Transcript Lecture3

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
Individual Firm Behavior:
Marginal and Average Costs
= Total Cost
= Profit
MC > AC;
Rents (temporarily) accrued
$
Ps
MC
MC and AC are equal;
No Rents accrued
ACs
PL
QL
Output (Q) per unit of Time
Qs
AC
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.
Individual Firm Behavior:
A Case of Monopoly Supply
Transfer from consumers
To producers
Lost consumer
surplus
$
MC
AC
PM
Lost
“producer
Surplus”
PC
D
ACM
QC
QM
Output (Q) per unit of Time MR
Unexpended
Resources
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
Supply Schedule
P3
P2
P1
Quantity Produced
The Larger Picture:
Social Surplus
Market-clearing price
Supply Schedule
Consumer Surplus
P1
Demand Schedule
Producer Surplus
Q1
Quantity per unit of Time
Social Surplus = Consumer + Producer Surplus
Analysis: Social Surplus,
A Tax on Producers
S2
Tax
revenue
Deadweight
loss
Size of Tax
S1
P2
P1
D
Q2
Q1
Quantity per unit of Time
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
~ Private Goods
Toll Goods
Free/Common Property Goods
Pure public Goods
Implications for Public Policy
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
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
Pure private goods
Soap, beer, ...
Congested:
Non-Excludable
Externality
MC>price
Over-consumption
Free Goods
Supply>demand
at zero price
Non-Rivalrous
Toll goods
No provision at efficient
price ($0); underCongested:
consumption
Toll goods
if P>0
with crowding
-- parking
Pure (‘classic’)
public goods
Congested:
Common
property
goods
Private supply
unlikely
Congested:
Ambient
Public good