Production, Rents and Social Surplus Keep reading Weimer &Vining

Last Week’s Objectives: The model: The concept of a perfectly competitive economy The virtues and limits of the competitive market model Utility and “consumer behavior” The concept(s) of efficiency Indifference Maps Pareto Optimality Potential Pareto Optimality Competitive Markets and Efficiency The “rationale” for government intervention

This week: The Behavior of Producers Rents: Monopolistic and Competitive Behavior Changes in Producer Surplus Social Surplus -- the larger story Analysis Example: A Producer Tax Social Surplus and Efficiency Beginning Public Goods Discussion of organ transplant policy

Producer Behavior in a Competitive Market A perfectly competitive market consists of firms that produce identical products that sell at the same price. Each firm’s volume of output is so small in comparison to the overall market demand that no single firm has an impact on the market price. Premises/Assumptions of the behavior of producers Motivated by profit-seeking Unprofitable firms tend to disappear Based on a given set of technologies, however: Technological innovation leads to temporary edge The Dynamism of technology This temporary edge leads to Rents: economic profits Consumer and Producer Surplus is the difference between the value of goods (MU) and their social cost (MC). A. In a competitive market, competition will drive price down to marginal cost. i. Any producer who develops a better technology and can produce at a lower price can earn extra profits, or rents. ii. If other producers copy them, then their rents will be eliminated by competition. This happened, for example, to Ford Motor Company (automobile assembly line) and Xerox (photocopiers). iii. Or else, if they can maintain control over their innovation, they will establish a monopoly. This happened for Microsoft. B. Rents are earned for technological advantages and also for control over scarce resources, like land or a brand name. i. The key is nonreproducible inputs. If the input can be reproduced, then the price will fall to the cost of production. But if it can't be reproduced, such as land in Amherst, it will produce monopoly profits and rents. ii. Rents will be capitalized as higher prices for assets. This is why Microsoft stock sells for more than Enron. It is also why land in Amherst sells for more than land in Hadley or Sunderland.

Rents (temporarily) accrued Individual Firm Behavior: Marginal and Average Costs = Total Cost MC > AC; Rents (temporarily) accrued = Profit MC AC $ MC and AC are equal; No Rents accrued Ps Some interesting things about MC and AC 1) Total costs are a function of 1) fixed costs and 2) variable costs 2) Notice: AC first falls and then rises. falls: as fixed costs are spread over larger units rises as the variable costs begin to dominate. 3)Notice that MC crosses at lowest point of AC 4)Notice: when MC is lower than AC, AC is falling and when MC is higher than AC, AC is rising, only when MC=AC does AC remain unchanged. Lets start with Qs: what is the total cost of producing Qs? Remember AC = TC/Qs., so multiplying AC*Qs yields TC that is shown by the pink rectangle: Now lets assume that the market price if the good is set to Ps. Firms would maximize profits by producing Qs, the quantity where MC is = to price. The blue rectangle is then profit. The existence of profits would signal other producers to join the market. As more firms enter the industry, total output of the good would rise and therefore price would fall. Eventually price would fall to Pl, the level at which the new MC = new AC. At Pl profits fall to zero, removing any incentive to enter the industry. ACs PL QL Qs Output (Q) per unit of Time

Rents and the Idealized Market With no constraints on the number of firms that can arise to produce each good, the Pareto Efficient equilibrium in the idealized competitive model is characterized by zero profits for all firms. Economic profits are called rents. Over the long run we expect rents to disappear. Only if some circumstance prevents the entry of new firms will rents persist. Therefore, we expect the dynamic process of profit seeking to move the economy toward the competitive ideal. To better understand this concept, it is useful to contrast pricing in a monopolistic industry with one that is competitive. Economic Profits=Total revenue minus payments at competitive market prices to all factors of production, including opportunity costs. Accounting profit is revenue minus expenses.

Transfer from consumers Individual Firm Behavior: A Case of Monopoly Supply Transfer from consumers To producers Lost consumer surplus Lost “producer Surplus” Unexpended Resources MC AC $ ACM QM PM PC First, the usual suspects, MC, AC, Demand and a new one MR A monopoly firm “sees” the MR curve. In the case of a producer who supplies a very small percentage of the market, an extra unit of production is unlikely to have an effect on market prices. In this case, increased production will not affect marginal revenue. On the other hand, if the producers supplies most or all of the market (such as in a monopoly or near-monopoly), then increased production is likely to reduce marginal revenue. For a Monopoly, the rule for profit maximization is MC=MR; That is, the rule says that the monopoly should increase output up to the level where the marginal cost curve intersects the marginal revenue curve, in order to maximize its profits. The price charged is the corresponding price on the demand curve. Notice that this is a two-stage analysis: at the first stage, the marginal cost, and the marginal revenue, determine the output. Profit maximizing output is the output at which they intersect. at the second stage, the output and the demand curve determine the price. In a competitive market, competition will drive price down to marginal cost. D QC MR Output (Q) per unit of Time

Aggregate Supply Schedules The Competitive Case In competitive markets Many firms with roughly the same capabilities Demand is essentially unaffected by the production of any single firm Firms respond to observed price Producer Surplus Loss P3 Quantity Produced Supply Schedule P2 Total cost is represented by the area under the supply curve. Each point on the supply curve is the cost of producing one more good. Changes in producer surplus represent changes in rents. The reduction of rents that would result in a change of price P3 to P2 is the blue area– this is the reduction in rents as price falls and the corresponding reduction of rents. P1

The Larger Picture: Social Surplus Price Quantity per unit of Time Demand Schedule Supply Schedule P1 Q1 Consumer Surplus Market-clearing price We know have the basic tools for analyzing efficiency in specific markets. Changes in consumer surplus (compensating variation) and changes in producer surplus (rents). The sum of consumer surplus and producer surplus in the market is called social surplus. Therefore changes in ps or cs measures changes in compensating variation and rents. This is associated with our pareto efficiency criterion. A necessary condition for pareto efficiency is that it not be possible to increase the sum of compensating variations (cs) and rents (ps) through any reallocation of factor inputs or final products. Producer Surplus Social Surplus = Consumer + Producer Surplus

Analysis: Social Surplus, A Tax on Producers revenue Q2 Size of Tax P2 Deadweight loss Price Quantity per unit of Time P1 Q1 S1 D

Summary Social surplus analysis captures... Changes in “compensating variation” for consumers (Consumer surplus) Changes in rents (producer surplus) Idealized Competitive Markets produce Pareto efficient allocations of goods and services No one can be made better off w/out making someone else worse off Social surplus is maximized Market operation is decentralized Pareto efficiency arises through voluntary actions without any need for public policy Hence the ICM provides an analytic “baseline” Are there departures for the ICM that would result in inefficient allocations of goods and services? What policy options can address such departures?

Moving forward… Idealized competitive market framework is useful for thinking about efficiency – and therefore our Pareto criterion. So what happens when equilibrium market behavior fails to maximize social surplus? We call these situations the traditional market failures. Public goods Externalities Natural monopolies Information asymmetries

Public Goods Attributes of Public Goods Classifying Public Goods Rivalry: What one consumes cannot be consumed by another. Excludability: One has control over use of the good. Congestion: level of demand at a particular supply Classifying Public Goods ~ Private Goods Toll Goods Free/Common Property Goods Pure public Goods Implications for Public Policy Perfectly private good is one that is characterized by complete rivalry in consumption. And complete excludability. Public goods on the other hand, are in various degrees nonrivalrous in consumption, nonexcludable in use or both.

Attributes of the Good Rivalry Excludability If I consume it, can you? Pizza? Weather information? Wilderness? Excludability Can you keep me from using it? Your car? The view from your back yard? The words to the song you write? Don’t forget about attenuated property rights Theft, ambiguity, custom, changes in legal status

Attributes of the Good, Continued Congestable? Does an additional unit of consumption within the relevant range diminish the benefit from other units of consumption? Hiking in the wilderness Traffic Cutting-edge fashion (“Yuck! -- they’re even doing it in the suburbs!”) Combinations of attributes of the good indicate the characteristics of the public policy problem.

A Classification of Goods Rivalrous Non-Rivalrous Pure private goods Soap, beer, ... Toll goods No provision at efficient price ($0); under- consumption if P>0 Excludable Congested: Congested: Toll goods with crowding -- parking Externality MC>price Over-consumption Free Goods Supply>demand at zero price Pure (‘classic’) public goods Private supply unlikely Non-Excludable Congested: Common property goods Congested: Ambient Public good