Factor markets and income distribution The Mc GrawHill

Factor markets and income distribution ©The Mc. Graw-Hill Companies, 2002

Capital and land • Physical capital – the stock of produced goods which contributes to the production of goods and services. • Land – the factor of production which nature supplies. • Together capital and land make up the tangible wealth of a country. 1 ©The Mc. Graw-Hill Companies, 2002

Investment • Capital depreciates over time – becoming less productive and less valuable. • Gross investment – the production of new capital goods and the improvement of existing capital goods. • Net investment – gross investment minus the depreciation of the existing capital stock. 2 ©The Mc. Graw-Hill Companies, 2002

Stocks and flows • A stock – the quantity of an asset at a point in time – the asset price is the sum for which the stock can be bought outright. • A flow – the stream of services that an asset provides during a period – the rental rate is the cost of using capital services. 3 ©The Mc. Graw-Hill Companies, 2002

Interest and present value • The present value of £ 1 at some future date is the sum that, if lent out today, would accumulate to £ 1 by that future date. – It depends upon how far into the future the sum accumulates – and on the rate of interest. • The price of a capital asset should be related to the stream of future payments that will be earned from the services it provides – discounted back to give the present value. 4 ©The Mc. Graw-Hill Companies, 2002

Real and nominal interest rates • The nominal interest rate – tells us how many actual pounds will be earned in interest by lending £ 1 for one year. • The real rate of interest – measures the return on a loan as the increase in goods that can be purchased rather than as the increase in the nominal value of the loan fund. • The real rate of interest is the nominal rate minus the inflation rate. 5 ©The Mc. Graw-Hill Companies, 2002

Future consumption The equilibrium real interest rate AA' shows the production possibility frontier between current and future consumption: A' by devoting resources to investment, future consumption can be increased. A Current consumption The slope of the frontier has magnitude –(1 + i) where i is the rate of return on investment. 6 ©The Mc. Graw-Hill Companies, 2002

Future consumption The equilibrium real interest rate U A' E U A Given society's preferences between present and future consumption, the optimal position is at E, where the indifference curve UU is at a tangent to the PPF. The slope of the red line represents –(1 + r), where r is the real interest rate that balances the productivity of investment and the thriftiness of consumers. Current consumption 7 ©The Mc. Graw-Hill Companies, 2002

The markets for capital and land • The derived demand curve for capital (and for land) services closely parallels the earlier analysis of labour demand. • But land is in fixed supply to the economy as a whole. • Rental rates tend to become equalised across alternative uses. 8 ©The Mc. Graw-Hill Companies, 2002

Changes in capital intensity • Over time, the UK economy is becoming more capital-intensive – the wage-rental ratio has increased, leading industries to substitute capital for labour – in the long run the supply of labour is less elastic than the supply of capital – new capital embodies latest technology. 9 ©The Mc. Graw-Hill Companies, 2002

The functional distribution of income in the UK The distribution of income between the factors of production changed little between 1981 -89 and 1998. 10 ©The Mc. Graw-Hill Companies, 2002