Production, Rents and Social Surplus

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

5. 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 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.

7. Transfer from consumers To producers Lost consumer surplus PM Lost “producer Surplus” ACM Unexpended Resources QM Individual Firm Behavior:A Case of Monopoly Supply MC AC $ PC D QC MR Output (Q) per unit of Time

8. Supply Schedule P3 P2 P1 Quantity Produced Aggregate Supply SchedulesThe 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

9. Supply Schedule Market-clearing price Consumer Surplus Price P1 Demand Schedule Producer Surplus Q1 Quantity per unit of Time The Larger Picture:Social Surplus Social Surplus = Consumer + Producer Surplus

10. Size of Tax P2 Price P1 Q2 Q1 Quantity per unit of Time Analysis: Social Surplus,A Tax on Producers S2 Tax revenue Deadweight loss 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 • 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

14. Attributes of the Good • Rivalry • 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 Congested: Excludable 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