[kferris2]

I was listening to the 3rd lecture in this series, and imputed interest was discussed. The idea struck me as odd. It seems that it is used to calculate the difference between gross and net income, yet no money actually exchanges hands. How can a true price be realized without an actual exchange?

[jmherbener]

Professor Manish is referring to the opportunity cost of foregone interest income when a person self-finances his business. Instead of self-financing, if an entrepreneur borrows from the credit markets, then he pays interest to the lender. The rate of interest is determined by the market. If an entrepreneur self-finances, then he foregoes earning interest on the funds that he could have earned by lending them in the credit markets to a borrower. He must account for this opportunity cost of using his own funds by recognizing that his net income from production includes the interest income he could have earned by lending out the funds he used instead to self finance his operation. Whether he self-fiances or not, however, the rate of interest is determined by the market.

[kferris2]

OK – I think I get it. It is just a construct that can be useful for the IRS, or comparing net incomes across industries, etc.

[jmherbener]

It’s more than just a construct for businesses to report to the government. It’s an aspect of economic calculation itself.

Let’s take a stylistic example. Joe and Mary Smith own the Main Street Diner, a mom and pop restaurant, in Grove City, Pennsylvania. For 2014, their net income was $80,000. During the year, Joe worked for 1,000 hours as a cook and Mary worked 1,250 hours as a waitress. They pay their cooks $12 an hour and their waitress $8 an hour. Considering the sources of their net income (i.e., what productive contribution did they make to the operation of their restaurant), $22,000 of their net income of $80,000 came from the value of their labor. They earned implicit or imputed wages since they could have earned $22,000 if they were hired elsewhere as a cook and waitress. Mary and Joe also invested $1 million of their own saving into the restaurant. The annual rate of interest on similar loans is 5 percent. Thus, $50,000 of their net income of $80,000 is implicit or imputed interest since they could have lent their $1 million to someone else and earned $50,000. Assuming that they make no other productive contribution, the residual $8,000 of their net income of $80,000 is profit for their entrepreneurship.

In making production decisions, it’s valuable for Joe and Mary to be able to calculate the sources of their income. If an economist wanted to compile everyone’s income, he would use these economic categories of sources of income: Wages for labor; Rent for land; Interest for capital; and Profit for entrepreneurship. Accurately compiling everyone’s income by source would require the economist to take account of implicit or imputed income earned in the four sources of income.

[kferris2]

I don’t mean to be thick, but I don’t understand why it has to be part of the economic calculation. Maybe I’m missing something. In the scenario you present, it reduces the profit they show. Let us say someone was ignorant about imputed interest, so they didn’t report it. Wouldn’t the same dollar amount make it into the compilation of income because that amount would be reported as profit instead of imputed interest?

I do get the value for Mary & Joe figuring their opportunity cost, so that makes sense to me.

In the lecture, I thought Professor Manish was talking about it in a different manner than your scenario. If I recall correctly, the scenario he presented was if the business owner self-financed instead of taking out a loan and paying interest on that loan. In that case, the imputed interest would increase the business expenses, thereby reducing their net income. In that scenario, it seems it would make a difference to a complication of income because it would reduce what was taken into account for income compilation.

[jmherbener]

Professor Manish was not discussing a business reporting to the government. He was referring to the method by which the categories of income (namely wages, rent, interest, and profit) can be applied to adding up everyone’s income. If Joe and Mary earn $80,000 in net income, how is that to be categorized? To do so, one needs to be able to calculate their imputed wages and imputed interest.

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