By Mr. LAU san-fat CH11-Dissipation of Rent-SV 1

HKALE Microeconomics Chapter 11: Dissipation of Rent &

Effects of Government Regulations

References: Advanced Level Microeconomics, LAM pun-lee,

CH 16 A-Level Microeconomics, CHAN & KWOK, CH 16 HKALE Microeconomics, LEUNG man-por, CH

17

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Dissipation of Rent Dissipation of Rent is a situation

where potential income is not captured. Instead, it dissipates in the sense that no person in the model claims it.

If no one has an exclusive right to claim the value or rent of that property, the income derived from it becomes non-exclusive income.

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Dissipation of Rent Under competition and with no one

having a special advantage, the value of a 'common property' which has no exclusive claimant will be dissipated or absorbed by the costs of other resources which must be dedicated to win it. Hence, its net value becomes zero.

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Dissipation of Rent Given that people maximizing

wealth and minimize costs, both consumers and producers will try to minimize the occurrence of dissipation of rent.

Any competitive criterion other than the use of the price system would lead to dissipation of rent.

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Price Ceiling The government decides to

'protect' the consumer against the market price that is 'too high'

Effects: Quantity transacted falls Shortage occurs at the controlled

price Non-price competition among

consumers becomes active Black market may appear

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A Theory of Price Control The case of rent control on housing

Remarks:•Rm = market rent•Rc = controlled rent

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A Theory of Price Control Steven Cheung's first

proposition: When the right to

receive income is partly or fully taken away from a contracting party, the diverted income will tend to dissipate unless the right to it is exclusively assigned to another individual.

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A Theory of Price Control As the right to receive rent differential is

taken away from the landlord, but not exclusively assigned to another individual or tenant, that amount becomes a non-exclusive income.

Competition among contracting parties for the non-exclusive income will tend to dissipate it.

The income dissipated constitutes a waste as valuable resources are allocated to the non-price competition.

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A Theory of Price Control Steven Cheung's second proposition:

Given the existence of non-exclusive income and its tendency to dissipate, each and every party involved will seek to minimize the dissipation subject to constraints. This will be done either through seeking alternatives in using or producing the good so that the decline in resource value is the lowest, through forming alternative contractual arrangements to govern the use or production of the good with the least rise in transaction costs, or through the least costly combination of the two procedures.

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A Theory of Price Control The landlord can form alternative contractual

arrangement with a prospective tenant, charging an additional lump-sum payment termed shoe money or key money at an exorbitant price.

If the rent control is expected to last forever, given the market rate = r, then

Since alternative contract has to be made, extra transaction costs are involved, i.e. dissipation of rent still occurs.

r

Rc - Rm money shoe

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A Theory of Price Control Question 1: Explain why under rent

control, (a) the leased buildings are in lack of proper maintenance; (b) the reconstruction rate of leased buildings is higher. In your answers, state your assumptions and conditions clearly.

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A Theory of Price Control After paying the key money, the

tenant tend not to give up the possession of the flat easily, implying that the turnover rate of tenants under the rent control will decline.

If the law or the landlord permits, the tenant who wants to move out will try to sublet his or her flat in order to recapture part of the key money from another tenant.

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A Theory of Price Control If the law allows the landlord to evict

the tenant at will for reconstructing the leased building, given that the amount of key money is greater than the cost of reconstruction (G), the rate of reconstructing leased buildings will rise; vice versa.

The economic condition for reconstruction of leased building is:

0Rc) - (Rm

gain Net Cr

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Price Floor The government wants to protect

the producers against the market price that is too low.

Effects: Quantity transacted falls Surplus occurs at the controlled price Non-price competition among sellers

becomes active Illegal price concession occurs

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Price Floor

Question 2: In Hong Kong, the government determines the minimum wage of foreign domestic helpers. What are the possible economic effects of this wage control? How could this control lead to dissipation of rent?

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Price Floor Dissipation of rent would occur if:

Workers spend resources to acquire the rights to union memberships

Workers try to produce false documents Workers try to bribe those union officers and

in turn encouraging people waste resources to compete for the union positions

At the margin, the cost of obtaining union membership or leadership is exactly equal to the expected higher earnings of having union employment or position.

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Price Floor Question 3: How could a monopoly

rent lead to dissipation of rent?

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Price Floor Firms compete to acquire the status of a

politically protected monopoly so as to earn monopoly rent. Hence, obtaining a monopoly right itself is a competitive activity.

The cost of competition, if not via the price mechanism, to gain a monopoly right (say via offering bribes to government officials) would absorb the expected monopoly rent, leading to dissipation of rent.

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Price Floor By auction, the successful bidder

will offer the government essentially all of the expected monopoly rent that the monopolist could earn.

Auctioning off a monopoly right to the highest bidder ensures that the most efficient firm wins the right and avoids rent dissipation from non-price competition because it works on the price system.

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Price Floor Question 4: Why auctioning off a

monopoly right would generate more income for the government than that generated from a unit tax on the monopolized product?

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Price Floor Unit tax would raise the AC and MC

curves and reduce the output level, whereas the auction would not affect the MC curve and the output level.

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Quantity Control: Quota Effective quota reduces quantity supplied Effects:

The supply curve become a kinked one Quantity transacted falls Product price rises Quota rent = (new equilibrium P – MC) x Q The price net of quota rent is smaller than the

equilibrium price Product quality would improve as higher price

in general after quota lowers the relative price of high-quality good.

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The Concept of Equilibrium With price control, the market is

regarded as at disequilibrium as there is either a shortage or surplus.

However, equilibrium is still attained if the relevant constraints (e.g. monetary and non-monetary costs) in obtaining a good are specified and rigid enough to yield implications refutable by facts.

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Case Study: Taxi Industry Government regulations include:

Quantity control: fixed number of taxi licenses

Price control: regulated tax fares The laws that penalize those drives

who violate it

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Case Study: Taxi IndustryRemarks:•Pe = equilibrium P•Qe = equilibrium Q•SS'S' = effective S curve•Ps = regulated fare = free market fare

Effects:•Quantity falls (to Qr)•Effective price rises (to Ps)•Monopoly rent [(Ps-Pr)xQr] exists•Market is still clear

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Case Study: Taxi IndustryRemarks:•If regulated fare is set at Px, i.e. below the market fare

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Case Study: Taxi Industry As shortage exists, taxi patrons would have

to wait for taxi services Taxi drivers would not have to be polite or

courteous to patrons With the added waiting cost and poorer

services, taxi patrons would be willing to pay less monetary price.

The demand for taxi services would then fall The taxi license value falls [(Px – Pr) x Qr] The market is still in equilibrium

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Case Study: Taxi IndustryRemarks:•If regulated fare is set at Pm, i.e. above the market fare

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Case Study: Taxi Industry As surplus exists, taxi drivers would have to

wait for passengers Taxi drivers would be more polite and

courteous to the patrons, or keeping their vehicles more clean

With better services, taxi patrons would be willing to pay more monetary price.

The demand for taxi services would then rise The taxi license value rises [(Pm – Pr) x Qr] The market is still in equilibrium

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Case Study: Taxi Industry Question 5: If the taxi fares were

deregulated, what would be the effects on the market value of taxi licenses?

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Rent Dissipation: Other Cases Question 6: How does dissipation of r

ent occurs in the following cases? Public medical services Home ownership scheme Public housing

Please see P.114-115, LAM pun-lee

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Sales Tax & Firm’s Structure Turnover tax: t1 + t2 + t3 +t4

Encouraging the integration of firms Encouraging direct sales from the

producer to the consumer

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Sales Tax & Firm’s Structure Pre-retail sales taxes: t2 + t3

Encouraging the manufacturer and wholesaler to claim themselves as the retailer for avoiding taxes

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Sales Tax & Firm’s Structure Retail sales tax: t4

Changing firm’s structure cannot evade the tax, but leading to lower quality

Enlarging the total tax base Encouraging direct sales from

producers

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Sales Tax & Firm’s Structure Value added tax: tn – t(n-1)

Enlarging the total tax base

t1-t0 t2-t1 t3-t2 t4-t3

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Unit vs. Ad Valorem Tax Constant per-unit tax:

inducing quality improvement as the same amount of tax reduces the relative price of the high-quality product in terms of the low-quality item

Ad valorem tax: Encouraging retailers to separate the

components of a good so that they can be sold separately in order to avoid the tax payment

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A Theory of Rationing With price control, waiting or

queuing may be commonly chosen to ration the limited quantity of product.

Assumptions behind the theory of rationing by waiting: Money price is zero Limited good is distributed by waiting

as a rationing mechanism Per-person allotment is fixed

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A Theory of Rationing People with higher time

value would less likely to wait; vice versa.

Remarks: Q1= per-person allotment n= total no. of packages S1= total amount of

goods X available for allotment

t1= waiting time per man

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A Theory of Rationing If holding per-person

allotment constant and increasing total amount for allotment to S2

Then: More people will join

the queue Per-person waiting

time will be less (to t2)

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A Theory of Rationing If starting the distribution time earlier

or having higher speed of distribution Then:

The queue will appear earlier Per-person waiting time remains

unchanged

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Why Queue? It is costly to acquire information

about transient change in demand and customers may not be willing to pay higher price (resulted from holding inventories)

Frequently altering prices would damage goodwill and incur extra costs.

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Why Queue? Holding prices deliberately lower than

the equilibrium could be a promotional strategy to stimulate future demand.

Holding prices lower than the equilibrium level may allow the manager to act on divergent objectives like making money.

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Concluding Remarks As dissipation of rent is inconsistent

with the postulate of maximization, people will try every means to reduce it.

Under communism, the imposition of many regulations, party discipline and social controls that restrain behavior could be regarded as ways of reducing rent dissipation.