Interest, Rents and Profits

I. Introduction and Review

The mid-term exam of last week should now become your guide to filling in gaps in your understanding of economics. Make sure you fully understand the concepts in the questions that you missed. Be prepared to apply those same principles correctly to new problems.

Take the time to review all the concepts featured in the exam. Also, spend time asking yourself questions about business that you encounter in your daily lives. For example, what are the costly inputs and sources of revenue for a newspaper? A movie theater? A book? How elastic are the demands in those markets? How competitive or monopolistic? The more you quiz yourself, the better you will learn the principles.

One difficulty many students had was differentiating between returns to scale and diminishing returns. For example, a surprising number of students missed question number 2, which simply asked what a possible secret to Wal-Mart’s success has been in terms of returns to scale.

Let’s review returns to scale. Imagine using a scale of one foot in measuring the dimensions of a room. Then change to a scale of inches. All dimensions increase by a factor of 12, because there are 12 inches to a foot. That is what scale means: it affects everything. In economics, changing the scale means changing all inputs by the same proportion. Increasing the scale means increasing all inputs. The returns to scale are then what happens to the output of a company when all inputs are increased. Is bigger better for the business?

Increasing returns to scale means that when you increase all the inputs, then your company’s output increases by an even greater proportion. For example, if you double your inputs then perhaps your output triples. That would be extremely profitable for your business. Your costs only double, but your revenue triples. Your profits skyrocket. It is a formula for success.

Wal-Mart’s secret to its success would, among the choices, be increasing returns to scale. The bigger it gets, the more efficient it becomes, the cheaper it can buy goods for (because it is obtaining volume discounts), and the more output it can produce.

Meanwhile, there is nothing special about constant returns to scale, which is to be expected. Decreasing returns to scale is a disaster for a business that is growing. So is diminishing returns to labor. If bigger is better, and it is for Wal-Mart, then the correct answer is increasing returns to scale.

Remember how I asked about the returns to the scale of the world population? It likely has increasing returns to scale. Twice as many people would mean more than twice as much output. Humans are creative, and twice as many humans would probably mean more than twice as many inventions like the light bulb, as people build on the work of others.

So, then, what is the Law of Diminishing Returns? That is a rule that applies to ONLY ONE input. It is when a company keeps its assembly line and factor size constant, for example, but keeps hiring more and more of one input, such as labor. Eventually each added employee will have less and less to do. The returns on the additional employees declines. But if all inputs were increased at the same time, then the Law of Diminishing Returns does not apply. Then it is a question of returns to scale.

Some of you had trouble with this question:

  1. The more someone has, the more he wants to make to be satisfied! What economics principle would best explain that phenomenon?

(a) Law of Demand

(b) Law of Diminishing Returns

(c) Law of Diminishing Marginal Utility

(d) Coase Theorem

Choices (a) and (d) can be eliminated immediately, but selecting between (b) and (c) is more difficult. The key here is that marginal utility refers to consumer satisfaction, while returns refers to output of a company. The question is geared towards consumer satisfaction, not output by a firm. It refers to what someone wants, not what a company produces. The correct answer is therefore (c).

Keep mulling over the questions and answers on the midterm throughout the remainder of the course. Know the concepts like the back of your hand, and learn from your mistakes. There will be a final exam when you can prove how much you learned.

By the end of the course, make sure you understand the concepts in the problems that you missed. Make sure you answer them correctly on the final exam.

II. So you want to make some money?

Traditionally there were four ways to make money:

(1) Perform labor to earn wages. This is how most people make most of their money.

(2) Invest capital to earn interest. This is what you can do once you save up some money.

(3) Allow someone to use your land in exchange for rent.

(4) Start a new business to earn profits. But watch out here: 9 out 10 new businesses fail.

Sounds simple enough, right? Look around you, and you’ll see people earning money each of the four above ways. Mostly, you’ll see the first way: get a job and earn some wages. That entails the least risk and is the easiest for most people. Adults and teenagers often follow the path of least resistance, and often imitate others. In economics, that means getting a job to work for a company. It’s great until the job becomes tiresome or the boss fires you. Then it’s not so great anymore. But as a teenager you can earn money from someone else while you are learning how business works. You need experience and savings before you can even try to make money the other three ways.

Economists have their own terminology which, as you’ve seen in this course, is often different from common usage. In economics, the basic terms of wages, interest, rent and profit are all redefined. Ughhhhhh! Here we go:

Economic wages are payments for the worker’s opportunity cost of time. When Charles earns $7 per hour working for a dry cleaners, those wages are payments for his opportunity cost of time. He could be working someone else making money. The market rate of $7 implies that his time is worth that much at this stage in his life.

Economic rent is the payment for a perfectly inelastic input. If increasing the payment does not increase the supply of the input, then this is a rent. It is similar, but not identical, to rent paid on scarce land. Increasing the rent does not increase the supply the land. The supply is fixed. Don’t worry if you don’t understand this yet. We’ll spend more time on it below.

Interest is straightforward: it is the cost of the use of money over time. If you borrow $10,000 for your business, then you have to pay interest (say 5%) for using that money. The person who lent you the money wants something for it. He’s not going to give it to you for free.

Economic profits is concept we’ve addressed before. It is total revenues minus total costs, including opportunity costs of time and money in the costs.

III. Interest

There’s no free lunch, according to the famous saying. It costs money to make money is another aphorism. Most ATMs charge $1.50 just to withdraw cash from your own account.

If you asked me to loan you $1000, then I might answer: why? What’s in it for me? You would then say that you promise to give it back. I would then say why should I give it to you in the first place? If I just keep the money, then I won’t have to worry about your giving it back.

You would then offer to pay me money in exchange for loaning you $1000. We would bargain. You might offer me $25. I might reply that is not enough for me to go the trouble and take the risk to loan you $1000. Then you might offer me $50. I might wonder if I can get a better deal somewhere else. Ultimately we might settle on an amount that makes it worthwhile for me and advantageous for you. Some states have limits on how much interest can be charged. Query: should laws limit the amount of interest that can be charged?

If I agreed to loan you $1000 for an extra payment by you of $50, then the interest rate would be $50/$1000 = 5%. Usually rates are stated in annual terms. If the $50 is paid and the full $1000 must be paid one year later, then the interest rate is 5% per year.

Sometimes people repay money all at once, rather than with interest payments. Suppose I gave you $1000 and you promised to pay me back $1500 in 10 years. Then economists ask what is the rate of return or yield on that investment by me in your business?

That is more difficult to calculate. I am receiving 50% return on my investment, but ten years from now. At first glance, you may think to simply divide 50% by 10 years to calculate a rate of return of 5% per year. That is a rough approximation, but not entirely precise.

What is wrong with it? The flaw is that it fails to address the time value to money.

IV. The Time Value of Money

Suppose I told you that I will be giving you $100, but that you have a choice: either (1) I will give you the $100 today, or (2) I will give it to you in two years. Which would you prefer?

Today, of course. But why? Is the $100 really worth more today than in two years in the future?

Yes, it is. You could take $100 today and invest it, and have it grow to more than $100 in two years. Or you could buy something with it that you could enjoy for the two years. Or you could give it to a charity that could make good use of it for the two years.

Money, like anything else, has an opportunity cost. Just as it is a waste of your time to sit and watch television for a few hours, it is a waste of money to have it sit idle without earning anything for several years. At a minimum, it could be earning interest.

From Matthew 25:14-30 (RSV): For it will be as when a man going on a journey called his servants and entrusted to them his property; to one he gave five talents, to another two, to another one, to each according to his ability. Then he went away. He who had received the five talents went at once and traded with them; and he made five talents more. So also, he who had the two talents made two talents more. But he who had received the one talent went and dug in the ground and hid his master’s money. Now after a long time the master of those servants came and settled accounts with them. And he who had received the five talents came forward, bringing five talents more, saying, ‘Master, you delivered to me five talents; here I have made five talents more.’ His master said to him, ‘Well done, good and faithful servant; you have been faithful over a little, I will set you over much; enter into the joy of your master.’ And he also who had the two talents came forward, saying, ‘Master, you delivered to me two talents; here I have made two talents more.’ His master said to him, ‘Well done, good and faithful servant; you have been faithful over a little, I will set you over much; enter into the joy of your master.’ He also who had received the one talent came forward, saying, ‘Master, I knew you to be a hard man, reaping where you did not sow, and gathering where you did not winnow; so I was afraid, and I went and hid your talent in the ground. Here you have what is yours.‘ But his master answered him, ‘You wicked and slothful servant! You knew that I reap where I have not sowed, and gather where I have not winnowed? Then you ought to have invested my money with the bankers, and at my coming I should have received what was my own with interest. So take the talent from him, and give it to him who has the ten talents. For to every one who has will more be given, and he will have abundance; but from him who has not, even what he has will be taken away. And cast the worthless servant into the outer darkness; there men will weep and gnash their teeth.

Jesus was concerned with something far greater than money in this parable. But money does have a time value to it. Money tomorrow is not worth as much as the same amount of money today.

How can you compare future money to present money? By calculating the present value of money. That is how much one would need in the present which, with investment, would equal the proposed future payment. We use the interest rate to determine how something today should be worth in the future, or how much a payment promised in the future is worth today.

If I promise to give you $100 in 5 years, and the interest rate is 5%, then ask yourself how much you would need today to generate that same $100 in 5 years. It would be less than $100, because you could earn interest on it. In fact, you would only need $100 divided by (1.05) times itself 5 times (i.e, 1.05 x. 1.05 x 1.05 x. 1.05 x. 1.05)

Using a calculator, that comes to $78.35. That’s amazing, isn’t it? Receiving $100 in 5 years is equivalent to only $78.35 today, assuming an interest rate of 5%.

We can check our work. If you had $78.35 today and you invested it the bank at an interest rate of 5%, then next year it would be worth 5% more: $78.35 x 1.05 = $82.27

You would do the same thing in the second year, investing it for a return of 5%:

$82.27 x 1.05 = $86.38

And again in year three:

$86.38 x 1.05 = $90.70

And again in year four:

$90.70 x 1.05 = $95.24

And, finally, one more time for the fifth year:

$95.24 x 1.05 = $100

So $100 to be paid five years from now is the same thing as receiving only $78.35 today. That’s due to the effect of the time value of money.

V. Investment Decisions

Using the time value of money, now we can make investment decisions. As an owner of a company or just someone wanting to see your savings grow, you will need to make investment decisions.

Suppose your widget company is considering a new machine that will last for two years and costs $3500. Suppose also that it will be worthless afterwards. Suppose further that it will bring in revenue of $2000 per year, and that interest rates are 10%. Should you invest in the machine?

Ask yourself what the time value of the added income is. It equals:

($2000/1.10) + ($2000/(1.10×1.10)) = $1818.18 + $1652.89 = 3471.07

Look again at its cost. Your decision? Don’t buy it.

VI. Economic Rent

There are four equivalent definitions of economic rent. Pick the one you like the best and then use it to understand the others:

(1) Economic rent is the increased payment for a (scarce) good due to its very limited supply.

(2) Economic rent is the amount that a payment exceeds the supply cost. The rent is the excess of a good’s actual price above the good’s supply cost.

(3) Economic rent is the increased payment for an input that is in perfectly inelastic supply.

(4) Economic rent is the payment of a factor of production in excess of the factor’s opportunity cost or supply cost.

This is one of the most complex concepts of the course. But this should help: economic rent is the amount that a monopoly can charge in excess of the good’s cost. Economic rent is the surplus enjoyed by the recipient, at the expense of the person paying it.

Suppose there is only one house on a peninsula overlooking the ocean out of both sides of the house. The economic rent is the excess in price that the owner can charge due its unique location. The supply is one, and anyone determined to have that house must pay whatever price is charged. Of course, the Law of Demand places a limit on the rent, because people can’t pay what they don’t have, nor will they pay more than what they value something at. But the overcharge due to the uniqueness of the good is what constitutes the economic rent.

VII. Economic Profits

Remember that economic profits include far more than ordinary accounting profits or profits in the ordinary sense of the term. Economic profits are total revenues minus costs that include opportunity costs, time value of money, and other hidden costs missing from most claims about profits. Economic profits are much harder to come by.

Who enjoys true economic profits? Monopolies do, because they can increase their price and reap economic rents. Microsoft garners hefty profits year after year, with no end in sight. But ultimately all monopolies, even Microsoft, fall prey to competition and those economic profits dry up. However, that process can be painfully slow for consumers seeking to realize those competitive benefits now.

Inventors and other innovators can enjoy real economic profits. Thomas Edison did, with his numerous marvelous patented inventions. Patents give the holder an exclusive right to the product for 17 years. Competition is prevented for that time, and enormous economic profits can be obtained without competition driving the price down. AT&T used Alexander Graham Bell’s patent on the telephone to build a highly profitable company for a century. But ultimately its economic profits dried up, too.

VIII. Assignment

Review your mid-term exam and understand why you missed certain questions. Then answer the problems below:

  1. Receiving $100 next year is not the same as receiving $100 today because of the _________________.
  1. Free enterprise does not cause interest rates. Impatience does! Explain both views.
  1. I agree to pay you $1,000 in one year, if you pay me ______ today. The interest rate is 5%. Fill in the blank, showing your work.
  1. Sarah S. owns a clothing store. She can spend $100,000 today to increase her inventory of fancy clothes, which would increase her profits by $104,000 in one year without any further benefit. Interest rates are 5%. Should she make the investment?
  1. Many students missed this question on the exam: If total utility is maximized, then

(a) average utility is minimized

(b) average utility is maximized

(c) marginal utility is maximized

(d) marginal utility is zero

Answer this question correctly this time, and explain your answer.

  1. The New York Yankees drafted Chris R. as a good left-handed pitcher, a rare type of player, and pays him $200,000 for his first year in the minor leagues. Outside of baseball, his wage would be $30,000 a year. What is his economic rent?
  1. Many people missed this question on the exam: All of the following are fixed costs for starting a new school EXCEPT:

(a) textbooks

(b) electricity

(c) rent

(d) landscaping

If you answered this incorrectly on the exam, then explain it correctly now. If you answered this correctly on the exam, then pick another problem that you missed and explain it correctly.

  1. During hurricane season a town’s power plant was completely destroyed. People wanted to buy kerosene to run their emergency generators. But the price of kerosene doubled! What is the effect of the price increase? Should a new law force the price of kerosene down by half?
  1. Explain what economic rent is in your own words, using your own example.

Extra Credit (4 points for 10 and 11; 6 points for 12)

  1. Suppose you were buying a house and agreed to the purchase price. Then, at the last minute, you said that the seller could keep the house for another year and you would pay the same amount next year to buy it and move in then. The seller thought that was a good deal because he got to live in the house for another year. Was he right?
  1. Explain which of these earn economic rent, and how much: Sarah C. earns $500 for playing her violin at events, but would play for free. Anthony collects $800 for renting his basement, which equals the electricity, property, interest and costs of his time collecting the rent. Lisa, because of her special talent, earns $30,000 a year growing soybeans when others like her only make $20,000 with similar land.
  1. Explain Jesus’ parable about the talents, using general principles learned during this course.