Slide 1What is rent?Three Types of Profit: 2Three Types of Profit: 3Two Functions of Price: 1Slide 6Two Functions of PriceThe Invisible Hand TheoryResponses to Profits and LossesSlide 10Two Attractive FeaturesFree Entry and ExitEconomic Rent Versus Economic ProfitSlide 14Slide 15The Invisible Hand in ActionSlide 17Slide 18What else generates rent?Slide 20Sustainable Yield CurveSustainable harvests and effortRenewable resourcesNo-renewable resourcesSlide 25Slide 26Scarcity RentHow do we decide on scarcity rent/royalty?Rent Capture II: Waste AbsorptionFinancial Capital: Interest and SeignorageMonopoly rentThe Demand and Marginal Cost Curves for a MonopolistCollecting patent rentMB MCEconomic RentChapter 8: The Quest for Profit and the Invisible HandSlide 2MB MCCopyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved. What is rent?Unearned economic profitWhat is economic profitReturns above and beyond a fair return to capital, labor and entrepreneurial skillsWhat is economic profit in a perfect free market economy?ZeroMarkets cannot not drive rent to zeroChapter 8: The Quest for Profit and the Invisible HandSlide 3MB MCCopyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved. Three Types of Profit: 2Economic 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) = interestChapter 8: The Quest for Profit and the Invisible HandSlide 4MB MCCopyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved. Three Types of Profit: 3Normal Profit = accounting profit – economic profit= fair payment to implicit costsi.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.Chapter 8: The Quest for Profit and the Invisible HandSlide 5MB MCCopyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved. Two Functions of Price: 1The 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 forestPoor people do not value life saving medicine, e.g. eflornithineThere is no role for ethical, moral or social valuesChapter 8: The Quest for Profit and the Invisible HandSlide 6MB MCCopyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.Chapter 8: The Quest for Profit and the Invisible HandSlide 7MB MCCopyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved. Two Functions of PriceThe allocative function of priceTo direct resources away from overcrowded markets and toward markets that are underservedBUT, 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 rentChapter 8: The Quest for Profit and the Invisible HandSlide 8MB MCCopyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved. The Invisible Hand TheoryProfits 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 desirabilityChapter 8: The Quest for Profit and the Invisible HandSlide 9MB MCCopyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved. Responses to Profits and LossesMarkets 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’ levelChapter 8: The Quest for Profit and the Invisible HandSlide 10MB MCCopyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved. The Invisible Hand TheoryIn the long-run, in a competitive market, all firms will tend to earn zero economic profits.Consumer gets the good as cheaply as possibleBut remember, normal profits cover all the costs of productionZero economic profits are the consequence of price movements caused by the entry and exit of firms trying to maximize economic profits.Chapter 8: The Quest for Profit and the Invisible HandSlide 11MB MCCopyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved. Two Attractive FeaturesThe market outcome is efficient in the long run.P = MC= min ATCThe 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.Chapter 8: The Quest for Profit and the Invisible HandSlide 12MB MCCopyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved. Free Entry and ExitFree entry and exit must exist for the allocative function of price to operateBarriers to entry can be caused by legal constraints and unique market characteristicsBarrier to entry exists when only fixed quantity of resource is availablePatents and copyrightsMedicine prices in US and CanadaTextbook prices in US and EuropeCompatibility between productsFirm sizeQuotasChapter 8: The Quest for Profit and the Invisible HandSlide 13MB MCCopyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved. Economic RentVersus Economic ProfitEconomic RentThat part of a payment for a factor of production that exceeds the owner’s reservation priceThink about land. Market forces will not push economic
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