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

● The Principle of Marginal Productivity

● Inputs and Their Derived Demand Curves
● Investment, Capital, and Interest
● The Determination of Rent
● Payments to Entrepreneurship: Are Profits
Too High or Too Low?
● Criticisms of Marginal Productivity Theory
● Appendix: Discounting and Present Value
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 The Principle of Marginal
Productivity
● Marginal productivity  demand for a
factor of production
● Hire inputs up to the point where the
marginal revenue product = price of the
input (MRP = P)

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 TABLE15-1 Naomi’s Natural
Farm Schedules

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 Inputs and Their Derived
Demand Curves
● The demand curve for an input is the
downward-sloping portion of its marginal
revenue product curve.
● The demand for an input is called a derived
demand because it is derived from the
underlying demand for the final product.

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 FIGURE15-1 MRP Schedule for
Naomi’s Natural 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

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 Inputs and Their Derived
Demand Curves
● A shift in the demand curve for a
commodity causes a similar shift in the
demand curve for the factors used in
producing that commodity.

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 15-2 A Shift in the
FIGURE
Demand Curve for 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

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

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 FIGURE 15-3 The Investment
Production 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

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

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

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

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 15-4 The Derived
FIGURE
Demand Curve for Loans
D

Rate of Interest in Percent per Year

0
Dollars Demanded per Year

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

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

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

Rate of Interest in Percent per Year

7.5% E

A B
5.5

S D

0
Dollars Lent per Year

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

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 The Determination of Rent

● Fixed supply of land  determination of

the market level of land rent by the demand
side
● Economic rent = an "extra" payment for a
factor of production (such as land) that does
not change the amount of the factor that is
supplied

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 The Determination of Rent

● Economic rent is, thus, that portion of the

factor payment that exceeds the minimum
payment necessary to induce any of that
factor to be supplied.

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 The Determination of Rent

● Land Rents: Complicated Version

♦ Capital invested on any piece of land must
yield the same return as capital invested on any
other piece of land that is actually in use.
♦ Any land that is exactly on the borderline
between being used and not being used is
called marginal land.

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 The Determination of Rent

● Land Rents: Complicated Version

♦ Rent on a piece of land = cost of producing
the output on that land minus the cost of
producing it on marginal land

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

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 The Determination of Rent

● Land Rents: Complicated Version

  demand 
■ community uses land previously thought to be
submarginal
■ more intensive exploitation of already used land

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 FIGURE15-6 Determination of
Land Rent in Littleville
Annual Rent per Acre
D S

$2,000 E

D
S
1,000

Acres of Land

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 The Determination of Rent

● Land Rents: Complicated Version

♦ This increases the differential between other
plots of land and marginal land and, therefore,
increases rent.

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 The Determination of Rent

● Generalization: Economic Rent Seeking

♦ Economic rent is any payment made to a factor
above the amount necessary to induce any of
that factor to be supplied to its present
employment.
♦ Some portion of every factor’s income will
consist of economic rent in this sense, unless
the factor’s supply curve is horizontal.

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Application of Rent Theory:
Salaries of Professional Athletes
● When athletes would be willing to play for
quite a bit less than their salary, the
“excess” salary is economic rent.
♦ This same analysis applies to any factor of
production whose supply curve is not
horizontal.
♦ Only those factors that can be reproduced by a
number of producers at constant cost earn no
rents.

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“A-ROD”: Earning Lots of Rent

● Alex Rodriquez, Texas Rangers, recently

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

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

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

$2,000 E

D
S
1,000

Acres of Land

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

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

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

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

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

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

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

32%

26%

Actual
profit
3.8%

Profit per Dollar of Sales

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

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

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

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