economic Rent Seeking♦ Economic rent is any payment made to a factor

above the amount necessary to induce any of that factor to be supplied to its present employment.

♦ Some portion of every factor’s income will consist of economic rent in this sense, unless the factor’s supply curve is horizontal.

● Generalization: Economic Rent Seeking♦ Economic rent is any payment made to a factor

above the amount necessary to induce any of that factor to be supplied to its present employment.

♦ Some portion of every factor’s income will consist of economic rent in this sense, unless the factor’s supply curve is horizontal.

● When athletes would be willing to play for quite a bit less than their salary, the “excess” salary is economic rent.♦ This same analysis applies to any factor of

production whose supply curve is not horizontal.

♦ Only those factors that can be reproduced by a number of producers at constant cost earn no rents.

● When athletes would be willing to play for quite a bit less than their salary, the “excess” salary is economic rent.♦ This same analysis applies to any factor of

production whose supply curve is not horizontal.

♦ Only those factors that can be reproduced by a number of producers at constant cost earn no rents.

Application of Rent Theory: Salaries of Professional AthletesApplication of Rent Theory: Salaries of Professional Athletes


“A-ROD”: Earning Lots of Rent“A-ROD”: Earning Lots of Rent

● Alex Rodriquez, Texas Rangers, recently signed a 10-year, $252 million contract

● This makes him the highest paid athlete in history.

● Assuming he would play baseball for significantly less, much of his contract represents economic rent

● Alex Rodriquez, Texas Rangers, recently signed a 10-year, $252 million contract

● This makes him the highest paid athlete in history.

● Assuming he would play baseball for significantly less, much of his contract represents economic rent

● People sometimes think that rents on housing are economic rents.♦ They could then be lowered without reducing

the quantity supplied.

● This may be true in the short run.

● People sometimes think that rents on housing are economic rents.♦ They could then be lowered without reducing

the quantity supplied.

● This may be true in the short run.

Rent Controls: The Misplaced AnalogyRent Controls: The Misplaced Analogy


● But in the long run, the housing market is quite competitive.♦ An effective rent control law is, therefore,

likely to lead to a reduction in housing and consequent shortages.

● But in the long run, the housing market is quite competitive.♦ An effective rent control law is, therefore,

likely to lead to a reduction in housing and consequent shortages.

Rent Controls: The Misplaced AnalogyRent Controls: The Misplaced Analogy


FIGURE 15-7 A Shift in Demand with a Vertical Supply Curve

FIGURE 15-7 A Shift in Demand with a Vertical Supply Curve


$2,000

An

nu

al R

ent

per

Ac

re

Acres of Land

1,000

D

D

S

S

E


Payments to EntrepreneurshipPayments to Entrepreneurship

● Profits are a small portion of GDP.

● They are the residual: what remains from revenue after all other factors have been paid

● Profits are a small portion of GDP.

● They are the residual: what remains from revenue after all other factors have been paid



● What Accounts for Profits?♦ In pure competition, economic profits

disappear in the long run.

♦ In the real world, however, they persist for different reasons:■Monopoly power■Risk bearing■Returns to innovation

● What Accounts for Profits?♦ In pure competition, economic profits

disappear in the long run.

♦ In the real world, however, they persist for different reasons:■Monopoly power■Risk bearing■Returns to innovation



● Taxing Profits♦ We do not know whether the observed profit

rate provides more than the minimum reward necessary to attract entrepreneurial talent into the market.

● Taxing Profits♦ We do not know whether the observed profit

rate provides more than the minimum reward necessary to attract entrepreneurial talent into the market.



● Taxing Profits♦ This relationship between observed profit rates

and minimum necessary rewards is crucial when we start to consider the policy ramifications of taxes on profits.

● Taxing Profits♦ This relationship between observed profit rates

and minimum necessary rewards is crucial when we start to consider the policy ramifications of taxes on profits.



● Taxing Profits♦ If an industry earns profit rates well above the

minimum required to attract entrepreneurial talent, those profits contain a large element of economic rent.

♦ In that case, we could tax away these excess profits (rents) without fear of reducing the industry’s production.

● Taxing Profits♦ If an industry earns profit rates well above the

minimum required to attract entrepreneurial talent, those profits contain a large element of economic rent.

♦ In that case, we could tax away these excess profits (rents) without fear of reducing the industry’s production.


● Taxing Profits♦ On the other hand, if the profits being earned

by the industry do not include economic rents, then a windfall profits tax can seriously curtail research and development and production.

● Taxing Profits♦ On the other hand, if the profits being earned

by the industry do not include economic rents, then a windfall profits tax can seriously curtail research and development and production.


Public Opinion on ProfitsPublic Opinion on Profits


Profit per Dollar of Sales

32%

What people

estimate

26%

What people think is a

“reasonable” profit

3.8%

Actualprofit


Criticism of Marginal Productivity TheoryCriticism of Marginal Productivity Theory

● Some people criticize the theory for providing what is seen as a moral justification for the status quo in income distribution.

● Marginal productivity theory, however, has no moral content.

● Some people criticize the theory for providing what is seen as a moral justification for the status quo in income distribution.

● Marginal productivity theory, however, has no moral content.


Criticism of Marginal Productivity TheoryCriticism of Marginal Productivity Theory

● A better criticism is that the theory gives only incomplete insight into many current, pressing problems of income distribution, including poverty and underdevelopment.

● A better criticism is that the theory gives only incomplete insight into many current, pressing problems of income distribution, including poverty and underdevelopment.


● The present value of a future income stream depends inversely upon the interest rate used in discounting.

● The general formula for the present value of $1.00 to be received N years from today when the rate of interest is

i = $1.00 (1 + I)N

● The present value of a future income stream depends inversely upon the interest rate used in discounting.

● The general formula for the present value of $1.00 to be received N years from today when the rate of interest is

i = $1.00 (1 + I)N

Appendix: Discounting and Present ValueAppendix: Discounting and Present Value

15 pricing the factors of production rent is that portion of the produce of the earth which is paid...

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