Economics 2023-02

1. Economics 2023-02 Class 15

2. Today’s class … • We start today with another economic rent example, followed by an example question based on Tuesday’s class • Then we will look at how market prices both ration and allocate, and long-run adjustment in competitive markets • Then we will look at interest rates and present value, and the relationship between innovation and economic profit. • Then it’s time for Spring Break.

3. Definition: Economic Rent • Economic rent is the excess of a factor of production’s earnings over its reservation price, i.e. its opportunity cost. • This is jargon, different from normal usage of ‘rent’ • If a rap artist makes $1 million a year, but his next best employment would be pumping gas for $15,000 a year, his economic rent would be $985,000 a year • Rare talents lead to persistent rents

4. Example 15.1 Suppose Ford has sued GM for $1 billion for infringement of Ford's patent on a revolutionary new engine.

5. GM has a reasonable claim that it developed an equivalent technology independently.

6. The legal issues are complex, and experts regard the case as too close to call. Whichever side hires the better lawyer is sure to win.

7. Smith Smith and Jones are the best two patent lawyers in the world. Both are outstanding but Jones is ever so slightly better. Jones

8. What are the equilibrium fees for Smith and Jones in this case? Assuming Jones always wins his cases, Fees aside, whichever side hires Jones will be $1 billion better off than if it hadn't hired Jones. So in equilibrium Jones's fee would be $1 billion, Smith's zero.

9. Although competition drives economic profit to zero, economic rent can persist indefinitely. Technological change, e.g. TV, the internet, movies, mean that ‘stars’ [who may be only slightly better than others] can earn very high incomes that are mostly economic rent, and do so for a long time. Mick Jagger has had a staggeringly high income most years since he left the London School of Economics in the early 1960s ….

10. In 2006, Roger Federer earned $8,343,885 playing tennis. His next best alternative would have been airline pilot at salary $143,000. His economic rent in 2006 was • Can’t tell with these data • $8,343,885 • $8,200,885 • $(8,343,885/143,000) = $58.35.

11. Sample question: Phil's demand curve for visits to the Gannett walk-in medical clinic is as shown.

12. The marginal cost of providing medical services at Gannett is $10 per visit, and that is the price the clinic charges. Phil has a choice between two health policies that are identical except for the fact that Policy A does cover the cost of visits to the walk-in clinic while policy B does not.

13. The premiums the insurance company charges for policies A and B exactly cover their respective costs. Which policy will Phil choose and how much larger will his consumer surplus be each semester under that policy than under the other policy?

14. Under policy A, Phil will demand 40 walk-in visits per year, whereas under policy B he will demand only 30.

15. a. Policy B, $50 more surplus. b. Policy B, $100 more surplus. c. Policy A, $100 more surplus. d. Policy A, $200 more surplus. e. None of the above is correct.

16. Under policy A, Phil will demand 40 walk-in visits per year, whereas under policy B he will demand only 30.

17. Policy A, which covers the cost of the 40 walk-in visits per semester, will charge $400 per semester more than Policy B. If he chooses B, he will pay $300 for his first 30 visits, but $400 less for his policy. With policy A he will use another 10 visits, whose $100 extra cost makes up the balance of the $400 extra he pays for that policy.

18. Each of the additional visits he consumes under policy A is worth less to him than its $10 marginal cost, for a total waste equal to $50 per year, the area of the shaded triangle.

19. a. Policy B, $50 more surplus. b. Policy B, $100 more surplus. c. Policy A, $100 more surplus. d. Policy A, $200 more surplus. e. None of the above is correct. Answer: a. He will choose policy B and enjoy $50 more surplus per year than if he had chosen policy A.

20. What prices do in competitive markets: The rationing function of price: to distribute scarce goods to those consumers who value them most highly. The allocative function of price: to direct resources away from overcrowded markets and toward markets that are underserved.

21. Adam Smith’s Invisible Hand

22. In competitive markets, the carrot of economic profit and the stick of economic loss are the only forces necessary to assure not only that 1) existing supplies in any market will be allocated efficiently, but also that 2) resources will be allocated across markets to produce the most efficient possible mix of goods and services.

23. Consider a competitive industry in which the current market price enables firms to earn a positive economic profit.

24. Price falls, making each firm’s economic profit smaller than before. The existence of positive economic profits attracts new firms, shifting supply outward.

25. As long as price remains above the minimum value of ATC, profits lure new entrants. Supply continues to shift out until price falls to min ATC, which means zero economic profit for the typical firm.

26. At that point economic profit is zero and there is no further incentive to enter.

27. What if the firms are originally earning economic losses?

28. Firms leave, and supply continues to shift inward until price rises to min ATC.

29. Sugar cane can be grown anywhere with warm weather and plenty of water. US sugar prices exceed world prices because of import quotas. If the quotas were removed • US sugar prices would fall • Land used now in Florida to grow sugar would tend to be used more for other things • Employment in sugar growing in Florida would fall • Candy producers would be less likely to move to Canada and Mexico • All of the above.

30. Prices, efficiency, and markets • If all markets were perfectly competitive, in the long run entry and exit would lead to zero economic profits everywhere and P = MC everywhere, and economic efficiency. • In reality, not all markets are perfectly competitive, and adjustment takes time. Markets adjust toward the long run equilibrium, but may not get to it before it has changed again – we don’t always live in the best of all possible worlds! 

31. Present Value and the Time Value of Money Example 15.2. Suppose the annual interest rate on bank deposits is 10 percent. If you deposit $100 on January 1 of this year, how much will it be worth by January 1 of next year? $100 (1.10) = $110.

32. For any given interest rate, the present value of a sum of money that you will receive at a specified time in the future is the amount of money you would have to put in the bank today at that interest rate in order to have exactly the stated sum on the future date.

33. Example 15.3. If the annual interest rate is 10 percent, what is the present value of $110 to be received one year from now? As we saw in the previous example, $100 deposited today at 10 percent p.a. interest will be worth $110 a year from now. So the present value of $110 a year from now is $100.

34. Example 15.4. If the annual interest rate is 5 percent, what is the present value of $52.50 a year from now? Let PV = the present value of $52.50 to be received in 1 year. PV (1.05) = $52.50. So PV = $52.50/ 1.05 = $50.

35. If you put $50 in the bank today at 5 percent interest, in a year's time you will have $52.50. More generally, when the interest rate (expressed as a decimal) is r, the present value of $M received one year from now is given by PV = M/(1+r).

36. Example 15.5. When the annual interest rate is 10 percent, what is the present value of a payment of $121 to be received 2 years from now? Put $100 in the bank today at 10 percent interest. After one year: $100(1.1) = $110 After two years: $110 (1.10) = $100 (1.1)2 = $121

37. PV = 121/(1.1)2 = $100 More generally, if annual interest rate is r, present value of M dollars delivered T years from now PV = M/(1 + r)T

38. The time value of money exists because money can be used to purchase real assets that generate increased output over time; and also because people would rather consume now than consume later. Would you pay the same amount now for guaranteed delivery a year from now as you would to have the same thing right now? Also, a 12 foot tree 6 years from now is equivalent to a 5 foot tree right now.

40. Ignoring risk and uncertainty …. • The biggest problem about the future is that it is inevitably unknown …. • “Predictions are difficult, especially about the future…”  • What these slides say about present value and investment etc. is for a world of certainty, assuming away real-world uncertainty and risk …. • Understanding things in this simplified model helps understand reality ….

41. This is not about inflation …. • Purchasing power has time value – we could use money, purchasing power, now to buy real assets that would generate a real return – so a promise of equivalent purchasing power in the future is worth less now. • Most present value calculations are actually done in ‘real terms’ – projecting the future without any inflation. • For purely monetary things, it is fine to use nominal interest rates; but for real flows, one should use real interest rates.

42. Present value in reverse: the miracle of compound interest $1000 deposited at 7 percent interest by Ben Franklin in late 1700s = $3 trillion today $1000 deposited at 7 percent interest in 1945 = $64,000 today

44. Example 15.6 Jones can enter a business whose revenues and costs occur through time as follows: Revenues Costs now 0 $300 1 year hence 0 0 2 years hence $363 0 3 years & more 0 0

45. If Jones enters this business and the interest rate is 10 percent per year, what is the present value of his economic profit? Present value of economic profit = present value of revenue - present value of costs = 363/(1.1)2 - 300 = 300 - 300 = 0.

46. Example 15.7. Should Jones enter this business if the interest rate is 12 percent? Enter only if PV of economic profit > 0. At 12 percent, PV of revenue = 363/(1.12)2 = 289.38 PV of economic profit = 289.38 - 300 = -$10.62 < 0, so don't enter.

47. Example 15.8. Should Jones enter if the interest rate is 8 percent? PV of revenue = 363/(1.08)2 = 311.21 PV of economic profit = $311.21 - $300 = $11.21> 0, so Jones should enter.

48. Almost all investment projects require that costs be incurred now and in the short run to generate benefits in the future long run. The higher the interest rate, the lower is the present value of benefits received in the future. So as a general rule, an investment project is less likely to be worthwhile when interest rates are high than when interest rates are low.

49. Why does the Fed lower interest rates during a recession?

50. Why does the Fed lower interest rates during a recession? • With lower interest rates, more investment proposals will have expected Present Value of economic profit > 0 • That’s a macro question, I dunno • It’s got something to do with money supply • To stimulate investment • Both 1 and 4 are good answers