15

Pricing the Factors

of Production
Rent is that portion of the produce of the earth which is paid to
the landlord for use of the original and indestructible
powers of the soil.
DAVID RICARDO (1772–1823)
Contents
Contents
●●The
The Principle
Principle of
of Marginal
Marginal Productivity
Productivity
●●Inputs
Inputs and
and Their
Their Derived
Derived Demand
Demand Curves
Curves
●●Investment,
Investment, Capital,
Capital, and
and Interest
Interest
●●The
The Determination
Determination of
of Rent
Rent
●●Payments
Payments toto Entrepreneurship:
Entrepreneurship: Are
Are Profits
Profits
Too
Too High
High or
or Too
Too Low?
Low?
●●Criticisms
Criticisms of
of Marginal
Marginal Productivity
Productivity Theory
Theory
●●Appendix:
Appendix: Discounting
Discounting and
and Present
Present Value
Value
Copyright© 2003 South-Western/Thomson Learning. All rights reserved.
 The
The Principle
Principle of
of Marginal
Marginal
Productivity
Productivity
●●Marginal productivity 
Marginal productivity  demand
demand for
for aa
factor
factor of
of production
production
●●Hire
Hire inputs
inputs up
up to
to the
the point
point where
where the
the
marginal
marginal revenue
revenue product
product == price
price of
of the
the
input
input (MRP
(MRP == P)P)

Copyright© 2003 South-Western/Thomson Learning. All rights reserved.

 TABLE 15-1
TABLE 15-1 Naomi’s
Naomi’s Natural
Natural
Farm
Farm Schedules
Schedules

Copyright© 2003 South-Western/Thomson Learning. All rights reserved.

 Inputs
Inputs and
and Their
Their Derived
Derived
Demand
Demand Curves
Curves
●●The
The demand
demand curve
curve for for an
an input
input isis the
the
downward-sloping
downward-sloping portion
portion of of its
its marginal
marginal
revenue
revenue product
product curve.
curve.
●●The
The demand
demand for
for an
an input
input isis called
called aa derived
derived
demand
demand because
because itit isis derived
derived fromfrom thethe
underlying
underlying demand
demand for for the
the final
final product.
product.

Copyright© 2003 South-Western/Thomson Learning. All rights reserved.

 FIGURE 15-1
FIGURE 15-1 MRP
MRP Schedule
Schedule for
for
Naomi’s
Naomi’s Natural
Natural Farm
Farm
$26
24
22
A
20
MRP per Bag of Corn per Week

18
16 D B
14
12
10 C
8
6
4
2
0
–2
–4
–6
–8
–10
–12
–14
–16
0 1 2 3 4 5 6 7 8 9 10 11 12

Bags of Corn per Week

Copyright© 2003 South-Western/Thomson Learning. All rights reserved.

 Inputs
Inputs and
and Their
Their Derived
Derived
Demand
Demand Curves
Curves
●●A
A shift
shift in
in the
the demand
demand curvecurve for
for aa
commodity
commodity causescauses aa similar
similar shift
shift in
in the
the
demand
demand curve
curve forfor the
the factors
factors used
used inin
producing
producing that that commodity.
commodity.

Copyright© 2003 South-Western/Thomson Learning. All rights reserved.

 FIGURE 15-2
FIGURE 15-2 A
A Shift
Shift in
in the
the
Demand
Demand Curve
Curve for
for Corn
Corn
$50 D1
MRP per Bag of Corn

40

30
D0
20

10
D0
D1
0 1 2 3 4 5 6 7 8 9 10

Bags of Corn per Week

Copyright© 2003 South-Western/Thomson Learning. All rights reserved.

 Investment,
Investment, Capital,
Capital, and
and
Interest
Interest
●●Investment
Investment (a (a flow)
flow) == increase
increase in
in capital
capital (a
(a
stock)
stock)
●●Rate
Rate of
of interest
interest == price
price at
at which
which funds
funds can
can
be
be rented
rented (borrowed)
(borrowed)

Copyright© 2003 South-Western/Thomson Learning. All rights reserved.

 FIGURE 15-3
FIGURE 15-3 The
The Investment
Investment
Production
Production Process
Process

Other
1 2 3 4 5
inputs
Investment flow: Added
Decide to increase Raise Buy inputs, use capital
the capital stock funds them to build up stock Production
capital stock
Initial
capital
stock

Copyright© 2003 South-Western/Thomson Learning. All rights reserved.

 Investment,
Investment, Capital,
Capital, and
and
Interest
Interest
●●The
The Demand
Demand for
for Funds
Funds
♦♦How
How does
does the
the firm
firm decide
decide how
how much
much toto
borrow?
borrow?
♦♦Sets
Sets marginal
marginal revenue
revenue product
product ofof the
the
investment
investment financed
financed byby the
the funds
funds == the
the
interest
interest payment
payment charged
charged for
for borrowing
borrowing

Copyright© 2003 South-Western/Thomson Learning. All rights reserved.

 Investment,
Investment, Capital,
Capital, and
and
Interest
Interest
●●The
The Demand
Demand for
for Funds
Funds
♦♦The
The productivity
productivity of of today's
today's investment
investment willwill
occur
occur inin the
the future;
future; its
its present
present value
value isis found
found
by
by discounting.
discounting.
♦♦In
In the
the discounting
discounting process,
process, thethe higher
higher the
the
interest
interest rate,
rate, the
the lower
lower thethe value
value of
of future
future
income.
income.

Copyright© 2003 South-Western/Thomson Learning. All rights reserved.

 Investment,
Investment, Capital,
Capital, and
and
Interest
Interest
●●The
The Downward-Sloping
Downward-Sloping Demand
Demand Curve
Curve for
for
Funds
Funds
♦♦The
The marginal
marginal revenue
revenue product
product curve
curve for
for an
an
investment
investment isis negatively
negatively related
related toto the
the interest
interest
rate.
rate.
♦♦Consequently,
Consequently, the the higher
higher the
the interest
interest rate,
rate, the
the
less
less people
people and
and firms
firms will
will want
want toto borrow
borrow to to
finance
finance their
their investments.
investments.

Copyright© 2003 South-Western/Thomson Learning. All rights reserved.

 FIGURE 15-4
FIGURE 15-4 The
The Derived
Derived
Demand
Demand Curve
Curve for
for Loans
Loans
D

Rate of Interest in Percent per Year

0
Dollars Demanded per Year

Copyright© 2003 South-Western/Thomson Learning. All rights reserved.

 Investment,
Investment, Capital,
Capital, and
and
Interest
Interest
●●The
The Supply
Supply of
of Funds
Funds
♦♦Interest
Interest == reward
reward toto people
people for
for saving,
saving, i.e.,
i.e., for
for
foregoing
foregoing present
present consumption
consumption
Normally,  interest
♦♦Normally, interest   savings
savings

Copyright© 2003 South-Western/Thomson Learning. All rights reserved.

 Investment,
Investment, Capital,
Capital, and
and
Interest
Interest
●●The
The Supply
Supply of
of Funds
Funds
♦♦However,
However, people
people who
who have
have specific
specific target
target
goals
goals for
for accumulated
accumulated savings
savings may
may lower
lower their
their
current
current rate
rate of
of saving
saving when
when interest
interest rates
rates rise.
rise.
♦♦Typically,
Typically, therefore,
therefore, the
the supply
supply curve
curve ofof
savings
savings isis positively
positively sloped,
sloped, but
but fairly
fairly steep.
steep.

Copyright© 2003 South-Western/Thomson Learning. All rights reserved.

 FIGURE 15-5
FIGURE 15-5 Equilibrium
Equilibrium in
in the
the
Market
Market for
for Loans
Loans
D S

Rate of Interest in Percent per Year

7.5% E

A B
5.5

S D

0
Dollars Lent per Year

Copyright© 2003 South-Western/Thomson Learning. All rights reserved.

 Investment,
Investment, Capital,
Capital, and
and
Interest
Interest
●●The
The Issue
Issue of
of Usury
Usury Laws:
Laws: Are
Are Interest
Interest
Rates
Rates Too
Too High?
High?
♦♦Governments
Governments may may attempt
attempt to
to limit
limit interest
interest
rates
rates by
by imposing
imposing usury
usury laws.
laws.
♦♦When
When they
they dodo so,
so, they
they benefit
benefit the
the people
people whowho
are
are able
able to
to borrow
borrow funds,
funds, but
but they
they harm
harm thethe
lenders
lenders and
and the
the people
people who
who would
would like
like to
to
borrow
borrow but
but cannot
cannot find
find funds.
funds.

Copyright© 2003 South-Western/Thomson Learning. All rights reserved.

 The
The Determination
Determination of
of Rent
Rent

●●Fixed
Fixed supply
supply of land 
of land  determination
determination of of
the
the market
market level
level of
of land
land rent
rent by
by the
the demand
demand
side
side
●●Economic
Economic rent
rent == anan "extra"
"extra" payment
payment forfor aa
factor
factor of
of production
production (such
(such asas land)
land) that
that does
does
not
not change
change the
the amount
amount of of the
the factor
factor that
that isis
supplied
supplied

Copyright© 2003 South-Western/Thomson Learning. All rights reserved.

 The
The Determination
Determination of
of Rent
Rent

●●Economic
Economic rentrent is,
is, thus,
thus, that
that portion
portion of
of the
the
factor
factor payment
payment thatthat exceeds
exceeds thethe minimum
minimum
payment
payment necessary
necessary to to induce
induce any
any of
of that
that
factor
factor to
to be
be supplied.
supplied.

Copyright© 2003 South-Western/Thomson Learning. All rights reserved.

 The
The Determination
Determination of
of Rent
Rent

●●Land
Land Rents:
Rents: Complicated
Complicated Version
Version
♦♦Capital
Capital invested
invested on on any
any piece
piece of
of land
land must
must
yield
yield the
the same
same return
return as
as capital
capital invested
invested on on any
any
other
other piece
piece of
of land
land that
that isis actually
actually inin use.
use.
♦♦Any
Any land
land that
that isis exactly
exactly onon the
the borderline
borderline
between
between being
being used
used and
and not
not being
being used
used isis
called
called marginal
marginal land.land.

Copyright© 2003 South-Western/Thomson Learning. All rights reserved.

 The
The Determination
Determination of
of Rent
Rent

●●Land
Land Rents:
Rents: Complicated
Complicated Version
Version
♦♦Rent
Rent on
on aa piece
piece of
of land
land == cost
cost of
of producing
producing
the
the output
output onon that
that land
land minus
minus the
the cost
cost of
of
producing
producing itit on
on marginal
marginal land
land

Copyright© 2003 South-Western/Thomson Learning. All rights reserved.

 TABLE 15-2
TABLE 15-2 Nonrent
Nonrent Costs
Costs and
and
Rent
Rent on
on Three
Three Pieces
Pieces of
of Land
Land

Copyright© 2003 South-Western/Thomson Learning. All rights reserved.

 The
The Determination
Determination of
of Rent
Rent

●●Land
Land Rents:
Rents: Complicated
Complicated Version
Version
 demand
demand 

■■community
community uses
uses land
land previously
previously thought
thought to
to be
be
submarginal
submarginal
■■more
more intensive
intensive exploitation
exploitation of
of already
already used
used land
land

Copyright© 2003 South-Western/Thomson Learning. All rights reserved.

 FIGURE 15-6
FIGURE 15-6 Determination
Determination of
of
Land
Land Rent
Rent in
in Littleville
Littleville
Annual Rent per Acre
D S

$2,000 E

D
S
1,000

Acres of Land

Copyright© 2003 South-Western/Thomson Learning. All rights reserved.

 The
The Determination
Determination of
of Rent
Rent

●●Land
Land Rents:
Rents: Complicated
Complicated Version
Version
♦♦This
This increases
increases thethe differential
differential between
between other
other
plots
plots of
of land
land and
and marginal
marginal land
land and,
and, therefore,
therefore,
increases
increases rent.
rent.

Copyright© 2003 South-Western/Thomson Learning. All rights reserved.

 The
The Determination
Determination of
of Rent
Rent

●●Generalization:
Generalization: Economic
Economic Rent
Rent Seeking
Seeking
♦♦Economic
Economic rent rent isis any
any payment
payment made made toto aa factor
factor
above
above the
the amount
amount necessary
necessary to to induce
induce any
any of of
that
that factor
factor to
to be
be supplied
supplied toto its
its present
present
employment.
employment.
♦♦Some
Some portion
portion ofof every
every factor’s
factor’s income
income will
will
consist
consist of
of economic
economic rent rent in
in this
this sense,
sense, unless
unless
the
the factor’s
factor’s supply
supply curve
curve isis horizontal.
horizontal.

Copyright© 2003 South-Western/Thomson Learning. All rights reserved.

Application
Application of
of Rent
Rent Theory:
Theory:
Salaries
Salaries of
of Professional
Professional Athletes
Athletes
●●When
When athletes
athletes would
would be be willing
willing to
to play
play for
for
quite
quite aa bit
bit less
less than
than their
their salary,
salary, the
the
“excess”
“excess” salary
salary isis economic
economic rent.
rent.
♦♦This
This same
same analysis
analysis applies
applies to
to any
any factor
factor of
of
production
production whose
whose supply
supply curve
curve isis not
not
horizontal.
horizontal.
♦♦Only
Only those
those factors
factors that
that can
can be
be reproduced
reproduced by by aa
number
number of of producers
producers at at constant
constant cost
cost earn
earn no
no
rents.
rents.
Copyright© 2003 South-Western/Thomson Learning. All rights reserved.
“A-ROD”:
“A-ROD”: Earning
Earning Lots
Lots of
of Rent
Rent

●●Alex
Alex Rodriquez,
Rodriquez, Texas
Texas Rangers,
Rangers, recently
recently
signed
signed aa 10-year,
10-year, $252
$252 million
million contract
contract
●●This
This makes
makes him
him the
the highest
highest paid
paid athlete
athlete in
in
history.
history.
●●Assuming
Assuming he he would
would play
play baseball
baseball for
for
significantly
significantly less,
less, much
much of
of his
his contract
contract
represents
represents economic
economic rent
rent
Rent
Rent Controls:
Controls: The
The Misplaced
Misplaced
Analogy
Analogy
●●People
People sometimes
sometimes think
think that
that rents
rents on
on
housing
housing are
are economic
economic rents.
rents.
♦♦They
They could
could then
then be
be lowered
lowered without
without reducing
reducing
the
the quantity
quantity supplied.
supplied.
●●This
This may
may be
be true
true in
in the
the short
short run.
run.

Copyright© 2003 South-Western/Thomson Learning. All rights reserved.

Rent
Rent Controls:
Controls: The
The Misplaced
Misplaced
Analogy
Analogy
●●But
But in
in the
the long
long run,
run, the
the housing
housing market
market isis
quite
quite competitive.
competitive.
♦♦An
An effective
effective rent
rent control
control law
law is,
is, therefore,
therefore,
likely
likely to
to lead
lead to
to aa reduction
reduction in
in housing
housing andand
consequent
consequent shortages.
shortages.

Copyright© 2003 South-Western/Thomson Learning. All rights reserved.

 FIGURE 15-7
FIGURE 15-7 A
A Shift
Shift in
in Demand
Demand
with
with aa Vertical
Vertical Supply
Supply Curve
Curve
S
D
Annual Rent per Acre

$2,000 E

D
S
1,000

Acres of Land

Copyright© 2003 South-Western/Thomson Learning. All rights reserved.

 Payments
Payments to
to
Entrepreneurship
Entrepreneurship
●●Profits
Profits are
are aa small
small portion
portion of
of GDP.
GDP.
●●They
They are
are the
the residual:
residual: what
what remains
remains from
from
revenue
revenue after
after all
all other
other factors
factors have
have been
been
paid
paid

Copyright© 2003 South-Western/Thomson Learning. All rights reserved.

 Payments
Payments to
to
Entrepreneurship
Entrepreneurship
●●What
What Accounts
Accounts for
for Profits?
Profits?
♦♦In
In pure
pure competition,
competition, economic
economic profits
profits
disappear
disappear in in the
the long
long run.
run.
♦♦In
In the
the real
real world,
world, however,
however, they
they persist
persist for
for
different
different reasons:
reasons:
■■Monopoly
Monopoly power
power
■■Risk
Risk bearing
bearing
■■Returns
Returns to
to innovation
innovation

Copyright© 2003 South-Western/Thomson Learning. All rights reserved.

 Payments
Payments to
to
Entrepreneurship
Entrepreneurship
●●Taxing
Taxing Profits
Profits
♦♦We
We dodo not
not know
know whether
whether thethe observed
observed profit
profit
rate
rate provides
provides more
more than
than the
the minimum
minimum reward
reward
necessary
necessary toto attract
attract entrepreneurial
entrepreneurial talent
talent into
into
the
the market.
market.

Copyright© 2003 South-Western/Thomson Learning. All rights reserved.

 Payments
Payments to
to
Entrepreneurship
Entrepreneurship
●●Taxing
Taxing Profits
Profits
♦♦This
This relationship
relationship between
between observed
observed profit
profit rates
rates
and
and minimum
minimum necessary
necessary rewards
rewards isis crucial
crucial
when
when wewe start
start to
to consider
consider the
the policy
policy
ramifications
ramifications ofof taxes
taxes on
on profits.
profits.

Copyright© 2003 South-Western/Thomson Learning. All rights reserved.

 Payments
Payments to
to
Entrepreneurship
Entrepreneurship
●●Taxing
Taxing Profits
Profits
♦♦IfIf an
an industry
industry earns
earns profit
profit rates
rates well
well above
above the
the
minimum
minimum required
required toto attract
attract entrepreneurial
entrepreneurial
talent,
talent, those
those profits
profits contain
contain aa large
large element
element ofof
economic
economic rent.rent.
♦♦In
In that
that case,
case, we
we could
could tax
tax away
away these
these excess
excess
profits
profits (rents)
(rents) without
without fear
fear of
of reducing
reducing the
the
industry’s
industry’s production.
production.

Copyright© 2003 South-Western/Thomson Learning. All rights reserved.

 Payments
Payments to
to
Entrepreneurship
Entrepreneurship
●●Taxing
Taxing Profits
Profits
♦♦On
On the
the other
other hand,
hand, ifif the
the profits
profits being
being earned
earned
by
by the
the industry
industry do
do not
not include
include economic
economic rents,
rents,
then
then aa windfall
windfall profits
profits tax tax can
can seriously
seriously curtail
curtail
research
research and
and development
development and and production.
production.

Copyright© 2003 South-Western/Thomson Learning. All rights reserved.

Public
Public Opinion
Opinion on
on Profits
Profits
What
people
estimate
What people
think is a
“reasonable”
profit

32%

26%

Actual
profit
3.8%

Profit per Dollar of Sales

Copyright© 2003 South-Western/Thomson Learning. All rights reserved.

 Criticism
Criticism of
of Marginal
Marginal
Productivity
Productivity Theory
Theory
●●Some
Some people
people criticize
criticize the
the theory
theory for
for
providing
providing what
what isis seen
seen asas aa moral
moral
justification
justification for
for the
the status
status quo
quo in
in income
income
distribution.
distribution.
●●Marginal
Marginal productivity
productivity theory,
theory, however,
however, has
has
no
no moral
moral content.
content.

Copyright© 2003 South-Western/Thomson Learning. All rights reserved.

 Criticism
Criticism of
of Marginal
Marginal
Productivity
Productivity Theory
Theory
●●AA better
better criticism
criticism is
is that
that the
the theory
theory gives
gives
only
only incomplete
incomplete insight
insight into
into many
many current,
current,
pressing
pressing problems
problems ofof income
income distribution,
distribution,
including
including poverty
poverty and
and underdevelopment.
underdevelopment.

Copyright© 2003 South-Western/Thomson Learning. All rights reserved.

 Appendix:
Appendix: Discounting
Discounting and
and
Present
Present Value
Value
●●The
The present
present valuevalue ofof aa future
future income
income stream
stream
depends
depends inversely
inversely upon upon the the interest
interest rate
rate
used
used in
in discounting.
discounting.
●●The
The general
general formula
formula for for the
the present
present value
value of
of
$1.00
$1.00 to
to be
be received
received N N years
years from
from today
today
when
when the
the rate
rate of of interest
interest isis
$1.00  (1
ii == $1.00 (1 ++ I)N
I)N

Copyright© 2003 South-Western/Thomson Learning. All rights reserved.