Chapter 18/Pricing the Factors of Production
CHAPTER 18
PRICING THE FACTORS OF PRODUCTION
TEST YOURSELF
1. Which of the following inputs do you think include relatively large economic rents in
their earnings?
a. Nuts and bolts
b. Petroleum
c. A champion racehorse
Use supply-demand analysis to explain your answer.
(a) Nuts and bolts: no economic rent. Many manufacturers easily produce nuts and bolts,
and in the long run their costs are constant, that is to say, the supply curve is close to
horizontal. If the price were lower, they would not be produced.
2. Three machines are employed in an isolated area. They each produce 2,000 units of
output per month, the first requiring $20,000 in raw materials, the second $25,000, and
the third $28,000. What would you expect to be the monthly charge for the first and
second machines if the services of the third machine can be hired at a price of $9,000
per month? Which parts of the charges for the first two machines are economic rent?
In equilibrium, the prices of the first two machines will be bid up, so that their use
3. Economists conclude that a tax on the revenues of firms will be shifted in part to
consumers of the products of those firms in the form of higher prices. However, they
believe that a tax on the rent of land usually cannot be shifted and must be paid
entirely by the landlord. What explains the difference? (Hint: Draw the supply-demand
graphs.)
Chapter 18/Pricing the Factors of Production
4. Many economists argue that a tax on apartment buildings is likely to reduce the supply
of apartments, but that a tax on all land, including the land on which apartment
buildings stand, will not reduce the supply of apartments. Can you explain the
difference? How is this answer related to the answer to Test Yourself Question 3?
The answer is basically the same as the answer to question 3. When apartments are taxed,
landlords (who find their after-tax returns reduced) lower the quantity offered for sale, by
5. Distinguish between investment and capital.
6. Explain the difference between an invention and an innovation. Give an example of
each.
7. What is the difference between interest and profit? Who earns interest and in return
for what contribution to production? Who earns economic profit and in return for
what contribution to production?
Interest is the return to the suppliers of capital or the lenders of funds. Profit is the return
DISCUSSION QUESTIONS
1. A profit-maximizing firm expands its purchase of any input up to the point where
diminishing returns have reduced the marginal revenue product so that it equals the
input price. Why does it not pay the firm to “quit while it is ahead,” buying so small
a quantity of the input that the input’s MRP remains greater than its price?
If a firm buys so small a quantity of an input that its MRP exceeds its price, the firm will
2. If you have a contract under which you will be paid $10,000 two years from now,
why do you become richer if the rate of interest falls?
The current value of your contract is less than $10,000, by an amount reflecting the
current rate of interest. If the interest rate falls, some people who find their opportunities
Chapter 18/Pricing the Factors of Production
you are therefore richer.
3. Do you know any entrepreneurs? How do they earn a living? How do they differ
from managers?
4. “Marginal productivity does not determine how much a worker will earn—it
determines only how many workers will be hired at a given wage. Therefore,
marginal productivity analysis is a theory of demand for labor, not a theory of
distribution.” What, then, do you think determines wages? Does marginal
productivity affect their level? If so, how?
Marginal productivity determines only the demand for labor, while the wage of labor is
determined by the interaction of both supply and demand. The quotation is correct if the
5. (More difficult) American savings rates are among the lowest of any industrial
country. This has caused concern about our ability to finance new plants and
equipment for U.S. industry. Some politicians and others have advocated lower
taxes on saving as a remedy. Do you expect such a program to be very effective?
Why?
Lower taxes on saving would raise the reward to people for saving and would therefore
6. If rent constitutes only 2 percent of the incomes of Americans, why may the concept
nevertheless be significant?
7. Litigation in which one company sues another often involves costs for lawyers and
other court costs literally amounting to hundreds of millions of dollars per case.
What does the concept of an economic rent have to do with the matter?
Chapter 18/Pricing the Factors of Production
ANSWERS TO APPENDIX QUESTIONS
TEST YOURSELF
1.Compute the present value of $1,000 to be received in three years if the rate of interest is
11 percent.
2. A government bond pays $100 in interest each year for three years and also returns the
principal of $1,000 in the third year. How much is it worth in terms of today’s money if
the rate of interest is 8 percent? If the rate of interest is 12 percent?
The present value is:
$100 $100 $1100