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STUDY GUIDE—RENTS AND EXTERNALITIES
- The Benefit From Consumption: Consumer Surplus
We begin by developing the idea that the gross benefit to an individual from consuming a commodity is the area under the demand curve to the left of the the quantity consumed. This represents the amount of other goods that the consumer is willing give up, measured in dollars, to consume that quantity of the good. The opportunity cost of consuming that quantity is the total amount spent—price times quantity—and the excess of the gross benefit over the amount spent is the consumer surplus or consumer rent. The last unit consumed will have a value equal to the price paid—this is the marginal benefit—and a marginal cost that is also equal to the price paid. This is shown in Figure 1.1 The consumer thus adds to her consumption of the commodity to the point where the marginal benefit from consuming it equals the marginal cost.
FIGURE 1.1:
When we horizontally add the demand curves for all consumers we obtain a market demand curve. The area under this curve to the left of the quantity consumed represents the gross benefit to all consumers from consuming this quantity, the area representing price time quantity is the alternative opportunity cost and the area under the demand curve and above the price paid equals their consumer surplus. The situation for the aggregate of consumers is portrayed in Figure 1.2.
It must be noted here that the size of these areas will depend on the distribution of income among consumers—if we were to redistribute income from consumers who like this good a lot to consumers who like it less, the quantity demanded will decline at each price (assuming the good is a normal good) as will the area under the demand curve and the consumer surplus. While consumer surplus thus provides a good qualitative picture of the social benefit from consuming a commodity the actual quantitative magnitudes must be viewed cautiously.
FIGURE 1.2:
It also should be noted that the benefits represented by the area under the demand curve are the benefits solely to the individuals consuming the product. People not consuming the product may feel worse off or better off because other people are consuming it—examples might typically be heroin and bibles. These benefits, positive or negative, are not measured by the area under the demand curve and are called consumption externalities.
- Opportunity Costs and Rents
The total revenue received by producers can be divided into two parts—opportunity costs and rents. This is illustrated for the case of an agricultural product in Figure 2.1.
FIGURE 2.1:
Because of diminishing returns in the application of labor and capital to land, suc- cessive increments of output require increasing quantities of labor and capital inputs and are therefore produced at increasing cost. The marginal cost is the cost of adding one unit to output. The total cost of a given level of output is the sum of the marginal costs of producing the successive units and is therefore represented by the area under the supply curve to the left of the quantity produced. This area represents the alternative opportunity cost of producing the specified quantity of output—the dollars worth of labor and capital used and hence the dollar amount of other goods that could have been produced by using this labor and capital elsewhere in the economy. Since the price must be high enough to induce producers to produce
An example constructed with reference to hockey-player Wayne Gretsky is presented in Figure 2.4.
FIGURE 2.4:
It is assumed that Wayne’s next best alternative to having a hockey career is sales, paying an income of $50,000 and that he loves the game so much that he would be willing to play professionally rather than work elsewhere for $30,000. Yet the demand for Wayne’s services as a professional hockey player is such that his equilibrium wage under free bidding of teams for his services would be $5,000,000. The interesting issue is whether Wayne gets the rents for his services or these rents are captured by the team that “owns” his rights.
The strikes and strike-threats of players’ associations in professional sports are typically the result of fights with team-owners over who gets the rents from players’ services.
- Putting It Together: The Gain From Trade
On the question of what level of output is socially optimal, the economist is limited to commenting on issues of efficiency. Though economists can often say something about how a particular development will affect the distribution of income, economics provides no information on whether a particular distribution of income is good or bad—this requires value judgments.
The efficiency gain from consuming a particular product can be analyzes with reference to Figure 3.1. The socially efficient level of output is that quantity that maximizes the sum of the consumer and producer surpluses. It is the most efficient output level because the marginal social benefit of producing and consuming another unit equals the marginal social cost. There is no guarantee, however, that as output is increased to the efficient level from below everyone in the society gains—all that can be said is that with appropriate distribution of the consumer and producer surplus, everyone can gain.
FIGURE 3.1:
Now consider the possibility that the residents of a country or local area can purchase and sell the commodity on the world market at a fixed price. This situation is analyzed in Figure 3.2.
FIGURE 3.2:
There is an efficiency gain by reducing domestic production and increasing domestic consump- tion, importing the difference from abroad. Taking advantage of this opportunity leads to a loss to domestic producers that is more than offset be a greater gain to domestic consumers.
An efficiency gain also results when the world price is above the domestic free market price, as shown in Figure 3.3. In this case, however, consumers lose and producers gain, with producers gaining more than consumers lose.
- The Incidence of Commodity Taxation
To finance its expenditures the government must levy taxes. Sometimes it is useful to tax the production, consumption, or sale of particular commodities. We now show that, despite superficial appearances, it makes no difference whether a given tax is levied on the consumers or producers of the particular commodity. The analysis is conducted with reference to Figure 4.1. The tax can be viewed as driving a wedge between the price paid by the consumer and the price received by the producer.
FIGURE 4.1:
The proportions of the tax revenue ultimately paid by consumers and producers out of their respective rents depends on the slopes of the demand and supply curves for the commodity. This is shown in figures 4.2, 4.3, 4.4 and 4.5. In all cases where either the demand curve or the supply curve is not vertical there will be an efficiency loss from the tax.
FIGURE 4.2:
FIGURE 4.3:
FIGURE 4.4:
FIGURE 4.5:
Commodity taxes are inferior to neutral taxes—those that have no efficiency effects. But every tax that can, in practice, be levied has an efficiency effect of some kind and is therefore non-neutral.
important issue is whether the private costs plus the costs of eliminating the smoke emissions exceed the social cost inclusive of the effects of those emissions.
FIGURE 5.3:
A policy of simply levying a tax at each point in time on firms that pollute the envi- ronment equal to the damage they are doing at that point in time will in most cases be the most efficient way to handle the problem—to the extent that firms end up emiting smoke, the social benefits from doing so will exceed the costs, subject of course to the usual caveats about distribution effects. The difficulty, of course, lies in measuring the environmental costs.
In cases where the social benefits exceed the private benefits from consuming a commod- ity, production of the commodity can be subsidized, as shown in Figure 5.
FIGURE 5.4:
External benefits from policing and the dispensing of justice cannot typically be handled by subsidization of private police forces because the government must ultimately be charged with these matters—private police forces will necessarily act in the interests of those hiring them when those interests conflict with the social interest.
- Collusion Among Suppliers
Competitive pricing is an essential feature of supply and demand analysis. The supply curve gives the minimum price at which producers will supply the product. This minimum results from competition among sellers. We now examine the effects of collusion among suppliers for purposes of controlling output and, hence, the price paid by consumers. Such collusive arrangements are usually illegal and not enforceable in the courts, except when created by the government in order to subsidize producers in industries favored by the political process. There are, of course, many impediments to competition in a typical economy—a full consideration of these is relegated to subsequent lessons.
A classic example of a government engineered collusive arrangement is the Egg Producers’ Marketing Board. It is analyzed in Figure 6.1.
FIGURE 6.1:
The Board, acting on behalf of its members with the support of the government, will limit output quotas of its members to the point where the profits of the industry—the excess of revenue over cost—are maximized. This will be where the marginal revenue from producing another unit equals the marginal cost. Because the marginal revenue of egg production by the group is less than the marginal benefit of eggs to consumers, production will occur where the marginal social benefit of another unit exceeds that unit’s marginal social cost, so the output level will be socially inefficient. The right to have a quota is valuable in that it enables the sale of eggs at a price above their cost of production. This right constitutes an asset which can normally be bought and sold. Egg producers who receive the quotas when the program is instituted thus obtain all the benefits from the program—when they retire or leave the industry they can sell their quota rights to new entrants for their full present value. New entrants are thus no better off than they would have been in the absence of the program.
An alternative is to prohibit the sale of quotas. A producer leaving the industry has then to relinquish her quota so that the Marketing Board can give it to someone else. This raises the issue of the criteria under which these relinquished quotas are to be allocated to potential new entrants.
The efficiency losses from collusive arrangements such as this one can be avoided by giving cash subsidies to producers instead of allowing them to “tax” consumers by restricting
FIGURE 7.1:
If the law (system of property rights) gives producers the right to pollute as they choose, consumers will bribe producers by the amount P 1 b u h(= C 1 c aP 0 ) to induce them to produce the quantity Q 0 at a net price of uQ 0. (Producers will charge the price P 0 and rebate their profits at that price, P 0 a u h, back to consumers.) Instead of the loss from pollution given by the area h c b k(= C 1 c bP 1 ) consumers will lose only the amount C 1 c aP 0 , the bribe to producers, plus the consumer surplus area P 0 a bP 1 , leaving them better off by the area a b c. If the law says that no one has the right to pollute the atmosphere without the consent of those affected, producers will pay consumers the amount h a u k for permission to produce the output Q 0 (rather than no output at all) and sell it at the price P 0. Their gain will be the area P 0 a h. In either case, the efficient amount of pollution will occur.
The problem is, of course, that transactions costs are not zero. It is nearly always impos- sible to get the agreement of everyone in a group on a matter of compensation because the costs of pollution will be hard to measure and different for different individuals. Because of the difficulty of verifying costs some individuals invariably will behave strategically, holding out for an outrageous share in return for allowing the agreement to go forward. The impor- tance of the Coase Theorem is in its delineation of the role of property rights and transactions costs in enabling or preventing the achievment of Pareto-optimality.
When transactions costs prevent Pareto-optimality from being achieved through private transactions, the government can often induce it. For example, the socially efficient amount of pollution can be achieved in Figure 7.1 by levying a tax of u a per unit of output. Producers will lobby against the tax and environmental groups in favor of it.
The policies of government will often be determined by the relative effectiveness of the rent-seeking activities of the gainers and losers. This will be determined, in turn, by whether transactions costs of within-group agreement are lower for the gainers than for the losers.
STUDY QUESTIONS
- Suppose that the demand curve for marijuana, measured in kilos, in a region is
Q = 10000 − 20 P
and that the plant grows wild in useable form. Show how you would go about calculating the social benefit from the legalization of marijuana use. Should the use of marijuana be legalized in this case?
- Demonstrate that economic rents can be taxed away without affecting Pareto-efficiency.
- Land and other natural resources are freely available to society, created when the earth was created. The economic rent to these resources can be taxed away by the government without affecting the allocation of resources and, hence, without efficiency costs. Why, then, should society allow individuals to own these resources? Or, if individuals are free to own them, why shouldn’t the government tax away all economic rent? Should the same argument apply to the rents earned from the talents of Tom Hanks, Frank Sinatra, Stevie Wonder and other star performers?
- During the past few decades substantial efforts have been made through international negotiations to reduce the tariffs countries levy on each others’ goods. Most of the bargaining in these negotiations has taken the form of countries granting concessions— lowering their tariffs and quotas and allowing foreign goods to enter in competition with domestic production—in return for the agreement of other countries to let domestic goods enter in competition with their home production. This “I’ll let you export to me if you’ll let me export to you” focus seems strange in view of the fact that countries benefit by importing as much as possible in return for giving up as few exports as possible. The focus of bargaining should presumably reflect a willingness to export only in return for a better deal on imports or, “I’ll let you import more from me if you’ll let me import more from you”. How can you explain this seeming contradiction?
- Consider an egg marketing board given the right to set the quantity and price of eggs. Show that setting price and quantity so as to maximize the profits of egg producers has an effect on economic efficiency equivalent to that of a tax imposed on egg production that maximizes the tax revenue to the government. Demonstrate further that it makes no difference whether the tax is imposed on the production or consumption of eggs.
