Valuation Philosophy3.2
6. MEASUREMENT OF ECONOMIC EFFICIENCY BENEFITS
6.4 Benefits to the Producer
To begin with, we will simplify the analysis and measure benefits to a firm or business that is a price taker. A firm is a price taker when its output is a small part of a national or international market for that product.
Continuing our gasoline example, one individual independent oil producer would be so small as to have no effect on the price of gasoline. Figure 7-2 illustrates the relationship between the market for gasoline (measured in millions of gallons) and the individual oil producer (whose output is measured simply in gallons of gas). The equilibrium price is set in a national or international market based on total consumer demand and total industry supply. The demand curve facing the individual producer is horizontal at the current market-clearing price for gasoline. The reason for this is the independent producer’s contribution to supply makes up such a small fraction of the total supply of gasoline that doubling its production of gasoline or cutting production in half would have no effect on price. In addition, the independent oil producer can sell all it wants at the existing market price.
Besides the horizontal demand curve, Figure 7-2 shows the independent oil producer has an upward-sloping marginal cost curve. That is, as the producer attempts to pump more oil and refine more gasoline from a given size oil deposit in a given amount of time, its costs per unit of output rise as it must intensify management, add more capital inputs, and add more shifts of labor (and pay a premium for the difficult-to-fill night shift). The marginal cost curve is the independent producer’s supply curve. It reflects the minimum dollar amount for which the producer would supply each additional gallon of gasoline.
To calculate the net economic efficiency benefits to the independent oil producer, we note that sales of the first 500 gallons of gas cost only $0.75 per gallon to produce, but the owner receives the market-clearing price of
$1.50 per gallon. Thus the owner receives a producer surplus, or economic profit, of $0.75 per gallon on these first 500 gallons. The next 500 gallons of gas cost $1 per gallon to produce, but are again sold for $1.50 per gallon.
The producer surplus on these units is $0.50 per gallon. It is only the 2000th gallon in which the price received by the producer equals the minimum supply cost, and therefore no producer surplus is received on the last unit produced. Thus, the total producer surplus for 2000 gallons of gas is $1000 ($1.50-0.50 times 2000 pounds with the product divided by two since producer surplus is a triangle). This is the shaded area in Figure 7-2.
Notice the similarity in logic between derivation of producer and consumer surplus. In both cases, economic efficiency benefits are the net gain over and above the costs.
Another means by which to calculate producer surplus and to see its relationship to a firm's profit is to recognize that the producer surplus triangle is the difference between a firm's total revenue and total variable cost. The total revenue to the producer is $3000 ($ 1.50 times 2000 gallons).
The total variable cost is the area under the marginal cost curve up to the profit-maximizing level of output (here 2000 gallons). In this example the area under the marginal cost curve is $2000. Thus, the producer surplus is
$1000 ($3000-2000), just as was calculated before. Note that, just as in the case of the consumer, producer surplus is the gain over and above the firm's actual expenditures. The firm’s expenditures are the cost of inputs. The use of inputs by this producer results in an opportunity cost to society, since society must forego whatever else the inputs would have produced in their next best use.
Next let us examine the benefits of a relaxation of a county groundwater protection regulation that would reduce the cost of oil production to this, the only oil producer in this county. For example, instead of twice-daily drawing and analysis of groundwater quality samples to detect and any seepage of oil into the groundwater, monthly samples are being proposed.
These effects would be translated into lower production costs and hence a downward shift in the producer's marginal cost curve.
As Figure 7-3 illustrates, this downward shift in the producer's marginal cost curve has two effects. First, the producer receives a resource cost savings, as the original level of output (2000 gallons of gas) can be produced at a lower cost. Thus, these resources can be freed up to produce other goods and services that society values. The resource cost savings on the original level of output is equal to $500 ($.25 times 2000 gallons). This
is denoted as the trapezoidal area labeled A in Figure 7-3.
The second benefit to the producer and society arises because, with the lower cost of production, it is profitable for the independent producer to increase the rate and duration of pumping and expand refining to 2500 gallons. With the new marginal cost curve, the cost of producing the 2000th gallon is now less than the price. As such, a profit maximizing oil producer will expand production until the new marginal cost equals the market price. As such there is a gain in benefits equal to $62.50 ($0.25 times 500 additional gallons of gas divided by two since producer surplus is a triangle). This is the triangular area labeled B in Figure 7-3. Another way to view this second gain in economic benefits is to realize that society gets
$750 worth of gasoline ($1.50 times 500 gallons) but it only costs $687.50.
Thus the net gain is $62.50.
Because this change in output by this producer is so small relative to the market, there is no change in the price of gasoline to consumers. If there is no change in price, there is no change in consumer surplus and hence no net
economic efficiency benefits to the consumer. In essence, this small additional amount of oil is added at the margin where price equals gross willingness to pay. Oil production will be reduced elsewhere, where production costs more than it now does here, by 500 gallons. We now turn to analyzing resource projects or policies that are so large in scope they do affect the market supply and hence price of the final good.