Cost, Rent And Profit

Cost, Rent and Profit Definitions of (Economic) Rent and Transfer earnings (Economic) Rent is v the part of anticipated return that is not necessary to keep a factor in its current use. v the part of anticipated return that can be taken away without affecting its current use. v the part of anticipated return over and above the transfer earnings. Transfer earnings is v the part of anticipated return that is the minimium amount a factor must earn in order to prevent it from transferring to another use. v the part of anticipated return that is the minimium amount a factor must earn in order to keep it in its current use. v the part of anticipated return that is necessary to keep a factor in its current use. Relationship between Rent and Transfer earnings Anticipated Return = (Economic) Rent + Transfer earnings Suppose Mr. Pang, a school teacher, is earning $33,000 a month. Suppose further that the highest-valued alternative occupation available to him is a property agent, which monthly income is expected to be $20,000 a month. In this example, the anticipated return that Mr. Pang is earning is $33,000. He needs to, at least, earn $20,000 a month as a school teacher in order to keep him in the teaching profession. Thus the transfer earnings of being a school teacher to Mr. Pang is $20,000 and the (economic) rent of being a school teacher to Mr. Pang is $13,000. The (economic) rent (i.e. the $13,000) can be taken away without affecting his choice of being a school teacher. For example, if the government requires all school teacher to obtain a licence that requires each school teacher to pay $13,000 a month, Mr. Pang would still choose to be a school teacher. The relative magnitude of transfer earning and (economic) rent depends on which “another use” is referred to The relative magnitude of transfer earning and (economic) rent depends on which “another use” is referred to. Suppose Mr. Pang can chose be a school teacher in another school, which monthly income is also $33,000 a month. In this case, if “another use” is referred to “being employed in another school”, the transfer earnings of being a teacher in this school is $33,000 while the (economic) rent of being a teacher in this school is very close to zero. Rent is part of the cost if the option of outright sale is included. Transfer earnings is the opportunity cost of using the factor. Thus rent can be considered as the part of anticipated return over and above the opportunity cost of using the factor (if the option of outright sale is not included). However, if the option of outright sale is included. The selling price of the factor must at least equal to the discounted present value of the entire anticipated return. Thus the cost of owning the factor is the discounted present value of the entire anticipated return. Therefore rent is part of the cost (of owning the factor) if the option of outright sale is included.

A-Level Economics Notes

P. 1

Cost, Rent and Profit

Rent and Transfer earnings: Graphical Approach $

S Rent

Transfer earnings

0 $

D Quantity of factor input Normal Case

S

$

Rent S Transfer earnings D Quantity of factor input Special Case 1 : Supply of the factor is fixed In this case, all the expected return are rent. 0

D Quantity of factor input Special Case 2 : Supply of the factor is perfectly elastic In this case, all the expected return are transfer earnings. 0

Rent: Points to be noted v Rent can be earned by any factor. v Rent does not affect the allocation / quantity supplied of existing factors. v Rent may or may not be eliminated by competition.

Profit Definitions of Profit Profit is v the unanticipated windfall gain in wealth. v the actual rate of return over and above the market interest rate. Is ‘profit maximization’ a useful postulate? ‘Profit maximization’ is not a useful postulate because profit is windfall in nature. One cannot maximize something that is unexpected. Thus profit cannot be maximized. It does affect decision-making and is useless in explaining and predicting behaviour.

Comparison between profit and rent Rent Anticipated Can be capitalized Can persist Part of the cost

Profit Unanticipated Cannot be capitalized Cannot persist / Not expected to last Not a cost

(if the option of outright sale is included)

A-Level Economics Notes

P. 2