1. Production, Rents and Social Surplus
Keep reading Weimer &Vining

2. 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

3. 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

4. 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.

5. 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

6. 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.

7. 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

8. 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

9. 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

10. 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

11. 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?

12. 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

13. 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.

14. 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

15. 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.

16. 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