Unit 10 — Profits and Interest

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Purpose:

To show the economic reasons for payments of interest and normal profits, the causes of “windfall” profits, and how the decision to invest in plant and equipment is related to the interest rate and expected returns on the investment.

Objectives:

  1. Interest rates are determined by the supply and demand for loanable funds, and both the supply and the demand for funds are affected by the level of interest rates. If the interest rate is lower in one market than another, the supply of funds to that market will be reduced.
  2. Factory buildings and equipment help in the production of output; they have marginal physical product. The demand for new fixed investment depends on the expected returns on investment; if the expected return exceeds the prevailing interest rate, the firm would be willing to borrow in order to invest in plant and equipment.
  3. Entrepreneurs and others who hold equity stakes often earn a return in excess of the normal return to an investment.

    1. Such returns are called pure economic profit; they are due to the temporary monopoly or “windfall” profits that may occur because of the innovative or risk-taking activity of the entrepreneur.
    2. “Windfall” profits encourage other firms or entrepreneurs to enter the industry; ultimately this drives prices and profits down.

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Steven Jobs

Steve Jobs

American business magnate, inventor, and Co-Founder and Chief Executive Officer of Apple Computer.

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Laurence Levitan

Laurence Levitan

Senator in the Maryland Legislature for nearly twenty years, specializing in fiscal affairs and government operations.

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Ian Spatz

Ian Spatz

Public policy expert and Senior Advisor in the national health care practices of Manatt, Phelps & Phillips and Manatt Health Solutions, where he provides insights into health-reform efforts.

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Stephen Wozniak

Stephen Wozniak

Computer engineer and Co-Founder of Apple Computer, where his inventions and machines contributed significantly to the personal computer revolution of the 1970s; he created the Apple I and Apple II computers.

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WHAT’S YOUR
ECONOMICS IQ?

  1. Suppose that the current rate of interest is 6%, and a particular asset will yield an annual rate of return of $1,500. The market value of this asset is...

    $25,000. 1500 = .06 X. 1500 / .06 = 25,000

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  2. Which of the following is usually the MOST IMPORTANT factor in determining the interest rate on a loan?

    The degree of risk involved. All other factors may have some bearing as well, but the primary determining factor will usually be degree of risk.

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  3. The present value of a dollar will be unaffected over time so long as...

    none of the above.

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  4. We can conclude from this diagram that the input is...

    chart chart

    Land. We know by the vertical supply curve that this is a fixed input which, by the economist's definition, is land.

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  5. The price of this input is called...

    chart chart

    Rent. The fixed supply curve tells us that this is land, a fixed input, so income derived from this input is rent.

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  6. Karl Marx would MOST LIKELY agree with which of the following statements? Profits are...

    that part of labor’s productivity that the capitalist retains.

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Glossary

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