I want to explore the fact that the market price of a commodity is regulated by the most expensive source that is put to use in order to satisfy demand. That is, in principle the price has very little to do with the actual cost of producing the whole quantity of the commodity that is sold, and everything to do with how much it costs to produce the last bit. This leads to rent payments to the owners of the static resources used to produce the commodity which can be quite large and wholly uncorrelated with the part the owner plays in the production process. However unfair this state of affairs may seem, it is important to realize that it is a necessity. At the end I will look into community ownership as a way to mitigate the perceived unfairness of the arrangement.

The Parable of the Breadmakers

One upon a time there was a breadmaker called Alice, who sold break at €1 per Kg. One day the demand for bread rose above the 4 Kg per day that she could bake. Another breadmaker, Bob, came around who could sell an equivalent loaf of bread for €2/Kg. This might be because Bob wastes a lot more flour than Alice, for example. People needed more bread than Alice could provide so they had to buy some from Bob, even though it was "overpriced". When they bought 4 Kg from Alice (all that she could bake) and 1 Kg from Bob, the average price was 1.2€/Kg, but each extra Kg cost €2 (the marginal price). Now, as soon as Alice found out about Bob's price, she raised the price of her bread and, as long as it stayed below €2/Kg, people were better off buying from her first anyway. In fact, they soon ended up paying €2/Kg for all the bread. In this way, the marginal cost determined the price. One family moved away and the demand for bread dropped below 4Kg again, putting Alice and Bob in competition. It was to Alice's interest to undercut Bob, but there was no need for her to go as low as €1: €1.95/Kg would do.

There are several morals to the story. First, these kinds of price increases tend to be persistent. Second, before Alice doubled her price, you used to be able to get 5 Kg of bread for €6, and afterwards you have to pay €10. Presumably it still costs a little under €6 to produce the bread, so you are paying a €4 premium to Alice apparently for nothing.

There are two essential ingredients for cooking this example: product equivalence and perfect information. These ingredients don't usually apply to everyday situations, but they do apply in financial commodities markets, such as the market for oil, or in the production and distribution of electricity. A third ingrediend is anonimity: if my little example happens in a small community, Alice's behaviour and "profiteering" will likely be frowned upon, but in a commodity exchange you don't know, nor does it matter, who you are ultimately trading with, as all trades are ultimately cleared through the exchange and who finally delivers your product may well be different from who you originally contracted with.

What is rent?

If you are wondering where the extra €4 that Alice was getting went, in many analogous situations they go to rent. Let's take a long, hard look at the following diagram.

On the vertical axis I represent the rate of production of some commodity, say, wheat. The first point I want to make is that everything in economics is measured in rates: time is essential even if (as in this particular case) it is implicit. On the horizontal axis I represent the unit price of the commodity. The supply curve indicates at what rate the commodity can be produced for less than the corresponding price. To the left of the supply curve there is a similar curve, representing the actual cost (labour and raw materials) of production, instead of the price. The difference between the two is profit. In this graph I am allowing a handsome 10% profit. Now, since the buyers pay the same price for all the produce, the amount of money spent (per unit time) is the area of the whole shaded rectangle, not just the area to the left of the supply curve. The dark gray area is an amount paid over and above what is needed to make up for production costs and for profit. In the case of crops, this is the rent of land. Here's why.

Alice's Garden

Supose that wheat is selling for €1/Kg. Alice (who knows nothing about farming) has a house in the countryside surrounded by some fertile land. One day, Bob the agricultural engineer comes along and claims that if he could grow wheat on Alice's land, the yield would be so large that just €0.40/Kg would pay for the seed and his living expenses for the year. Alice agrees to allow Bob to do that, and split any profit with him. Assuming Bob is right, each of them makes €0.30/Kg. Bob makes a whopping 75% profit on his investment! Unfortunately for Bob, before it's time to plant next year Carol, who graduated from the same school as Bob, comes to Alice and offers her 2/3 of the profit. Alice decides to work with Carol next year. The numbers work out as before, but now Alice gets €0.40/Kg and Carol gets €0.20/Kg. Carol still makes a 50% profit. There is some rate of profit (say, 10%) below which nobody will be willing to front the money for this enterprise, but Alice can probably find someone (call him Dan) willing to give her €0.55/Kg. Dan still makes €0.05 on each €0.40 he invests, which is pretty good, but now 55% of the revenue goes to Alice's rent.

I don't know about you, but although I did not have a problem with the Alice of the previous section (she was getting rewarded for her work and superior skill), I do have some qualms about the Alice of this section: she's not doing any of the work or fronting any money, and she gets 11 times more money than Dan once he takes into account his expenses. And all this why? because the fertile land happens to be next to Alice's house. I think this is the basic reason why land ownership is so problematic, and explains the amount of blood that has been spilled over land reform over the last few hundred years.

Update [2005-10-18 16:37:15 by Migeru]: I may or may not come up with a third installment, but I am eager for feedback.