Samuelson's book Summary Chapter 14

Chapter 14 Summary

A. Land and Rent 1. The return to fixed factors like land is called pure economic rent, or rent for short. Since the supply curve for land is vertical and totally inelastic, the rent will be price-determined rather than price-determining. 2. A factor like land that is inelastically supplied will continue to work the same amount even though its factor reward is reduced. For this reason, Henry George pointed out that rent is in the nature of a surplus rather than a reward necessary to coax out the factor's effort. This provides the basis for his single-tax proposal to tax the unearned increment of land value, without shifting the tax forward to consumers or distorting production. Modern tax theory extends this proposition by showing that inefficiencies are minimized by taxing goods that are relatively inelastic in supply or demand. B. Capital and Interest 3. A third factor of production is capital, a produced durable good that is used in further production. In the most general sense, investing in capital represents deferred consumption. By postponing consumption today and producing buildings or equipment, society increases consumption in the future. It is a technological fact that roundabout production yields a positive rate of return. 4. Recall the definitions: Capital goods: durable produced goods used for further production Rentals: net annual dollar returns on capital goods Rate of return on capital: net annual receipts on capital divided by dollar value of capital (measured as percent per year) Interest rate: yield on funds, measured as percent per year Real interest rate: yield on funds corrected for inflation, also measured as percent per year Present value: value today of a stream of future returns generated by an asset Profits: a residual income item equal to revenues minus costs 5. Assets generate streams of income in future periods. By calculating the present value, we can convert the stream of returns into a single value today. This is done by asking what amount of dollars today will generate the stream of future returns when invested at the market interest rate. 6. The exact present-value formula is as follows: Each dollar payable t years from now is a present value (V) of $1/(1 + i) "to the" t. So for any net receipt stream (N1, N2, . . . , Nt, . . .) where Nt is the dollar value of receipts t years in the future, we have:

7. Interest is a device that serves two functions in the economy. As a motivating device, it provides an incentive for people to save and accumulate wealth. As a rationing device, interest allows society to select only those investment projects with the highest rates of return. However, as more and more capital is accumulated, and as the law of diminishing returns sets in, the rate of return on capital and the interest rate will be beaten down by competition. Falling interest rates are a signal to society to adopt more capital-intensive projects with lower rates of return. 8. Saving and investment involve waiting for future consumption rather than consuming today. Such thrift interacts with the net productivity of capital to determine interest rates, the rate of return on capital, and the capital stock. The funds or financial assets needed to purchase capital are provided by households that are willing to sacrifice consumption today in return for larger consumption tomorrow. The demand for capital comes from firms that have a variety of roundabout investment projects. In long_run equilibrium, the interest rate is thus determined by the interaction between the net productivity of capital and the willingness of households to sacrifice consumption today for consumption tomorrow. 9. Important qualifications of classical capital theory include the following: Technological change shifts the productivity of capital; imperfect foresight means that capital's return is highly volatile; and investors must consider the impact of taxes and inflation. 10. Profits are revenues less costs. Reported business profits are chiefly corporate earnings. Economically, we distinguish three categories of profits. (a) An important source is profits as implicit returns. Firms generally own many of their own nonlabor factors of production - capital, natural resources, and patents. In these cases, the implicit return on unpaid or owned inputs is part of profits. (b) Another source of profits is uninsurable risk, particularly that associated with the business cycle or sovereign risk. (c) Finally, innovational profits will be earned by entrepreneurs who introduce new products or innovations.