Copyright Economics/How Economics Works

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Contents 1 How Economics Works 1.1 Surplus 1.2 One more example, this time dealing with theft. 1.3 Next: Trades and Problems

How Economics Works

Copyright Economics - How economics works, Trades and Problems, Solutions, Conclusion

Surplus

The basic idea used to evaluate the benefit of a trade in economics is surplus. Consumer surplus is how much more the consumer values the good than they have to pay for it. Producer surplus is how much more the producer can sell the good for than they had to pay to produce it. For the purposes of this article, producer surplus can be considered the same as profit. Summed together they are called social gain. Here is a simple example:

• Alice can grow a bushel of potatoes for $10.
• Bob is willing to pay up to $45 for a bushel of potatoes.
• Alice agrees to sell the potatoes to Bob for $25.
• Alice is the producer and she gets $25 - $10 = $15 worth of producer surplus from the trade
• Bob is the consumer and he gets $45 - $25 = $20 worth of consumer surplus from the trade.
• The social gain is $20 + $15 = $35 from the trade.
• Another way to calculate the social gain is $45 - $10 = $35 as this is the value to the consumer minus how much it takes to produce it. Notice that neither the price nor the recipient of the surplus affects the social gain, although the recipient of the surplus is affected by price. If the price is higher, more of the surplus goes to the producer. If the price is lower, more of the surplus goes to the consumer. In either case the social gain is the same.

• As formulas:
• Consumer Surplus = CS
• Producer Surplus = PS
• Price = P
• Consumer Value = CV
• Producer Cost = PC
• Social Gain = SG
• CS = CV - P
• PS = P - PC
• SG = CS + PS
• SG = (CV - P) + (P - PC) = CV - PC

In other words, to figure out if a trade is economically beneficial, you calculate the consumer surplus and add it to the producer surplus. Or you take the value to the consumer minus the cost to produce. Of course things get more complicated when there are more people involved. For example:

• Alice can grow one bushel of potatoes for $10 and only one bushel.
• Bob is willing to pay up to $45 for one bushel of potatoes and only one bushel.
• Carol is willing to pay up to $15 for one bushel of potatoes and only one bushel.
• Dave can grow one bushel of potatoes for $40 and only one bushel.
• Bob and Alice agree to trade the potatoes for $25.
• Carol and Dave do not trade since $40 > $15.
• Alice is the producer and she gets $25 - $10 = $15 worth of producer surplus from the trade
• Bob is the consumer and he gets $45 - $25 = $20 worth of consumer surplus from the trade.
• The social gain is $20 + $15 = $35 from the trade.

Notice none of the additional people in this example contributed to social gain. If Bob and Dave had traded one bushel for $45 and Alice and Carol had traded one bushel for $10 then producer surplus would be ($45 - $40) + ($10 - $10) = $5 and consumer surplus would be ($45 - $45) + ($15 - $10) = $5 with a social gain of $10. Not coincidentally this equals $35 + ($15-$40) since $-25 is the social gain if Carol and Dave had traded in the above example. Since the surpluses of this trade are negative it will not happen as long as everyone has the freedom to choose trading partners. Alice can underbid Dave so if there is only one trade it will be with Alice. Bob can outbid Carol so if there is only one trade it will involve Bob. (Of course if you put Alice and Carol on one side of a concrete wall and Dave and Bob on the other, then Alice would trade with Carol, and Dave would trade with Bob, and the concrete wall would have lowered the social gain to $10.) Surpluses allow two things:

1. A method to determine if a trade will occur since trades will only happen when consumer surplus and producer surplus are not negative (CS >= 0 and PS >= 0).
2. A method to determine how beneficial a trade is to society since it is the consumer's value minus the producer's cost. (SG = CV - PC). *

• Note that this assumes that all costs are taken into account. If there is some additional cost that is not paid by the producer or the consumer then a trade might still be harmful to society. This caveat would apply to things like burning a ton of coal with the attendant environmental costs.

Another important point is that social gain is maximized in this example merely by each of the individual parties trying to maximize their individual surpluses. This is an important point since freedom to choose trades and individual maximizing surpluses will maximize social gain as well as an all knowledgeable benevolent dictator could. Social gain is better maximized by selfish individuals with limited knowledge than altruistic individuals with limited knowledge. Most markets operate this way. Intellectual property markets are not one of the market types that maximize social gain with selfish individuals with limited knowledge.

So far I have done all the examples with money. If this bothers you, it can also be done with other scarce quantities. The most common alternative ways use time or energy. It is generally harder to do. An example would be:

• Alice can grow a bushel of potatoes in 2 hours of work.
• Alice can grow a bushel of beans in 4 hours of work.
• Bob can grow a bushel of potatoes in 6 hours of work.
• Bob can grow a bushel of beans in 5 hours of work.
• Alice and Bob each want one bushel of potatoes and one bushel of beans.
• Alice grows two bushels of potatoes and this takes her 4 hours of work.
• Bob grows two bushels of beans and this takes him 10 hours of work.
• Alice trades one bushel of potatoes for one bushel of beans from Bob.
• Alice's gain is 2 hours of time since it would have taken her 2 + 4 = 6 hours to produce the beans and potatoes that she ends up with.
• Bob's gain is 1 hour of time since it would have taken him 5 + 6 = 11 hours to produce the beans and potatoes that he ends up with.
• The social gain is 2 hours of Alice's time plus 1 hour of Bob's time.
• Note: 1 hour of Bob's time does not equal 1 hour of Alice's time since their opportunity costs are different. (What each of them can do with their time is different so when they gain an hour they can create different amounts of new things.)

Social gain can be calculated without ever using money. In this case the social gain comes from the fact that Alice and Bob take different ratios of time to grow beans and potatoes. Social gain is usually calculated with money for reasons of simplicity. Other factors like energy or time are then converted into money to do the calculation.

Hopefully by now you understand the concept of surpluses quite well. I will give you two more examples to help bridge the gap between normal goods and intellectual property.

This first bridging example talks about some of the details of social gain when combined with entry costs.

• Alice can buy a loom for $35.
• Alice can buy all the materials for a carpet for $10
• Bob will pay up to $40 for a carpet.
• Carol will pay up to $30 for a carpet.
• Dave will pay up to $25 for a carpet.
• Eve will pay up to $20 for a carpet.
• The price for carpets is $25.
• Bob, Carol and Dave all buy a carpet from Alice for $25.
• The total consumer surplus is ($40 - $25) + ($30 - $25) + ($25 - $25) = $20.
• The total producer surplus is ($25 - ($35 + $10)) + ($25 - $10) + ($25 - $10) = $10.
• Note that the producer cost for the first is $45 since it includes the cost of the loom and the cost of the materials.
• Social gain is $20 + $10 = $30.

The big thing to notice in this example is that sometimes there is a large cost associated with entering some market. This can sometimes cause the initial producer surplus to be negative. The trade may still take place if the total producer surplus is positive with more trades.

One more example, this time dealing with theft.

• Alice has stopped growing potatoes.
• Bob is willing to pay up to $45 for one bushel of potatoes.
• Carol is willing to pay up to $15 for one bushel of potatoes.
• Dave can grow one bushel of potatoes for $40.
• Mallory is willing to pay up to $3 for one bushel of potatoes.
• Dave plans to sell the bushel of potatoes to Bob for $43 dollars.
• Mallory steals the potatoes and eats them.
• The social gain is $3 - $40 = -$37 which is negative and less than the $5 possible social gain.
• Decreased social gain is the first harm since 'trades' in which the producer cost is greater than the consumer value (PC > CV) can happen.
• If Mallory were willing to pay up to $50 for the potatoes there still would be harm if he stole the potatoes.
• Dave will not grow the potatoes in the first place if he thinks theft is too likely as his producer surplus would then equal -$40. (PC = $40, P = $0, PS = P - PC = -$40).
• Note that if Mallory had stolen from Bob a similar result would happen since this would make Bob's consumer surplus -$45
• Creating negative surpluses is the second harm.
• A subtle third harm is creating a future disincentive to produce or consume.
• The disincentive to produce or buy prevents the $45 - $40 = $5 social gain from ever happening even if no theft were to take place. This happens if Dave decides to not produce the potatoes at all.

Theft of physical property is bad since it almost always produces a negative social gain, creates negative surpluses, and decreases future production and consumption. That is why there are laws regarding theft. These produce enough of a disincentive to keep theft at a low level.

Next: Trades and Problems