To begin our study of the key factor of production known as capital, we want to start off by formally distinguishing between real capital and financial 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 automobile, and producer durable goods like machine tools and computers. The third category of capital goods is inventories, and includes things like cars and dealers lots. And note here that all three categories of these capital goods are bought and sold in capital goods markets. For example, companies like Apple, or Hewlett-Packard, or Lenovo sell computers to businesses, and these computers in turn, are used by firms to help improve the efficiency of their payroll systems or production management. [MUSIC]. Now, one of the most important tasks of a national economy, a big business, or an individual household, is to allocate its capital across different possible investments. For example, should a country like India or Vietnam devote its investment resources to heavy manufacturing like steel, or to information technologies like the Internet. Should a company like Intel or Samsung build a $4 billion factory to produce the next generation of microprocessors? And should rancher Jones or farmer Wong, hoping to improve record keeping, buy a customized accounting program, or make do with one of the popular varieties available for a few hundred dollars? This is where interest rates, and the rate of return to capital come in, and we can think about the problem in this way. When we invest in capital we are laying out our money today to obtain return in the future. So in deciding upon the best investment to make, we will certainly need to know how much the investment will earn. That's the rate of return. Of course to figure that out, we also need to know how much the money we will use to invest is going to cost us. That's the interest rate. In fact we can think of the interest rate simply as the price paid for the use of the loanable funds. Where, in this key definition, 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 one dollar 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 absolute amount. Put another way, it is less clumsy to say that interest is 12% annually, then that interest is $120 per year from $1,000. 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 $2,880, and one of $1,800 per year per $12,000. In fact, both interest payments indicate an interest rate of 15%, which is not immediately obvious from the absolute figures. In this key definition, 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. Specifically, the annual net return per dollar of invested capital. And that is precisely why it is called the rate of return on capital. To see this a little more clearly, let's consider the example of the Ugly Duckling Rental company. Say the company buys a used car for $10,000 and then rents it out for $2,500 per year. After calculating all of the expenses associated with owning the car, such as maintenance, insurance, and depreciation, and ignoring any change in car prices, Ugly Duckling earns a net rental of $1,200 each year. So what is the rate of return? Let's pause the presentation now and see if you can figure that out. Well, the answer is 12%. We can calculate that simply by dividing the net rental payment of $1,200 per year by the initial investment outlay for the used car of $10,000. And know 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 I have no other expenses? That's right, 10% per year or $1 divided by $10. So now that you have a handle on interest rate, and the rate of return on capital, let's move on to our next module to the functions of the interest rate and a critical concept of depreciation.