Module 8: INTEREST, RENT, AND PROFIT

OVERVIEW:

As an individual decides to use land, labor, capital, and entrepreneurship, the decisions
incur a certain form of payment for the use of these resources. This chapter will provide
a background on interest, rent and profit and how they are used in economics.

LEARNING OBJECTIVES:

After reading and studying this module, you should be able to:

1. Define interest
2. Identify the determinants and real interest rates
3. Identify the effects of interest in business
4. Explain how interest rates affect you as a customer

EXPLORE:

INTEREST

The word “interest” is often encountered in our daily lives when there are discussions
about loans and earnings. In economics, interest is used in two ways – it can be the price
of the credit which is often referred to as loanable funds and the return that capital
earns as an input in the production process.

Loanable funds are the amount of money lent out by one individual (lender) to another,
called a borrower. The borrower would pay an interest rate to the lender for the use of
that fund. For example, you borrow P10, 000 from a lending company with an interest
rate of 10% per month. After a month you must pay out P10, 100, with 100 as the
interest rate. In this case, interest is defined as payment for the immediate use of
money.

Interest rates affect the level of production of investment goods. A change in interest
rates results in a change in investment demand.

DETERMINANTS OF INTEREST RATE

Interest rate Is the chairman by the demand for and supply of money available as
loanable funds. Demand for loanable funds comprises the demand for consumer loans,
investment loans, and even the government while the supply of loanable funds comes
from people who save or consume less of their incomes.

NOMINAL AND REAL INTEREST RATES

The nominal interest rate is the rate determined by the supply and demand in the
market for loanable funds. Considered as the simplest type of interest rate, this is the
stated rate of a given loan. For example, the loans nominal rate is 5%, then the
borrowers can expect to pay 5 pesos of interest for every 100 pesos being loaned. This is
the actual monetary price that borrowers pay to lenders.

The real interest rate is the nominal interest rate adjusted for inflation. Because of
inflation, the lender's purchasing power is reduced so they can no longer buy the same
amount of goods when maturity comes, compared to the money they have right now.
By computing, a real interest rate inflation is already factored in. These can be
computed by the formula:

Real Interest Rate = Nominal Interest Rate – Expected Inflation Rate

A loan with a nominal interest rate of 7% and inflation of 4% would yield a real interest
rate of 3%. Understanding the differences between nominal and real interest rates
would allow individuals to make better decisions on their loans and investments. For
borrowers and lenders, they are interested in the real interest rates

RENT

When rent is mentioned, what's the first thing that strikes you? Naturally, be, it would
be the amount you pay if you're renting a house, an apartment, or if your student,
perhaps monthly payment in your dormitory or boarding house. Economic rent is the
price paid for the use of land and other natural resources or factors of production that is
in fixed supply. Rent has been traditionally associated with land, a fixed factor of
production. The concept of economic rent applies to economic factors, not just land.
Economic rent is a payment more than opportunity costs. According to David Ricardo,
rent is a surplus of revenue over cost which arises due to differences in the level of
usability of the land. The scarcity of land becomes the concept of rent.

ECONOMIC RENT: LAND

To analyze how the price of land, the rent, is determined, we look at the supply of land
and its level of demand. Since the supply of land is perfectly inelastic, it is the level of
demand that determines the rent on land. Since the supply of land is fixed, the man
becomes determinant of rent.

How is the demand for land determined then? Economic rent also relies on productivity
differences, several determinants include:

 The productiveness of the land

 Prices of other resources which are combined with the land

Aside from land used for crops, the land has other uses such as for building houses,
industrial factories, or highways. Since there are choices for which land can be used,
opportunity cost becomes a consideration. Individual firms then must pay rent the cover
opportunity cost if they want to keep the land for a specific purpose over the other. The
modern theory improves on David Ricardo’s theory of rent and extends the concept of
rent the links it to other factors of production in inelastic supply in the short run.

RENT SEEKING

If you own some property, you can receive rent being its owner. It is only your right to
benefit from the property in a structure that will favor you. Prophet, however, when
economic gains are obtained without reciprocating any benefits to the society, this is
cold rent seeking.

PROFIT

As income received by entrepreneurs’ profit is defined as a return on entrepreneurial

activity. This is the income made by an entrepreneur for using his entrepreneurial
abilities to run a business. Profits are divided into normal profits and economic profits.
Profit is a form of non-wage income.

Payments made entrepreneurs their return on their risk-taking is called normal profits.
Supplying entrepreneurship in the market would yield normal profits. Economic profit is
the entrepreneurs return above and beyond normal profits.

To explain economic profit further, let's assume a small bakery is operating wherein its
total revenue is good enough to pay for wages, interest, and rent as well as provides a
normal profit to the owner. When total revenue exceeds these economic costs, what
remains in the total revenue is an added reward to the entrepreneur. This revenue or
return is called the economic profit of pure profit which makes it above the normal
profit.

Profit=Value of Outputs-Value of Inputs

The value output is the total revenues received by the entrepreneur while the value of
inputs is the total cost incurred in the exercise of business. These gains are the
attraction for producers to engage in an industry.

MARKET NICHES

As intrapreneurs become eager to receive economic profits, they would like to know
market niches since these can provide economic profits. For instance, a market niche of
monopoly would allow a firm to gain more there is no competition. The market niche is
defined as a segment of the market that demands a commodity that is slightly
differentiated from other commodities. When an itch is identified, for example, the
market for sports gear, firms will intend to supply every sport-related gear possible,
such as for swim men, basketball, from babies to adults. Examples of a market niche are
the market for the luxury automobile industry, the market for organic foods, and
apparel.

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