Rent, Interest, Profits and Capitalization
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Rent, Interest, Profits and Capitalization
How the "Boss" Collects Economic Rent
Robert W.
The concept of economic rent is important, but not very
interesting if explained using the standard example of land. An example that I use is of interest to most
students and illustrates the fact that economic rent is the biggest component
of most "superstar" earnings.
Bruce Springstein, or the "boss" as some fans call him, is a
rock star that most students of the current, and recent past generations, know
quite a bit about. He got his start
playing small bars in the 1960s along the
A hypothetical market for Springstein's labor is given in Figure 30-1. This market shows that any pay above $100 per concert hour is pure economic rent because it does not cause Bruce to play anymore than the three hours physically possible. Springstein's fans may questions whether it is "right" for the "boss" to receive such a high wage. In fact, some fans probably think that his high wage is what causes concert tickets to be so expensive. It is easy to show that they have the causation backwards. Fans have only their own behavior to blame for his high wage. Both the willingness of fans to pay high concert ticket prices, and their willingness to see him play in large auditoriums which drives up his marginal physical product (MPP), has increased the demand (MRP) for his services by concert promoters and consequently the wage they are willing to pay him. A sure way for fans to lower his, and other superstar wages, is to boycott their performances. As Johnny Carson once said, "I'm especially grateful, as I have no other marketable skills."
Figure 30-1
The Model Matters ‑ Rent Control
David Hemenway,
When presenting `real world' illustrations of economic principles, I try to emphasize the importance of the assumptions being made. For example, almost all economists (including myself) believe that a ceiling on rents will reduce the quantity of housing units available. This is certainly the result of the competitive model. However, if the competitive assumptions do not hold, the conclusion may not follow. In a monopoly model, for example, rent control conceivably might increase the supply of housing. (See the figure below.) This is similar to rate regulation of natural monopolies (e.g., utilities) increasing output. The same principle is inherent in the possibility that minimum wage laws or union‑set wages might increase not only the price of labor, but the amount employed in a monopsony market.
Figure 30‑2
Are Professional Athletes Worth What They are Paid?
Eric K. Steger,
Quite often my students say that the huge salaries earned by professional athletes are excessive. They say that nobody is worth that kind of salary. I quickly disagree and point out that the market, although not perfectly competitive, says that these people are "worth" whatever they are paid. The moment when the athlete's marginal contribution to the team is less than the cost of the team, the team will terminate this athlete's services. I point out that the professional athlete is simply a labor resource input into a profit motivated production function. Due to this fact, an employer will not pay an excessive salary.
Smog, Urban Crime, and Economic Rents
Ralph T. Byrns
Suppose a humanitarian, primarily concerned with the plights of the impoverished, were given a "Magic Button" that would, at zero resource cost, completely eliminate pollution. Would it be consistent with the humanitarian's desires to activate the button? Curiously, the answer is NO.
The reason is that when highly polluted urban cores become more attractive for residents, numerous affluent suburbanites move downtown to avoid the transportation and time costs of commuting. This bids up rents in urban centers, driving poor people into suburban slums, where they would live no better than previously, but would be forced to commute. This line of reasoning suggests that the poor actually benefit from pollution. Parallel reasoning suggests that elimination of street crime or other forms of urban malaise would also harm the urban poor by bidding up central city rents.
After discussing these issues at some length with your class (and we promise lively debates) you might point out that this reasoning focuses on substitution effects (the changes in the relative prices of residential locations), while the positive income effects emerging from the elimination of such social bads may provide benefits to the poor that more than offset the perverse effects on income distribution of the substitution effects. If so, it may be that the poor do not gain because of urban problems. (This exercise aids students in comprehending capitalization and economic rents. We first heard the general idea from Armen Alchian.)
Thomas J. Shea,
In discussing the Schumpeterian view of profit as a return to a "special factor of production‑‑ the entrepreneur," students need to have an example of an entrepreneur rather than an inventor. The one that gets their attention is Hugh Hefner. I tell them that he did not invent sex (it was invented by the Phoenicians) nor "sex magazines" (they were invented by the Babylonians). But he was the first to successfully package a magazine that skillfully combined a pseudo‑intellectual philosophy, some fine writing by Faulkner, Hemingway and others, as well as airbrushed photographs of incredibly beautiful women. He reaped huge profits as a result of what Schumpeter would have called entrepreneurial talent.
Dynamic Economic Processes: The Bubble and Crash
Mark E. Schaefer,
The investment accelerator and the cobweb model are two frequently discussed examples of dynamical processes in economics. We need to expand our standard repertoire to include the case of destabilizing speculation or the so‑called "asset bubble." You can count on having enthusiastic student response and an energetic class session when you raise the topic of wide swings in the stock market. An unsustainable rise in the price of one stock or the whole market is often compared to an expanding soap bubble which must finally burst.
You may want to focus the discussion by asking three questions. How does a bubble, or rise, in the price of a stock get started? What inherent internal process will eventually burst any purely speculative bubble in the price of stock? What early warning signal should alert you that the turning point is near, so you can switch sides from "long" to "short"?
The following sketch of a possible bubble may give the students something to sharpen their teeth on. To say that a stock is overvalued we need to know the true value, which can be conceptualized as the present discounted value of the future stream of dividends actually paid out to shareholders. Some will suggest that expected future appreciation of the share price influences present demand for shares, which is probably true, but which is also the conceptual error of double counting which sets the stage for the bubble to even exist.
The first act in the bubble drama is the noticeable rise in the price of the asset. This run‑up may be due to the announcement or rumor of new favorable information. It may be due to a string of random but positive price changes which will occasionally happen by the laws of chance. Or it may be the result of manipulation by a small close‑knit group of market participants who intend to bilk the large uniformed but greedy mass.
The second act starts when speculators notice and pile on, leveraging themselves by using borrowed money ("call" loans or overnight loans which can be immediately recalled, perhaps forcing the borrower to sell in a declining market) whose interest rate is variable but below the expected appreciation rate of the asset. This frenzy of buying to beat the expected price rise causes the market price to overshoot the true value of the asset, creating a bubble which will eventually burst. The hysteria may become so intense that lenders also switch to borrowing and speculating in an attempt to capture the rates of return that they see their customers reaping. So the interest rate rises, perhaps drastically.
The third act of the drama begins when the interest rate on loans eventually exceeds the appreciation rate of the stock. Then the leveraged speculators are suddenly losing money. They are being squeezed and must sell. The stock stops rising, hesitates briefly at its peak and begins to fall. This turning point is followed by the fourth act in which panic sets in as highly levered buyers are forced to sell to meet margin requirements on the stock they have purchased on borrowed money. As they trample on each other trying to get out of the stock, its market price plummets.
This crash in value of the asset leads to the fifth and final act in which the price falls below the true value. If the price ever begins a recovery, the trend of rising price toward true value is noticed by speculators and act one of the drama begins again. We know the turning point is near when the interest rate on loans begins to rise and approach the appreciation rate of the stock. Appropriate defensive action should then be taken.
Why All Stock Purchases Are "Mistakes"
Eric Steger,
I state that all stock purchases are mistakes. Obviously, students protest and say I'm wrong. I explain the following:
(1) If you sell the stock for less than you paid for it, it is a mistake. They agree
(2) If the stock remains at the same price and pays no dividends, the opportunity costs of interest forgone hurts investors.
(3) If the stock is purchased at the all time low and sold and the all time high, this is also a mistake. They ask "how” I explain that an investor with 20-20 hindsight should have mortgaged his/her home and "scraped together" every penny to invest in the stock. This mistake here is that you didn't buy enough of this stock.
I explain that you can always set yourself up to be a loser in stock purchases if you have this perspective.
Explaining The Role of the Stock Market
James E. Harmon,
In the "conventional wisdom" the stock market is believed to be an accurate measuring instrument of the health of the economy. Many column inches of commentary to this effect pervade the media. But the price of stock is governed by its expected price/earnings ratio, which is only the investor's belief about future profits. Further, as James Balog of Drexel, Burnham, Lambert notes "over the past 50 years only 3% of all corporate capital has come from common stock. The rest comes either from retained earnings or debt" (Christian Science Monitor, Nov. 26, 1985, p. 31 in John Yemma's “Business” column). If only 3 cents of every corporate capital dollar comes from the stock market, then what is the actual or major function of the stock market in the economy?
Let the student ponder this in groups or entire class. Usually a bright one will light up finally and blurt it out. If they cannot break through, gently suggest that they look at it as a socially approved lottery in which certain kinds of people play as they bet against each other's money and beliefs. The stock market, then, may be a better indication of the nation's euphoria or neuroses than anything else.
This exercise also sets the stage for further discussion of risk capital and small business financing, corporate debt (bonds), retained earnings, and administered pricing. I have used this for 15 years to generate interest in the subject among my students. The kernel of this idea is drawn from the 1950s writings of A.A. Berle about the role of the corporation.
Aaron A. Hutcheson,
The "Time Value of Money" is discussed in economics classes in many different ways: inflation, deflation, present value, real purchasing power, appreciation, depreciation, and etc. A "prop" that I have found most useful to get the attention of students and to make the economic point is to use a "shrunken" dollar. The shrinking process is described visually below.
Figure 30-3
Why Do Positive Rates of Interest Exist?
Charlotte Twight,
I introduce students to the concept of positive interest rates by asking the class if someone has a ten dollar bill (or twenty!) that I can use to illustrate a few points in the day's lecture. When some unsuspecting soul volunteers the hard cash, I take it and very slowly and conspicuously walk back to the front of the room, get out my wallet, put the money in my wallet, and put the wallet away. I then turn to the class, as if to commence the lecture. There is typically much laughter and commotion at this point. The person who volunteered the cash usually begins to protest, in response to which I feign surprise and say I just wanted to use the money for a year. Wouldn't that be all right if I just returned the $10 to the person a year from now? Of course at an intuitive level, especially when their own money is at stake, they know that's not okay, and it's amazing how quickly the students will tell me all the reasons: risk, opportunity cost, and the like, why they would require compensation if they were to allow me to have the use of their money for a year. There is often at least one venturesome person who states that it would be all right for me to keep the money for a year and return it without interest if he or she could be assured of an A in the course! This offer, of course, further illustrates the point that some compensation would be required.
Revealing Time Preference: A Bidding Game
Edward D. Lotterman,
A good understanding of the human preferences which underlie basics such as interest and discounting is important in many economics and business courses. A simple technique for illustrating time preferences for money is to conduct a short bidding game with one or more students. It is necessary to bring a dollar bill as well as loose change amounting to another dollar to class. The money should be placed on a table or desk in view of the class, the dollar bill on one hand, and the pile of loose change also equaling a dollar on the other. A student is selected and given the choice of one dollar in loose change now or the dollar bill at a later date (the day of the final exam is a good choice). Most students naturally prefer to have the dollar today. The next step is to remove a penny from the pile of change and ask the student what his preferences are given this new choice, $1 at a future date, or $.99 right away. The process is repeated with the sum of money offered at the present successively reduced by 1 or 2 cent increments until the student decides to wait for the dollar in the future. At that point go back to the last sum the student preferred to have at the present and give him that amount. (Most students will be absolutely flabbergasted when you give them the money).
Then on the blackboard or overhead,
go through the process of calculating that student's time preference for money
or implicit interest rate. Most students are willing to pay very high rates of
interest in games such as this, usually 15‑25% in my experience in the
If you are willing to spend the cash, it is often useful to select a sample of four people, send them out of the room so that they cannot observe each other, and then go through the process with them one by one. This highlights interesting differences between individuals in time preferences. You can try to see if there are differences between men and women, graduate students and undergrads, business students and econ students and the like. You will probably run out of money before you come up with any results that are statistically significant, but the process can be fun. Costs can be reduced by using a smaller sum of money than a dollar, but in my experience $.25 or less is not enough, it is too much of a "game" and you get very spurious, inconsistent results. I doubt that this game is original with me, but do not know who to credit with the idea. None of my profs used it when I was a student!
The Magazine Subscription Problem
Stephen H. Archer,
To help students' understanding of the time value of money and the greater worth of present dollars compared to future dollars, I use the practical magazine subscription decision. Most publishers offer a major discount if one is willing to subscribe to their magazines on a multiple year basis. Students are usually familiar with these come‑ons. But how can they make an intelligent choice from among the alternatives presented?
For example, suppose the magazine's offer is to subscribe for one year at $18 and two years at $34. I have to assume that (1) the subscriber wants the magazine for at least two years and (2) next year's one year rate will be the same as this year's rate, $18. In this example, the expenditure of $16 more today saves an expenditure of $18 one year from now. If the subscriber must take the $16 out of a savings account earning 6%, then the opportunity cost of money is 6% and the present value of $18 is $18/1.06 = $16.98. Sixteen dollars is less cost than the present value of $18, so choose to subscribe for two years.
In terms of rate of return, spending the $16 now saves us $18 in one year, so the rate of return on the $16 is $18/16‑1.0 = .125 or 12.5%. One can earn 12.5% by buying the second year subscription now; this exceeds the 6% return in the savings account. One earns $2 by subscribing for the second year now versus $16(.06) = $.96 in the savings account.
You could extend this type of illustration to the discount that insurance companies offer for paying premiums annually instead of semiannually.
Backwards Bending Supplies of Loanable Funds?
Ralph T. Byrns
Proponents of supply side economics argued that cuts in tax rates should increase saving, reduce interest rates, and increase investment. Use the loanable funds model to outline the theoretical foundations for this view. (Some of the discussion about saving and interest rates in Chapter 19 may be helpful.) Use income and substitution effects to show how higher after‑tax rates of returns may reduce instead of increase saving, using logic that parallels the development of `backward‑bending' labor supply curves.
Mortgage Rates, Tax Deductions, and Housing Prices
Ralph T. Byrns
Use the present value formula to show why rising mortgage rates should reduce the demand for housing, and vice versa. Treat the PV as the demand price for a future stream of housing services. Let the Yi represent the value of the future housing services in period i. Now use competitive assumptions to show how the equilibrium price of housing should equal the capitalized value of future rental incomes. (This idea can be extended into a discussion of how the value of owner‑occupied housing is imputed for the GDP accounts.) Discuss how income tax deductions of interest payments on home mortgages artificially raises the prices of homes aid otherwise distorts the housing market.