The Benefits of Capital Formation

Saving means abstaining from consumption now in the expectation of being able to consume more in the future. Saving thus provides the resources needed to increase the stock of capital goods in the economy. A large stock of capital goods raises the rate of consumption that can be sustained in the future. Saving clearly benefits the saver, but it also benefits those who don't save. Indeed, the benefits from saving are diffused throughout the whole economy. Most of us benefit from advances in computer technology, though few of us contributed to the saving that made such advances possible.

Saving and capital formation also lead to higher wages and incomes for workers. In a competitive economy wages are a function of the productivity of workers, and this productivity is in turn a function of the amount and quality of the equipment and tools that workers use. A worker with a tractor is far more productive than a worker with a mule-drawn plow. Since more productive workers are paid more, some of the benefits from capital formation are spread to workers who did not necessarily contribute to the saving that made the capital formation possible.

Summary:

1. Wealth can be defined as a high level of sustainable consumption in an economy. The elements of a wealthy society are production, resources, knowledge, capital, technology, and institutions.

2. Roundabout production is the process of saving and investing in capital goods production in order to produce more in the future.

3. Time preference is a measure of an individual's concern for present versus future consumption

4. Interest is the price that individuals must be paid for waiting to consume later, or the price that individuals are willing to pay in order to consume now rather than later.

5. The rate of interest is determined in the market for loanable funds by the demand and supply of loanable funds.

6. In reality there are a multiplicity of interest rates such as prime rates, government rates, and credit card rates — determined by the degree of risk, cost, and time allowed for payment. Taking the rate of inflation into account, the real rate of interest is lower than the nominal rate of interest.

7. The returns to capital are composed of pure interest, a risk premium, and economic profits or losses.

8. Present value is the amount of money in the present that is equivalent to a certain amount of money in the future.

9. The discount rate is the interest rate used to discount future amounts of revenues and costs in order to obtain present values.

LECTURE 12: RENTS, PROFITS, AND ENTERPRENYURSHIP

 

1. Types of Rent

2. Rents and Firms

3. Profits and the Allocation of Resources

 

Types of Rent

Rent: A payment to a factor of production in excess of its opportunity cost.

Pure economic rent: The payment to a factor of production that is perfectly inelastic in supply.

Inframarginal rent: A type of rent that accrues to specialized factors of production.

In economic analysis the concept of rent has a broader meaning than the payment for the lease of a factor such as land. For the economist, rent refers to payment to any factor of production — land, labor, or capital — beyond its opportunity cost, or the forgone value of its next most productive use. Nearly every factor you can name has alternative uses. An acre of farmland could be used as the site of an industrial park. An engineer could be put to use typing correspondence. The economic theory of rents, therefore, has a much broader application than simply the payment for lease.

Economists distinguish among various types of economic rent.

1. A pure economic rent is the return to a factor of production that has a perfectly inelastic supply curve. In such a case the price of die resource is determined solely by the level of demand for its services because supply is fixed and does not change as price changes. Land in the aggregate is the classic example of a resource whose supply is given and whose return is characterized as a pure economic rent.

2. Another type of economic rent is paid to factors of production with rising supply curves. These rents are called inframarginal rents, and they represent payments to a factor of production above and beyond its opportunity cost as reflected in its supply price. Virtually all factors of production earn inframarginal rents.

3. Finally, there are categories of rents that accrue to firms. Quasi-rents are returns to a firm owner in a competitive industry above the opportunity cost of the owner's invested capital. Quasi-rents are thus the short-run economic profits of competitive firms. Monopoly rents are the returns that accrue to the owner of a monopoly firm when the firm restricts output and raises price. Monopoly rents are the profits of the monopolist. Competitive and monopoly profits are recast as quasi-rents and monopoly rents to illustrate the relation between economic rent and economic profits.

Land Rents

How is land priced? The obvious answer is that the price of land is determined where its demand and supply curves intersect. While this is correct, there are some special aspects of the price-determination process in the case of land. These aspects concern how the supply curve of land is defined. Although the focus in our discussion will be on the supply of land, keep in mind the role of the demand curve for land. This demand curve is based on the marginal productivity of land. In this regard the demand curve for land is the same as the demand curve for any factor of production — it is based on the expected marginal revenue product of land as a factor of production. When land is rented, rent is paid to the landowner. The greater the demand for the land, the larger the rent will be. In equilibrium, where the demand and supply of land are equal, the rent to the landowner is equal to the marginal revenue product of the land to the renter.

Figure 1. Pure Economic Rent and the Supply of Land

(a)The supply curve for land in the aggregate is perfectly inelastic with respect to rent, which means that the return to land in the aggregate is a pure economic rent.

(b)The supply curve of land to competing uses appears as it is normally drawn — sloping upward to the right. This slope reflects the fact that land has competing uses and hence that the price of using land or rent plays an important role in determining the uses to which land is put.

What are the economic implications of this vertical supply curve for all land? First, the perfectly inelastic nature of land in the aggregate means that the supply of land is unresponsive to price. Whether land is priced at $1 per acre per year or $1 million per acre per year, the supply of land in the aggregate will not change. In economic terms this fixed quantity, Q in Figure la, means that the rental price of land will be determined solely by the level of demand. Thus, the level of rent on the vertical axis depends on where the demand curve for land intersects the fixed supply curve.

The return to land in the aggregate is labeled a pure economic rent. To understand this concept, recall that economic rent is defined as a payment in excess of the opportunity cost of a factor of production. Recall also that a factor's opportunity cost is reflected in its supply schedule because a supply schedule indicates what it takes to bid resources away from their next-best alternative use. A vertical supply curve such as in Figure la means that land in the aggregate has no opportunity cost; nothing is given up for its supply, for it has no alternative uses. Very simply, this means that the whole return to land in the aggregate is a pure economic rent. In Figure la, land garners REQO in pure rent.

The concept of pure economic rent is normally associated with the supply curve of all land. However, it is possible that other resources will exhibit a range of their supply curve that is perfectly inelastic and that they therefore stand to earn pure economic rents. This characteristic may be true of uniquely talented performers in the world of sport and art.