HKALE Microeconomics: Theory about rent.

Dissipation of Rent and Effects of Government Regulations

1. m 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

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

2. + 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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3. + 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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4. + 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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5. + 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

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

6. SA Theory of Price Control

= The case of rent control on housing

Rent

Remarks:
«Rm = market rent
eRc = controlled rent

0 Housing units
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7. 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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8. 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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9. m 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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10. m 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

Rm - Re
shoe money =

Tr
= Since alternative contract has to be made, extra
transaction costs are involved, i.e. dissipation of rent
still occurs.
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11. + 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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12. 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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13. + 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:

Net gain = RU-RQ)_ 0

r
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14. 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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15. + 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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16. Price Floor

a 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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17. m Price Floor

= Question 3: How could a monopoly rent
lead to dissipation of rent?

By Mr. LAU san-fat CH11-Dissipation of Rent-SV 17

18. + 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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19. 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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20. 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?

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

21. + 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.

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

22. m 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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23. + 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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24. + 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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25. + Case Study: Taxi Industry

Remarks:

«Pe = equilibrium P

«Qe = equilibrium Q

°SS'S' = effective S curve

«Ps = regulated fare
= free market fare

Effects:

eQuantity falls (to Qr)
Effective price rises (to Ps)
Monopoly rent [(Ps-Pr)xQr]
0 Qr Qe Quantity of services exists

(Number of taxis) | «Market is still clear
By Mr. LAU san-fat CH11-Dissipation of Rent-SV

25

26. a Case Study: Taxi Industry

P Remarks:

elf regulated fare is set at
Px, i.e. below the
market fare

0 e Quantity of services
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27. 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

By Mr. LAU san-fat CH11-Dissipation of Rent-SV 27

28. a Case Study: Taxi Industry

Remarks:
elf regulated fare is set at
Pm, i.e. above the

market fare
Pm B
Ps À
Pr
PCR
A
0 Qm Qr Qe | Quantity of services

By Mr. LAU san-fat CH11-Dissipation of Rent-SV 28

29. 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

By Mr. LAU san-fat CH11-Dissipation of Rent-SV 29

30. + Case Study: Taxi Industry

= Question 5: If the taxi fares were
deregulated, what would be the effects
on the market value of taxi licenses?

By Mr. LAU san-fat CH11-Dissipation of Rent-SV 30

31. + Rent Dissipation: Other Cases

= Question 6: How does dissipation of
rent occurs in the following cases?
= Public medical services
« Home ownership scheme
= Public housing

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

By Mr. LAU san-fat CH11-Dissipation of Rent-SV 31

32. m Sales Tax & Firm’s Structure

= Turnover tax: tl + t2 + t3 +44

= Encouraging the integration of firms

» Encouraging direct sales from the

producer to the consumer

Supplier of u

raw material

—> | Manufacturer |

a
|

Wholesaler

—

Retailer

—

Consumer |

By Mr. LAU san-fat

CH11-Dissipation of Rent-SV

33. m 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

lo 8
Manufacturer = Wholesaler |» Retailer
|
|
| |
|

| |

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

34. m 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

By Mr. LAU san-fat

Retailer

—

Consumer |

CH11-Dissipation of Rent-SV

35. Sales Tax & Firm’s Structure

= Value added tax: t, — t...1)
= Enlarging the total tax base

t1-t0 t2-t1
Supplier of

[>| Manufacturer
raw material

t3-t2

Wholesaler (>

t4-t3

Retailer

—

Consumer |

By Mr. LAU san-fat

CH11-Dissipation of Rent-SV

36. 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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37. + 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

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

38. + A Theory of Rationing

= People with higher time Queueing time
value would less likely to |
wait; vice versa.

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

goods X available for
allotment
= ti= waiting time per man
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e N

39. + A Theory of Rationing

= If holding per-person Queueing time

allotment constant and

increasing total amount
for allotment to S2

= Then:

= More people will join the =v |

queue |

= Per-person waiting time
will be less (to t2)

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40. + 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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41. + 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.

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

42. + 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.

By Mr. LAU san-fat CH11-Dissipation of Rent-SV 42

43. + 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.

By Mr. LAU san-fat CH11-Dissipation of Rent-SV 43