Topic 2: The Market Forces of Supply and Demand PDF

Topic 2. The market forces of supply and demand 1 Objectives of the chapter 2 Markets and types of markets 3 Market demand 4 Market supply 5 Market equilibrium and comparative statics 6 The concept of elasticity 7 Consumer Surplus and Producer Surplus 8 Taxes Bibliography Krugman,...

Topic 2. The market forces of supply and demand 1 Objectives of the chapter 2 Markets and types of markets 3 Market demand 4 Market supply 5 Market equilibrium and comparative statics 6 The concept of elasticity 7 Consumer Surplus and Producer Surplus 8 Taxes Bibliography Krugman, P et al.. Principles of Economics, chapters 3, 5 and 6. Mankiw, N.G. Principles of Economics, Auditorium, chapters 4, 5, 7, and 8. Students should become familiar with recommended readings.  1 Objectives What is a competitive market. What determines the demand for a good in a competitive market. What determines the supply of a good in a competitive market. How supply and demand together set the price of a good and the quantity sold. The key role of prices in allocating scarce resources in market economies. 2 Markets and types of markets A market is a group of buyers and sellers of a particular good or service. Buyers determine demand. Sellers determine supply. Markets can take many forms and may be organized (stock exchange) or less organized (ice cream). Perfectly competitive markets are defined by four primary characteristics: 1) There are a high number of agents, buyers and sellers, which operate independently. Each buyer has identical characteristics to other buyers. The same is true for all sellers. 2) The goods being offered for sale are homogeneous. 3) Market agents are small enough on the size of the market as not to influence the price of goods. They are price-takers. 4) Information and mobility of goods and agents are perfect and have no cost. Not all goods are sold in a perfectly competitive market. A market with only one seller is called a monopoly market. Some markets fall between perfect competition and monopoly. In the real world, there are relatively few perfectly competitive markets. 3 Market demand Demand comes from the behavior of buyers. The quantity demanded of any good is the amount of the good that buyers are willing and able to purchase. The PRICE of the product is the key determinant of the quantity demanded. Law of demand: the quantity demanded of a good falls when the price of the good rises, other things being equal.  3.1 Individual demand Price Quantity Demand schedule: of of coffees A table that shows the coffees demanded relationship between the price of a good and the quantity €0.00 16 demanded. 1.00 14 Example: 2.00 12 Helen’s demand for coffees. 3.00 10 4.00 8 Notice that Helen’s preferences 5.00 6 obey the 6.00 4 Law of Demand.  Helen’s Demand Schedule & Curve Quantity Price of Price demand coffees coffs ed $6.00 €0.0 16 $5.00 1.00 14 $4.00 2.00 12 $3.00 3.00 10 $2.00 4.00 8 $1.00 5.00 6 6.00 4 $0.00 Quantity 0 5 10 15 of coffees 2.2 Market demand The quantity demanded in the market is the sum of the quantities demanded by all buyers at each price. Suppose Helen and Ken are the only two buyers in the coffe market. (Qd = quantity demanded) Price Helen’s Qd Ken’s Qd Market Qd €0.00 16 + 8 = 24 1.00 14 + 7 = 21 2.00 12 + 6 = 18 3.00 10 + 5 = 15 4.00 8 + 4 = 12 5.00 6 + 3 = 9 6.00 4 + 2 = 6 When the price is €2.00, When the price is €2.00, The market demand at Helen will demand 12 Ken will demand 6 €2.00 will be 18 coffees. coffees. coffees. Helen’s Demand + Ken’s Demand = Market Demand Price of Price of Price of The market coffees demand curve is coffees coffees the horizontal sum of the individual 2.00 2.00 2.00 demand curves! 1.00 1.00 1.00 18 21 12 14 6 7 Quantity of coffees Quantity of coffees Quantity of coffees When the price is €1.00, When the price is €1.00, The market demand at Helen will demand 14 Ken will demand 7 €1.00 will be 21 coffees. coffees. coffees.  Qd P P $6.00 (Market) €0.0 24 $5.00 1.00 21 $4.00 2.00 18 $3.00 3.00 15 $2.00 4.00 12 $1.00 5.00 9 $0.00 Q 6.00 6 0 5 10 15 20 25 2.3 Shifts in the Demand Curve The demand curve shows how much consumers want to buy at any price, holding constant the many other factors that influence buying decisions. If any of these other factors change, the demand curve will shift.. 1. Income The relationship between income and quantity demanded depends on what type of good the product is. Normal good: a good for which, other things being equal, an increase in income leads to an increase in demand. Inferior good: a good for which, other things being equal, an increase in income leads to a decrease in demand. Normal Good An increase Price of coffees in income... €3.00 2.50 2.00 1.50 …increases demand 1.00 0.50 D2 D1 Quantity of coffees 0 1 2 3 4 5 6 7 8 9 10 11 12 Inferior Good Price of coffee €3.00 A decrease in 2.50 income... 2.00 …decreases 1.50 demand 1.00 0.50 D2 D1 Quantity of coffees 0 1 2 3 4 5 6 7 8 9 10 11 12 2. Prices of Related Goods When a fall in the price of one good reduces the demand for another good, the two goods are called substitutes. When a fall in the price of one good increases the demand for another good, the two goods are called complements. 3. Tastes. Anything that causes a shift in tastes toward a good will increase demand for that good and shift its D curve to the right. 4. Expectations Your expectations about the future may affect your demand for a good or service today. Expectations: About future income. About future prices. About economy. 5. Number of buyers An increase in the number of people buying something will increase the quantity demanded at each price, which shifts the demand curve to the right. CAETERIS PARIBUS A demand curve shows what happens to the quantity demanded when only the price varies. The curve is drawn assuming income, tastes, expectations, number of buyers and the prices of related products are not changing. The Latin phrase literally means “other things being equal” and refers to a hypothetical situation in which some variables are assumed to be constant, in the real world many things change at the same time. The demand curve slopes downward because, ceteris paribus, higher prices mean a lower quantity demanded (which causes a movement along the demand curve). This is a “change in quantity demanded.” Price B €2.00 1.00 A D 0 4 8 Quantity demanded When there is a change in income, the prices of related goods, tastes, expectations, or the number of buyers, ceteris paribus, the quantity demanded at each price changes; this is represented by a shift in the demand curve. This is a “change in demand” P $6.00 Suppose the number of buyers increases. $5.00 Then, at each price, quantity demanded will increase $4.00 (by 5 in this example). $3.00 $2.00 $1.00 $0.00 Q 0 5 10 15 20 25 30 Variables that influence buyers: Shifts in the demand curve: Price Increase in demand Decrease in demand Demand curve, D2 Demand curve, D1 Demand curve, D3 0 Quantity 4. Market supply Supply comes from the behaviour of sellers. The quantity supplied of any good is the amount that sellers are willing and able to sell. The price is one determinant of the quantity supplied. When the price is high, selling is more profitable, and so the quantity supplied increases. This relationship between price and quantity supplied is called the law of supply: Other things equal, when the price of a good rises, the quantity supplied of the good also rises.  4.1 Individual supply The supply schedule is a table that shows the relationship between the price of a good and the quantity supplied. Example: Cafeteria Torres’ Quantity supply of coffees. Price of coffees of coffees supplied €0.00 0 Notice that Cafeteria Torres’ supply 1.00 3 schedule obeys the Law of Supply. 2.00 6 3.00 9 4.00 12 5.00 15 6.00 18  Price Quantity P of of lattes €6.00 lattes supplied €5.00 €0.00 0 €4.00 1.00 3 €3.00 2.00 6 3.00 9 €2.00 4.00 12 €1.00 5.00 15 €0.00 Q 6.00 18 0 5 10 15 4.2. Market supply Market supply is the sum of the supplies of all sellers. The quantity supplied in the market is the sum of the quantities supplied by all sellers at each price. Suppose Torres and Star Cafeteria are the only two sellers in this market. (Qs = quantity supplied) Price Torres Star Market Qs €0.00 0 + 0 = 0 1.00 3 + 2 = 5 2.00 6 + 4 = 10 3.00 9 + 6 = 15 4.00 12 + 8 = 20 5.00 15 + 10 = 25 6.00 18 + 12 = 30  QS P P (Market) $6.00 €0.00 0 $5.00 1.00 5 $4.00 2.00 10 3.00 15 $3.00 4.00 20 $2.00 5.00 25 $1.00 6.00 30 $0.00 Q 0 5 10 15 20 25 30 35 4.3 Shifts in the Supply Curve The supply curve shows how much producers offer for sale at any given price, holding constant all other factors that may influence producers’ decisions about how much to sell. If any of these other factors change, the supply curve will shift. 1. Input Prices A fall in input prices makes production more profitable at each output price, so firms supply a larger quantity at each price, and the Supply curve shifts to the right. P $6.00 Suppose the price of coffee beans $5.00 falls. $4.00 At each price, the quantity of $3.00 coffee cups supplied $2.00 will increase $1.00 (by 5 in this example). $0.00 Q 0 5 10 15 20 25 30 35 2. Technology Technology determines how much inputs are required to produce a unit of output. A cost-saving technological improvement has same effect as a fall in input prices, shifts the S curve to the right. 3. Expectations. Suppose a firm expects the price of the good it sells to rise in the future. The firm may reduce supply now, to save some of its inventory to sell later at the higher price. 4. Number of sellers An increase in the number of sellers increases the quantity supplied at each price, shifts the S curve to the right. The supply curve slopes upward because, ceteris paribus, higher prices mean a greater quantity supplied (which causes a movement along the supply curve). This is a “change in quantity supplied.” When we graph a supply curve, a change in price does not shift the curve but represents a movement along it. Price of S coffee cups C €3.00 A rise in the price of coffee cups results in a movement along A the supply curve. 1.00 Quantity of coffee cups 0 1 5 Variables that influence sellers When there is a change in input prices, technology, expectations or the number of sellers, ceteris paribus, the quantity supplied at each price changes; this is represented by a shift in the supply curve. This is a “change in supply”. Supply curve, S3 Supply Price curve, S1 Supply Decrease curve, S2 in supply Increase in supply 0 Quantity 5. Market’s equilibrium and comparative statics Having analyzed supply and demand separately, we now combine them to see how they determine the quantity of a good sold in a market and its price. 5.1 Market’s equilibrium Market’s equilibrium refers to a situation in which the price has reached the level where quantity supplied equals quantity demanded: Equilibrium Price The price that balances quantity supplied and quantity demanded. On a graph, it is the price at which the supply and demand curves intersect. Equilibrium Quantity The quantity supplied and the quantity demanded at the equilibrium price. On a graph it is the quantity at which the supply curve and demand curve cross.  The equilibrium of supply and demand Price of coffee cups Supply Equilibrium price Equilibrium €2.00 Equilibrium Demand quantity 0 1 2 3 4 5 6 7 8 9 10 11 12 13 Quantity of coffee cups  Excess supply Price of coffee cup Supply Surplus €2.50 2.00 Demand 0 4 7 10 Quantity of Quantity Quantity cofee cups demanded supplied  Excess Demand Price of coffee cups Supply €2.00 1.50 Shortage Demand 0 4 7 10 Quantity of Quantity Quantity coffee cups supplied demanded 5.2 Changes in equilibrium When some event shifts the supply or demand curves, the equilibrium in the market changes. The analysis of such a change is called comparative statics because it involves comparing two static situations—an old and a new equilibrium. When analyzing how some event affects a market, we proceed in three steps: 1. We study whether the event shifts the supply curve, the demand curve, or in some cases both curves. 2. We look whether the curve shifts to the right or to the left. 3. We use the supply-and-demand model to examine how the shift affects the equilibrium price and quantity. EXAMPLE 1: The Market for Hybrid Cars P price of S1 hybrid cars P1 D1 Q Q1 quantity of hybrid cars 1. EVENT TO BE ANALYZED: Increase in price of gas. P S1 STEP 1: P2 D curve shifts because STEP 2: price of gas P1 affects demand for D shifts right hybrids. because STEP 3: high gas S curve price doeshybrids makes not D1 D2 The shift shift, causes because an price more attractive Q increase of gas in price does not cars. Q1 Q2 relative to other Qd and quantity affect cost of of Qs hybrid cars. producing hybrids. Notice: When P rises, P producers supply a larger quantity S1 of hybrids, even P2 though the S curve has not shifted. P1 Always be careful to distinguish between a shift in D1 D2 a curve and a Q movement along Q1 Q2 Qs Qd the curve. 2. EVENT: New technology reduces cost of P producing hybrid cars. S1 S2 STEP 1: S curve shifts because STEP 2: event affects P1 cost of production. S shifts right P2 D curve does because event not STEPbecause shift, 3: reduces cost, D1 The shift causes production technology makes production Q price is not to onefallof the Q1 Q2 Qs more profitable at Qd and quantity factors that to rise. affect any given price. demand. 3 EVENT: price of gas rises AND new technology reduces production costs  Terms for Shift vs. Movement Along Curve Change in supply: a shift in the S curve – occurs when a non-price determinant of supply changes (like technology or costs) Change in the quantity supplied: a movement along a fixed S curve – occurs when P changes Change in demand: a shift in the D curve – occurs when a non-price determinant of demand changes (like income or # of buyers) Change in the quantity demanded: a movement along a fixed D curve – occurs when P changes 6. The concept of elasticity The elasticity is a measure of the responsiveness of quantity demanded or quantity supplied to one of its determinants. 6.1 Elasticity of demand It is used to measure how much demand responds to changes in its determinants. 6.1.1 The price elasticity of demand The price elasticity of demand is a measure of how much the quantity demanded of a good responds to a change in the price of that good, computed as the percentage change in quantity demanded divided by the percentage change in price.  The price elasticity of demand measures how much Qd responds to a change in P. Loosely speaking, it measures the price-sensitivity of buyers’ demand. Ep =Percentage change in quantity demanded Percentage change in price ∆Q d (Q d 1 − Q d 0 ) ∆%Q d Q d ∆Q d P Q0 d (Q d 1 − Q d 0 ) P0 EP = = = ⋅ d = = ⋅ d ∆% P ∆P ∆P Q ( P1 − P0 ) ( P1 − P0 ) Q 0 P P0 Percentage change = end value-start value x100 start value  Price elasticity Percentage change in Qd = of demand Percentage change in P P Example: P rises Price by 10% P2 elasticity P1 of demand D equals Q 15% Q2 Q1 = 1.5 Q falls 10% by 15%  Price elasticity Percentage change in Qd = of demand Percentage change in P Along a D curve, P and Q move in opposite directions, which would P make price elasticity negative. P2 We will drop the minus sign and report all price elasticities as P1 absolute values. D Larger elasticities (in absolute Q value) imply greater sensitivity and Q2 Q1 responsiveness. Calculating Percentage Changes 1. Standard method of computing the percentage (%) change: end value – start value Demand for x 100 your websites start value P Going from A to B, B the % change in P equals €250 A (€250–€200)/€200 = 25% €200 the % change in Q equals D (8–12)/12 = -33.3% Q 8 12 ∆%Q d 33.3% EP = = = 1.3 ∆% P 25%  Problem: The standard method gives different answers depending on where you start. Demand for your websites P From A to B: elasticity = 33.3/25 = 1.33 B €250 From B to A, A P falls (200-250)/250=-20% €200 Q rises (12-8)/8= 50% D Q 8 12 ∆%Q d 50% EP = = = 2.5 ∆% P 20% 2. The midpoint method of computing the percentage (%) change: (Q d 1 − Q d 0 ) Qd1 + Qd 0   2  EP =   ( P1 − P0 )  P1 + P0   2  The midpoint is the number halfway between the start & end values, also the average of those values. It doesn’t matter which value you use as the “start” and which as the “end” – you get the same answer either way! Point A: Price: €200; Quantity 12 Point B: Price €250; Quantity 8 Using the midpoint method, the % change in P equals: 250 –200 x 100% = 22.2% 225 The % change in Q equals: 12 – 8 x 100% = 40.0% 10 The price elasticity of demand equals: 40/22.2 = 1.8 What determines price elasticity of demand? To learn the determinants of price elasticity, we look at a series of examples. Each compares two common goods. In each example: – Suppose the prices of both goods rise by 20%. – The good for which Qd falls the most (in percent) has the highest price elasticity of demand. Which good is it? Why? – What lesson does the example teach us about the determinants of the price elasticity of demand? EXAMPLE 1: Orlando tomato sauce vs. Sunscreen The prices of both goods rise by 20%. For which good does Qd drop the most? Why? Lesson: Price elasticity is higher when close substitutes are available. EXAMPLE 2: T-shirts vs. Clothing The prices of both goods rise by 20%. For which good does Qd drop the most? Why? Lesson: Price elasticity is higher for narrowly defined goods than broadly defined ones. EXAMPLE 3: Insulin vs. Caribbean Cruises The prices of both of these goods rise by 20%. For which good does Qd drop the most? Why? Lesson: Price elasticity is higher for luxuries than for necessities. EXAMPLE 4: Gasoline in the Short Run vs. Gasoline in the Long Run The price of gasoline rises 20%. Does Qd drop more in the short run or the long run? Why? Lesson: Price elasticity is higher in the long run than the short run. The determinants of price elasticity of demand: The price elasticity of demand depends on:  the extent to which close substitutes are available  whether the good is a necessity or a luxury  how broadly or narrowly the good is defined  the time horizon. Demand tends to be more elastic: the larger the number of close substitutes. if the good is a luxury. the more narrowly defined the market. the longer the time period. The Variety of Demand Curves Economists classify demand curves according to their elasticity. The price elasticity of demand is closely related to the slope of the demand curve. Rule: The flatter the curve, the greater the elasticity. The steeper the curve, the lesser the elasticity. 1. Perfectly inelastic demand (one extreme case) Price elasticity % change in Q 0% = = =0 of demand % change in P 10% D curve: P D vertical P1 Consumers’ price sensitivity: P2 0 P falls Q Elasticity: by 10% Q1 0 Q changes by 0% 2. Inelastic demand Price elasticity % change in Q < 10% = = 1 of demand % change in P 10% D curve: P relatively flat P1 Consumers’ price sensitivity: P2 D relatively high P falls Q Elasticity: Q1 Q2 by 10% >1 Q rises more than 10% 5. Perfectly elastic demand (the other extreme) Price elasticity % change in Q any % = = = infinity of demand % change in P 0% D curve: P horizontal P2 = P1 D Consumers’ price sensitivity: extreme P changes Q Elasticity: Q1 Q2 by 0% infinity Q changes by any % Inelastic Demand: - Quantity demanded does not respond strongly to price changes. - Price elasticity of demand is less than one. - Steeper. Elastic Demand: - Quantity demanded responds strongly to changes in price. - Price elasticity of demand is greater than one. - Flatter Price Elasticity and Total Revenue The total revenue is the amount paid by buyers and received by sellers of the good. Revenue = P x Q  Imagine running your own business and trying to decide whether to raise the price or not. A price increase has two effects on revenue: Higher P means more revenue on each unit you sell. But you sell fewer units (lower Q), due to Law of Demand.  Your decision will depend on which of the two effects is larger  It depends on the price elasticity of demand. 1. Elastic demand Price elasticity Percentage change in Q = of demand Percentage change in P Revenue = P x Q If demand is elastic, then price elasticity of demand > 1 % change in Q > % change in P The fall in revenue from lower Q is greater than the increase in revenue from higher P, so revenue falls. Elastic demand increased (elasticity = 1.8) P revenue due lost to higher P revenue If P = €200, due to Q = 12 and €250 lower Q revenue = €2400. €200 If P = €250, D Q = 8 and revenue = €2000. When D is elastic, Q 8 12 a price increase causes revenue to fall.  2. Inelastic demand Price elasticity Percentage change in Q = of demand Percentage change in P Revenue = P x Q If demand is inelastic, then price elasticity of demand < 1 % change in Q < % change in P The fall in revenue from lower Q is smaller than the increase in revenue from higher P, so revenue rises. In our example, suppose that Q only falls to 10 (instead of 8) when you raise your price to €250. Inelastic demand increased elasticity = 0.9 revenue due P to higher P lost If P = €200, revenue Q = 12 and due to €250 lower Q revenue = €2400. €200 If P = €250, Q = 10 and D revenue = €2500. When D is inelastic, Q a price increase 10 12 causes revenue to rise. 6.1.2 The Income Elasticity of Demand Income elasticity of demand measures how much the quantity demanded of a good responds to a change in consumers’ income. It is computed as the percentage change in the quantity demanded divided by the percentage change in income. Ei =Percentage change in quantity demanded Percentage change in income Two types of goods: 1. Normal goods: Higher income raises quantity demanded. Because quantity demanded and income move in the same direction, normal goods have positive income elasticities. 2. Inferior goods: Higher income lowers the quantity demanded. Because quantity demanded and income move in opposite directions, inferior goods have negative income elasticities. Among normal goods, income elasticities vary substantially in size. - Necessities tend to have small income elasticities - Luxuries tend to have large income 6.1.3 The Cross-Price Elasticity of Demand The cross-price elasticity of demand measures how much the quantity demanded of one good responds to a change in the price of another good. It is computed as the percentage change in quantity demanded of the first good divided by the percentage change in the price of the second good. ECP =Percentage change in quantity demanded of good 1 Percentage change in the price of good 2 Whether the cross-price elasticity is a positive or negative number depends on whether the two goods are substitutes or complements. 1. Substitutes are goods that are typically used in place of one another. An increase in the price of one of them induces people to buy the other. Because the price of one and the quantity demanded of the other move in the same direction, the cross-price elasticity is positive. 2. Complements are goods that are typically used together. In this case, the cross-price elasticity is negative, indicating that an increase in the price of one reduces the quantity demanded of the other. 6.2 The Price Elasticity of Supply The price elasticity of supply measures how much the quantity supplied responds to changes in the price. The price elasticity of supply depends on the flexibility of sellers to change the amount of the good they produce when price changes. Price elasticity of supply is the percentage change in quantity supplied resulting from a percentage change in price. EP =Percentage change in quantity supplied Percentage change in price For example, suppose that an increase in the price of electronic cigarettes from €10 to €15 each one raises the amount produced from 4,000 to 8,000 units. Percentage change in price = (15 -10)/10= 50% Percentage change in quantity supplied = (8,000-4,000)/4,000 =100% Price elasticity of supply = 100%/50% = 2 The elasticity of 2 reflects the fact that the quantity supplied moves proportionately twice as much as the price.  Price elasticity Percentage change in Qs = of supply Percentage change in P P Example: S P rises Price P2 by 50% elasticity P1 of supply equals Q 100% Q1 Q2 = 2.0 50% Q rises by 100% The Variety of Supply Curves Economists classify supply curves according to their elasticity. The slope of the supply curve is closely related to price elasticity of supply. Rule: The flatter the curve, the greater the elasticity. The steeper the curve, the lesser the elasticity. 1. Perfectly inelastic (one extreme) Price elasticity % change in Q 0% = = =0 of supply % change in P 10% S curve: P S vertical P2 Sellers’ price sensitivity: P1 0 P rises Q Elasticity: by 10% Q1 0 Q changes by 0% 2. Inelastic Price elasticity % change in Q < 10% = = 1 of supply % change in P 10% S curve: P relatively flat S P2 Sellers’ price sensitivity: P1 relatively high P rises Q Elasticity: by 10% Q1 Q2 >1 Q rises more than 10% 5. Perfectly elastic (the other extreme) Price elasticity % change in Q any % = = = infinity of supply % change in P 0% S curve: P horizontal P2 = P1 S Sellers’ price sensitivity: extreme P changes Q Elasticity: by 0% Q1 Q2 infinity Q changes by any % The more easily sellers can change the quantity they produce, the greater the price elasticity of supply. For many goods, price elasticity of supply is greater in the long run than in the short run, because firms can build new factories, or new firms may be able to enter the market. 7 Consumer Surplus and Producers Surplus 7.1 Consumer Surplus A buyer’s willingness to pay (wtp) for a good is the maximum amount the buyer will pay for that good. It measures how much the buyer values the good or service. Name WTP Example: 4 buyers’ WTP Anthony €250 for a trip to Paris Ben 175 Charles 300 Dave 125 Q: If price of a trip to Paris is €200, who will buy a trip to Paris, and what is quantity demanded? A: Anthony & Charles will buy a trip to Paris, Ben & Dave will not. Name WTP Hence, Qd = 2 Anthony €250 when P = €200. Ben 175 Charles 300 Dave 125  Derive the P (price demand who buys Qd of trip) schedule: €301 & up nobody 0 Name WTP 251 – 300 Charles 1 Anthony €250 176 – 250 Anthony, Charles 2 Ben 175 Ben, Anthony, 126 – 175 3 Charles Charles 300 Dave, Ben, Anthony, Dave 125 0 – 125 4 Charles  P €350 P Qd 300 250 €301 & up 0 200 251 – 300 1 150 176 – 250 2 100 126 – 175 3 50 0 – 125 4 0 Q 0 1 2 3 4  This D curve looks like a staircase P with 4 steps – one per buyer. €350 If there were a huge # of buyers, as in a competitive market, 300 there would be a huge # 250 of very tiny steps, 200 and it would look more like a smooth curve. 150 At any Q, the height of the 100 D curve is the WTP of the marginal buyer, the buyer 50 who would leave the market if P were 0 Q any higher. 0 1 2 3 4 Consumer surplus is the amount a buyer is willing to pay minus the buyer actually pays: CS = WTP – P Name WTP Suppose P = 260. Anthony €250 Charles’ CS = 300 – 260 = €40. Ben 175 The others get no CS because they do not buy a trip to Paris at Charles 300 this price. Dave 125 Total CS = €40.  P P = €260 Charles’ €350 WTP Charles’ CS = 300 300 – 260 = 40 Total CS = 40 250 200 150 100 50 0 Q 0 1 2 3 4  Instead, suppose P P = €220 Charles’ WTP Charles’ CS = €350 €300 – 220 = €80 300 Anthony’s WTP Anthony’s CS = 250 €250 – 220 = €30 Total CS = €110 200 150 Total CS equals the 100 area under the demand curve 50 above the price, from 0 to Q. 0 Q 0 1 2 3 4 CS with Lots of Buyers & a Smooth D Curve Price P The demand for shoes per pair € 60 At Q = 5(thousand), the 50 marginal buyer is willing to pay €50 for 40 pair of shoes. 30 Suppose P = €30. 1000s of pairs Then his consumer 20 of shoes surplus = €20. 10 D 0 Q 0 5 10 15 20 25 30 CS is the area b/w P and the D curve, from 0 P The demand for shoes to Q. € 60 Recall: area of a triangle equals 50 ½ x base x height h Height of 40 this triangle is €60 – 30 = €30. 30 So, 20 CS = ½ x 15 x €30 = €225. 10 D 0 Q 0 5 10 15 20 25 30 How a Higher Price Reduces CS If P rises to €40, CS = ½ x 10 x €20 P 1. Fall in CS = €100. 60 due to buyers Two reasons for the fall 50 leaving market in CS. 40 30 2. Fall in CS due to 20 remaining buyers 10 paying higher P D 0 Q 0 5 10 15 20 25 30 Consumer surplus, the amount that buyers are willing to pay for a good minus the amount they actually pay for it, measures the benefit that buyers receive from a good as the buyers themselves perceive it. Consumer surplus is a good measure of economic well-being if policymakers want to respect the preferences of buyers 7.2 Producer Surplus Cost is the value of everything a seller must give up to produce a good (i.e., opportunity cost). Includes cost of all resources used to produce good, including value of the seller’s time. Example: Costs of 3 English teachers. name cost A seller will only produce and sell the Angelo €10 good if the price exceeds his or her cost. Hunter 20 Hence, cost is a measure of Kitty 35 willingness to sell.  P Qs We can derive the supply schedule from the cost data: €0 – 9 0 name cost 10 – 19 1 Angelo €10 20 – 34 2 Hunter 20 35 & up 3 Kitty 35  At each Q, the P height of the S curve is the cost of the €40 marginal seller, Kitty’s cost the seller who would 30 leave the market if Hunter’s the price were any 20 cost lower. 10 Angelo’s cost name cost Angelo €10 0 Q Hunter 20 0 1 2 3 Kitty 35  P PS = P – cost €40 Producer surplus (PS): the amount a seller 30 is paid for a good minus the seller’s cost. 20 10 0 Q 0 1 2 3  P PS = P – cost €40 Suppose P = €25. Kitty’s cost Angelo’s PS = €15 30 Hunter’s Hunter’s PS = €5 20 cost Kitty’s PS = €0 10 Angelo’s cost Total PS = €20 Total PS equals the 0 Q area above the supply 0 1 2 3 curve under the price, from 0 to Q. PS with Lots of Sellers & a Smooth S Curve Price P The supply of shoes per pair 60 50 S Suppose P = €40. 40 At Q = 15(thousand), the marginal seller’s cost is 30 1000s of pairs €30, 20 of shoes and her producer surplus is €10. 10 0 Q 0 5 10 15 20 25 30 PS is the area b/w The supply of shoes P and the S curve, from P 0 to Q. 60 The height of this 50 S triangle is €40 – 15 = €25. 40 So, 30 PS = ½ x b x h h = ½ x 25 x €25 20 = €312.5 10 0 Q 0 5 10 15 20 25 30 How a Lower Price Reduces PS If P falls to €30, P 1. Fall in PS PS = ½ x 15 x €15 60 due to sellers = €112.5 leaving market 50 S Two reasons for the fall in PS. 40 30 2. Fall in PS due to 20 remaining sellers 10 getting lower P 0 Q 0 5 10 15 20 25 30 Producer surplus measures the benefit to sellers of participating in a market. We use producer surplus to measure the well-being of sellers in much the same way as we use consumer surplus to measure the wellbeing of buyers. 7.3 Market Efficiency CS = (value to buyers) – (amount paid by buyers) CS measures the net benefit buyers receive from participating in the market (the welfare of consumers). PS = (amount received by sellers) – (cost to sellers) PS measures the net benefit sellers receive from participating in the market (the welfare of producers). Total surplus = CS + PS TS measures the total gains from trade in a market. Total surplus = CS + PS = (value to buyers) – (amount paid by buyers) + (amount received by sellers) – (cost to sellers) = (value to buyers) – (cost to sellers)  Total = (value to buyers) – (cost to sellers) surplus An allocation of resources is efficient if it maximizes total surplus. Efficiency means: – Raising or lowering the quantity of a good would not increase total surplus. – The goods are being produced by the producers with lowest cost. – The goods are being consumed by the buyers who value them most highly. – Efficiency means making the pie as big as possible. – In contrast, equity refers to whether the pie is divided fairly. Market equilibrium: P = €30 P Q = 15,000 60 50 S Total surplus = CS + PS 40 CS Is the market equilibrium 30 PS efficient? 20 10 D 0 Q 0 5 10 15 20 25 30 Which Buyers Get to Consume the Good? Every buyer whose WTP is P ≥ €30 will buy. 60 Every buyer 50 S whose WTP is < €30 will not. 40 So, the buyers who 30 value the good most highly are the ones who 20 consume it. 10 D 0 Q 0 5 10 15 20 25 30 Which Sellers Produce the Good? Every seller whose cost is ≤ €30 will produce P the good. 60 Every seller whose cost is > €30 will not. 50 S Hence, the sellers with 40 the lowest cost produce the good. 30 20 10 D 0 Q 0 5 10 15 20 25 30 Does Equilibrium Q Maximize Total Surplus? At Q = 20, cost of producing P the marginal unit 60 is €35 50 S value to consumers of the marginal unit 40 is only €20 Hence, can increase 30 total surplus by reducing Q. 20 This is true at any Q 10 greater than 15. D 0 Q 0 5 10 15 20 25 30 At Q = 10, cost of producing P the marginal unit 60 is €25 50 S value to consumers of the marginal unit 40 is €40 Hence, can increase 30 total surplus by increasing Q. 20 This is true at any Q less 10 than 15. D 0 Q 0 5 10 15 20 25 30 The equilibrium quantity maximizes total surplus. At any other quantity, total surplus is smaller than at the equilibrium quantity. It is efficient : 1. Free markets allocate the supply of goods to the buyers who value them most highly, as measured by their willingness to pay. 2. Free markets allocate the demand for goods to the sellers who can produce them at least cost. 3. Free markets produce the quantity of goods that maximizes the sum of consumer and producer surplus. We cannot increase economic well-being by changing the allocation of consumption among buyers or the allocation of production among sellers or by increasing or decreasing the quantity of the good. The market equilibrium is efficient (Adam Smith and the Invisible Hand, The Wealth of Nations, 1776): The equilibrium quantity maximizes total surplus under perfect competition. The goods are produced by the producers with lowest cost and consumed by the buyers who value them most highly. The government cannot improve on the market outcome. Laissez faire. Welfare economics demonstrate markets are usually a good way to organize economic activity. But we assumed markets are perfectly competitive Market failures: - Market power - Externalities,  8. Taxes Price The price paid by consumers is higher The price received by firms is lower Supply Price buyers Size of tax pay Price Who without tax benefits? Price sellers receive Demand the quantity declines. 0 Quantity Quantity Quantity with tax without tax  Price Supply Price buyers Size of tax (T) pay Tax revenue (T × Q) Price sellers receive Quantity Demand sold (Q) 0 Quantity Quantity Quantity with tax without tax  A deadweight loss is the fall in total Price surplus that results from a market distortion, such as a tax A Supply Price buyers = PB pay B Price C without tax = P1 E Price D sellers = PS receive F Demand 0 Q2 Q1 Quantity  The magnitude of the deadweight loss depends on how much the quantity supplied and quantity demanded respond to changes in the price. That, in turn, depends on the price elasticities of supply and demand. The greater the elasticities of demand and supply: the larger will be the decline in equilibrium quantity the greater the deadweight loss of a tax the lower the tax burden for those agents  (a) Inelastic Supply Price Supply When supply is relatively inelastic, the deadweight loss of a tax is small Size of tax because only a small number of transactions are forgone. Demand 0 Quantity  (b) Elastic Supply When supply is relatively Price elastic, the deadweight loss of a tax is large, a large number of transactions fail to occur because of the tax Size Supply of tax Demand 0 Quantity  (c) Inelastic Demand Price Supply Size of tax When demand is relatively inelastic, the deadweight loss of a tax is small. Demand 0 Quantity  (d) Elastic Demand Price Supply Size of tax Demand When demand is relatively elastic, the deadweight loss of a tax is large. 0 Quantity  End of topic 2. For any questions you can always come during my office hours on Tuesdays from 12:30 to 14:30. Contact me in advance via Aula Virtual email to make an appointment at a specific time and to avoid delays.