Short essay questions and responses

¶ … economic rent" and describe the role it plays in the California Water Pricing Case. Compare the distribution of economic rents in the case where farmers are allowed to resell their water on an open market to a situation where farmers must pay marginal cost for their water.

Economic rent is a measure of market power, or the difference between what a factor of production (land, labor, or capital) is paid and how much it would demand to be paid to remain in use (such as for a worker to agree to go to work everyday). In perfectly competitive markets, there is no economic rent, given that prices are driven down as low as possible, because of competition between suppliers. An example of economic rent is as follows: "A soccer star may be paid $50,000 a week to play for his team when he would be willing to turn out for only $10,000, so his economic rent is $40,000 a week… Reducing rent does not change production decisions, so economic rent can be taxed without any adverse impact on the real economy, assuming that it really is rent" (Economic rent, 2011, the Economist).

In the case of the California Water Pricing case, agricultural producers often paid far less money for water than residential users, essentially pricing their economic rent far lower than they might be willing to pay for it. This resulted in tremendous inefficiency and waste on the part of producers. Adopting a marginal price structure would make it more expensive for farmers to waste water, and thus create a beneficial effect for the environment overall. However, such a scheme, effectively making the economic rent more commensurate with the farmers' need for water, would not place the financial burden equally on all farmers, because some farmers' crops need more water and some farmers live in more drought-stricken zones. The distribution of economic rent between farmers would thus not be equitable.

Q2. Explain how a monopolist can be regulated by means of a price ceiling. How does the price ceiling change the monopolist's incentives and behavior in selecting the quantity to sell and the price at which to sell it? If the goal of regulation is to replicate a competitive market, how should that price ceiling be set? What are the consequences of setting the price ceiling too high? What are the consequences of setting the price ceiling too low?

When a monopoly is allowed to exist, the government usually sets a price ceiling for the good or service provided. If regulation upon the monopoly did not exist, the monopolist could charge whatever price it desired, so long as people did not stop buying the product altogether. A monopoly means that a company has no rivals in the market producing the same or a similar product and there are few comparable goods and services that act as substitutes. For a necessary good or service (such as transportation or utilities) the effects upon consumers can be potentially devastating, without price ceilings curtailing the monopoly's ability to charge high prices and ration its supplies.