Extra Slides for Review (Slides 1-30)

1. Demand

1

$0.00

$1.00

$2.00

$3.00

$4.00

$5.00

$6.00

0 5 10 15

Price of Coffee

Quantity of Coffee

2

Tony’s Demand Schedule & CurvePrice

of coffee

Quantity of coffee

demanded

$0.00 16

1.00 14

2.00 12

3.00 10

4.00 8

5.00 6

6.00 4

Market Demand versus Individual Demand• The quantity demanded in the market is the sum of the

quantities demanded by all buyers at each price.

• Suppose Tony and Dani are the only two buyers in the coffee market. (Qd = quantity demanded)

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6

8

10

12

14

16

Tony’s Qd

2

3

4

5

6

7

8

Dani’s Qd

+

+

+

+

=

=

=

=

6

9

12

15

+ = 18

+ = 21

+ = 24

Market Qd

$0.00

6.00

5.00

4.00

3.00

2.00

1.00

Price

$0.00

$1.00

$2.00

$3.00

$4.00

$5.00

$6.00

0 5 10 15 20 25

P

Q

4

The Market Demand Curve for Coffee

PQd

(Market)

$0.00 24

1.00 21

2.00 18

3.00 15

4.00 12

5.00 9

6.00 6

Willingness to Pay (WTP)

A buyer’s willingness to pay for a good is the maximum amount the buyer will pay for that good.

WTP measures how much the buyer values the good.

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name WTP

Flea $300

Anthony 250

Chad 175

John 125

Example: 4 buyers’ WTP for an iPod

WTP and the Demand Curve

Q: If price of iPod is $200, who will buy an iPod, and what is quantity demanded?

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A: Flea & Anthony will buy an iPod, Chad & John will not.

Hence, Qd = __ when P = $200.

name WTP

Flea $300

Anthony 250

Chad 175

John 125

WTP and the Demand Curve

Derive the demand schedule:

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4John, Chad, Anthony, Flea

0 – 125

3Chad, Anthony, Flea

126 – 175

2Anthony, Flea176 – 250

1Flea251 – 300

0nobody$301 & up

Qdwho buysP (price of iPod)

name WTP

Flea $300

Anthony 250

Chad 175

John 125

$0

$50

$100

$150

$200

$250

$300

$350

0 1 2 3 4

WTP and the Demand Curve

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P Qd

$301 & up 0

251 – 300 1

176 – 250 2

126 – 175 3

0 – 125 4

P

Q

Qd=0

Qd=1

Qd=2

Qd=3

Qd=4

$175

$125

$0

$50

$100

$150

$200

$250

$300

$350

0 1 2 3 4

About the Staircase Shape…

This D curve looks like a staircase with 4 steps.

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P

Q

If there were a huge # of buyers, as in a competitive market,

there would be a huge # of very tiny steps,

and it would look more like a smooth curve.

Shifts of D Curve

• Economic variables held constant when specifying demand include income, wealth, prices of related goods, preferences, price expectations, the number of buyers…

• If one of the above variables change, the demand curve will shift.

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$0.00

$1.00

$2.00

$3.00

$4.00

$5.00

$6.00

0 5 10 15 20 25 30

P

Q

Suppose the number of buyers increases. Then, at each price, quantity demanded will increase (by 5 in this example).D curve shifts to the right.

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2. Supply

12

$0.00

$1.00

$2.00

$3.00

$4.00

$5.00

$6.00

0 5 10 15

13

Starbucks’ Supply Schedule & CurvePrice

of coffee

Quantity of coffee supplied

$0.00 0

1.00 3

2.00 6

3.00 9

4.00 12

5.00 15

6.00 18

P

Q

Market Supply versus Individual Supply• The quantity supplied in the market is the sum of the

quantities supplied by all sellers at each price.

• Suppose Starbucks and Jitters are the only two sellers in this market. (Qs = quantity supplied)

1418

15

12

9

6

3

0

Starbucks

12

10

8

6

4

2

0

Jitters

+

+

+

+

=

=

=

=

30

25

20

15

+ = 10

+ = 5

+ = 0

Market Qs

$0.00

6.00

5.00

4.00

3.00

2.00

1.00

Price

$0.00

$1.00

$2.00

$3.00

$4.00

$5.00

$6.00

0 5 10 15 20 25 30 35

P

Q

The Market Supply Curve

PQS

(Market)

$0.00 0

1.00 5

2.00 10

3.00 15

4.00 20

5.00 25

6.00 30

15

Cost and the Supply Curve• 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 sellers in the lawn-cutting business.

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name cost

Angelo $10

Hunter 20

Kitty 35

A seller will only produce and sell the good if the price exceeds his/her cost.

Hence, cost is a measure of

willingness to sell.

Cost and the Supply Curve

17

335 & up

220 – 34

110 – 19

0$0 – 9

QsPDerive the supply schedule from the cost data:

name cost

Angelo $10

Hunter 20

Kitty 35

Cost and the Supply Curve

18

$0

$10

$20

$30

$40

0 1 2 3

P

Q

P Qs

$0 – 9 0

10 – 19 1

20 – 34 2

35 & up 3

$35

Shifts of S Curve

• Economic variables held constant when deriving a supply curve include production technology, input prices, taxes and subsidies, and price expectations

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• Examples of inputs: for coffee: milk, sugar, coffee machines, buildings…

• A fall in input prices makes production more profitable at each output price, so firms supply a larger quantity at each price, and the S curve shifts to the right.

Example: input prices

20

$0.00

$1.00

$2.00

$3.00

$4.00

$5.00

$6.00

0 5 10 15 20 25 30 35

P

Q

Suppose the price of milk falls. At each price, the quantity of coffee supplied will increase (by 5 in this example).

Example: input prices

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3. Welfare Measures

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(1) Consumer Surplus (CS)

Consumer surplus is the amount a buyer is willing to pay minus the buyer actually pays.

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name WTP

Flea $300

Anthony 250

Chad 175

John 125

Suppose P = $260.

Flea’s CS = $300 – 260 = $__.

The others get no CS because they do not buy an iPod at this price.

Total CS = $___.

$0

$50

$100

$150

$200

$250

$300

$350

0 1 2 3 4

CS and the Demand Curve

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P

Q

Flea’s WTP P = $260

Flea’s CS =

$300 – 260 = ___

Total CS = ___

$0

$50

$100

$150

$200

$250

$300

$350

0 1 2 3 4

CS and the Demand Curve

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P

Q

Flea’s WTP

Anthony’s WTP

Instead, suppose P = $220

Flea’s CS =

$300 – 220 = ___

Anthony’s CS =

$250 – 220 = ___

Total CS = ____

$0

$50

$100

$150

$200

$250

$300

$350

0 1 2 3 4

CS and the Demand Curve

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P

Q

The lesson:

Total CS equals the area below

the demand curve & above the price.

0

10

20

30

40

50

60

0 5 10 15 20 25 30

P

Q

CS with Lots of Buyers & a Smooth D Curve

Q: P = $30, CS=?

A: CS is the area below the D curve and above the P. Recall: area of a triangle equals ½ x base x heightSo, CS=½ x 15 x $30 = _____

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The Demand for Shoes

D

h

$

Price per pair

1000s of pairs of shoes

$0

$10

$20

$30

$40

0 1 2 3

(2) Producer Surplus

P

Q

Producer surplus (PS): the amount a seller is paid for a good minus the seller’s cost.

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$0

$10

$20

$30

$40

0 1 2 3

Producer Surplus and the S Curve

P

Q

Suppose P = $25

Angelo’s PS = ___

Hunter’s PS = ___

Total PS = ____

Kitty’s

cost

Hunter’s cost

Angelo’s cost

Total PS equals the area below the price and

above the supply curve.

$25

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0

10

20

30

40

50

60

0 5 10 15 20 25 30

P

Q

PS with Lots of Sellers & a Smooth S Curve

The supply of shoes

SQ: P=$40, PS=?A: PS is the area below the P and above the S curve.

The height of this triangle is $40 – 15 = $25.

So,PS= _____________ = $312.5

h

Price per pair

1000s of pairs of shoes

$15

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Modeling the Market Process: A Review of the Basics

Chapter 2

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1. Market Models: Fundamentals

• Defining the Relevant Market– A market: the interaction between _________ &

___________ to exchange a well-defined commodity

– Defining the market context is one of critical steps in economic analysis

• Specifying the Market Model– Qualitative and quantitative relationship

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2. Supply and Demand: An Overview

• Primary objective of the supply and demand model is to facilitate an analysis of market conditions and any observed change in price

• Sellers’ decisions are modeled through a _______ function and buyers’ decisions are modeled through a _______ function

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Competitive Market for Private Goods

• Private goods are commodities that have two characteristics: excludable and rival in consumption

• A competitive market is characterized by:– A large number of buyers and sellers with no control over

price– The product is homogenous or standardized– The absence of entry barriers– Perfect information

Important Characteristics of Goods

• A good is excludable if a person can be prevented from using it if he does not pay for it. – excludable: fish tacos– not excludable: national defense

• A good is rival in consumption if one person’s use/consumption of it diminishes others’ use/consumption. – rival: fish tacos– not rival: national defense

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Classic division of goods in economy

Rival in consumption(consumption diminishes its value)

Not rival

Excludable(have to pay)

private goods: food clothing

natural monopolies (club goods): cable TV

Not excludablecommon resources: fish in the sea

public goods: national defensetornado siren

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3. Demand

• Demand refers to the quantities of a good the consumer is willing and able to buy at a set of prices during some time period, ceteris paribus (c.p.)– The willingness to pay (WTP), or demand price,

measures the marginal benefit (MB) from consuming another unit of the good

• Law of Demand says there is an _________ relationship between price (P) and quantity demanded of a good (qd), c.p.

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• Market demand captures the decisions of all consumers willing and able to purchase a good – For a private good, market demand is found by

horizontally summing individual demands

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Market DemandBottled Water

Price

Quantity

P = –0.01QD + 11.5

$11.50

D

1,150

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4. Supply

• Supply refers to the quantities of a good the producer is willing and able to bring to market at a given set of prices during some time period, c.p.

• Law of Supply – there is a direct relationship between price (P) and quantity supplied (qs) of a good, c.p.– Rising marginal cost (MC) supports this positive

relationship (willingness to sell should cover MC)

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• Market Supply captures the combined decisions of all producers in a given industry– Derived by horizontally summing the individual

supply functions

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Market SupplyBottled Water

Price

Quantity

S

P = 0.0025QS + 0.25

0.25

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5. Market Equilibrium• Supply and demand together determine a unique equilibrium

price (PE) and equilibrium quantity (QE), at which point there is no tendency for change

– PE occurs where ____________

• Model for bottled water– D: P = –0.01QD + 11.5– S: P = 0.0025QS + 0.25– Equilibrium found where

–0.01QD + 11.5 = 0.0025QS + 0.25, or where QE = 900 and PE = _________

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Market EquilibriumBottled Water

Price

Quantity

S

0.25

D

2.50

900

11.50

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Market Adjustment to Equilibrium• Disequilibrium occurs if the prevailing market price is at some level

other than the equilibrium level– If actual price is below its equilibrium level, there will be a shortage

• Shortage = excess demand = QD – QS

– If actual price is above its equilibrium level, there will be a surplus• Surplus = excess supply = QS – QD

• Price movements serve as a signal that a shortage or surplus exists, whereas price stability suggests equilibrium

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6. Efficiency Criteria

(1) Allocative Efficiency

• At the market level, allocative efficiency requires that resources be appropriated such that additional benefits to society are equal to additional costs incurred, i.e., _____________– The value society places on the good is equivalent

to the value of the resources given up to produce it

• At the firm level, this efficiency is achieved at a competitive market equilibrium, assuming firms are _________________________

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Profit Maximization

• Total Profit () = Total Revenue (TR) - Total Costs (TC)– TR = P x Q– TC is all economic costs, explicit and implicit

• Profit is maximized where TR/Q = TC/Q, or where ________________

• MR = TR/Q, additional revenue from producing another unit of Q

• MC = TC/Q, additional cost from producing another unit of Q

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Profit Maximization

• In competitive industries, firms face constant prices determined by the market, which means P = MR

• Therefore the competitive market equilibrium achieves allocative efficiency because:– maximization requires: MR = MC– Competitive markets imply: P = MR– So maximization in competition means: P = MC,

which defines allocative efficiency

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Profit Maximization

Bottled Water $

Quantity

2.50

0.25

MC

P = MR

qE = 36

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(2) Technical Efficiency

• Technical Efficiency refers to production decisions that generate _____________________given some stock of resources

• Market forces can achieve technical efficiency so long as competitive conditions prevail– Competitive firms must minimize costs to remain

viable in the market because they cannot raise price to cover the added cost of inefficient production

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7. Welfare Measures(1) Consumer Surplus (CS)

• Consumer surplus is the net benefit to buyers estimated by the excess of marginal benefit (MB) of consumption over market price (P), aggregated over all units purchased

• Graphically measured as the triangular area above the price and below the demand curve up to the quantity sold

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Consumer Surplus

Bottled Water Market

CS = ___________________________

= ____________

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(2) Producer Surplus (PS)

• Producer surplus is the net gain to sellers of a good estimated by the excess of the market price (P) over marginal cost (MC), aggregated over all units sold

• Graphically measured as the triangular area above the MC curve up to the price level over all units sold

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Producer Surplus

Bottled Water Market

PS = ____________________________

= _____________

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(3) Deadweight Loss (DWL)

• Society’s welfare can be captured through the sum of CS and PS

• Comparing these measures before and after a market disturbance helps quantify how society is affected by that disturbance through Deadweight Loss (DWL)

• DWL is the net loss of consumer and producer surplus due to an allocatively inefficient market event

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DWL of Price Regulated above PE Bottled Water

Policy forces price to $6.50

DWL = (C + E)

= ____________________________________

=_____________

• Refer to slide 46:

Greg Mankiw, Principles of Economics, Ch7—

An allocation of resources is efficient if it maximizes total surplus. The market equilibrium is efficient.

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