Overview
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 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.
a) 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.
b) "windfall" profits encourage other firm or entrepreneurs to enter the industry; ultimately this drives prices and profits down.
4. The cost to society of producing a certain good (i.e. shifting productive resources into the production of that good) is the value of the goods that those resources could have otherwise produced.
| Key Economic Concepts normal profit, return on a fixed investment, economic profit, present value of an investment, interest rate, anti-usury laws, marginal value product of capital, supply and demand for loanable funds. |
| Contemporary Issues During the boom years of the 1990s, many companies in the high-tech industries did not produce any profits, even though their revenues were skyrocketing. This happened because, as they grew, their costs grew even faster than their revenues. However, this lack of profits did not prevent the stock prices of these companies from shooting up, as investors bet that, sooner or later, their profitability would improve. As the boom turned to bust, the stock prices of many such companies plunges and large numbers of them were forced out of business. What does this tell us about why financial markets tend to overshoot? |
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