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Theme 6: THE MARKETS FOR THE FACTORS OF PRODUCTION
1.THE FACTORS OF PRODUCTION are the inputs used to produce goods and services. Labor, land, and capital are the three most important factors of production. Although in many ways factor markets resemble the goods markets, but they are different in one important way: The demand for a factor of production is a derived demand. That is, a firm’s demand for afactor of production is derived from its decision to supply a good in another market. The demand for computer programmers is inextricably tied to the supply of computer software, and the demand for gas station attendants is inextricably tied to the supply of gasoline.
=Land (natural resource) - natural resources used in the creation of products, paid in economic rent, because they are simply irreproduceable.
=Labor - human efforts provided in the creation of products, paid in wage.
=Capital goods - human-made goods or means of production (including machinery, building and so forth) used in the production of other goods, paid in interest.
Income from exploiting the 3 production factors comprises the national income.
Capital and labor are active factors while land is passive. One can only shift capital and labor rather than land which is given limited, to get a production-factor combination, which is further reflected in the technology a firm employs to produce products and services.
Labor operates capital to produce. The ratio of labor over capital is a major decision almost all firms must make. In the decision process, decision makers must understand that neither too much labor per unit of capital nor too much capital per unit of labor is acceptable since either way efficiency is not achieved. The 2 factors must come around someplace that both of them contribute equally to the final economic value realized.
2.DERIVED DEMAND FOR RESOURCES:
Derived demand is a term in economics, where demand for one good or service occurs as a result of the demand for another intermediate/ final good or service. This may occur as the former is a part of production of the second. For example, demand for coal leads to derived demand for mining, as coal must be mined for coal to be consumed. As the demand for coal increases, so does its price. The increase in price leads to a higher demand for the resources involved in mining coal. And therefore:
Where MRP is the marginal revenue product of labor, MPP is the marginal physical product of labor, and P is the price of the physical product of labor.
Derived demand applies to both consumers and producers. Producers have a derived demand for employees. The employees themselves are not demanded; rather, the skills and productivity that they bring are.
Example: Demand for tickets is a derived demand for entertainment. Demand for entertainment is the demand being satisfied when a ticket is bought. Hence purchasing the ticket is purely a means to an end. The ticket is merely a license to attend a specified event at a specified time and place. The ticket agency is merely that, an agent of the principal (the event owner) authorized to make a transaction with a prospective attendee on the behalf of the principal.
When supply for a particular good or service increases, the derived demand for factors of production needed in producing this good or service also increases. Therefore this drives up the price for the factors of production and a firm's average cost curve increases as it has incurred a variable cost eg: increase in wages. Conversely, when supply for a good or service decreases so does the derived demand for its inputs. This causes the price of factors of production to decrease, decreasing a firm's average cost curve.
This is similar to the concept of joint demand or complementary goods. One good or service is the complement of another. E.g. when you buy a car it will not work ling unless it has fuel (petrol/ Diesel etc). As a result, if the price of fuel rises as they have been doing recently, so to does the overall cost of owning the car. Hence fuel is the complementary good of the car.
3.MARGINAL REVENUE PRODUCT AND MARGINAL RESOURCE COST:
As long as the firms using the factors of production are competitive and profit-maximizing, each factor’s rental price must equal the value of the marginal product for that factor. Labor, land, and capital each earn the value of their marginal contribution to the production process.
Marginal revenue product –change in output that results from changing the labor input by one unit, all other factors remaining constant: MRP = change in total revenue/change in the quantity of the resource employed.
It indicates how much total revenue changes by employing another unit of variable input.
Marginal revenue product is an essential component of factor market analysis and marginal productivity theory. The extra revenue generated by an input is the key influence on the price an employer is willing and able to pay to hire the input. An input with a greater marginal revenue product is bound to receive a higher price, payment, or income than one with a lower marginal revenue product.
Mathematical relation: The marginal revenue product of labour MRPL is the increase in revenue per unit increase in the variable input = ∆TR/∆L
MR = ∆TR/∆Q; MPL = ∆Q/∆L;MR x MPL = (∆TR/∆Q) x (∆Q/∆L) = ∆TR/∆L;
Note that the change in output is not limited to that directly attributable to the additional worker. Assuming that the firm is operating with diminishing marginal returns then the addition of an extra worker reduces the average productivity of every other worker (and every other worker affects the marginal productivity of the additional worker) - in English everybody is getting in each other's way.
As above noted the firm will continue to add units of labor until the MRPL = w
Mathematically until: MRPL = w; MR(MPL) = w; MR = w/MPL; MR = MC which is the profit maximizing rule.
Under perfect competition, marginal revenue product is equal to marginal physical product (extra unit produced as a result of a new employment) multiplied by price.
This is because the firm in perfect competition is a price taker. It does not have to lower the price in order to sell additional units of the good.
Firms operating under conditions of monopoly or imperfect competition are faced with downward sloping demand curves. If they want to sell extra units of output, they must lower price. Under such market conditions, marginal revenue product will not equal MPP×Price. This is because the firm is not able to sell output at a fixed price per unit.
The MRP curve of a firm in monopoly or imperfect competition will slope downwards at a faster rate than in perfect competition. This can be explained as follows:
1.MPP slopes downwards because of the operation of the Law of Diminishing Returns. MRP depends on MPP.
2.Because the firm faces a downward sloping demand curve for its product, it must lower price to sell extra units of output.
Marginal resource cost (MRC) - The amount that each additional unit of a resource adds to the firm’s total (resource) cost: MRC = change in total (resource) cost/unit change in resource quantity.
To maximize profit a firm should employ the quantity of a resource at which MRP=MRC. To maximize profit, a firm should hire any additional units of a specific resource as long as each successive unit adds more to the firm’s TR than it adds to cost TC.
4. SHORT-TERM AND LONG-TERM DEMAND FOR LABOR UNDER PERFECT COMPETITION
The demand and supply of labor are determined in the labor market. The participants in the labor market are workers and firms. Workers supply labor to firms in exchange for wages. Firms demand labor from workers in exchange for wages.
The firm's demand for labor. The firm's demand for labor is a derived demand; it is derived from the demand for the firm's output. If demand for the firm's output increases, the firm will demand more labor and will hire more workers. If demand for the firm's output falls, the firm will demand less labor and will reduce its work force.
Marginal revenue product of labor. When the firm knows the level of demand for its output, it determines how much labor to demand by looking at the marginal revenue product of labor. The marginal revenue product of labor (or any input) is the additional revenue the firm earns by employing one more unit of labor. The marginal revenue product of labor is related to the marginal product of labor. In a perfectly competitive market, the firm's marginal revenue product of labor is the value of the marginal product of labor.
In a perfectly competitive labor market, the individual firm is a wage-taker; it takes the market wage rate as given, just as the firm in a perfectly competitive product market takes the price for its output as given. The market wage rate in a perfectly competitive labor market represents the firm's marginal cost of labor, the amount the firm must pay for each additional worker that it hires.
The perfectly competitive firm's profit-maximizing labor-demand decision is to hire workers up to the point where the marginal revenue product of the last worker hired is just equal to the market wage rate, which is the marginal cost of this last worker.
The firm's labor demand curve. The firm's profit-maximizing labor-demand decision is depicted graphically in figure
When the marginal revenue product of labor is graphed, it represents the firm's labor demand curve. The demand curve is downward sloping due to the law of diminishing returns; as more workers are hired, the marginal product of labor begins declining, causing the marginal revenue product of labor to fall as well.
What causes the labor-demand curve to shift:
-The output price: Demand for labor: VMPL = MPL ˣ P of output.
-Technological change: Technological advance can raise MPL: increase demand for labor; Labor-saving technology can reduce MPL: decrease demand for labor.
-Supply of other factors:Affect marginal product of other factor.
INCrease in labor demand:
5.SUPPLY FOR LABOR
In mainstream economic theories, the supply of labor is the total hours (adjusted for intensity of effort) that workers wish to work at a given real wage rate. Thus, it is a trade-off between work and leisure. Consequently there are two effects on the amount of desired labor supplied due to a change in the real wage rate. As, for example, the real wage rate rises the opportunity cost of leisure increases. This tends to cause workers to supply more labor (the "substitution effect"). However, as the real wage rate rises, workers earn a higher income for a given number of hours. If leisure is a normal good - the demand for it increases as income increases - this increase in income will tend to cause workers to supply less labor (the "income effect"). If the "substitution effect" is stronger than the "income effect" then the labor supply curve will be upward sloping and vice versa. Labor-supply curve reflects how workers’ decisions about the labor-leisure trade-off respond to a change in opportunity cost of leisure.
Causes the labor-supply curve to shift:
-Changes in tastes
-Changes in alternative opportunities
-Immigration .
EQUILIBRIUM:
Wages in competitive labor markets:
-Adjusts to balance the supply & demand for labor
-Equals the value of the marginal product of labor
Changes in supply or demand for labor:
-Change the equilibrium wage
-Change the value of the marginal product by the same amount.
Thus, an increase in labor supply reduces the wage and raises employment.(see graph)
6. MARKET SUPPLY CURVE OF LABOR
The backward-bending supply curve of labour is a thesis that claims that as wages increase, people will substitute leisure for working. Eventually, wages can increase to a point where less labour is offered in the market.
The labor supply curve of a single worker may not be smooth and straight. It is likely to be backward bending or sloping in nature. On such a labor supply curve, a worker will initially increase the supply of a number of hours of work with a rise in the rate of wages. Once his estimated need of wage income is satisfied he is likely to prefer leisure or rest from work. Leisure is an attractive alternative to work and hence it is the opportunity cost at further hikes in the wage rate.
Market Demand and Supply Curves for Labor: Under a perfect competitive market both demand and supply curves are likely to be normal in behavior. Demand curve for labor will then be downward sloping. In a market numerous firms operate; so the demand curve will be more flexible than in the case of individual firms. Labor supply curve will be composed of the additions of labor supplied by individuals. This is likely to slope upwards. It indicates that both labor of a higher quality and skills are supplied only at a rising rate of wages. Under competition, with a very large number of workers and with less significant personal differences, the supply curve will be highly flexible tending to be a horizontal straight line. Given the demand and supply schedules or curves competitive market equilibrium can be determined.
In Figure DD and SS represent the competitive labor demand curve and the competitive supply curve respectively. The two curves intersect at point e which is a point of equilibrium. Under equilibrium condition, N number of workers offer supply of labor and receive the wage rate W. If labor market shows a greater homogeneity and if the qualitative variations are very few then the supply curve will be more flexible as represented by S1S1. With such a supply curve under the given demand conditions, a new point of equilibrium e1 is established. At this point more workers N1 offer services at a lower wage rate W1. Thus demand and supply conditions together determine level of employment and rate of wages in a competitive market.
7. WAGES AND FACTORS OF IT.
Wages is the payment made to labor for the services they render in production. In other words, wages refer to the rewards paid for the services of labor. Wages are the price of labor. It could be in various types or forms. Below are two types of wages;
1. Nominal wages: Nominal wages refer to the total amount of money paid to a laborer at a particular period of time. Nominal wage, also called money wage, is the total amount of money paid to labor at a stated or stipulated period of time. It is measured in monetary terms.
2. Real wages: real wages refer to the total amount of quantity of goods and services the labor can use his money to buy. Real wage refers to the purchasing power of labor.
Wage rate:It is the rate at which labor is paid for the services it renders in production. It can be classified into time rate system and piece rate system.1.Time rate system. 2.Piece rate system.
Factors responsible for variation in wages are as follows:
1. Differences in cost of training: Professions that are costly or expensive to execute in the course of training tend to attract higher wages than those with cheaper cost of training.
2. Differences in period of training: Some professions attract longer periods of training, for example, the medical profession, and therefore attract higher wages.
3. Skill needed to work: Some professions which require special skill during training tend to have higher wages than those which do not require any skill.
4. Activities of trade unions: Some trade unions determine what their members have to be paid, eg, chartered accountants, and this tends to make them earn high wages.
5. Forces of supply and demand: When the demand for a particular labor is higher than the supply, such labor tends to receive higher wages.
6. Level of productivity: It is assumed that in an ideal situation, the more a worker becomes productive, the higher his wages will be and vice versa.
7. Differences in hours of work: It is also assumed that in an ideal situation, the longer the number of hours worked, the higher the wages, especially when the piece rate system is used.
8. Level of risk associated with a job: Certain jobs, eg, piloting, petroleum engineering etc involve greater risks when in operation and therefore are associated with higher wages.
9. Entry qualification: Certain profession requires tough qualification and lengthy years of training, eg, medical doctor, lawyer, etc which tend to attract higher wages while those with little or no entry qualifications tend to receive lower wages.
10. Prestige associated with jobs: Certain jobs attract high prestige from the society eg, medicine, law, engineering etc, and they therefore attract higher wages while those with low or no prestige receive low wages.
8. WAGES DETERMINATION IN A COMPETITIVE AND MONOPSONY
The wage paid by an employer is given by the supply curve at the optimum level of labor for the firm. The optimum
quantity of labor is determined first. This is established by the equality MRC=MRP (marginal resource cost equals marginal revenue product) in both competitive and monopsonistic markets.
But the wage determination itself is different in the two types of markets.
WAGE DETERMINATION IN PERFECT COMPETITION
Perfect competition in a resource market means that there are many small buyers of the resource, and that none can influence the market. The supply curve is identical to the marginal resource cost curve (MRC), and is horizontal. The wage is given directly by the intersection of the supply line and MRP curve (which is the demand for labor).
WAGE DETERMINATION IN MONOPSONY
A firm has a monopsonistic power when it is able to pay a lower price for a larger quantity of a resource used. A monopsony typically exists when a firm is the sole employer in a region or a profession. For a monopsony, the marginal resource cost curve is above the supply curve. The optimum quantity of labor is determined by the intersection of MRC and MRP. The wage is obtained by extending that quantity level down to the supply curve.
The wage paid by a monopsony is lower than the wage paid by firms in perfect competition in the labor market. In addition, the quantity of labor used is also smaller.
9. The ROLE OF TRADE UNIONS IN THE LABOR MARKET
Trade unions are organizations of workers that seek through collective bargaining with employers to protect and improve the real incomes of their members, provide job security, protect workers against unfair dismissal and provide a range of other work-related services including support for people claiming compensation for injuries sustained in a job
Trade union power
Unions have less power and influence in the labour market than they did two decades ago although in several big industries they can still exert their “industrial muscle”. Power has gradually ebbed away for a variety of reasons:
=Employment legislation which has outlawed illegal strikes, given employers the right to seek compensation for the effects of certain forms of industrial action and requires all unions to hold secret ballots of their members before any strike action is permitted
=The effects of increased competition in product markets – in nearly every domestic market for goods and services, there is greater competition than there was a few years ago. Be it the intensity of global competition from lower-cost producers or the deregulation of markets that has increased market contestability, trade unions have had to adjust to a world where the pricing power of manufacturers and service industries has been severely curtailed.
=Patterns of employment: There has been a long term change in the structure of employment in the British economy away from traditionally strong union sectors such as heavy engineering, coal-mining, steel and textiles, towards service sector jobs in the private sector where union density is much lower
Unions and wage negotiations – labour market theory.
Unions might seek to exercise their collective bargaining power with employers to achieve a mark-up on wages compared to those on offer to non-union members.
Unions seek to improve the wages and working conditions of their members; this can be accomplished by: 1.increasing the demand for the product manufactured by the
members (for instance, by discouraging imports); 2.decreasing the supply of labor (e.g. craft unions);3.acquiring power over all employees (e.g. industrial unions)
10. VARIABLE SALARY:
Wage regulation refers to attempts by a government to regulate wages paid to citizens.
Minimum wage regulation attempts to set an hourly, or other periodic monetary standard for pay at work. A recent example was the U.K. National Minimum Wage Act 1998. Germany is currently debating whether to introduce its own.
Collective agreements between trade unions and employers can regulate wages of workers according to the needs of the business.
Arbitration involves makes collective agreements between trade unions and employers legally binding and mediated through a state appointed judge or magistrate.
An economic analysis of the law holds very simply that any intervention in a contract between two parties creates an inefficient labour market. Wages kept artificially high, by imposing any administrative or monetary costs on employers distorts the labour market equilibrium. For a national economy in a globalised world, that means jobs will go overseas and the unemployment rate rises. Major proponents of this sort of labour economics include Nobel Prize winner from the University of Chicago, Professor Gary Becker. Professor Becker keeps a blog with well known academic and judge, Richard Posner. Posner is a lawyer and economist, and wrote a book called Economic Analysis of Law. His starting assumption is that unions are the cartelisation of the labour market. Both would agree, that if its aim is to improve the living standards of society, wage regulation defeats itself. Posner says, “Economics is not a theory about consciousness. Behaviour is rational when it conforms to the model of rational choice, whatever the state of mind of the chooser.”[1] So any conscious attempt to improve working standards are impossible under this view.
11.DISRIMINATION IN LABOR MARKETS AFFECTING EARNINGS:
Another source of differences in wages is discrimination. Discrimination occurs when the marketplace offers different opportunities to similar individuals who differ only by race, ethnic group, sex, age, or other personal characteristics. Discrimination reflects some people’s prejudice against certain groups in society. Although discrimination is an emotionally charged topic that often generates heated debate, economists try to study the topic objectively in order to separate myth from reality.
It might seem natural to gauge the amount of discrimination in labor markets by looking at the average wages of different groups. For instance, in recent years the wage of the average black worker in the United States has been about 20 percent less than the wage of the average white worker. The wage of the average female worker has been about 30 percent less than the wage of the average male worker. These wage differentials are sometimes presented in political debate as evidence that many employers discriminate against blacks and women.
Yet there is an obvious problem with this approach. Even in a labor market free of discrimination, different people have different wages. People differ in the amount of human capital they have and in the kinds of work they are able and willing to do. The wage differences we observe in the economy are, to a large extent, attributable to the determinants of equilibrium wages we discussed in the preceding section. Simply observing differences in wages among broad groups—whites and blacks, men and women—says little about the prevalence of discrimination.
The study of wage differences among groups does not establish any clear conclusion about the prevalence of discrimination in U.S. labor markets. Most economists believe that some of the observed wage differentials are attributable to discrimination, but there is no consensus about how much. The only conclusion about which economists are in consensus is a negative one: Because the differences in average wages among groups in part reflect differences in human capital and job characteristics, they do not by themselves say anything about how much discrimination there is in the labor market.
In competitive markets, workers earn a wage equal to the value of their marginal contribution to the production of goods and services. There are, however, many things that affect the value of the marginal product. Firms pay more for workers who are more talented, more diligent, more experienced, and more educated because these workers are more productive. Firms pay less to those workers against whom customers discriminate because these workers contribute less to revenue.
The theory of the labor market we have developed in the last two chapters explains why some workers earn higher wages than other workers. The theory does not say that the resulting distribution of income is equal, fair, or desirable in any way.
12. INCOME INEQUALITY
Income inequality refers to the extent to which income is distributed in an uneven manner among a population. In the United States, income inequality, or the gap between the rich and everyone else, has been growing markedly, byevery major statistical measure, for some 30 years.
Income includes the revenue streams from wages, salaries, interest on a savings account, dividends from shares of stock, rent, and profits from selling something for more than you paid for it.
To understand what life is like in a country—to know, for example, how many of its inhabitants are poor—it is not enough to know that country’s per capita income. The number of
poor people in a country and the average quality of life also depend on how equally—or unequally—income is distributed.
A fundamental graphical representation of the form of a distribution is given by the Lorenz-Curve. It plots the cumulative contribution to a quantity over a contributing population. It is often used in economics to depict the inequality of wealth or income distribution in a population.
Graph shows the proportion of the distribution assumed by the bottom y% of the values. It is often used to represent income distribution, where it shows for the bottom x% of households, what percentage y% of the total income they have. The percentage of households is plotted on the x-axis, the percentage of income on the y-axis. It can also be used to show distribution of assets. In such use, many economists consider it to be a measure of social inequality. It was developed by Max O. Lorenz in 1905 for representing inequality of the wealth distribution.
Every point on the Lorenz curve represents a statement like "the bottom 20% of all households have 10% of the total income."A perfectly equal income distribution would be one in which every person has the same income. In this case, the bottom "N"% of society would always have "N"% of the income. This can be depicted by the straight line "y" = "x"; called the "line of perfect equality."
By contrast, a perfectly unequal distribution would be one in which one person has all the income and everyone else has none. In that case, the curve would be at "y" = 0 for all "x" < 100%, and "y" = 100% when "x" = 100%. This curve is called the "line of perfect inequality."
The Gini coefficient is the area between the line of perfect equality and the observed Lorenz curve, as a percentage of the area between the line of perfect equality and the line of perfect inequality. The higher the coefficient, the more unequal the distribution is. In the diagram on the right, this is given by the ratio A/(A+B), where A and B are the indicated areas.
The Lorenz curve can often be represented by a function L(F), where F is represented by the horizontal axis, and L is represented by the vertical axis.
For a population of size n, with a sequence of values yi, i = 1 to n, that are indexed in non-decreasing order ( yi ≤ yi+1), the Lorenz curve is the continuous piecewise linear function connecting the points ( Fi, Li ), i = 0 to n, where F0 = 0, L0 = 0, and for i = 1 to n:
The Gini coefficient (also known as the Gini index or Gini ratio) is a measure of statistical dispersion developed by the Italian statistician and sociologist Corrado Gini and published in his 1912 paper "Variability and Mutability".
The Gini coefficient measures the inequality among values of a frequency distribution (for example levels of income). A Gini coefficient of zero expresses perfect equality where all values are the same (for example, where everyone has an exactly equal income). A Gini coefficient of one (100 on the percentile scale) expresses maximal inequality among values (for example where only one person has all the income).
The Gini coefficient can range from 0 to 1; it is sometimes expressed as a percentage ranging between 0 and 100. More specifically, the upper bound of the Gini coefficient equals 1 only in populations of infinite size. In a population of size N, the upper bound is equal to 1 − 2 / (N + 1).
A low Gini coefficient indicates a more equal distribution, with 0 corresponding to complete equality, while higher Gini coefficients indicate more unequal distribution, with 1 corresponding to complete inequality. To be validly computed, no negative goods can be distributed. Thus, if the Gini coefficient is being used to describe household income inequality, then no household can have a negative income. When used as a measure of income inequality, the most unequal society will be one in which a single person receives 100% of the total income and the remaining people receive none (G=1); and the most equal society will be one in which every person receives the same income (G=0).
13. CAPITAL AND INVESTMENT. DEMAND FOR THE FIRM TO INVEST IN LONG-TERM
Capital consists of the buildings and machinery that are used to produce output. Financial capital,- the funds that are used to purchase capital. Capital differs from the other factors of production in that capital is produced using all of the other factors of production. The production of capital involves a process of roundabout production in which society uses some of its resources today to produce capital instead of commodities intended for immediate consumption. Thus, the production of capital requires that society forgoes current consumption. To acquire this capital, society must engage in saving. This saving makes it possible to engage in capital investment that enhances society's future productive capacity.
The demand for capital is tied to the marginal revenue product of capital. Additional capital is acquired as long as the marginal revenue product of capital exceeds the marginal factor cost of capital. When purchasing capital, though, firm's must take into account the revenue generated by capital over its entire productive life. Since capital tends to last for a relatively long period of time, the calculation of the marginal revenue product requires taking into account revenue generated in the relatively distant future as well as revenue generated in the more immediate future.
In particular, the present value of a payment of $K received in T years in the future is given by:
where r is the market interest rate.
The demand curve:
The demand curve for capital shifts to the left (declines) when interest rates rise (as illustrated below).
Investment has different meanings in finance and economics. Finance investment is putting money into something with the expectation of gain, that upon thorough analysis, has a high degree of security for the principal amount, as well as security of return, within an expected period of time. In contrast putting money into something with an expectation of gain without thorough analysis, without security of principal, and without security of return is speculation or gambling.
In macroeconomics, investment is the amount purchased per unit time of goods which are not consumed but are to be used for future production (ie. capital). Investment in human capital includes costs of additional schooling or on-the-job training. Inventory investment is the accumulation of goods inventories; it can be positive or negative, and it can be intended or unintended. In measures of national income and output, "gross investment" (represented by the variable I) is also a component of gross domestic product (GDP), given in the formula GDP = C + I + G + NX, where C is consumption, G is government spending, and NX is net exports. Thus investment is everything that remains of total expenditure after consumption, government spending, and net exports are subtracted (i.e. I = GDP − C − G − NX).
Non-residential fixed investment (such as new factories) and residential investment (new houses) combine with inventory investment to make up I. "Net investment" deducts depreciation from gross investment. Net fixed investment is the value of the net increase in the capital stock per year.
Fixed investment, as expenditure over a period of time ("per year"), is not capital. The time dimension of investment makes it a flow. By contrast, capital is a stock— that is, accumulated net investment to a point in time (such as December 31).
Investment is often modeled as a function of Income and Interest rates, given by the relation I = f(Y, r). An increase in income encourages higher investment, whereas a higher interest rate may discourage investment as it becomes more costly to borrow money. Even if a firm chooses to use its own funds in an investment, the interest rate represents an opportunity cost of investing those funds rather than lending out that amount of money for interest.
'LONG-TERM INVESTMENTS' -An account on the asset side of a company's balance sheet that represents the investments that a company intends to hold for more than a year. They may include stocks, bonds, real estate and cash that has been set aside for a specific purpose or project. In addition to investments a company plans to hold for an extended period of time, Long Term Investments also consist of the stock in a company's affiliates and subsidiaries.
The difference between short term and long term investments lie in the company's motive for owning them. Short term investments consist of stocks, bonds, etc. a company has bought and will sell shortly. The investments made under long term investments may never be sold. An excellent example would be Berkshire Hathaway's relationship with Coca-Cola. Berkshire owns 200 million shares of the soft-drink giant, and will most likely continue to hold them forever, regardless of the price they are selling for in the open market.
Long term interest rates tend to follow the business cycle. When a boom is expected, the expectations of higher inflation lead to higher long term interest rates. At the top of a boom when the
market begins to weaken, the long interest rates are adjusted downwards. An exception of this trend is during periods of very instable inflation.
14.THE EQUILIBRIUM INTEREST RATE IN A COMPETITIVE CAPITAL MARKET
The interest rate is the cost of demanding or borrowing loanable funds. Alternatively, the interest rate is the rate of return from supplying or lending loanable funds. The interest rate is typically measured as an annual percentage rate. For example, a firm that borrows $20,000 in funds for one year, at an annual interest rate of 5%, will have to repay the lender $21,000 at the end of the year; this amount includes the $20,000 borrowed plus $1,000 in interest ($20,000 Ч .05).
The equilibrium interest rate is determined in the loanable funds market. All lenders and borrowers of loanable funds are participants in the loanable funds market. The total amount of funds supplied by lenders makes up the supply of loanable funds, while the total amount of funds demanded by borrowers makes up the demand for loanable funds. The demand curve for loanable funds is downward sloping, indicating that at lower interest rates borrowers will demand more funds for investment. The supply curve for loanable funds is upward sloping, indicating that at higher interest rates lenders are willing to lend more funds to investors. The equilibrium interest rate is determined by the intersection of the demand and supply curves for loanable funds, as indicated in Figure:
15. TIME PREFERENCES AND DEFINITION OF THE INTEREST RATE
The time preference theory of interest is an attempt to explain interest through the demand for accelerated satisfaction. This is particularly important in microeconomics.
There is no absolute distinction that separates "high" and "low" time preference, only comparisons with others either individually or in aggregate. Someone with a high time preference is focused substantially on his well-being in the present and the immediate future relative to the average person, while someone with low time preference places more emphasis than average on their well-being in the further future.
Time preferences are captured mathematically in the discount function. The higher the time preference, the higher the discount placed on returns receivable or costs payable in the future.
The time preference that an individual exhibits at any given moment is determined solely by their personal preferences.
In the neoclassical theory of interest due to Irving Fisher, the interest rate determines the relative price of present and future consumption. Time preference, in conjunction with relative levels of present and future consumption, determines the marginal rate of substitution between present and future consumption. These two rates must necessarily be equal, and this equilibrium is brought about by the relative prices of present and future consumption.
In Neoclassical economics the rate of time preference is usually taken as a parameter in an individual's utility function which captures the trade off between consumption today and consumption in the future, and is thus exogenous and subjective. It is also the underlying determinant of the real rate of interest. The rate of return on investment is generally seen as return on capital, with the real rate of interest equal to the marginal product of capital at any point in time. Arbitrage, in turn, implies that the return on capital is equalized with the interest rate on financial assets (adjusting for factors such as inflation and risk). Consumers, who are facing a choice between consumption and saving, respond to the difference between the market interest rate and their own subjective rate of time preference ("impatience") and increase or decrease their current consumption according to this difference. This changes the amount of funds available for investment and capital accumulation, as in for example the Ramsey growth model. In the long run steady state, consumption's share in a person's income is constant, which pins down the rate of interest as equal to the rate of time preference, with the marginal product of capital adjusting to ensure this equality holds. It is important to note that in this view, it is not that people discount the future because they can receive positive interest rates on their savings. Rather, the causality goes in the opposite direction; interest rates must be positive in order to induce impatient individuals to forgo current consumptions in favor of future.
16. NOMINAL AND REAL INTEREST RATES
There are risks as systematic, regulatory and inflation. Systematic risk - that the borrower will not be able to make interest and amortization payments and repay the loan at maturity. Regulatory risk
includes changes in the law and in the taxation that makes it more difficult for the creditor to collect a loan or that results in higher taxes on the repayment amount. The inflation risk- that inflation has made the money of the loan less worth, i.e. that the purchasing power of the money has decreased.
The interest rate that takes all these risks and the time value of money into account is the nominal interest rate. This rate does not correct for changes in purchasing power. The nominal
interest rate is the one that is quoted in e.g. newspapers. Deducting the premium for the inflation risk, results in the real interest rate. The real interest rate describes the relative price between consumption today and consumption in the future. The rate of time preference1 is a measure that describes how “impatient” people are to spend rather that save money. If the real interest rate is higher than the rate of time preference, people tend to be more willing to defer spending. Thus,
consumption is negatively related to the level of the real interest rate, whereas saving is positively related. In summary, the real interest rate depends on the compensation investors and households demand for foregoing consumption today. A low real interest rate leads to higher consumption since the incentive to save money is low and vice versa.
The exact relationship between the nominal and the real interest rate is described through the Fisher equation:1+n = (1+r)(1+i)
Where n is the nominal interest rate, r is the real interest rate and i is the inflation rate.
17. DISCOUNTING. DISCOUNTING AND INVESTMENT DECISIONS
Discounting is a financial mechanism in which a debtor obtains the right to delay payments to a creditor, for a defined period of time, in exchange for a charge or fee. Essentially, the party that owes money in the present purchases the right to delay the payment until some future date. The discount, or charge, is simply the difference between the original amount owed in the present and the amount that has to be paid in the future to settle the debt.
The discount is usually associated with a discount rate, which is also called the discount yield. The discount yield is simply the proportional share of the initial amount owed (initial liability) that must be paid to delay payment for 1 year.
Discount Yield = "Charge" to Delay Payment for 1 year / Debt Liability
Many factors affect investment decisions, and exponential discounting is one of the most important. It is a method that allows one to value a company, project or other asset. You will use the expected cash flows and take into account the time-value of money. Exponential discounting strives to value cash flows in the future as how much you would currently invest to get the future cash flow. It uses a specific rate of return. An important hallmark of exponential discounting is that it assumes times consistency. The declination is at a consistent rate.
Distance between two points is all that is important when finding the discount factor, not the time when it occurs. This can cause the strategy to be less accurate, and this inaccuracy must be understood when investment decisions are made.
The discounted present value formula is DPV = FV/(1+i)^n = FV(1-d)^n. The discounted present value is DPV, the nominal value of a future cash amount is FV, the interest rate is I, the discount rate is d, and the amount of years before the cash flow comes is n.
Exponential discounting allows people to make more informed decisions about investments because it gives them a better idea of what the investment may actually be worth because of the foresight into future risk and valuations. The discount rate looks to take into account factors that may not be predictable such as the chance that the money will not return as expected. Of course it is important to understand the role of inflation when making investments, and exponential discounting can help accommodate that.
Exponential discounting allows investors to take risk into account when choosing investments. There is no guarantee in most investments that the money will be there. The weighted average cost of capital (WACC) is often utilized as an excellent way to take time value of money and risk premium into account.
There are also problems with intergenerational equity. Non-exponential discounting has been seen in human behavior. Thus this may not be as accurate a picture as can be seen in other methods and lead to investment decisions that are not as sound. An alternative to exponential discounting is hyperbolic discounting. This takes into account that in the short-turn discount factors fall at a greater rate than in a longer time span.
18. The CONCEPT OF PRESENT VALUE AND EFFICIENCY OF INVESTMENT DECISIONS
Firms purchase capital goods to increase their future output and income. Income earned in the future is often evaluated in terms of its present value. The present value of future income is the value of having this future income today.
Present value formula. The present value of receiving $20,000 one year from now can be calculated using the present value formula. The formula for finding the present value of X dollars received t years from now at the current market interest rate r is
For example, if X = $20,000, t = 1, and r = .05, the present value of $20,000 received one year from now is 20,000/(1.05)1 = $19,047.62.
Firm's investment decision. The firm's investment decision is to determine whether to purchase new capital. In determining whether to purchase new capital—for example, new equipment—the firm will take into account the price of the new equipment, the revenue that the new equipment will generate for the firm over time, and the scrap value of the new equipment. The firm will also take into account the interest rate, which represents the firm's opportunity cost of investing in the new equipment. It will use the interest rate to calculate the present value of the future net income that it expects to earn from its purchase of the new capital equipment. If the present value is positive, the firm will choose to purchase the new equipment. If the present value is negative, it is better off forgoing the investment in new equipment.
The decision to invest in other types of capital goods can also be made on the basis of present value calculations. For example, the decision to invest in human capital by attending college is based on the present value of the future income that an individual can earn with a college degree. If the present value is positive, the individual will choose to attend college. If the present value is negative, the individual will not attend college and will perhaps take a job instead.
19. INTERNAL RATE OF RETURN:
The IRR is a rate of return used in capital budgeting to measure and compare the profitability of investments. It is also called the discounted cash flow rate of return (DCFROR) or the rate of return (ROR). In the context of savings and loans the IRR is also called the effective interest rate. The term internal refers to the fact that its calculation does not incorporate environmental factors (e.g., the interest rate or inflation).
The internal rate of return (or IRR) is a common financial valuation metric used by financial analysts to calculate and assess the financial attractiveness / viability of capital intensive projects or investments.
As the IRR is normally easier to understand than the result of adiscounted cash flow (DCF) analysis (i.e. the net present value or NPV) for non-financial executives, it is often used to explain and justify investment decisions, although a good financial modeler should know that the IRR is after all an estimated value, especially when calculated in Excel, and should be used in conjunction with other financial metrics such as the NPV and comparable valuation multiples when presenting a business or investment case.
The IRR is the interest rate that makes the net present value of all cash flow equal to zero. In financial analysis terms, the IRR can be defined a discount rate at which the present value of a series of investments is equal to the present value of the returns on those investments.
All projects or investments with an IRR that has been calculated in a financial modeling exercise to be greater than the Weighted Average Cost of Capital (or WACC) should technically be considered as financially viable and accepted.
When choosing between projects or investments whose outcomes or performance are absolutely independent of one another, a good financial modeler should deem the project or investment with the highest calculated IRR to be the most financially attractive, so long as we continue to keep in mind that the IRR value also needs to be higher than the WACC.
20. NATURAL RESOURCES AS A FACTOR OF PRODUCTION, ITS STRUCTURE
The four factors of production-labor, capital, land, and entrepreneurship. This are the four inputs used in the production process. To produce output, activities must acquire the services of these factor inputs, which they do through factor markets.
Land: Land is the naturally occurring materials of the planet that are used for the production of goods and services, including the land itself; the minerals and nutrients in the ground; the water, wildlife, and vegetation on the surface; and the air above. The natural resources and materials of the land become the goods produced. Without these materials of the land, there is no production. Production is, in fact, the basic process of transforming naturally occurring materials that provide little satisfaction in their natural state, to goods and services that provide more satisfaction.
21. FEATURES OF DEMAND AND SUPPLY
Supply and demand is perhaps one of the most fundamental concepts of economics and it is the backbone of a market economy. Demand refers to how much (quantity) of a product or service is desired by buyers. The quantity demanded is the amount of a product people are willing to buy at a certain price; the relationship between price and quantity demanded is known as the demand relationship. Supply represents how much the market can offer. The quantity supplied refers to the amount of a certain good producers are willing to supply when receiving a certain price. The correlation between price and how much of a good or service is supplied to the market is known as the supply relationship. Price, therefore, is a reflection of supply and demand.
“Supply” is the quantities of a good or service that producers are willing and able to sell at various prices at any given time.
-Producers are willing to supply a good or service if they can make an acceptable profit. Profit is equal to all revenues (total sales) minus total costs.
-The greater the expectation of profit, the more willing producers will be to purchase the resources that are required to produce a good or service.
-The price at which producers can sell their product will strongly influence profit. As the price of the product increases, producers will be willing to supply more to the market.
The Law of Supply:The “law of supply” states that at high prices producers are willing to supply more and at low prices they will supply less.
“Demand” is the quantities of a good or service that consumers are willing and able to buy at various prices at any given time. Demand begins with a want or some use (utility) for a good or service. Suppose people want to get from home to the job site each day.To satisfy this want they will have to make a choice—take a bus, car, train, taxi, car pool, ride a bicycle, walk. Based on the costs and benefits of the alternatives, consumers will reach a decision.
The Law of Demand
The “law of demand” states that consumers will buy less at higher prices and more at lower prices. Drivers that determine the strength (or weakness) of consumer demand are often called “determinants of demand.”
22. THE LAND MARKET AND OTHER NATURAL RESOURCES: LIMITS AND METHODS OF REGULATION
Land Market Value is the land rental value, minus land taxes, divided by a capitalization rate. Each of these terms is defined as follows:
1.Land Rental Value is the annual fee individuals are willing to pay for the exclusive right to use a land site for a period of time. This may include a speculative opportunity cost.
2.Land Taxes is the portion of the land rental value that is claimed for the community.
3.Capitalization Rate is a market determined rate of return that would attract individuals to invest in the use of land, considering all of the risks and benefits which could be realized.
4.Land Market Value is the land rental value, minus land taxes, divided by a capitalization rate.
The mathematical relationship is then:
|
Land Market Value |
= |
Land Rental Value - Land Taxes |
Land Rental Value = Market Value x Capitalization Rate + Land Taxes
Land is the entire non-reproducible, physical universe, including all natural resources. A land site includes everything within the earth, under its boundaries and over it, extending infinitely into space. In addition to a location for a house or building, a land site would include the minerals, water, trees, view, sunshine and air space. The shape of the site can be described as an inverted cone with its apex at the center of the earth and extending upward through the surface into space.
LIMITATIONS ON LAND OWNERSHIP AND USE
While land is the gift of nature, certain legal, political and social constraints have been imposed in most societies throughout the years. Every nation imposes certain public limitations on land ownership and use for the common good of all citizens. Four forms of governmental control include:
1.Taxation -- Power to tax the land to provide public revenue and to return to the community the costs incurred to pay for the various public benefits, services and environmental protection, which are provided by the government;
2.Eminent Domain -- Right to use, hold or take land for common public uses and benefits;
3.Police Power -- Right to regulate land use for the welfare of the public, in the areas of safety, health, morals, general welfare, zoning, building codes, traffic regulations and sanitary regulations;
4.Escheat -- Right to have land revert to the public's agent, the government, when taxes are not paid or when there are no legal heirs.
FACTORS THAT CONTRIBUTE TO LAND VALUE
The physical attributes of land include quality of location, fertility and climate; convenience to shopping, schools and parks; availability of water, sewers, utilities and public transportation; absence of bad smells, smoke and noise; and patterns of land use, frontage, depth, topography, streets and lot sizes.
The legal or governmental forces include the type and amount of taxation, zoning and building laws, planning and restrictions.
The social factors include population growth or decline, changes in family sizes, typical ages, attitudes toward law and order, prestige and education levels.
The economic forces include value and income levels, growth and new construction, vacancy and availability of land. It is the influences of these forces, expressed independently and in relationship to one another, that help the people and the assessor measure value.
23. THE STRUCTURE OF PROPERTY RIGHTS TO LAND, THE ROLE OF PRIVATE AND PUBLIC PROPERTY
Land tenure is the relationship, whether legally or customarily defined, among people, as individuals or groups, with respect to land. (For convenience, “land” is used here to include other natural resources such as water and trees.) Land tenure is an institution, i.e., rules invented by societies to regulate behaviour. Rules of tenure define how property rights to land are to be allocated within societies. They define how access is granted to rights to use, control, and transfer land, as well as associated responsibilities and restraints. In simple terms, land tenure systems determine who can use what resources for how long, and under what conditions.
Land tenure is an important part of social, political and economic structures. It is multidimensional, bringing into play social, technical, economic, institutional, legal and political aspects that are often ignored but must be taken into account. Land tenure relationships may be well-defined and enforceable in a formal court of law or through customary structures in a community. Alternatively, they may be relatively poorly defined with ambiguities open to exploitation.
Land tenure thus constitutes a web of intersecting interests. It includes:
= Overriding interests: when a sovereign power (e.g., a nation or community has the powers to allocate or reallocate land through expropriation, etc.)
= Overlapping interests: when several parties are allocated different rights to the same parcel of land (e.g., one party may have lease rights, another may have a right of way, etc.)
= Complementary interests: when different parties share the same interest in the same parcel of land (e.g., when members of a community share common rights to grazing land, etc.)
= Competing interests: when different parties contest the same interests in the same parcel (e.g., when two parties independently claim rights to exclusive use of a parcel of agricultural land. Land disputes arise from competing claims.)
Land tenure is often categorised as:
= Private: the assignment of rights to a private party who may be an individual, a married couple, a group of people, or a corporate body such as a commercial entity or non-profit organization. For example, within a community, individual families may have exclusive rights to residential parcels, agricultural parcels and certain trees. Other members of the community can be excluded from using these resources without the consent of those who hold the rights.
= Communal: a right of commons may exist within a community where each member has a right to use independently the holdings of the community. For example, members of a community may have the right to graze cattle on a common pasture.
= Open access: specific rights are not assigned to anyone and no-one can be excluded. This typically includes marine tenure where access to the high seas is generally open to anyone; it may include rangelands, forests, etc, where there may be free access to the resources for all. (An important difference between open access and communal systems is that under a communal system non-members of the community are excluded from using the common areas.)
= State: property rights are assigned to some authority in the public sector. For example, in some countries, forest lands may fall under the mandate of the state, whether at a central or decentralised level of government.
24. LAND RENT AND ITS VARIANTS
In political economy including physiocracy, classical economics, and other schools of economic thought excepting neoclassical economics, land is recognized as an inelastic factor of production. Rent is the distribution paid to freeholders for "allowing" production on the land they control.
"As soon as the land of any country has all become private property, the landlords, like all other men, love to reap where they never sowed, and demand a rent even for its natural produce. The wood of the forest, the grass of the field, and all the natural fruits of the earth, which, when land was in common, cost the labourer only the trouble of gathering them, come, even to him, to have an additional price fixed upon them. He must then pay for the licence to gather them; and must give up to the landlord a portion of what his labour either collects or produces. This portion, or, what comes to the same thing, the price of this portion, constitutes the rent of land ...."Adam Smith: The Wealth of Nations.
David Ricardo is credited with the first clear and comprehensive analysis of differential land rent and the associated economic relationships (Law of Rent).
Johann Heinrich von Thünen was especially influential in developing the spatial analysis of rents, which highlighted the importance of centrality and transport. Simply put, it was density of population increasing the profitability of commerce and providing for the division and specialization of labor that commanded higher municipal rents. And the high rents determined that land in a central city would not be allocated to farming, but would be allocated instead to more profitable residential or commercial uses.
Observing that a tax on the unearned rent of land would not distort economic activities, Henry George proposed that publicly collected land rents (land value taxation) should be the primary (or only) source of public revenue; though he also advocated public ownership, taxation and regulation of natural monopolies and monopolies of scale that cannot be eliminated by deregulation.
Variants:
Gross rent
Gross rent refers to the rent paid for the services of land and the capital invested on it. It consists of economic rent, interest on capital invested for improvement of land and reward for risk taken by the landlord in investing his capital.
Scarcity rent
Scarcity rent refers to the price paid for the use of the homogeneous land when its supply is limited in relation to demand. If all units of land are homogeneous, but demand exceeds supply, the entire land will earn economic rent by virtue of its scarcity.
Differential rent
Differential rent refers to that rent, which arises owing to differences in fertility of land. The surplus that arises due to difference between the marginal and intra-marginal land is the differential rent. It is accrued generally under extensive cultivation of land. The term was first stated by David Ricardo.
Contract rent
Contract rent refers to that rent which is mutually agreed upon between the land-owner and the user. It may be equal to the economic rent of the factor.
25.Modern agricultural policy in Western countries
Western European agricultural policy is not based on a consistent set of objectives and means. On the one hand, the programs demand rapid mechanization of production and structural rationalization of the agricultural sector. On the other hand, those who support these programs acknowledge that agriculture has several social functions which are not compatible with extensive structural rationalization.
The most widely accepted value behind the programs is the utilization of the most modern techniques of production.This leads to an “adjustment model” where the technology saving the most labour and land at any time is taken as an external factor, i.e., it is not considered to be subject to modification or compromise which might make it more consistent with other desired objectives. The other important external factor is the market for agricultural commodities. An adjustment of production to the market, therefore, has to be done by reducing the inputs of labour or land or both, not by slowing or reversing technological changes. The amounts of labour and land to be used in agriculture become the “adjustment variables”.
The main shortcoming of this “adjustment model” is the assumption that agriculture has no social value which ranks higher than increased labour productivity. It is a challenge to sociologists, economists and other social scientists to investigate whether this assumption is a ‘good’ or a ‘bad’ one at the stages of economic and social development at which we now stand in the countries of Western Europe.
26. the PROBLEM OF RENTAL INCOME DISTRIBUTION
Income received by way of rent from residential, commercial or industrial property is assessable income when it is received and includes: Advance rent, Late rent, Current rent; Bond money (only if you derived it because a tenant defaults to pay the rent or due to damage to the property which require repairs); Insurance payments for loss of rent; Reimbursement of deductible expenses.
However, rental income excludes:
- Rent due but not paid.
Rental income also excludes money received from a boarder in the following circumstances:
- From a family member as this is considered a domestic arrangement
- From an exchange student, as this is also considered a domestic arrangement
- From a boarder who only pays for expenses that are shared (food, electricity etc). In this case there is no benefit to the owner, which means no assessable income and therefore no deductions.
If the tax payer is running a boarding house then the income is assessable and deductions can be claimed.