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Finance 30210: Managerial Economics
Supply, Demand, and Equilibrium
Efficiency vs. Equity
An allocation of resources that maximum total welfare
An allocation of resources provides a “fair” distribution of welfare
Under certain circumstances, the competitive market process guarantees this
Can we trust markets to produce a desirable outcome?
If we can’t have everything we want, so we need to decide what to do with the limited resources we do have.
Under what circumstances does the market process result in efficient outcomes?
#1: Many buyers and sellers – no individual buyer/firm has any real market power
#2: Homogeneous products – no variation in product across firms
#3: No barriers to entry – it’s costless for new firms to enter the marketplace
#4: Perfect information – prices and quality of products are assumed to be known to all producers/consumers
#5: No Externalities –ALL costs/benefits of the product are absorbed by the consumer/producer
#6: Transactions are costless – buyers and sellers incur no costs in an exchange (i.e. no taxes)
Can you think of situations where all these assumptions hold?
50 Fish/hr300 Max/Day
30 Fish/hr300 Max/Day
20 Fish/hr160 Max/Day
Lets try an example…suppose that you are a fisherman. Top catch larger quantities of fish, you have to go farther from shore and your catch per hour drops
Zone A Zone B Zone C
You bought a boat for $1,000Maintenance on the boat is $50/DayYou pay $16/hour in labor costsYou pay $20/hour for fuel and other expenses
What costs are fixed, sunk, and variable?
50 Fish/hr300 Max/Day
30 Fish/hr300 Max/Day
20 Fish/hr160 Max/Day
Lets try an example…suppose that you are a fisherman. To catch larger quantities of fish, you have to go farther from shore and your catch per hour drops
Boat = $50Labor = $16/hrGas = $20/hr
Lets take this section by section…
Zone A Zone B Zone C
Quantity Total Cost Fixed Cost Variable Cost
Average Cost Marginal Cost
0 $50 $50 $0 --- ---
1 $50.72 $50 $.72 $50.72 $.72
2 $51.44 $50 $1.44 $25.72 $.72
3 $52.16 $50 $2.16 $17.39 $.72
Zone A FishHrFish
hr/72$.
/50
/36$
# of Fish
Dollars
FC$50
TC
VC = $.72*F
# of Fish
Dollars
MC$.72
AC
Let’s try and picture this…
0 0
50 Fish/hr300 Max/Day
30 Fish/hr300 Max/Day
20 Fish/hr160 Max/Day
Lets try an example…suppose that you are a fisherman. Top catch larger quantities of fish, you have to go farther from shore and your catch per hour drops
Boat = $50Labor = $16/hrGas = $20/hr
Lets take this section by section…
Zone A Zone B Zone C
Quantity TC FC VC AC MC300 $266 $50 $216 $0.88 $.72
301 $267.20 $50 $217.20 $0.88 $1.20
302 $268.40 $50 $218.40 $0.88 $1.20
303 $269.60 $50 $219.60 $0.88 $1.20
Zone B FishHrFish
hr/20.1$
/30
/36$
# of Fish
Dollars
FC$50
TC
VC =$216 + $1.20*F
# of Fish
Dollars
MC$1.20AC
Let’s try and picture this…
300 300
$266
$.88
50 Fish/hr300 Max/Day
30 Fish/hr300 Max/Day
20 Fish/hr160 Max/Day
Lets try an example…suppose that you are a fisherman. Top catch larger quantities of fish, you have to go farther from shore and your catch per hour drops
Boat = $50Labor = $16/hrGas = $20/hr
Lets take this section by section…
Zone A Zone B Zone C
Quantity TC FC VC AC MC600 $626 $50 $576 $1.04 $1.20
601 $627.80 $50 $577.80 $1.04 $1.80
602 $629.60 $50 $579.60 $1.04 $1.80
603 $631.40 $50 $581.40 $1.04 $1.80
Zone C FishHrFish
hr/80.1$
/20
/36$
# of Fish
Dollars
FC$50
TC
VC =$576 + $1.80*F
# of Fish
Dollars
MC$1.80
AC
Let’s try and picture this…
600 600
$626
$1.04
# of Fish
Dollars
FC$50
TC
# of Fish
Dollars
MC
$.72
All together…
0 0
$1.20
Slope = 1.80
Slope = 1.20
Slope = .72
300 600
$1.80AC
300 600
Perfectly competitive firms are “price takers”. They see a market price and can’t change it. Suppose that the market price is $1.20.
Fish Price Total Revenue Total Cost Profit0 $1.20 $0 $50 -$50
1 $1.20 $1.20 $50.72 -$49.52
2 $1.20 $2.40 $51.44 -$49.04
3 $1.20 $3.60 $52.16 -$48.56
300 $1.20 $360 $266 $94
301 $1.20 $361.20 $267.20 $94
302 $1.20 $362.40 $268.40 $94
303 $1.20 $363.60 $269.60 $94
600 $1.20 $720 $626 $94
601 $1.20 $721.20 $627.80 $93.40
602 $1.20 $721.40 $629.60 $91.80
603 $1.20 $721.60 $631.40 $90.20
# of Fish
Dollars
$50
TC
# of Fish
Dollars
-$50
We are looking to maximize profits where profits are the difference between total revenues and total costs
0 0
$0Slope = 1.80
Slope = 1.20
Slope = .72
300 600
$94
300 600
TR
Profit
Profits are increasing
Profits are maximized
Profits are decreasing
Profits are increasing
Profits are maximized
Profits are decreasing
We could also go at this by looking at costs and benefits at the margin. For a perfectly competitive firm the market price equals marginal revenue.
Fish Total Cost Total Revenue Marginal Revenue Marginal Cost
0 $50 $0 $1.20 $.72
1 $50.72 $1.20 $1.20 $.72
2 $51.44 $2.40 $1.20 $.72
3 $52.16 $3.60 $1.20 $.72
300 $266 $360 $1.20 $.72
301 $267.20 $361.20 $1.20 $1.20
302 $268.40 $362.40 $1.20 $1.20
303 $269.60 $363.60 $1.20 $1.20
600 $626 $720 $1.20 $1.20
601 $627.80 $721.20 $1.20 $1.80
602 $629.60 $721.40 $1.20 $1.80
603 $631.40 $721.60 $1.20 $1.80
# of Fish
Dollars
-$50
Lets plot out marginal revenues and costs rather than total costs and revenues…
0
$0
$94
300 600
Dollars
MC
$.72
0
$1.20
$1.80
300 600
MR
Profit
Marginal revenue is greater than marginal cost
Profits are increasing
Marginal revenue is equal to marginal cost
Profits are maximized
Marginal revenue is less than marginal cost
Profits are decreasing
# of Fish
Dollars
When we talk about a supply curve we are talking about the profit maximizing decisions of individual firms at prevailing market prices
0
$1.20
300 600
Dollars
MC
$.72
0
$1.20
$1.80
300 600
MR
At a market price of $1.20, MR = MC for any quantity of fish between 300 and 600
At a market price of $1.20, this firm will be willing to supply any quantity of fish between 300 and 600
Now, suppose that the market price is $0.72.
Fish Price Total Revenue Total Cost Profit
0 $0.72 $0 $50 -$50
1 $0.72 $0.72 $50.72 -$50
2 $0.72 $1.44 $51.44 -$50
3 $0.72 $2.16 $52.16 -$50
300 $0.72 $216 $266 -$50
301 $0.72 $216.72 $267.20 -$50.48
302 $0.72 $217.44 $268.40 -$50.96
303 $0.72 $218.16 $269.60 -$51.44
600 $0.72 $432 $626 -$194
601 $0.72 $432.72 $627.80 -$195.08
602 $0.72 $433.44 $629.60 -$196.16
603 $0.72 $434.16 $631.40 -$197.24
# of Fish
Dollars
$50
TC
# of Fish
Dollars
-$50
Again, lets plot revenues, costs, and profits…
0 0
$0
Slope = 1.80
Slope = 1.20
Slope = .72
300 600 300 600
TR
Profit
Profits are maximized (losses are minimized)
Profits are decreasing
Profits are maximized (losses are minimized)
Profits are decreasing
Fish Total Cost Total Revenue Marginal Revenue Marginal Cost
0 $50 $0 $.72 $.72
1 $50.72 $0.72 $.72 $.72
2 $51.44 $1.44 $.72 $.72
3 $52.16 $2.16 $.72 $.72
300 $266 $216 $.72 $.72
301 $267.20 $216.72 $.72 $1.20
302 $268.40 $217.44 $.72 $1.20
303 $269.60 $218.16 $.72 $1.20
600 $626 $432 $.72 $1.20
601 $627.80 $432.72 $.72 $1.80
602 $629.60 $433.44 $.72 $1.80
603 $631.40 $434.16 $.72 $1.80
We could also go at this by looking at costs and benefits at the margin. For a perfectly competitive firm the market price equals marginal revenue.
Dollars
MC
$.72
0
$1.20
$1.80
300 600
MR
Dollars
-$50
0
$0
300 600
Profit
Marginal revenue is equal to marginal cost
Marginal revenue is less than marginal cost
Profits are maximized
Profits are decreasing
Again, lets plot marginal revenues, marginal costs, and profits…
# of Fish
Dollars
When we talk about a supply curve we are talking about the profit maximizing decisions of individual firms at prevailing market prices
0
$1.20
300 600
Dollars
MC
$.72
0
$1.20
$1.80
300 600
MR
At a market price of $.72, MR = MC for any quantity of fish between 0 and 300
At a market price of $.72, this firm will be willing to supply any quantity of fish between 0 and 300
$.72
# of Fish
Dollars
When we talk about a supply curve we are talking about the profit maximizing decisions of individual firms at prevailing market prices
0
$1.20
300 600
Dollars
MC
$.72
0
$1.20
$1.80
300 600
MR
At a market price of $1.80, MR = MC for any quantity of fish between 600 and 760
At a market price of $1.80, this firm will be willing to supply any quantity of fish between 600 and 760
$.72
$1.80
# of Fish
Dollars
What if the prevailing market was $1.35?
0
$1.35
300 600
Dollars
MC
0
$1.35
300 600
MR
At a market price of $1.35, 600 fish are profitable to supply, but the 601st is not!
At a market price of $1.35, this firm will be willing to supply exactly 600 fish.
# of Fish
Dollars
So we can get an individual firm’s supply curve by following marginal costs! Suppose that there are 1000 fishermen in the village – all with the same costs.
0
$1.80
300 600
Individual Supply
$1.20
$.72
# of Fish
Dollars
0
$1.80
300,000 600,000
Market Supply
$1.20
$.72
Market supply adds up the decisions of each individual firm at each prevailing market price
So where do prices come from? We need to know how many fish people are actually willing to buy at any prevailing market price.
# of Fish
Dollars
0
$1.80
500,000 900,000
$1.20
$.72
150,000
A demand curve is just a record of how much the market collectively is willing to buy at any given market price
Price Fish
$2.00 50,000
$1.80 150,000
$1.50 200,000
$1.20 500,000
$1.00 540,000
$.72 600,000
$.50 700,000
# of Fish
Dollars
0
$1.80
300,000 600,000
$1.20
$.72
In equilibrium, total supply should equal total demand. If not, the price will adjust.
Supply
Demand
Price Fish
$2.00 50,000
$1.80 150,000
$1.50 200,000
$1.20 500,000
$1.00 540,000
$.72 600,000
$.50 700,000
At a $1.80 price, fishermen will bring at least 600,000 fish to the market, but only 150,000 will get sold – the price needs to drop
At a $.72 price, fishermen will bring at most 300,000 fish to the market, but 600,000 are demanded– the price needs to rise
500,000
In equilibrium, total supply should equal total demand
The market determines the equilibrium price of $1.20 and 500,000 fish sold by the 1,000 fishermen
Market
Dollars
0
$1.80
300,000 600,000
$1.20
$.72
Demand
Supply
500,000
Dollars
$.72
0
$1.20
$1.80
300 600
Individual
At the prevailing market price of $1.20, each fisherman supplies between 300 and 600 fish
MC
MR
Dollars
$.72
0
$1.20
$1.80
300 600
MC
MR
Fish Total Revenue Total Cost Profit
300 $360 $266 $94
301 $361.20 $267.20 $94
302 $362.40 $268.40 $94
303 $363.60 $269.60 $94
$144
Boat = $50Labor = $16/hrGas = $20/hr
FishHrFish
hr/20.1$
/30
/36$
* Labor Productivity = 30 Fish/Hr
Price= $1.20
- Gas Cost = $0.67
Labor’s Value Added= $0.53
$16/hr = hourly wage
Producer Surplus = $144
- Fixed Cost = $50
Accounting Profit= $94
$94
$1,000*100 = 9.4% Return
A Few Diagnostics…
Is this fisherman earning economic profits?
# of Fish
Dollars
0
$1.80
300,000 600,000
$1.20
$.72
Suppose that the excess returns causes 800 more fishermen (all with identical costs) to enter the market.
Supply
Demand
Price Fish
$2.00 50,000
$1.80 150,000
$1.50 200,000
$1.20 500,000
$1.00 540,000
$.72 600,000
$.50 700,000
540,000 1,080,000 1,368,000
In equilibrium, total supply should equal total demand
The market determines the equilibrium price of $1.00 and 540,000 fish sold by the 1,800 fishermen
Market
Dollars
0
$1.80
300,000 600,000
$1.00
$.72
Demand
Supply
540,000
Dollars
$.72
0
$1.00
$1.80
300 600
Individual
At the prevailing market price of $1.00, each fisherman supplies 300 fish
MC
MR
$1.20
Dollars
$.72
0
$1.00
$1.80
300 600
MC
MR
$84
Boat = $50Labor = $16/hrGas = $20/hr
FishHrFish
hr/72$.
/50
/36$
Fish Price Total Revenue Total Cost Profit
0 $1.00 $0 $50 -$50
1 $1.00 $1.00 $50.72 -$49.72
2 $1.00 $2.00 $51.44 -$49.44
3 $1.00 $3.00 $52.16 -$49.16
300 $1.00 $300 $266 $34
* Labor Productivity = 50 Fish/Hr
Price= $1.00
- Gas Cost = $0.40
Labor’s Value Added= $0.60
$30/hr > hourly wage
Producer Surplus = $84
- Fixed Cost = $50
Accounting Profit= $34
$34
$1,000*100 = 3.4% Return
A Few Diagnostics…
Dollars
MC
$.72
0
$1.20
$1.80
300 600
Let’s see if we can’t generalize this a bit. We want marginal costs to be increasing – this reflects decreasing productivity at the margin
# of Fish
Dollars
FC$50
TC
0 300 600
# of Fish
Dollars
TC
# of Fish
Dollars
-$50
0 0
$0
Slope = P
300 600
$94
300 600
TR
Profit
F*
F*
We are still looking for where marginal revenue equals marginal costs (i.e. the slopes are the same)
Dollars
-$50
0
$0
300 600
Profit
Dollars
MC
0
F*MRP*
F*
We are still looking for where marginal revenue equals marginal costs
# of Fish
Dollars
0
P*
Dollars
MC
0
P* MR=P
F* F*
Supply
For any market price (which equals marginal revenue for a perfectly competitive firm, there is a profit maximizing quantity where MR = MC
That optimizing quantity becomes a point on that firms supply curve
We are still looking for where marginal revenue equals marginal costs
# of Fish
Dollars
0
Individual Supply
P*
# of Fish
Dollars
0
Market Supply
P*
We still aggregate decisions across individual suppliers to get market supply (again, assume 1,000 fishermen)
F 1000*F
SupplySupply
In equilibrium, total supply should equal total demand
The market determines the equilibrium price of $1.44 and 400,000 fish sold by the 1,000 fishermen
Market
Dollars
0
$1.44
Demand
Supply
400,000*
Dollars
0
$1.44
Individual
At the prevailing market price of $1.44, each fisherman supplies 400 fish
MC
MR
400
Dollars
0
$1.44
400
MC
MR
Boat = $50Labor = $16/hrGas = $20/hr
* Labor Productivity = 25 Fish/Hr
Price= $1.44
- Gas Cost = $.80
Labor’s Value Added= $0.64
$16/hr = hourly wage
Producer Surplus = $288
- Fixed Cost = $50
Accounting Profit= $238
$238
$1,000*100 =23.8% Return
We can still perform whatever diagnostics we want…
Is this fisherman earning economic profits?
PS = (1/2)(400)(1.44)=288
$288
For this calculation to work, labor productivity must be 25 fish per hour
# of Fish
Dollars
0
$1.44
Suppose that the excess returns causes 800 more fishermen (all with identical costs) to enter the market.
Supply
Demand
400,000
$1.03
576,000
Dollars
0
$1.44
400320720,000
Dollars
0
$1.03
320
MC
MR
Boat = $50Labor = $16/hrGas = $20/hr
* Labor Productivity = 35 Fish/Hr
Price= $1.03
- Gas Cost = $.57
Labor’s Value Added= $0.46
$16/hr = hourly wage
Producer Surplus = $165
- Fixed Cost = $50
Accounting Profit= $115
$115
$1,000*100 =11.5% Return
We can still perform whatever diagnostics we want…
At 320 fish, your productivity is 35 Fish/hour
PS = (1/2)(320)(1.03)=165
$165
Suppose that we have three fishermen with different productivities. Each bought a boat for $1,000 and have the same costs as before.
30 Fish/hr300 Max/Day
20 Fish/hr200 Max/Day
10 Fish/hr100 Max/Day
Boat = $50Labor = $16/hrGas = $20/hr
$1.20 per fish
$1.80 per fish
$3.60 per fish
Each of the above fishermen will provide fish to the marketplace as long as the market price is equal to or greater to their marginal cost
Dollars
0
$3.60
$1.80
$1.20
Fish
300 500 600
For a market price that is at least $1.20, but below $1.80, only fisherman #1 sells fish. He can supply up to 300
For a market price that is at least $1.80, but below $3.60, fisherman #1 sells 300 fish and fisherman #2 sells up to 200 fish.
For a market price that is at least $3.60, fisherman #1 sells 300 fish, fisherman #2 sells 200 fish and fisherman #3 sells 100 fish
All a supply curve really does is order production from lowest cost to highest cost
Dollars
0
$3.60
$1.80
$1.20
Fish
300 500 600
Adding a demand curve will give us the equilibrium price and identify the fisherman who participate in the market as well as the fisherman’s economic profits
Demand
Supply
$3.00
Boat = $50Labor = $16/hrGas = $20/hr Producer Surplus = $540
- Fixed Cost = $50
Accounting Profit= $490
$490
$1,000*100 = 49% Return
Fisherman #1
PS= $540- Fixed Cost = $50
Accounting Profit= $190
$190
$1,000*100 = 19% Return
Fisherman #2
Producer Surplus = $240
PS= $240
PSQS Quantity Supplied
“Is a function of”
Market Price (+)
A Supply Function represents the rational decisions made by a profit maximizing firm(s).
Quantity
Price
S
Lower marginal costs are in this portion – they will make the largest profits
High marginal costs are in this portion – they will make the lowest profits (if they are sold)
As you move up the supply curve, the rise in price encourages increased production of existing producers (intensive margin) as well as the entry of new producers (extensive margin)
Everything we talked about on the supply side is mirrored on the demand side. Just at producers are maximizing profits, consumers maximize their welfare.
Welfare
0 Q
Dollars
MU
0
F*MC P*
F*Q
Welfare = Total Utility – Total Cost
Most consumers experience diminishing marginal utility – each successive item consumed is worth less in terms of satisfaction
By the same token, a demand curve naturally ranks potential consumers from highest valuation to lowest valuation. Suppose that we have three potential consumers.
Would pay up to $2/fish. Can consume 100 fish per week.
Would pay up to $1/fish. Can consume 50 fish per week.
Would pay up to $.50/fish. Can consume 20 fish per week.
What would this demand curve look like?
Dollars
0
$2
$.50Fish
100 150 170
$1
If fish cost more than $2, nobody buys them!
If fish cost between $2 and $1, only Captain buys them!
If fish cost between $.50 and $1, Captain AND Andrew Zimmern buy them!
If fish cost more less than $.50 , EVERYBODY buys them!
Price Quantity Demanded
Above $2 0
$2 0 – 100
Between $2 and $1 100
$1 100 - 150
Between $1 and $.50 150
$.50 Between 150 and 170
Between $.50 and $0 170
Dollars
0
$2
$.50Fish
100 150 170
$1
For any market price, we know how many fish are sold and how much each consumer benefits from the market (consumer surplus)
$1.50
At a market price of $1.50
Captain buys 100 fish for $1.50 apiece. He saves $.50 per fish for a total of $50 in savings (surplus)
Neither the baby of Andrew Zimmern are willing to buy fish for $1.50.
CS = $50
Dollars
0
$2
$.50Fish
100 150 170
$1
For any market price, we know how many fish are sold and how much each consumer benefits from the market (consumer surplus)
$.75
At a market price of $.75
Captain buys 100 fish for $.75 apiece. He saves $1.25 per fish for a total of $125 in savings (surplus)
Andrew Zimmern buys 50 fish for $.75. He saves $.25 per fish for a total of $12.50 in surplus
The baby still is unwilling to buy fish!CS = $125
CS = $12.50
Quantity
Price
PDQD Quantity Demanded
“Is a function of”
Market Price (-)
A Demand Function represents the rational decisions made by a representative consumer(s)
D
high marginal valuations are located here
low marginal valuations are located here
As you move down the demand curve, the lower price encourages increased consumption by existing customers (intensive margin) as well as attracting new consumers (extensive margin)
Key Point: Demand curves represent marginal utility (what we are willing to pay for one additional item). Consumer surplus measures total value.
Quantity
Price
DQuantity
Price
D
Water Diamonds
P*
P*
Example: The Diamond/Water Paradox
Market Equilibrium: There exists a price where supply equals demand – the market will find this price automatically.
Quantity
Price
D
S
P*
Q*
At a price above the equilibrium price, supply is greater than demand. A surplus drives the price down
At a price below the equilibrium price, demand is greater than supply. A shortage drives the price up
Efficiency vs. Equity
An allocation of resources that maximum total welfare
An allocation of resources provides a “fair” distribution of welfare
Under certain circumstances, the market process guarantees this
Can we trust markets to produce a desirable outcome?
Recall an earlier discussion about allocations of resources.
Let’s suppose that we are talking about the market for bananas.
Quantity
Price
D
S
$5
1,000
$8
$2
There was a pound of bananas sold that cost $3 to supply and was valued by someone at $7. This transaction created $4 of wealth - $2 went to a seller (producer surplus) and $2 went to a buyer (consumer surplus)
There was a pound of bananas sold that cost $2 to supply and was valued by someone at $8. This transaction created $6 of wealth - $3 went to a seller (producer surplus) and $3 went to a buyer (consumer surplus)
$3
$7
Would this transaction be wealth creating? NO!
$12
$0
Competitive markets provide efficient outcomes in that every wealth creating transaction was undertaken. In other words, consumer surplus and producer surplus are maximized.
Quantity
Price
D
S
$5
1,000
$0
$12
Consumer Surplus = (1/2)*($12- $5)*1,000
$3,500
Producer Surplus = (1/2)*($5- $0)*1,000
$2,500
Note that $6,000 of wealth was created by this market!
Firm Historical Emissions (Tons/yr)
Marginal Abatement Cost ($/Ton)
Apache 50 12
BP 50 18
Chevron 50 24
Devon 50 30
Exxon 50 36
First Texas 50 42
Gulf 50 48
Hess 50 54
Industry Total 400
Example: Suppose we have the following petroleum firms. Further suppose that there is pressure from the public to reduce pollution levels.
How would you go about reducing emissions by 50%
Apache
BP
Chevron
Devon
Exxon
First
Gulf
Hess
$ Per Unit Pollution Reduction
Quantity of Emissions Reduction
$12
$18
$24
$30
$36
$42
$48
$54
The cheapest way to reduce pollution by 50% would be to require the cheapest 4 firms to reduce their emissions completely and let the other four firms continue as in the past
Problems: • Unfair• Requires information on
abatement costs
Firm Historical Emissions (Tons/yr)
Marginal Abatement Cost ($/Ton)
Tons of emission to be reduced
Total abatement cost
Apache 50 12 25 300
BP 50 18 25 450
Chevron 50 24 25 600
Devon 50 30 25 750
Exxon 50 36 25 900
First Texas 50 42 25 1,050
Gulf 50 48 25 1,200
Hess 50 54 25 1,350
Industry Total 400 200 6,600
We could follow an “across the board” emission reduction program (note: pollution taxes would have the same basic effect)
Example: Cap and Trade as a solution to pollution reduction.Firm Historical
Emissions (Tons/yr)
Marginal Abatement Cost ($/Ton)
Apache 50 12
BP 50 18
Chevron 50 24
Devon 50 30
Exxon 50 36
First Texas 50 42
Gulf 50 48
Hess 50 54
Industry Total 400
Could BP profit from selling a pollution permit to Gulf? What should the selling price be?
Let markets work for you!!!
Apache
BP
Chevron
Devon
Exxon
First
Gulf
Hess
$ Per Unit Pollution Reduction
Quantity of Emissions Reduction
Hess
Gulf
First
Exxon
Devon
Chevron
BP
ApacheD
S
The Market for pollution permits
$12
$18
$24
$30
$36
$42
$48
$54
Equ
ilibr
ium
pric
e ra
nge
$33
Firm Historical Emissions (Tons/yr)
Marginal Abatement Cost ($/Ton)
Initial Permit Holdings
Permits Sold
Permits Bought
Final Permit Holdings
Required Emission Reduction
Emission Abatement Cost
Apache 50 12 25 25 0 0 50 $600
BP 50 18 25 25 0 0 50 $900
Chevron 50 24 25 25 0 0 50 $1200
Devon 50 30 25 25 0 0 50 $1500
Exxon 50 36 25 0 25 50 0 $0
First Texas
50 42 25 0 25 50 0 $0
Gulf 50 48 25 0 25 50 0 $0
Hess 50 54 25 0 25 50 0 $0
Industry Total
400 200 100 100 400 200 $4,200
The cap and trade program lowered the cost of pollution reduction by $2,400 (from $6,600 to $4,200).
Firm Initial Pollution Reduction
Final Pollution Requirement
Marginal Abatement Cost ($/Ton)
Abatement Cost Additions/Savings
Permits Bought
Permits Sold
Permit Cost/Permit Revenue
Net Gain
Apache 25 50 (+25) 12 $300 0 25 -$825 -$525
BP 25 50 (+25) 18 $450 0 25 -$825 -$375
Chevron 25 50 (+25) 24 $600 0 25 -$825 -$225
Devon 25 50 (+25) 30 $750 0 25 -$825 -$75
Exxon 25 0 (-25) 36 -$900 25 0 $825 -$75
First Texas 25 0 (-25) 42 -$1050 25 0 $825 -$225
Gulf 25 0 (-25) 48 -$1200 25 0 $825 -$375
Hess 25 0 (-25) 54 -$1350 25 0 $825 -$525
Industry Total
200 200 -$2,400 200 200 $0 -$2,400
Note that cost of purchasing permits equals revenues from selling permits and so add no additional costs. Lets set the equilibrium permit price at $33.
Apache
BP
Chevron
Devon
Exxon
First
Gulf
Hess
$ Per Unit Pollution Reduction
Quantity of Emissions Reduction
Hess
Gulf
First
Exxon
Devon
Chevron
BP
ApacheD
S
The consumer/producer surplus represents the gains by all firms
$12
$18
$24
$30
$36
$42
$48
$54
$33
$525
$375$225
$75
$225
$375
$525
$75
We could do this numerically as well…
PQD 2100
Every $1 increase in price lowers demand by 2 units
PQS 3
Every $1 increase in price raises supply by 3 units
In Equilibrium SD QQ PP 32100 P510020$P 60202100 DQ
60203 SQ
Price
Quantity
S
D
$20
60
PQD 2100 PQS 3
Consumer and producer surplus give us a numerical value of a marketplace…
Price
Quantity
S
D
$20
60
$50
$0
Note: a $50 price will set quantity demanded equal to zero.
Consumer Surplus
900$20$50$602
1
CS
Producer Surplus
600$0$20$602
1
PS
$900
$600
Demand is not simply a function of price, but is, instead, a function of many variables
• Income• Prices of other goods
(Substitutes vs. Compliments)
• Tastes • Future Expectations• Number of Buyers
,...PDQD
“Is a function of”
Price Demand Shifters
Quantity
Price
$10
100
D(…)
Holding all the demand shifters constant at some level, quantity demanded at a price of $10 is 100
120
At the initial price of $10, but with a new value for one of the demand shifters, quantity demanded has risen to 120 (An increase in demand)
D(.’.)
Example: Increase in Demand
# of Rooms
Rate per night
000,50$ID
Example: How would the loss in income during the last recession impact the hotel industry?
...S
$150
50,000
000,75$ID
40,000
At the current $150 market price, supply is still 50,000, but with a lower level of income, demand has fallen to 40,000
At the new income level of $50,000, $150 can no longer be the equilibrium price
The decrease in income (which causes a decrease in demand) causes a drop in sales and a drop in market price
# of Rooms
Rate per night
000,50$ID
Example: How would the loss in income during the last recession impact the hotel industry?
...S
$150
50,000
000,75$ID
45,000
$125
IPQD 7280 PQS 4
With I = $10
PP 4107280 P6150
80
25$
Q
P
Price
Quantity
S
D
$25
80
Every $1 increase in income increases demand by 7 units
Price
Quantity
S
D
$25
80
With I = $20
PP 4207280 P6220
147
67.36$
Q
P
The $10 increase in income raises demand by 70
147
$36.67
Supply is not simply a function of price, but is, instead, a function of many variables
• Technology• Input prices• Number of sellers
,...PDQS
“Is a function of”
Price Supply Shifters
Quantity
Price
$10
100
S(…)
Holding all the supply shifters constant at some level, quantity supplied at a price of $10 is 100
80
At the initial price of $10, but with a new value for one of the supply shifters, quantity demanded has fallen to 80
S(.’.)
Marginal costs
Example: Decrease in Supply
Pounds
Price per pound
...D
Example: How would a drop in the wage rate in Columbia influence the price of coffee?
8$wS
$5
10,000 18,000
At the current $5 market price, supply has risen to 18,000, but demand is still at 10,000
At the wage level of $6, $5 can no longer be the equilibrium price
6$wS
Pounds
Price per pound
...D
Example: How would a drop in the wage rate in Columbia influence the price of coffee?
8$wS
$5
10,000 16,000
The lower wage (which causes an increase in supply) , results in a lower price and higher sales
6$wS
$4
PQD 280 wPQS 5.4
With w = $10
105.4280 PP
P685
52
16.14$
Q
P
Price
Quantity
S
D
$14.16
52
Price
Quantity
S
D
$15
52
With w = $20
205.4280 PP
P690
50
15$
Q
P
The $10 increase in wages lowers supply by 5
Every $1 increase in wages decreases supply by .5 units
50
$14.16
Demand curves slope downwards – this reflects the negative relationship between price and quantity. Elasticity of Demand measures this effect quantitatively
Quantity
Price
$2.50
5
000,50$ID
$2.75
4
%20100*5
54
%10100*50.2
50.275.2
210
20
%
%
P
QDD
Note that elasticities vary along a linear demand curve
Quantity
Price
$35
30
D
3.2D
60 80
$20
61.DPQ 2100
P Q % Change in Q
% Change in P
Elasticity
$35 30
$34 32 6.7 -2.9 -2.3
$20 60
$19 62 3.3 -5 -.61
$10 80
$9 82 2.5 -10 -.255
12 18 24 30 36 42 48 54 60 66 72 78 84 90 96
-10
-9
-8
-7
-6
-5
-4
-3
-2
-1
0
D
DDD Q
P
P
Q
P
Q
%
%
Slope
Supply curves slope upwards – this reflects the positive relationship between price and quantity. Elasticity of Supply measures this effect quantitatively
%25100*200
200250
%50100*00.2
00.200.3
5.50
25
%
%
P
QSs
Quantity
Price
$2.00
200
S
$3.00
250
Yom Kippur war oil embargo
Iranian Revolution/ Iran Iraq War Gulf War
OPEC Cuts
911
PDVSA StrikeIraq WarAsian Expansion
Example: What effect would a shutdown of oil production in Iran have on oil prices?
Price in 2010 = $67
Iran produces around 4M Barrels per day. This represents around 4% of the total world supply.
P
QDD
%
%We also know that the elasticity of demand for oil is around -.05
D
DQP
%
%
With a little rearranging…
8005.
4%
P
$67(1.80) = $120
It would be foolish to consider the entire oil market as perfectly competitive, but perhaps considering the non-OPEC market as perfectly competitive market is not entirely crazy
Country Joined OPEC
Production (Bar/D)
Algeria 1969 2,180,000
Angola 2007 2,015,000
Ecuador 2007 486,100
Iran 1960 3,707,000
Iraq 1960 2,420,000
Kuwait 1960 2,274,000
Libya 1962 1,875,000
Nigeria 1971 2,169,000
Qatar 1961 797,000
Saudi Arabia 1960 10,870,000
United Arab Emirates
1967 3,046,000
Venezuela 1960 2,643,000
There are around 100 Non-OPEC countries producing collectively 55 Million Bar/D.
Country Production (BBD)
Russia 9,810,000
United States 8,514,000
China 3,795,000
India 3,720,000
Canada 3,350,000
Suppose that we consider the following supply demand model:
bPaQd
Parameters to be estimated
dPcQs
Parameters to be estimated
To estimate four parameters, we need four pieces of information
Variable 2010 Value
Market Price $67
Market Quantity (Bar/D) 90M
OPEC Supply 35M
Non-OPEC Supply (Bar/D) 55M
Elasticity of Supply (Bar/D) .10
Elasticity of Demand -.05
Competitive SupplyDemand OPEC Supply
35sQ
bPaQd
Let’s start with the demand side first. We can relate the equilibrium elasticity to the parameter ‘b’
d
ddd Q
P
P
Q
P
Q
%
%
The parameter ‘b’ represents the change in quantity demanded per dollar change in price
dd Q
Pb
A little rearranging…
P
Qb d
d
067.67
9005.
b
Variable 2010 Value
Market Price $67
Market Quantity (Bar/D) 90M
OPEC Supply 35M
Non-OPEC Supply (Bar/D) 55M
Elasticity of Supply (Bar/D) .10
Elasticity of Demand -.05
PaQd 067.
Now that we know ‘b’, we can find ‘a’
Again, a little rearranging…
PQa d 067.
5.9467067.90 a
PQd 067.5.94
We are halfway home!
Variable 2010 Value
Market Price $67
Market Quantity (Bar/D) 90M
OPEC Supply 35M
Non-OPEC Supply (Bar/D) 55M
Elasticity of Supply (Bar/D) .10
Elasticity of Demand -.05
dPcQs
Repeat the process with the supply side. We can relate the equilibrium elasticity to the parameter ‘d’
s
sss Q
P
P
Q
P
Q
%
%
The parameter ‘c’ represents the change in quantity supplied per dollar change in price
ss Q
Pd
A little rearranging…
P
Qd s
s
082.67
5510.
d
We’re estimating the non-OPEC supply, so be sure to use only the non-OPEC quantity!
Variable 2010 Value
Market Price $67
Market Quantity (Bar/D) 90M
OPEC Supply 35M
Non-OPEC Supply (Bar/D) 55M
Elasticity of Supply (Bar/D) .10
Elasticity of Demand -.05
PcQs 082.
Now that we know ‘d’, we can find ‘c’
Again, a little rearranging…
PQc s 082.
5.4967082.55 c
PQs 082.5.49
That’s it!
Variable 2010 Value
Market Price $67
Market Quantity (Bar/D) 90M
OPEC Supply 35M
Non-OPEC Supply (Bar/D) 55M
Elasticity of Supply (Bar/D) .10
Elasticity of Demand -.05
Suppose that we consider the following supply demand model:
PQd 067.5.94 PQs 082.5.49
Let’s double check our results
Variable 2010 Value
Market Price $67
Market Quantity (MBar/D)
90
Competitive SupplyDemand OPEC Supply
35sQ
67$
149.10
082.5.4935067.5.94
P
P
PP
QQ sd
9067067.5.94 dQ
Now, back to the original question. Suppose that Iran’s oil supply is shut down. OPEC supply drops by 4 BBD
PQd 067.5.94 PQs 082.5.49
Now factor that into the Supply/Demand Model
Variable
Market Price $94
Market Quantity (Bar/D)
88
Competitive SupplyDemand OPEC Supply
31sQ
94$
149.14
082.5.4931067.5.94
P
P
PP
QQ sd
8894067.5.94 dQ
Quantity
Price S
D
67$*P
90
'D
86 88
94$'P
Now, back to the original question. Suppose that Iran’s oil supply is shut down. OPEC supply drops by 4 BBD
Variable
Market Price $94
Market Quantity (BBD)
88
OPEC Quantity 31
Non-OPEC Quantity 57
The drop in OPEC supply pushes price up which gives non-OPEC countries the incentive to increase supply
120$'P
Partial Equilibrium vs. General Equilibrium
Quantity
Price S
D
*P
*Q
'D
Suppose that effective advertising increased the demand for lemonade. What would happen.
A rise in demand should increase sales and increase the price right? Is that all?
Partial equilibrium deals with a disturbance in one market. General Equilibrium recognizes that markets interact with one another and looks at the interrelations between markets
Quantity
Price S
D
*P
*Q
'D
A rise in demand for lemonade should increase sales and increase the price.
Price
Quantity
D
S Price
Quantity
D
S
Sugar Lemons
The rise in lemonade sales should raise demand for lemons and sugar which increases their prices
This increase in marginal costs should lower supply, right!
Where would you rather live? South Bend or Chicago?
Why?
What’s better in Chicago?
Pretty much everything is better in Chicago!
What’s better in South Bend?
It’s cheaper in South Bend!
The indifference principle states that once everything is accounted for, every city must be equally desirable. Otherwise, who would choose to live in an inferior city.
Houses
S
D
000,86$
Houses
Median Home Price S
D
000,238$
South Bend Housing marketChicago Housing Market
Lets say that the key advantage to South Bend is its low housing costs. If Chicago was still preferred, South Bend residents would start moving to Chicago – this will magnify the benefits of South Bend (cheaper housing)
Median Home Price
The difference between housing costs should just offset any advantages Chicago has!
Renting vs. Buying a House….what’s the better move?
Houses
S
D
000,120$
Rentals
Median Rent
S
D
600$
South Bend Housing marketSouth Bend Rental MarketMedian
Home Price
Suppose that the median rental rate is $600 per month ($7200 per year) and the current mortgage rate is 6%
000,120$06.
7200$P
Can you spot the housing bubble?
Houses
2003S
2003D
000,185$
US Housing marketMedian Home Price
2007D
000,262$
Easy financing, low interest rates, and expectations of housing price increases created an artificial spike in housing demand…
000,210$
2010D
Expectations of future price increases drives housing demand up…
Expectations of price decreases drives demand back down
….but that demand spike didn’t last.
Housing prices appreciation (2003-2007): 9%/yr
Housing price appreciation (2003-2010): 2%/yr
Question: Are we in an ‘Education Bubble”?
Can we really justify the rapidly rising costs of college tuition or are students getting in over their heads taking out loans that they will never be able to afford?
Employees
Salary
S
D
000,26$
Employees
Salary S
D
000,38$
Enrollment
Tuition
D
S
$15,000
High School Labor Force College Educated Labor Force
Universities
Can these markets be in equilibrium?
Consider the earnings across different ages and different education levels.
Age Group
Attainment 25-29 30-34 35-39 40-44 45-49 50-54 55-59
College $43,121 $55,440 $62,244 $65,973 $66,280 $64,254 $65,240
High School $28,097 $31,366 $33,443 $35,283 $36,316 $35,270 $37,573
Differential $15,024 $24,074 $28,801 $30,690 $29,964 $28,984 $27,667
x 5 = $75,120
x 5 = $144,005
x 5 = $153,450
x 5 = $149,820
x 5 = $144,920
x 5 = $138,335
x 5 = $120,370 =$926,020
This isn’t really right because you don’t get all this money up front
386,350$
05.1
667,27$...
05.1
024,15$
05.1
024,15$3954 PV
You receive the first payment 4 years from now
Lets assume that you could earn 5% elsewhere
What are the costs of going to college?
Cost Annual Expense
Tuition $15,000
Lost Wages $26,000
Books, Fees, etc $1,000
Room & Board $5,000
This is not a relevant cost…you would have paid this anyways!!!
$36,000 x 4 = $164,000Note: we really should discount these costs as well!
386,350$
05.1
667,27$...
05.1
024,15$
05.1
024,15$3954 PV
So, a college education costs $164,000 and yields $350,386 in (discounted) lifetime benefits! Seems worth it!
Alternatively, we can think about the annual salary differential for a college graduate like the annual payout on a bond. The annual return to a college education would be like calculating the return necessary so that the PV of the wage differential equals the cost
Cost Annual Expense
Tuition $15,000
Lost Wages $20,000
Books, Fees, etc $1,000$36,000 x 4 = $164,000
Note: we really should discount these costs as well!
4 5 39
$15,024 $15,024 $27,667... $164,000
1 1 1PV
i i i
Annual return %11i
Thought of as an investment, a college education pays 11% per year!!
Employees
Salary
S
D
000,26$
Employees
Salary S
D
000,38$
Enrollment
Tuition
D
S
$15,000
High School Labor Force College Education Labor Force
Universities
If the costs of college were truly less than the benefits, we would see more people go to school
Wage differentials would fall and college tuitions would increase
Employees
Salary
S
D
000,26$
Employees
Salary S
D
000,38$
Enrollment
Tuition
D
S
$15,000
High School Labor Force College Education Labor Force
Universities
What we are seeing is a steady increase in demand for skilled labor as demand for unskilled labor falls
Wage differentials continue to increase as college tuitions increase
In the years following a divorce, statistics show that the woman’s living standard falls 27% while the man’s living standard rises by 10%
Feminists such as Patricia Ireland (NOW) would argue that this proves divorce is unfair to women
Couldn’t you just as easily argue that marriage is unfair to men?
On December 22, 2001, Richard Reid was arrested trying to blow up an American Airlines flight from Paris to Miami with a bomb hidden in his shoes.
Many human rights groups have fought heavily against the practice of racial profiling by airline security
Isn’t there a better way to secure the safety of our airplanes? (Hint: could we create a marketplace?)
Paul “Freck” Morgan started a website in 2001 offering a $20 Pay Per View event…..to watch him cut off his feet with a homemade guillotine.
Note: The site turned out to be a hoax…Paul never actually went through with it!
How should we feel about this entrepreneurial effort? (i.e. could we/should we repress this market?)