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Chapter 27 - CHAPTER 29 Interest Rent and Profit Chapter 29...

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CHAPTER 29 Interest, Rent, and Profit Chapter 29 concludes our study of factor markets by turning to the markets for capital, land, and entrepreneurial skill—the remaining factors of production. More specifically, this chapter develops the theories of interest, rent, and profit as payments to nonlabor factors of production. Combining this material with the Chapters 26 and 27 will give the students a well-developed look at the factors of production, the means by which they are priced and purchased/hired, and their impact on production costs and the prices of goods and services. CHAPTER OBJECTIVES Upon completing this chapter, your students should be able to: 1. Explain why interest exists. 2. Discuss the various reasons interest rates differ. 3. Compute present value. 4. Explain the difference between economic rent and pure economic rent. 5. Explain the difference between artificial and real rents. 6. Discuss various theories of profit. 7. Explain how profit and loss act as signals. KEY TERMS loanable funds real interest rate positive rate of time preference present value roundabout method of production economic rent nominal interest rate pure economic rent 24
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25 Chapter 29 CHAPTER OUTLINE I.INTEREST —The word interest is used in two ways in economics. On the one hand, interest refers to the price that borrowers pay for the use of loanable funds . Interest can also refer to the rate of return earned by capital as an input of production. Over time, there is a tendency for the price of loanable funds and the rate of return on capital to approach one another. Thus, even though we can define interest two different ways, we end up with one interest rate. A.Loanable Funds: Demand and Supply —According to the theory of loanable funds, the interest rate is determined by the equilibrium of the supply of and demand for loanable funds . 1.The Supply of Loanable Funds —The primary source of loanable funds is personal saving. Savers are paid a rate of interest for the use of their money, and the amount of money saved is directly related to the interest rate. The supply of loanable funds curve is upward sloping, showing that the supply of loanable funds increases as the interest rate increases, and decreases as the interest rate decreases. 2.The Demand for Loanable Funds —The demand for loanable funds is composed of the demand for consumption loans by individuals, investment loans by business, and the deficit-financing needs of the government. We will concentrate here on borrowing by households and businesses. a.The Demand for Loanable Funds: Consumption Loans Consumers demand loanable funds because they have a positive rate of time preference —that is, consumers prefer to consume today, rather than wait until later . As a result, consumers are willing to pay for the privilege of consuming now; therefore, they demand loanable funds to fill the gap between their current consumption desires and the funds they have to spend. In this sense, the interest rate on consumer loans is the
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