Capital, Interest, and Profit

The extensive use of tools, machinery, and other forms of physical capital set's human beings apart from other animals. An increase in the quantity land quality) of tools and the adoption of innovative, round about methods of production have made our current standard of living possible.

Roundabout methods of production require the sacrifice of current production because resources that might otherwise be used to produce consumption goods directly are employed in the construction of tools machines, and other constructed capital assets designed to increase future productive capability.

Interest is the price people are willing to pay to obtain goods and services now rather than in the future. Since earlier availability is usually attained through borrowing in the loanable funds market, the interest rate is often defined as the price of loanable funds.

Consumers and investors alike demand loanable funds and are willing to pay the price-the interest rate. This is so because consumers have a positive rate of time preference, and investors are willing to pay a premium for the loanable funds required to undertake potentially productive capital investment projects. If consumers did not prefer earlier availability and if capital investments were not productive, there would be no reason to expect a positive interest rate.

During inflationary times, the money rate of interest incorporates an inflationary premium reflecting the expected future increase in the price level. Under these circumstances, the money rate of interest exceeds the real rate of interest.

The money rate of interest on a specific loan reflects three basic factors-the pure interest rate, an inflationary premium, and a risk premium that is directly related to the probability of default by the borrower.

Since a dollar in the future is valued less than a dollar today, the value of future receipts must be discounted to calculate their current worth. The discounting procedure can be used to calculate the net present value of an expected income stream from a potential investment project. A project should be undertaken only if the net present value of the expected income from the project exceeds its current cost (purchase price).

The expectation of economic profit influences investment decisions in both human and physical capital. Other things constant, the higher the expected profit, the more attractive the project to an investor.

There are three basic sources of economic profit: (a) uncertainty, (b) entrepreneurial alertness, and (c) monopoly.

Since the future is uncertain, investors must expose themselves to un certainty arising from unanticipated shifts in market demand and costs. Since most people dislike uncertainty, investors must be paid a premium (a return in excess of the interest rate) to induce them to accept the uncertainty that necessarily accompanies investment. This uncertainty premium is a source of economic profit.

Astute entrepreneurs are able to recognize and undertake economically beneficial investment opportunities that have gone unnoticed by others. Entrepreneurial alertness to potential opportunities to combine resources in a manner that increases their value is a source of economic profit.

Profits may also emanate from monopoly power-entry barriers that shield suppliers from competitive pressure. Sole ownership of a vital resource, legal restraint of entry, and patents can bestow monopoly rights on owners of assets. Monopoly profits encourage entrepreneurs to invest resources to acquire a monopoly privilege.