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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