*Many students find the concepts of producer surplus and economic rent confusing. Hopefully, these excerpts will help clarify the concepts.
The following are excerpts from Varian (2014).
14.9 Producer’s Surplus
The demand curve measures the amount that will be demanded at each price; the supply curve measures the amount that will be supplied at each price. Just as the area under the demand curve measures the surplus enjoyed by the demanders of a good, the area above the supply curve measures the surplus enjoyed by the suppliers of a good.
We’ve referred to the area under the demand curve as consumer’s surplus. By analogy, the area above the supply curve is known as producer’s surplus. The terms consumer’s surplus and producer’s surplus are somewhat misleading, since who is doing the consuming and who is doing the producing really doesn’t matter. It would be better to use the terms “demander’s surplus” and “supplier’s surplus,” but we’ll bow to tradition and use the standard terminology.
23.7 Profits and Producer’s Surplus
We defined producer’s surplus to be the area to the left of the supply curve, in analogy to consumer’s surplus, which was the area to the left of the demand curve. It turns out that producer’s surplus is closely related to the profits of a firm. More precisely, producer’s surplus is equal to revenues minus variable costs, or equivalently, profits plus the fixed costs.
24.6 Fixed Factors and Economic Rent
If there is free entry, profits are driven to zero in the long run. But not every industry has free entry. In some industries the number of firms in the industry is fixed.
A common reason for this is that there are some factors of production that are available in fixed supply. We said that in the long run the fixed factors could be bought or sold by an individual firm. But there are some factors that are fixed for the economy as a whole even in the long run.
The most obvious example of this is in resource-extraction industries: oil in the ground is a necessary input to the oil-extraction industry, and there is only so much oil around to be extracted. A similar statement could be made for coal, gas, precious metals, or any other such resource. Agriculture gives another example. There is only a certain amount of land that is suitable for agriculture. A more exotic example of such a fixed factor is talent. There are only a certain number of people who possess the necessary level of talent to be professional athletes or entertainers. There may be “free entry” into such fields — but only for those who are good enough to get in!
There are other cases where the fixed factor is fixed not by nature, but by law. In many industries it is necessary to have a license or permit, and the number of these permits may be fixed by law. The taxicab industry in many cities is regulated in this way. Liquor licenses are another example
If there are restrictions such as the above on the number of firms in the industry, so that firms cannot enter the industry freely, it may appear that it is possible to have an industry with positive profits in the long run, with no economic forces to drive those profits to zero. This appearance is wrong. There is an economic force that pushes profits to zero. If a firm is operating at a point where its profits appear to be positive in the long run, it is probably because we are not appropriately measuring the market value of whatever it is that is preventing entry.
Here it is important to remember the economic definition of costs: we should value each factor of production at its market price — its opportunity cost. If it appears that a farmer is making positive profits after we have subtracted his costs of production, it is probably because we have forgotten to subtract the cost of his land.
Suppose that we manage to value all of the inputs to farming except for the land cost, and we end up with π dollars per year for profits. How much would the land be worth on a free market? How much would someone pay to rent that land for a year?
The answer is: they would be willing to rent it for π dollars per year, the “profits” that it brings in. You wouldn’t even have to know anything about farming to rent this land and earn π dollars — after all, we valued the farmer’s labor at its market price as well, and that means that you can hire a farmer and still make π dollars of profit. So the market value of that land — its competitive rent — is just π. The economic profits to farming are zero
Note that the rental rate determined by this procedure may have nothing whatsoever to do with the historical cost of the farm. What matters is not what you bought it for, but what you can sell it for — that’s what determines opportunity cost.
Whenever there is some fixed factor that is preventing entry into an industry, there will be an equilibrium rental rate for that factor. Even with fixed factors, you can always enter an industry by buying out the position of a firm that is currently in the industry. Every firm in the industry has the option of selling out — and the opportunity cost of not doing so is a cost of production that it has to consider.
Thus in one sense it is always the possibility of entry that drives profits to zero. After all, there are two ways to enter an industry: you can form a new firm, or you can buy out an existing firm that is currently in the industry. If a new firm can buy everything necessary to produce in an industry and still make a profit, it will do so. But if there are some factors that are in fixed supply, then competition for those factors among potential entrants will bid the prices of these factors up to a point where the profit disappears.
EXAMPLE: Taxi Licenses in New York City
Earlier we said that licenses to operate New York City taxicabs sell for about $100,000. Yet in 1986 taxicab drivers made only about $400 for a 50-hour week; this translated into less than an $8 hourly wage. The New York Taxi and Limosine Commission argued that this wage was too low to attract skilled drivers and that taxi fares should be raised in order to attract better drivers.
An economist would argue that allowing the fares to increase would have virtually no effect on the take-home pay of the drivers; all that would happen is that the value of the taxicab license would increase. We can see why by examining the commission’s figures for the costs of operating a taxi. In 1986, the lease rate was $55 for a day shift and $65 for a night shift. The driver who leased the taxi paid for the gasoline and netted about $80 a day in income.
24.7 Economic Rent
The examples in the last section are instances of economic rent. Economic rent is defined as those payments to a factor of production that are in excess of the minimum payment necessary to have that factor supplied.
Consider, for example, the case of oil discussed earlier. In order to produce oil you need some labor, some machinery, and, most importantly, some oil in the ground! Suppose that it costs $1 a barrel to pump oil out of the ground from an existing well. Then any price in excess of $1 a barrel will induce firms to supply oil from existing wells. But the actual price of oil is much higher than $1 a barrel. People want oil for various reasons, and they are willing to pay more than its cost of production to get it. The excess of the price of oil over its cost of production is economic rent.
rent = p∗y∗ − cv(y∗). (24.1)
This is precisely what we referred to as producer’s surplus earlier. Indeed, it is the same concept, simply viewed in a different light. Thus we can also measure rent by taking the area to the left of the marginal cost curve, as we saw earlier.
24.9 The Politics of Rent
Often economic rent exists because of legal restrictions on entry into the industry. We mentioned two examples above: taxicab licenses and liquor licenses. In each of these cases the number of licenses is fixed by law, thus restricting entry to the industry and creating economic rents.
Efforts directed at keeping or acquiring claims to factors in fixed supplies are sometimes referred to as rent seeking. From the viewpoint of society they represent a pure deadweight loss since they don’t create any more output, they just change the market value of existing factors of production.
It is somewhat misleading to say that rent is the same concept as producer’s surplus. Producer’s surplus equals rent only if all fixed cost is rental cost. The idea here is that producer’s surplus is the ‘source’ of a firm’s profits (Producer surplus = profit + fixed costs). But profit will be driven to zero, either by new entrants or by increased prices for fixed factors that are preventing entry into an industry (= rent). Rent exists if and only if entry is not free — when it is impossible for new entrants to enter and drive down profits. In such cases, the prices for fixed factors increase, driving up fixed costs and making the profit zero. It is important to note, however, that if there are fixed costs other than rent for entry-preventing factors of production, then it is possible to have producer’s surplus without rent payments. Of course, in the long run, there are no fixed costs by definition.
Another reason why it is slighting misleading to say that rent is the same concept as producer’s surplus: Rent is something paid to factors of production (one producer might be paying multiple rents), while producer surplus is something paid to a producer.
Varian, H. R. (2014). Intermediate microeconomics with calculus: a modern approach. WW Norton & Company.