How is the supply curve graphically depicted when economic rent is created?
vertical supply curve
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Open it Because of their limited availability in nature, certain resources—such as land and specialty commodities—possess highly inelastic supply curves in both the short run and long run (shown in Exhibit 1 as a vertical supply curve). When supply is relatively inelastic, a high degree of market demand can result in pricing that creates economic rent. This economic rent results from the fact that when price increase
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2. OBJECTIVES OF THE FIRM er competing firms to compete away any economic profit over the long run. Economic profit that exists over the long run is usually found where competitive conditions persistently are less than perfect in the market.
<span>2.1.3. Economic Rent
The surplus value known as economic rent results when a particular resource or good is fixed in supply (with a vertical supply curve) and market price is higher than what is required to bring the resource or good onto the market and sustain its use. Essentially, demand determines the price level and the magnitude of economic rent that is forthcoming from the market. Exhibit 1 illustrates this concept, where P 1 is the price level that yields a normal profit return to the business that supplies the item. When demand increases from Demand 1 to Demand 2 , price rises to P 2 , where at this higher price level economic rent is created. The amount of this economic rent is calculated as (P 2 – P 1 ) × Q 1 . The firm has not done anything internally to merit this special reward: It benefits from an increase in demand in conjunction with a supply curve that does not fully adjust with an increase in quantity when price rises.
Exhibit 1. Economic Rent
Because of their limited availability in nature, certain resources—such as land and specialty commodities—possess highly inelastic supply curves in both the short run and long run (shown in Exhibit 1 as a vertical supply curve). When supply is relatively inelastic, a high degree of market demand can result in pricing that creates economic rent. This economic rent results from the fact that when price increases, the quantity supplied does not change or, at the most, increases only slightly. This is because of the fixation of supply by nature or by such artificial constraints as government policy.
How is the concept of economic rent useful in financial analysis? Commodities or resources that command economic rent have the potential to reward equity investors more than what is required to attract their capital to that activity, resulting in greater shareholders’ wealth. Evidence of economic rent attracts additional capital funds to the economic endeavor. This new investment capital increases shareholders’ value as investors bid up share prices of existing firms. Any commodity, resource, or good that is fixed or nearly fixed in supply has the potential to yield economic rent. From an analytical perspective, one can obtain industry supply data to calculate the elasticity of supply , which measures the sensitivity of quantity supplied to a change in price. If quantity supplied is relatively unresponsive ( inelastic ) to price changes, then a potential condition exists in the market for economic rent. A reliable forecast of changes in demand can indicate the degree of any economic rent that is forthcoming from the market in the future. When one is analyzing fixed or nearly fixed supply markets (e.g., gold), a fundamental comprehension of demand determinants is necessary to make rational financial decisions based on potential economic rent.
Economic Rent and Investment Decision Making
The following market data show the global demand, global supply, and price on an annual basis for gold over the period 2006–2008. Based on the data, what observation can be made about market demand, supply, and economic rent?
Year 2006 2007 2008 Percent Change 2006–2008 Supply (in metric tons) 3,569 3,475 3,508 –1.7 Demand (in metric tons) 3,423 3,552 3,805 +11.2 Average spot price (in US$) 603.92 695.39 871.65 +44.3
Source: GFMS and World Gold Council.
The amount of total gold supplied to the world market over this period has actually declined slightly by 1.7 percent during a period when there was a double-digit increase of 11.2 percent in demand. As a consequence, the spot price has dramatically increased by 44.3 percent. Economic rent has resulted from this market relationship of a relatively fixed supply of gold and a rising demand for it.
2.2. Comparison of Profit Measures
All three types of profit are interconnected because, according to Equation 4, acco
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