mbmc economic rent. mbmc copyright c 2004 by the mcgraw-hill companies, inc. all rights reserved....

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Economic Rent

Chapter 8: The Quest for Profit and the Invisible Hand Slide 2

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Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.

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


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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


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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 returnsE.g. Farmer earns as much farming as he

would working elsewhere and renting his land to a neighbor.


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Two Functions of Price: 1

The rationing function of price To distribute scarce goods to those

consumers who value them most highlyBUT 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


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Two Functions of Price

The allocative function of priceTo 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


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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


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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


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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.


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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.


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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


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Economic RentVersus Economic Profit

Economic RentThat 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


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Textbook example: ignores injustice of rent

AssumeA community with 100 restaurants99 restaurants employ chefs with normal

ability for $30,000/yr (the same amount they could earn elsewhere)

The 100th restaurant employs a talented chef and customers are willing to pay 50% more for their meals


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AssumeTR at the each of the 99 restaurants is

$300,000, which yields a normal profitTR at the 100th restaurant is $450,000

(50% more)

How much will the good chef earn?Reservation price = $30,000 = opportunity

cost


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The Invisible Hand in Action

The Invisible Hand in Antipoverty Programs, e.g. the green revolutionHow will an irrigation project affect the

incomes of poor farmers who rent land?


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AssumeAn unskilled worker has two job choices

Textile workerRenting 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?


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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.?


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What else generates rent?

Renewable resources

Non-renewable resources

Money

Air waves

Patented information and other monopolies

Information in general

Other?

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Estimating and Capturing Rent

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Sustainable Yield Curve

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Sustainable harvests and effort

What is the relationship to scale?

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Renewable resources

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No-renewable resources

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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?

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Scarcity Rent

Oil Stocks

P

Marginal cost=supply

MC + rent (MUC)

S ca rc ity re n t

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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?

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Rent Capture II: Waste Absorption

Oil Stocks

P

Marginal cost=supply

MC + rent (MUC)

MC+MUC+MEC

S ca rc ity re n t

P o llu tio n re n t

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Financial Capital: Interest and Seignorage

What is seignorage? Reserve requirements Who should get it?

Ithaca hours

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Monopoly rent

Pri

ce (

$/u

nit

of

ou

tpu

t)

Quantity (units/week)

6

D

3

12 24

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

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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

Pri

ce (

$/u

nit

of

ou

tpu

t)

Quantity (units/week)

D

12

6

24

Why the Invisible Hand Breaks Down Under Monopoly

3

Marginal cost

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Collecting patent rent

Patent owner declares sales price Whoever wants can buy the patent at

declared price Pays property tax on patent

mbmc economic rent. mbmc copyright c 2004 by the mcgraw-hill companies, inc. all rights reserved....

Documents

invisible hand slide

normal profit

types of profit

unearned economic profit

economic profit returns

mbmc economic rent slide

mbmc copyright c

mcgrawhill companies