Capital, Interest and Profits - Review Notes

Economics Concepts, Theories and Practices for Managers

Capital

Capital consists of those durable produced goods that are in turn used as productive inputs for further production.

There are three major categories of capital goods: structures (factories), equipment (machine tools) and inventories(goods on the shelfs of retails stores).

Investing in capital goods involves indirect or roundabout production. An item to catch fish can be made by spending time which can be used to catch fish with hands. There is an opportunity cost here. But investment of time or the opportunity cost is made in a capital good because it allows more consumption in the future than the opportunity cost.

Interest

The rate of return on capital is the annual net income (rentals less expenses) per dollar of invested capital.

In a world free or risk, inflation and monopoly, the competitive rate of return on capital would be equal to the market interest rate. In a world of different risk for different assets, return on capital is the sum of market interest rate plus risk premium. Market interest rate for zero risk assets is a benchmark. The presence of risk indicates that return on capital is not constant every period. If fluctuates and from past data, an expected return and variability of return can be established.

Profit

Profits are defined as the difference between total revenues and total costs.

From the total revenue all expenses (wages, salaries, rents, materials, interest, excise taxes, and the rest are deducted. The residual amount is termed as profit. The profits go the enterpreneur.

1. Profits are implicit returns

If the enterpreneur does not charge the business for his labor, his capital and land and profit will be an implicit return to his factors of production.

2. Profits as a reward for risk taking

If the revenues of the business are charged with the implicit returns - what remains is a reward for risk taking.

3. Profit as monopoly returns




References

Paul Samuelson and William D. Nordhaus, Economics, 13th Edition, McGraw-Hill, 1989

Knols - 237 profit

Updated on 3 July 2021

First pub 11 Dec 2011 Transferred from Knol to this blog.