1. MBMC Economic Rent

2. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8: The Quest for Profit and the Invisible Hand Slide 2 What is rent? Unearned economic profit What is economic profit Returns above and beyond a fair return to capital, labor and entrepreneurial skills What is economic profit in a perfect free market economy? Zero Markets cannot not drive rent to zero

3. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8: The Quest for Profit and the Invisible Hand Slide 3 Three Types of Profit: 2 Economic Profit = total revenue – explicit costs – implicit costs (opportunity cost of the resources supplied by the firm’s owners) E.g. Take farmers total revenue, subtract total costs, including money farmer could have made working elsewhere, money he could have made renting his land to someone else, etc. Payments to factors of production (explicit and implicit) Payment to labor (human capital) = wage to land (natural capital) = rent (unearned income) to capitalists (finance and machinery/built capital) = interest

4. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8: The Quest for Profit and the Invisible Hand Slide 4 Three Types of Profit: 3 Normal Profit = accounting profit – economic profit= fair payment to implicit costs i.e. normal profit occurs when all factors of production, owned and unowned, earn their expected returns E.g. Farmer earns as much farming as he would working elsewhere and renting his land to a neighbor.

5. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8: The Quest for Profit and the Invisible Hand Slide 5 Two Functions of Price: 1 The rationing function of price To distribute scarce goods to those consumers who value them most highly BUT as economists determine value, you can only value something if you have money.  Amerindians in the Amazon do not value the forest  Poor people do not value life saving medicine, e.g. eflornithine There is no role for ethical, moral or social values

6. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8: The Quest for Profit and the Invisible Hand Slide 6

7. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8: The Quest for Profit and the Invisible Hand Slide 7 Two Functions of Price The allocative function of price To direct resources away from overcrowded markets and toward markets that are underserved BUT, from the economists perspective, markets in life saving medicines for poor people are overcrowded, while markets for facial hair loss formulas for rich people are underserved. Allocative function eliminate economic profit, but not rent

8. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8: The Quest for Profit and the Invisible Hand Slide 8 The Invisible Hand Theory Profits and Losses Would Ensure That supplies within a market would be distributed efficiently (rationing function)  Outputs will go to those consumers who value them the most (i.e. who can pay the most) Resources would be allocated across markets to produce the most efficient possible mix of goods and services (allocative function)  Inputs will go to those producers who can pay the most for them (i.e. who can create the highest valued products from them) Markets balance possibility with desirability

9. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8: The Quest for Profit and the Invisible Hand Slide 9 Responses to Profits and Losses Markets with firms earning economic profits will attract resources. Markets where firms are experiencing economic losses tend to lose resources. Shifts in demand will raise or lower prices, hence profits, leading to entry or exit of firms, returning prices to their ‘fair’ level

10. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8: The Quest for Profit and the Invisible Hand Slide 10 The Invisible Hand Theory In the long-run, in a competitive market, all firms will tend to earn zero economic profits. Consumer gets the good as cheaply as possible But remember, normal profits cover all the costs of production Zero economic profits are the consequence of price movements caused by the entry and exit of firms trying to maximize economic profits.

11. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8: The Quest for Profit and the Invisible Hand Slide 11 Two Attractive Features The market outcome is efficient in the long run. P = MC= min ATC The market is fair. The price the buyers pay is no higher than the cost incurred by sellers. The cost includes a normal profit. Normal profits include payments to all factors of production, including a CEO making 100 million a year.

12. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8: The Quest for Profit and the Invisible Hand Slide 12 Free Entry and Exit Free entry and exit must exist for the allocative function of price to operate Barriers to entry can be caused by legal constraints and unique market characteristics Barrier to entry exists when only fixed quantity of resource is available Patents and copyrights  Medicine prices in US and Canada  Textbook prices in US and Europe Compatibility between products Firm size Quotas

13. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8: The Quest for Profit and the Invisible Hand Slide 13 Economic Rent Versus Economic Profit Economic Rent That part of a payment for a factor of production that exceeds the owner’s reservation price  Think about land. Market forces will not push economic rent to zero because inputs cannot be replicated easily  But taxes can push it to zero

14. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8: The Quest for Profit and the Invisible Hand Slide 14 Economic Rent Versus Economic Profit Textbook example: ignores injustice of rent Assume A community with 100 restaurants 99 restaurants employ chefs with normal ability for $30,000/yr (the same amount they could earn elsewhere) The 100 th restaurant employs a talented chef and customers are willing to pay 50% more for their meals

15. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8: The Quest for Profit and the Invisible Hand Slide 15 Economic Rent Versus Economic Profit Assume TR at the each of the 99 restaurants is $300,000, which yields a normal profit TR at the 100 th restaurant is $450,000 (50% more) How much will the good chef earn? Reservation price = $30,000 = opportunity cost

16. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8: The Quest for Profit and the Invisible Hand Slide 16 The Invisible Hand in Action The Invisible Hand in Antipoverty Programs, e.g. the green revolution How will an irrigation project affect the incomes of poor farmers who rent land?

17. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8: The Quest for Profit and the Invisible Hand Slide 17 The Invisible Hand in Action Assume An unskilled worker has two job choices  Textile worker  Renting land to grow rice A state funded irrigation program doubles output of grain without changing the market price. What happens to income of landless? What happens to price of land? Who benefits?

18. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8: The Quest for Profit and the Invisible Hand Slide 18 The Invisible Hand in Action What happens when the farm bill awards $288 billion in subsidies to agro- industry? What’s the impact on new farmers? What happens when the government builds light rail, parks, libraries, etc.?

19. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8: The Quest for Profit and the Invisible Hand Slide 19 What else generates rent? Renewable resources Non-renewable resources Money Air waves Patented information and other monopolies Information in general Other?

20. MBMC Estimating and Capturing Rent

21. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Sustainable Yield Curve

22. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Sustainable harvests and effort What is the relationship to scale?

23. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Renewable resources

24. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. No-renewable resources

25. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. No-renewable resources What’s left out of this simplified model? What’s the opportunity cost of producing oil today? What’s happening to the price of oil?

26. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved.

27. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Scarcity Rent Oil Stocks P Marginal cost=supply MC + rent (MUC)

28. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. How do we decide on scarcity rent/royalty? Per barrel royalty? Percentage of price? Cap and auction extraction rights? Are we missing any other type of rent?

29. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Rent Capture II: Waste Absorption Oil Stocks P Marginal cost=supply MC + rent (MUC) MC+MUC+MEC

30. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Financial Capital: Interest and Seignorage What is seignorage? Reserve requirements Who should get it? Ithaca hours

31. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Monopoly rent Price ($/unit of output) Quantity (units/week) 6 D 3 1224 Marginal Cost 2 4 MR 8 Observations If P = $3 & Q = 12 MR < MC and output should be reduced Profits are maximized at 8 units where MR = MC P = $4 where quantity demanded = quantity supplied

32. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 2 4 MR 8 Because MR < P, the monopoly produces less than the socially optimal amount The deadweight loss of the monopoly to society = (1/2)($2/unit)(4units/wk) = $4/wk. Deadweight loss The Demand and Marginal Cost Curves for a Monopolist Price ($/unit of output) Quantity (units/week) D 12 6 24 Why the Invisible Hand Breaks Down Under Monopoly 3 Marginal cost

33. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Collecting patent rent Patent owner declares sales price Whoever wants can buy the patent at declared price Pays property tax on patent