0:12

To begin our study of the key factor of production known as capital,

Â we want to start off by formally distinguishing between

Â real capital and financial capital.

Â In fact there are three major categories of real capital goods.

Â The first is structures,

Â such as factories and homes.

Â The second is equipment,

Â including consumer durable goods such as automobile,

Â and producer durable goods like machine tools and computers.

Â The third category of capital goods is inventories,

Â and includes things like cars and dealers lots.

Â And note here that all three categories of

Â these capital goods are bought and sold in capital goods markets.

Â For example, companies like Apple,

Â or Hewlett-Packard, or Lenovo sell computers to businesses,

Â and these computers in turn,

Â are used by firms to help improve

Â the efficiency of their payroll systems or production management. [MUSIC].

Â Now, one of the most important tasks

Â of a national economy,

Â a big business, or an individual household,

Â is to allocate its capital across different possible investments.

Â For example, should a country like India or Vietnam

Â devote its investment resources to heavy manufacturing like steel,

Â or to information technologies like the Internet.

Â Should a company like Intel or Samsung build

Â a $4 billion factory to produce the next generation of microprocessors?

Â And should rancher Jones or farmer Wong,

Â hoping to improve record keeping,

Â buy a customized accounting program,

Â or make do with one of the popular varieties available for a few hundred dollars?

Â This is where interest rates,

Â and the rate of return to capital come in,

Â and we can think about the problem in this way.

Â 2:21

When we invest in capital we are laying out our money

Â today to obtain return in the future.

Â So in deciding upon the best investment to make,

Â we will certainly need to know how much the investment will earn.

Â That's the rate of return.

Â Of course to figure that out,

Â we also need to know how much the money we will use to invest is going to cost us.

Â That's the interest rate.

Â In fact we can think of the interest rate

Â simply as the price paid for the use of the loanable funds.

Â Where, in this key definition,

Â the term loanable funds is used to describe funds that are available for borrowing.

Â In particular, the interest rate is the amount of money that must be

Â paid for the use of one dollar of loanable funds for a year.

Â Because it is paid in kind,

Â interest is typically stated as a percentage of the amount of money borrowed,

Â rather than as absolute amount.

Â Put another way, it is less clumsy to say that interest is 12% annually,

Â then that interest is $120 per year from $1,000.

Â Furthermore, stating interest as a percentage,

Â makes it easy to compare interest paid on loans of different absolute amounts.

Â For example, by expressing interest as a percentage,

Â we can immediately compare an interest payment of say,

Â $432 per year per $2,880,

Â and one of $1,800 per year per $12,000.

Â In fact, both interest payments indicate an interest rate of 15%,

Â which is not immediately obvious from the absolute figures.

Â 4:21

In this key definition,

Â the rate of return on capital is

Â the additional revenue that a firm can earn from its employment of new capital.

Â This additional revenue is usually measured as a percentage rate per unit of time.

Â Specifically, the annual net return per dollar of invested capital.

Â And that is precisely why it is called the rate of return on capital.

Â To see this a little more clearly,

Â let's consider the example of the Ugly Duckling Rental company.

Â Say the company buys a used car for $10,000 and then rents it out for $2,500 per year.

Â After calculating all of the expenses associated with owning the car,

Â such as maintenance, insurance,

Â and depreciation, and ignoring any change in car prices,

Â Ugly Duckling earns a net rental of $1,200 each year.

Â So what is the rate of return?

Â Let's pause the presentation now and see if you can figure that out.

Â Well, the answer is 12%.

Â We can calculate that simply by dividing the net rental payment of $1,200

Â per year by the initial investment outlay for the used car of $10,000.

Â And know that the rate of return is a pure number per unit of time.

Â That is, it has the following form: dollars per period divided by dollars.

Â Now let's try another one. Suppose I buy a bottle of grape juice for

Â $10 and then sell it a year later as wine for $11.

Â What is my rate of return on this investment assuming I have no other expenses?

Â 6:13

That's right, 10% per year or $1 divided by $10.

Â So now that you have a handle on interest rate,

Â and the rate of return on capital,

Â let's move on to our next module to the functions of

Â the interest rate and a critical concept of depreciation.

Â