Chapter 18 – Rent, Interest, and Profit
18-1
Chapter 18 – Rent, Interest, and Profit
McConnell Brue Flynn 21e
DISCUSSION QUESTIONS
1. How does the economist’s use of the term “rent” differ from everyday usage? Explain:
“Though rent need not be paid by society to make land available, rental payments are very useful
in guiding land into the most productive uses.” LO1
2. Explain why economic rent is a surplus payment when viewed by the economy as a whole but
a cost of production from the standpoint of individual firms and industries. Explain: “Land rent
performs no ‘incentive function’ for the overall economy.” LO1
Chapter 18 – Rent, Interest, and Profit
18-2
3. How does Henry George’s proposal for a single tax on land relate to the elasticity of the supply
of land? Why are there so few remaining advocates of George’s proposal? LO1
4. If money is not an economic resource, why is interest paid and received for its use? What
considerations account for the fact that interest rates differ greatly on various types of loans? Use
those considerations to explain the relative sizes of the interest rates on the following: LO2
a. A 10-year $1,000 government bond.
b. A $20 pawnshop loan.
c. A 30-year mortgage loan on a $175,000 house.
d. A 24-month $12,000 commercial bank loan to finance the purchase of an automobile.
e. A 60-day $100 loan from a personal finance company.
Chapter 18 – Rent, Interest, and Profit
18-3
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written
consent of McGraw-Hill Education.
(a) A 10-year $1,000 government bond will have a relatively low rate of interest because
it is risk-free: The Federal government cannot default (since its promise to repay is in
currency that the government can have printed). However, the term to maturity normally
would lead to a higher interest rate than a shorter-term government bond. The loan size
is irrelevant here because the government pays the same interest regardless of the bond’s
denomination.
(b) A $20 pawnshop loan will have a high rate of interest. There’s good chance the good
pawned will not be redeemed but, in this case, the pawnbroker is not really at risk. The
pawned article undoubtedly has a resale value greater than $20. The high interest rate in
fact helps ensure that the good will not be redeemed—to the pawnbroker’s benefit. The
high interest rate also compensates for the small size of the loan.
(c) Mortgages are generally large loans at a relatively low interest rate. The loan is for a
very long term and the house is pledged as collateral. Under certain circumstances, the
loan may qualify for a government-subsidized mortgage insurance program, which
insures the lender against default. Additionally, the borrower may deduct the interest
from his/her taxable income. These contrasting considerations result in a lower interest
rate than most types of long-term loans.
(d) A 24-month $12,000 commercial bank loan to finance the purchase of an automobile
will certainly have a higher interest rate than a government bond, but its risk is reduced
by the fact that the automobile serves as collateral for the loan. However, the bank would
rather get its money back than a used car, so the bank certainly does not consider the loan
risk-free. The loan is of a relatively large size; this will tend to lower the interest rate.
The outcome of these conflicting considerations is an interest rate lower than for a
straight, unsecured, consumer loan but higher than for a loan to a well-established
business.
(e) A 60-day $100 loan from a personal finance company will have the highest rate of
all, except possibly for the pawnshop loan. Though it is very short term, it is considered
relatively high risk, because otherwise the borrower would have gotten the loan from a
bank; and the loan size is very small, making the administrative costs high in relation to
the loan size. Also, the fact that it is a personal loan implies there is no collateral like a
car or home to back it up.
Chapter 18 – Rent, Interest, and Profit
18-4
5. Why is the supply of loanable funds upsloping? Why is the demand for loanable funds
downsloping? Explain the equilibrium interest rate. List some factors that might cause it to
change. LO3
6. Here is the deal: You can pay your college tuition at the beginning of the academic year or the
same amount at the end of the academic year. You either already have the money in an interest–
bearing account or will have to borrow it. Deal, or no deal? Explain your financial reasoning.
Relate your answer to the time-value of money, present value, and future value. LO4
18-5
7. What are the major economic functions of the interest rate? How might the fact that many
businesses finance their investment activities internally affect the efficiency with which the
interest rate performs its functions? LO5
8. Distinguish between nominal and real interest rates. Which is more relevant in making
investment and R&D decisions? If the nominal interest rate is 12 percent and the inflation rate is
8 percent, what is the real rate of interest? LO5
Chapter 18 – Rent, Interest, and Profit
18-6
9. Historically, usury laws that put below-equilibrium ceilings on interest rates have been used by
some states to make credit available to poor people who could not otherwise afford to borrow.
Critics contend that poor people are those most likely to be hurt by such laws. Which view is
correct? LO5
10. How do the concepts of accounting profit and economic profit differ? Why is economic profit
smaller than accounting profit? What are the three basic sources of economic profit? Classify
each of the following according to those sources: LO6
a. A firm’s profit from developing and patenting a new medication that greatly reduces
cholesterol and thus diminishes the likelihood of heart disease and stroke.
b. A restaurant’s profit that results from the completion of a new highway past its door.
c. The profit received by a firm due to an unanticipated change in consumer tastes.
18-7
11. Why is the distinction between insurable and uninsurable risks significant for the theory of
profit? Carefully evaluate: “All economic profit can be traced to either uncertainty or the desire to
avoid it.” What are the major functions of economic profit? LO6
12. What are the combined rent, interest, and profit share of the income earned by Americans in a
typical year if proprietors’ income is included within the labor (wage) share? LO7
Chapter 18 – Rent, Interest, and Profit
18-8
13. LAST WORD Assume that you borrow $5,000, and you pay back the $5,000 plus $250 in
interest at the end of the year. Assuming no inflation, what is the real interest rate? What would
the interest rate be if the $250 of interest had been discounted at the time the loan was made?
What would the interest rate be if you were required to repay the loan in 12 equal monthly
installments?
REVIEW QUESTIONS
1. When using a supply-and-demand model to illustrate how land rents are set, economists
typically draw the supply curve as a vertical line because: LO1
a. The supply of land is fixed.
b. The supply of land is perfectly inelastic.
c. The quantity supplied of land does not increase when rents go up.
d. All of the above.
18-9
2. In the 1980s land prices in Japan surged upward in a “speculative bubble.” Land prices then
fell for 11 straight years between 1990 and 2001. What can we safely assume happened to land
rent in Japan over those 11 years? Use graphical analysis to illustrate your answer. LO1
3. The a main argument put forth by advocates of the single-tax movement was that: LO1
a. Taxing only income would make for a more equal society.
b. Taxing only land would be very efficient because taxing land does not decrease its supply.
c. Taxing only imports would help to protect local jobs and stimulate local entrepreneurs.
d. Having only one tax would be much easier for people to understand and much less costly to
administer than our current system with its wide variety of taxes.
4. Angela puts $1,000 in a savings account that pays 3 percent per year. What is the future value
of her money one year from now? LO4
a. $970.
b. $1,000.
c. $1,003.
d. $1,030.
Chapter 18 – Rent, Interest, and Profit
18-10
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written
consent of McGraw-Hill Education.
Answer: d. $1,030.
The future value one year from now of the $1,000 that Angela invests today at 3 percent
interest is $1,030. That is because her present value of $1,000 will grow into $1,030 in
one year’s time if it is invested at 3 percent interest. This is true because 3 percent of
$1,000 is $30. So next year Angela will have the amount she invested ($1,000) plus an
additional $30 of interest, or $1,030 in total.
Note, however, that future values depend upon the time horizon and the interest rate. For
instance, while the one-year-from-now future value of Angela’s money is $1,030 if it is
invested at 3 percent, the two-years-from-now future value would be $1,060.90 if it is
invested at 3 percent because that is how much money in total Angela would have in her
savings account if she allowed her initial deposit of $1,000 to compound for two full
years at 3 percent interest.
In a similar fashion, a higher interest rate would also change the future value. For
instance, future value of $1,000 in one year is $1,030 if invested at 3 percent but $1,060
if invested at 6 percent. Thus, the relationship between present values and future values
depends crucially on the interest rate.
5. As shown in Table 18.2, $1,000 invested at 10 percent compound interest will grow into
$1,331 after three years. What is the present value of $2,662 in three years if it is discounted back
to the present at a 10 percent compound interest rate? (Hint: $2,662 is twice as much as $1,331.)
LO4 Answer: $2000.
6. Entrepreneurs are the residual claimants at their respective firms. This means that they: LO6
a. Only get paid if there is any money left over after all the other factors of production have been
paid.
b. Must bear the financial risks of running their firms.
c. Receive whatever accounting profits or losses their firms generate.
d. All of the above.
Chapter 18 – Rent, Interest, and Profit
18-11
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written
consent of McGraw-Hill Education.
Answer: d. All of the above.
These statements about entrepreneurs as residual claimants are all true. Consequently,
“all of the above” is the correct answer.
To understand why, recall that as residual claimants, entrepreneurs will only get paid if
there is any money left over after paying all of the other factors of production. As an
example, wages and salaries have to be paid first. So does the rent. And so do any loan
repayments due to creditors.
Only if there is any money left over after paying everyone else to whom the firm owes
money will the entrepreneurs receive anything. And sometimes, of course, firms lose
money because payments to resource providers exceed revenues. In those cases, it is the
entrepreneurs who lose money. As a result, it is also the entrepreneurs who ultimately
bear the financial risks of running their firms.
7. True or false. As a capitalist economy, the vast majority of U.S. national income flows to the
owners of capital. LO7
PROBLEMS
1. Suppose that you own a 10-acre plot of land that you would like to rent out to wheat farmers.
For them, bringing in a harvest involves $30 per acre for seed, $80 per acre for fertilizer, and $70
per acre for equipment rentals and labor. With these inputs, the land will yield 40 bushels of
wheat per acre. If the price at which wheat can be sold is $5 per bushel and if farmers want to
earn a normal profit of $10 per acre, what is the most that any farmer would pay to rent your 10
acres? What if the price of wheat rose to $6 per bushel? LO1
Chapter 18 – Rent, Interest, and Profit
18-12
Feedback:
2. Suppose that the demand for loanable funds for car loans in the Milwaukee area is $10 million
per month at an interest rate of 10 percent per year, $11 million at an interest rate of 9 percent per
year, $12 million at an interest rate of 8 percent per year, and so on. If the supply of loanable
funds is fixed at $15 million, what will be the equilibrium interest rate? If the government
imposes a usury law and says that car loans cannot exceed 3 percent per year, how big will the
monthly shortage (or excess demand) for car loans be? What if the usury limit is raised to 7
percent per year? LO3
Chapter 18 – Rent, Interest, and Profit
18-13
Feedback:
Interest rate on
Loan
Demand for
Loanable Funds
Supply of
Loanable Funds
10%
$10 million
$15 million
9%
$11 million
$15 million
8%
$12 million
$15 million
7%
$13 million
$15 million
6%
$14 million
$15 million
5%
$15 million
$15 million
4%
$16 million
$15 million
3%
$17 million
$15 million
2%
$18 million
$15 million
1%
$19 million
$15 million
3. To fund its wars against Napoleon, the British government sold consol bonds. They were
referred to as “perpetuities” because they would pay £3 every year in perpetuity (forever). If a
citizen could purchase a consol for £25, what would its annual interest rate be? What if the price
were £50? £100? Bonds are known as “fixed income” securities because the future payments that
they will make to investors are fixed by the bond agreement in advance. Do the interest rates of
bonds and other investments that offer fixed future payments vary positively or inversely with
their current prices? LO4
Chapter 18 – Rent, Interest, and Profit
18-14
Feedback: To calculate the price of a perpetuity we use the formula, price =
(payment/interest rate), or to calculate the interest rate we use the formula, interest rate =
(payment/price).
4. Suppose that the interest rate is 4 percent. What is the future value of $100 four years from
now? How much of the future value is total interest? By how much would total interest be greater
at a 6 percent interest rate than at a 4 percent interest rate? LO4
Note that this answer could also be found via substitution back to Year 1, which gives us
Chapter 18 – Rent, Interest, and Profit
18-15
5. You are currently a worker earning $60,000 per year but are considering becoming an
entrepreneur. You will not switch unless you earn an accounting profit that is on average at least
as great as your current salary. You look into opening a small grocery store. Suppose that the
store has annual costs of $150,000 for labor, $40,000 for rent, and $30,000 for equipment. There
is a one-half probability that revenues will be $200,000 and a one-half probability that revenues
will be $400,000. LO6
a. In the low-revenue situation, what will your accounting profit or loss be? In the high-revenue
situation?
b. On average, how much do you expect your revenue to be? Your accounting profit? Your
economic profit? Will you quit your job and try your hand at being an entrepreneur?
c. Suppose the government imposes a 25 percent tax on accounting profits. This tax is only levied
if a firm is earning positive accounting profits. What will your after-tax accounting profit be in
the low-revenue case? In the high-revenue case? What will your average after-tax accounting
profit be? What about your average after-tax economic profit? Will you now want to quit your job
and try your hand at being an entrepreneur?
d. Other things equal, does the imposition of the 25 percent profit tax increase or decrease the
supply of entrepreneurship in the economy?
Chapter 18 – Rent, Interest, and Profit
18-16
Feedback: Part a: The accounting profit in each scenario equals revenue minus explicit
Part b: The average revenue will be a weighted average of the two cases above, where
the weights are the probabilities of each case. Here we assume that each case, or scenario,
You will not quit your job because the average profit of $57,500 is less than your current
income of $60,000. (NOTE, we ignore risk here.)
Part d: Yes, the reduction in after-tax profits induces some individuals not to undertake
investments or decisions that are pre-tax profitable.