WEBVTT NOTE 7.05. Capitalization and Rent 1 00:00:00.000 --> 00:00:05.160 5. Capitalization and Rent 2 00:00:05.160 --> 00:00:11.520 The subject of rent is one of the most confused in the entire economic literature. We must 3 00:00:11.520 --> 00:00:18.640 therefore reiterate the meaning of rent as set forth earlier. We are using rent to mean 4 00:00:18.640 --> 00:00:26.400 the unit price of the services of any good. It is important to banish any preconceptions 5 00:00:26.400 --> 00:00:33.400 This concept of rent is based on the original contribution of Frank A. Fetter. Fetter's conception has unfortunately had little influence on economic growth. 6 00:00:56.400 --> 00:01:03.520 thought, it is not only in accord with common usage, it provides a unifying principle, enabling 7 00:01:03.520 --> 00:01:10.480 a coherent explanation of the price determination of unit services, and of the whole goods that 8 00:01:10.480 --> 00:01:16.320 embody them. Without the rental price concept, it is difficult to distinguish between the 9 00:01:16.320 --> 00:01:24.080 pricing of unit services and of whole goods. Fetter used the rental concept to apply only 10 00:01:24.080 --> 00:01:30.380 to the services of durable goods, but it is clear that it can be extended to cover cases 11 00:01:30.380 --> 00:01:36.400 of non-durable goods where the unit service is the whole good. 12 00:01:36.400 --> 00:01:42.860 It therefore applies as well to prices of labor services, called wages, as it does to 13 00:01:42.860 --> 00:01:45.800 land or to any other factor. 14 00:01:45.800 --> 00:01:51.840 The rent concept applies to all goods, whether durable or non-durable. 15 00:01:51.840 --> 00:01:58.440 In the case of a completely non-durable good, which vanishes fully when first used, its 16 00:01:58.440 --> 00:02:05.240 unit of service is simply identical in size with the whole good itself. 17 00:02:05.240 --> 00:02:10.800 In regard to a durable good, of course, the rent concept is more interesting, since the 18 00:02:10.800 --> 00:02:17.160 price of the unit service is distinguishable from the price of the good as a whole. 19 00:02:17.160 --> 00:02:22.880 So far in this work we have been assuming that no durable producers' goods are ever 20 00:02:22.880 --> 00:02:29.720 bought outright, that only their unit services are exchanged on the market. 21 00:02:29.720 --> 00:02:35.360 Therefore our entire discussion of pricing has dealt with rental pricing. 22 00:02:35.360 --> 00:02:40.520 It is obvious that the rents are the fundamental prices. 23 00:02:40.520 --> 00:02:48.580 The marginal utility analysis has taught us that men value goods in units and not as wholes. 24 00:02:48.580 --> 00:02:55.760 The unit price, or rent, is then the fundamental price on the market. 25 00:02:55.760 --> 00:03:02.480 In Chapter 4, we analyzed rental pricing and the price of the good as a whole for durable 26 00:03:02.480 --> 00:03:04.320 consumers' goods. 27 00:03:04.320 --> 00:03:08.480 The principle is precisely the same for producers' goods. 28 00:03:08.480 --> 00:03:14.740 The rental value of the unit service is the basic one, the one ultimately determined on 29 00:03:14.740 --> 00:03:18.360 the market by individual utility scales. 30 00:03:18.360 --> 00:03:25.100 The price of the whole good, also known as the capital value of the good, is equal to 31 00:03:25.100 --> 00:03:32.960 the sum of the expected future rents discounted by what we then vaguely called a time preference 32 00:03:32.960 --> 00:03:37.800 factor and which we now know is the rate of interest. 33 00:03:37.800 --> 00:03:44.240 The capital value, or price of the good as a whole then, is completely dependent on the 34 00:03:44.240 --> 00:03:50.240 rental prices of the good, its physical durability and the rate of interest. 35 00:03:50.240 --> 00:03:57.060 Obviously, the concept of capital value of a good has meaning only when that good is 36 00:03:57.060 --> 00:04:01.760 durable and does not vanish instantly upon use. 37 00:04:01.760 --> 00:04:07.920 If it did vanish, then there would only be pure rent, without separate valuations for 38 00:04:07.920 --> 00:04:10.000 the good as a whole. 39 00:04:10.000 --> 00:04:16.200 When we use the term good as a whole, we are not referring to the aggregate supply of the 40 00:04:16.200 --> 00:04:18.880 whole good in the economy. 41 00:04:18.880 --> 00:04:25.360 We are referring, for example, not to the total supply of housing of a certain type, 42 00:04:25.360 --> 00:04:31.320 but to one house, which can be rented out over a period of time. 43 00:04:31.320 --> 00:04:38.420 We are dealing with units of whole goods, and these units, being durable, are necessarily 44 00:04:38.420 --> 00:04:45.880 larger than their constituent unit services, which can be rented out over a period of time. 45 00:04:45.880 --> 00:04:52.480 The principle of the determination of capital values, that is, prices of whole goods, is 46 00:04:52.480 --> 00:04:58.220 known as capitalization, or the capitalizing of rents. 47 00:04:58.220 --> 00:05:05.160 This principle applies to all goods, not simply capital goods, and we must not be misled by 48 00:05:05.160 --> 00:05:07.380 similarity of terminology. 49 00:05:07.380 --> 00:05:15.520 Thus, capitalization applies to durable consumers' goods such as houses, TV sets, etc. 50 00:05:15.520 --> 00:05:21.380 It also applies to all factors of production, including basic land. 51 00:05:21.380 --> 00:05:28.100 The rental price, or rent, of a factor of production is equal, as we have seen, to its 52 00:05:28.100 --> 00:05:31.280 discounted marginal value product. 53 00:05:31.280 --> 00:05:38.600 The capital value of a whole factor will be equal to the sum of its future rents, or the 54 00:05:38.600 --> 00:05:41.960 sum of its DMVPs. 55 00:05:41.960 --> 00:05:50.640 It is often more convenient to define rent as equal to the MVP rather than the DMVP. 56 00:05:50.640 --> 00:05:57.480 In that case, the capital value of the whole factor is equal to the discounted sum of its 57 00:05:57.480 --> 00:05:59.380 future rents. 58 00:05:59.380 --> 00:06:06.520 This capital value will be the price for which the whole good will exchange on the market. 59 00:06:06.520 --> 00:06:13.480 It is at this capital value that a unit of a whole good, such as a house, a piano, a 60 00:06:13.480 --> 00:06:19.120 machine, an acre of land, etc. will sell on the market. 61 00:06:19.120 --> 00:06:26.240 There is clearly no sense to capitalization if there is no market, or price, for the whole 62 00:06:26.240 --> 00:06:27.520 good. 63 00:06:27.520 --> 00:06:35.160 The capital value is the appraised value set by the market on the basis of rents, durability, 64 00:06:35.160 --> 00:06:37.400 and the interest rate. 65 00:06:37.400 --> 00:06:43.960 The process of capitalization can encompass many units of a whole good, as well as one 66 00:06:43.960 --> 00:06:44.960 unit. 67 00:06:44.960 --> 00:06:56.460 Consider the example of Chapter 4, Section 7, and generalize from it to apply not only to houses, but to all durable producers' goods. 68 00:06:56.460 --> 00:06:58.960 The good is a 10-year good. 69 00:06:58.960 --> 00:07:11.960 Expected future rents are 10 gold ounces per year, determined by consumer utilities for consumers' goods, or by MVPs for producers' goods. 70 00:07:11.960 --> 00:07:15.400 The rate of interest is 10% per annum. 71 00:07:15.400 --> 00:07:24.080 The present capital value of this good is 59.4 gold ounces, but this whole good is itself 72 00:07:24.080 --> 00:07:31.360 a unit of a larger supply, one of many houses, machines, plants, etc. 73 00:07:31.360 --> 00:07:38.320 At any rate, since all units of a good have equal value, the capital value of two such 74 00:07:38.320 --> 00:07:45.720 Research Houses or two such machines, etc., added together, equals precisely twice the 75 00:07:45.720 --> 00:07:51.180 amount of one, or 118.8 ounces. 76 00:07:51.180 --> 00:07:58.180 Since we are adding rents or DMVPs in money terms, we may keep adding them to determine 77 00:07:58.180 --> 00:08:03.000 capital values of larger aggregates of durable goods. 78 00:08:03.000 --> 00:08:09.520 As a matter of fact, in adding capital values, we do not need to confine ourselves to the 79 00:08:09.520 --> 00:08:17.120 same good. All we need do is to add the capital values in whatever bundle of durable goods 80 00:08:17.120 --> 00:08:24.080 we are interested in appraising. Thus, suppose a firm, Jones Construction Company, wishes 81 00:08:24.080 --> 00:08:31.040 to sell all its assets on the market. These assets, necessarily durable, consist of the 82 00:08:31.040 --> 00:08:45.040 The following. Three machines. Each machine has a capital value based on the sum of the DMVPs of 10 ounces. Therefore, total capital value is 30 ounces. 83 00:08:45.040 --> 00:08:58.040 One building with a capital value of 40 ounces. Four acres of land. Each acre has a capital value of 10 ounces. Total is 40 ounces. 84 00:08:58.040 --> 00:09:04.240 Total capital value of these assets, 110 ounces. 85 00:09:04.240 --> 00:09:11.220 But we must always remember in adding capital values that these are relevant only insofar 86 00:09:11.220 --> 00:09:17.560 as they are expressed in market price or potential market price. 87 00:09:17.560 --> 00:09:23.500 Many writers have fallen into the trap of assuming that they can, in a similar way, 88 00:09:23.500 --> 00:09:31.340 up the entire capital value of the nation or world and arrive at a meaningful figure. 89 00:09:31.340 --> 00:09:36.980 Estimates of national capital or world capital, however, are completely meaningless. 90 00:09:36.980 --> 00:09:42.540 The world or country cannot sell all its capital on the market. 91 00:09:42.540 --> 00:09:46.540 Therefore, such statistical exercises are pointless. 92 00:09:46.540 --> 00:09:53.100 They are without possible reference to the very goal of capitalization, correct estimation 93 00:09:53.100 --> 00:09:59.740 Capitalization of Potential Market Price As we have indicated, capitalization applies 94 00:09:59.740 --> 00:10:07.140 to all factors of production, or rather to all factors where there are markets for the 95 00:10:07.140 --> 00:10:09.860 whole goods that embody them. 96 00:10:09.860 --> 00:10:13.360 We may call these markets capital markets. 97 00:10:13.360 --> 00:10:21.340 They are the markets for exchange of ownership, total or partial, of durable producers' goods. 98 00:10:21.340 --> 00:10:29.140 Let us take the case of capital goods. The rent of a capital good is equal to its DMVP. 99 00:10:29.140 --> 00:10:36.980 The capitalized value of the capital good is the sum of the future DMVPs, or the discounted 100 00:10:36.980 --> 00:10:44.660 sum of the future MVPs. This is the present value of the good, and this is what the good 101 00:10:44.660 --> 00:10:48.780 will sell for on the capital market. 102 00:10:48.780 --> 00:10:55.260 The process of capitalization, because it permeates all sectors of the economy and because 103 00:10:55.260 --> 00:11:01.440 it is flexible enough to include different types of assets, such as the total capital 104 00:11:01.440 --> 00:11:06.720 assets of a firm, is a very important one in the economy. 105 00:11:06.720 --> 00:11:11.680 Prices of shares of the ownership of this capital will be set at their proportionate 106 00:11:11.680 --> 00:11:16.160 fraction of the total capital value of the assets. 107 00:11:16.160 --> 00:11:23.440 In this way, given the MVPs, durability and the rate of interest, all the prices on the 108 00:11:23.440 --> 00:11:30.260 capital market are determined, and these will be the prices in the ERE. 109 00:11:30.260 --> 00:11:37.660 This is the way in which the prices of individual capital goods, machines, buildings, etc. will 110 00:11:37.660 --> 00:11:43.780 be set on the market, and this is the way in which these values will be summed up to 111 00:11:43.780 --> 00:11:49.920 to set the price of a bundle of capital assets, similar and dissimilar. 112 00:11:49.920 --> 00:11:55.140 Share prices on the stock market will be set according to the proportion that they bear 113 00:11:55.140 --> 00:12:00.560 to the capitalized value of the firm's total assets. 114 00:12:00.560 --> 00:12:07.140 We have stated that all factors that can be bought and sold as whole goods on the market 115 00:12:07.140 --> 00:12:08.920 are capitalized. 116 00:12:08.920 --> 00:12:15.080 This includes capital goods, ground land, and durable consumers' goods. 117 00:12:15.080 --> 00:12:22.120 It is clear that capital goods and durable consumers' goods can be and are capitalized. 118 00:12:22.120 --> 00:12:24.320 But what of ground land? 119 00:12:24.320 --> 00:12:27.880 How can this be capitalized? 120 00:12:27.880 --> 00:12:34.440 We have seen in detail that the ultimate earnings of factors go to the owners of labor and of 121 00:12:34.440 --> 00:12:47.440 If land can be capitalized, does this not mean that land and capital goods are really the same thing after all? 122 00:12:47.440 --> 00:12:50.440 The answer to the latter question is no. 123 00:12:50.440 --> 00:13:02.440 Frank Fetter's main error in capital theory was his belief that capitalization meant the scrapping of any distinction between capital goods and land. 124 00:13:02.440 --> 00:13:10.680 It is still emphatically true that the earnings of basic land factors are ultimate and irreducible, 125 00:13:10.680 --> 00:13:17.960 as are labor earnings, while capital goods have to be constantly produced and reproduced, 126 00:13:17.960 --> 00:13:25.480 and therefore their earnings are always reducible to the earnings of ground land, labor and time. 127 00:13:25.480 --> 00:13:35.480 Basic land can be capitalized for one simple reason. It can be bought and sold as a whole on the market. 128 00:13:35.480 --> 00:13:44.480 This cannot be done for labor, except under a system of slavery, which of course cannot occur on the purely free market. 129 00:13:44.480 --> 00:13:53.480 Since this can be and is being done, the problem arises how the prices in these exchanges are determined. 130 00:13:53.480 --> 00:14:05.640 A major characteristic of land, as compared to capital goods, is that its series of future 131 00:14:05.640 --> 00:14:14.620 rents is generally infinite, since, whether as basic soil or site, it is physically indestructible. 132 00:14:14.620 --> 00:14:20.760 In the ERE, the series of future rents will, of course, always be the same. 133 00:14:20.760 --> 00:14:26.640 The very fact that any land is ever bought and sold, by the way, is a demonstration of 134 00:14:26.640 --> 00:14:29.640 the universality of time preference. 135 00:14:29.640 --> 00:14:35.780 If there were no time preference for the present, then an infinite series of future rents could 136 00:14:35.780 --> 00:14:37.520 never be capitalized. 137 00:14:37.520 --> 00:14:43.320 A piece of land would have to have an infinite present price, and therefore could never be 138 00:14:43.320 --> 00:14:44.560 sold. 139 00:14:44.560 --> 00:14:51.920 The fact that lands do have prices is an indication that there is always a time preference and 140 00:14:51.920 --> 00:14:58.240 that future rents are discounted to reduce to a present value. 141 00:14:58.240 --> 00:15:04.840 As in the case of any other good, the capital value of land is equal to the sum of its discounted 142 00:15:04.840 --> 00:15:06.440 future rents. 143 00:15:06.440 --> 00:15:13.000 For example, it can be demonstrated mathematically that if we have a constant rent expected to 144 00:15:13.000 --> 00:15:20.560 To be earned in perpetuity, the capital value of the asset will equal the annual rent divided 145 00:15:20.560 --> 00:15:22.760 by the rate of interest. 146 00:15:22.760 --> 00:15:30.320 Now it is obvious that on such land, the investor annually obtains the market rate of interest. 147 00:15:30.320 --> 00:15:37.620 If in other words, annual rents will be 50 and the rate of interest is 5%, the asset 148 00:15:37.620 --> 00:15:44.460 It will sell for 50 divided by 0.05 or 1,000. 149 00:15:44.460 --> 00:15:51.740 The investor who purchases the asset for 1,000 ounces will earn 50 ounces a year from it 150 00:15:51.740 --> 00:15:57.620 or 5%, the market rate of interest. 151 00:15:57.620 --> 00:16:05.300 Groundland then is capitalized just as our capital goods, shares in capital-owning firms 152 00:16:05.300 --> 00:16:08.340 and Durable Consumers Goods. 153 00:16:08.340 --> 00:16:14.520 All these owners will tend to receive the same rate of interest return, and all will 154 00:16:14.520 --> 00:16:19.180 receive the same rate of return in the ERE. 155 00:16:19.180 --> 00:16:24.020 In short, all owned assets will be capitalized. 156 00:16:24.020 --> 00:16:30.480 In the ERE, of course, the capital values of all assets will remain constant. 157 00:16:30.480 --> 00:16:38.080 They will also be equal to the discounted sum of the MVPs of their unit rents. 158 00:16:38.080 --> 00:16:43.640 We have seen that a key distinction between land and capital goods is that the owners 159 00:16:43.640 --> 00:16:51.060 of the former sell future goods for present money, whereas the owners of the latter advance 160 00:16:51.060 --> 00:16:58.320 present money, buy future goods, and later sell their product when it is less distantly 161 00:16:58.320 --> 00:16:59.320 future. 162 00:16:59.320 --> 00:17:05.280 This is still true, but then we must ask the question, how does the landowner come to own 163 00:17:05.280 --> 00:17:06.720 this land? 164 00:17:06.720 --> 00:17:14.160 The answer is, accepting his or his ancestors finding unused land and putting it to use, 165 00:17:14.160 --> 00:17:17.260 that he must have bought it from someone else. 166 00:17:17.260 --> 00:17:24.600 If he did so, then in the ERE, he must have bought it at its capitalized value. 167 00:17:24.600 --> 00:17:31.560 If he buys the piece of land at a price of 1,000 ounces and receives 50 ounces per annum 168 00:17:31.560 --> 00:17:37.800 in rent, then he earns interest, and only interest. 169 00:17:37.800 --> 00:17:45.840 He sells future goods, land service, in the production process, but he too first bought 170 00:17:45.840 --> 00:17:55.600 the whole land with money, therefore he too is a capitalist investor earning interest. 171 00:17:55.600 --> 00:18:03.760 Pure rent, that is, rent that is not simply a return on previous investment and is therefore 172 00:18:03.760 --> 00:18:12.880 not capitalized, seems therefore to be earned only by those who have found unused land themselves 173 00:18:12.880 --> 00:18:22.080 or inherited it from the finders but even they do not earn pure rent suppose that a man finds land 174 00:18:22.080 --> 00:18:30.080 unowned and worth zero and then fences it etc until it is now able to yield a perpetual rental 175 00:18:30.080 --> 00:18:38.720 of 50 ounces per annum could we not say that he earns pure rent since he did not buy the land 176 00:18:38.720 --> 00:18:44.480 capitalized from someone else, but this would overlook one of the most important features 177 00:18:44.480 --> 00:18:53.600 of economic life, implicit earnings. Even if this man did not buy the land, the land is now worth 178 00:18:53.600 --> 00:19:02.320 a certain capital value, the one it could obtain on the market. This capital value is, say, one 179 00:19:02.320 --> 00:19:04.320 The Theory of Money and Credit 180 00:19:32.320 --> 00:19:58.320 We must therefore conclude that no one receives pure rent except laborers in the form of wages, that the only incomes in the productive ERE economy are wages, the term for the prices and incomes of labor factors, and interest. 181 00:19:58.320 --> 00:20:05.840 but there is still a crucial distinction between land and capital goods for we see that a fundamental 182 00:20:05.840 --> 00:20:14.480 irreducible element is the capital value of land the capital value of capital goods still reduces 183 00:20:14.480 --> 00:20:22.640 to wages and the capital value of land in a changing economy there is another source of income 184 00:20:22.640 --> 00:20:27.280 Increases in the Capital Value of Ground Land 185 00:20:27.280 --> 00:20:33.280 Typical was the man who found unused land and then sold its services. 186 00:20:33.280 --> 00:20:37.120 Originally, the capital value of the land was zero. 187 00:20:37.120 --> 00:20:38.560 It was worthless. 188 00:20:38.560 --> 00:20:43.200 Now the land has become valuable because it earns rents. 189 00:20:43.200 --> 00:20:48.560 As a result, the capital value has risen to 1,000 ounces. 190 00:20:48.560 --> 00:20:55.440 His income or gain consisted of the rise of 1,000 ounces in capital value. 191 00:20:56.160 --> 00:21:04.960 This of course cannot take place in the ERE. In the ERE all capital values must remain constant. 192 00:21:05.600 --> 00:21:12.480 Here we see that a source of monetary gain is a rise in the capital value of land, 193 00:21:12.480 --> 00:21:18.080 a rise resulting from increases in expected rental yields of land. 194 00:21:18.560 --> 00:21:32.560 In the long run, increases in the capital value of capital goods are unimportant, since they resolve into increases in wages and increases in the capital value of ground land. 195 00:21:33.560 --> 00:21:47.560 If the economy becomes an ERE after this particular change from 0 to 1000, then this income was a one-shot affair, rather than a continuing and recurring item. 196 00:21:48.560 --> 00:21:57.160 The capital value of the land rose from zero to one thousand, and the owner can reap this income at any time. 197 00:21:57.160 --> 00:22:02.360 However, after this has been reaped once, it is never reaped again. 198 00:22:02.360 --> 00:22:10.460 If he sells the land for one thousand, the next buyer receives no gain from the increase in capital value. 199 00:22:10.460 --> 00:22:18.160 He receives only market interest. Only interest and wages accrue continuously. 200 00:22:18.160 --> 00:22:26.560 As long as the ERE continues, there will be no further gains or losses in capital value.