[MUSIC] Hi Professor Navarro here, and now that we've looked at land and labor as factors of production, I want to turn to the subject of capital as a factor of production. In fact, this is one of the most important and useful areas of microeconomics that we can master, because by better understanding the nature of capital markets We can answer questions that have enormous application to both our personal and business lives. On a personal level, we can answer questions like, should I rent or buy a home now, should I quit my job and return to school for a business or law degree, should I buy that expensive energy-efficient refrigerator, or go for a cheaper model, and should I invest in a portfolio of high-risk, high-technology stocks. Or settle for some safer tax-free municipal bonds. At a business level, capital analysis is equally crucial and can help business executives answer questions like, should I invest in new plant equipment? Should I expand my firm? And how much inventory should I maintain? The analysis of capital markets can help provide answers to these questions. Because it provides us with a framework for evaluating investments in new capital over time. [MUSIC] We've looked at land and labor as factors of production. Now let's turn to the subject of capital. This is one of the most important and useful areas of microeconomics that we can master. By understanding the nature of capital markets. We can answer questions that have enormous application to both our personal and professional lives. On a personal level, we can answer questions like should I rent or buy a home now? Should I quit my job to go back to school for a business or law degree? Should I buy that expensive energy efficient refrigerator, or pop for the cheaper model? And should I invest in a portfolio of high risk, high technology stocks? Or settle for some safer tax free municipal bonds? At a professional level, capital analysis is equally crucial, and can help business executives answer questions like, should I invest in new plant and equipment? Should I expand my firm? And how much inventory should I maintain? The analysis of capital markets can help answer these questions, because it provides us with a framework for evaluating investment in new capital over time. So let's roll up our sleeves and get to work, and let's start by distinguishing between real capital The bricks and mortar machines and financial capital, the stocks and bonds and other loanable funds used to finance real capital, in fact, there are three major categories of real capital goods. The first is structures such as factories and homes. The second is equipment including consumer durable goods such as automobiles and producer durable equipment like machine tools and computers. The third category of capital goods is inventories and includes things like cars in dealers lots. All three categories of these capital goods are bought and sold in capital goods markets. For example, IBM sells computers to businesses, and these computers in turn are used by firms to help improve the efficiency of their payroll systems or production management. Now, one of the most important tasks of an economy, business or household is to allocate its capital across different possible investments. Should a country devote its investment resources to heavy manufacturing like steel, or to information technologies, like the Internet? Should Intel build a $4 billion dollar factory to produce the next generation of microprocesors. Should Farmer Jones, hoping to improve his record keeping, buy a customized accounting program or make do with one of the popular varieties available for around $100? This is where interest rates and the rate of return to capital comes in, we can think about the problem this way. When we invest in capital, we are laying out money today to obtain a return in the future. In deciding upon the best investment to make, we need to know how much the money we will use is going to cost us. That's the interest rate. We also need to know how much the investment will earn. That's the rate of return. The interest rate is the price paid for the use of loanable funds, where the term loanable funds is used to describe funds that are available for borrowing. In particular the interest rate is the amount of money that must be paid for the use of $1 of loanable funds for a year. Because it is paid in kind, interest is typically stated as a percentage of the amount of money borrowed rather than as an absolute amount. Put another way, it is less clumsy to say that interest is 12% annually than that interest is $120 per year per $1000. Furthermore, stating interest as a percentage makes it easy to compare interest paid on loans of different absolute amounts. For example, by expressing interest as a percentage, we can immediately compare an interest payment of say $432 per year per $2880 and one of $1800 per year per $12,000. Both interest payments are 15%. Which is not obvious from the absolute figures. The rate of return on capital is the additional revenue that a firm can earn from its employment of new capital. This additional revenue is usually measured as a percentage rate per unit of time. The annual net return per dollar of invested capital, which is why it is called the rate of return on capital. To see this, let's consider the example of the Ugly Duckling rental company. [NOISE] Say the company buys a used Ford for $10,000, and then rents it out for $2,500 per year. After calculating all the expenses associated with owning the car, such as maintenance, insurance and appreciation, and ignoring any changing car prices, Ugly Duckling earns a net rental of $1200 each year. So what is the rate of return? The answer is 12%. We calculate that simply by dividing the net rental of $1,200 per year, by the initial investment outlay for the Ford of $10,000. And note that the rate of return is a pure number per unit of time. That is, it has the following form dollars per period divided by dollars. Now let's try another one. Suppose I buy a bottle of grape juice for $10 and then sell it a year later as wine for $11. What is my rate of return on this investment assuming that I have no other expenses? [SOUND] That's right, 10% per year or $1 divided by $10.
