The Power of Prices

Microeconomics
Prof. Rushen Chahal

2/12/2012

Prof. Rushen Chahal

Today
Marginal benefit and consumer surplus Marginal cost and producer surplus The efficiency of the marketplace Deadweight loss and market failure The efficiency of imports and exports

2/12/2012

Prof. Rushen Chahal

So Far This Semester

We ve began looking at some concepts central to microeconomics, especially supply and demand We understand that supply is upwards sloping and demand is downwards sloping We saw that market equilibrium occurs where supply and demand intersect

2/12/2012

Prof. Rushen Chahal

So Far This Semester

We see that at equilibrium, the price charged is equilibrium price, and the quantity bought/sold is equilibrium quantity We have seen that a shift in demand or supply will then lead to a new equilibrium price and quantity

2/12/2012

Prof. Rushen Chahal

Price Signals
Price signals help consumers decide how much to buy and help producers decide how much to sell. In other words:
Buyers buy. Sellers sell. Prices tell them how much to buy or sell.

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Prof. Rushen Chahal

Prices:
When prices rise, consumers will buy less and suppliers will sell more When prices fall, consumers will buy more and suppliers will sell less

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Prof. Rushen Chahal

Marginal Benefit
I like dumplings Every time I eat a dumpling, I get a certain amount of value out of it We can call the value that I get from consuming one additional dumpling (ONE UNIT!!!) my marginal benefit Marginal benefit the incremental value of an additional unit of a good.

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Prof. Rushen Chahal

Marginal Benefit
However, the value of eating each dumpling is not the same The first dumpling I eat gives me the most value
I m eating it on an empty stomach The taste is new and refreshing to me

The second dumpling gives me a little less value

It still tastes good, and I m still hungry, but it s not as good as the first dumpling

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Prof. Rushen Chahal

Marginal Benefit
The 3rd dumpling t gives me less value than the fourth dumpling The 4th dumpling gives me less value than the third dumpling The 5th dumpling gives me almost no value
I m getting more full, I m getting sick of dumplings

The 6th dumpling has no value to me at all

If I eat a 6th dumpling I will not benefit

If I eat a 7th dumpling I will vomit. So a 7th dumpling has negative value to me. I am better off if I don t eat it.

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Prof. Rushen Chahal

Marginal Benefit
So we see that as I consume more and more of a product (like dumplings) the value of each additional dumpling, or marginal benefit I get from each additional unit decreases Marginal benefit decreases for a certain period of time.
I will get zero benefit from dumplings once I am full. But after a few hours I will be hungry again and want more dumplings.

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Prof. Rushen Chahal

Marginal Benefit
We can think of the demand curve as a representation of my marginal benefit The first dumpling I consume gives me the most value, so I d be willing to pay the most for that first dumpling The second dumpling gives me less value, so I wouldn t be willing to pay as much for it as the first And so on . . .

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Prof. Rushen Chahal

2.5 3

Price

The first dumpling gives me the most satisfaction, so I m willing to pay more for it The second dumpling gives me less satisfaction than the first, so I m willing to pay less The 6th dumpling gives me no satisfaction, so I wouldn t be willing to pay anything for it Demand = Marginal Benefit

0 1
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0.5 1 1.5 2

Quantity

Prof. Rushen Chahal

Marginal Benefit
So marginal benefit is the additional value that consumers get from buying one more unit of the product The demand curve is going to represent marginal benefit As quantity increases, price decreases, just as increased consumption of a product leads to decreasing marginal benefit Let s look at another example

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Prof. Rushen Chahal

Marginal Benefit
Dwights demand for blue jeans. Price Quantity Dwights benefits from buying blue jeans. Quantity Marginal Benefit $20 Total Benefit $20

$20

$15

$15

$35

$10

$10

$45

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Prof. Rushen Chahal

Consumer Surplus
Consumer surplus - consumers total benefit minus cost; graphically, demand minus market price.

Consumer Surplus = Demand - Market Price

2/12/2012

Prof. Rushen Chahal

Consumer Surplus
Dwights demand for blue jeans. Price Quantity Dwights benefits from buying blue jeans. Total Benefit $20 Consumer Total Paid Surplus $20 $0

$20

$15

$35

$30

$5

$10

$45

$30

$15

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Prof. Rushen Chahal

Consumer Surplus
$ Consumer surplus in general.

Price =$10

Demand

1
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Quantity

The consumer surplus is the area under the demand curve and above the market price. It is what consumers gain from their purchases after deducting the cost.

Prof. Rushen Chahal

Consumer Surplus
$ $10 $5 $0 Price =$10

Demand

1
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Quantity

At a price of $10 per pair of jeans, Dwight buys three pair, and receives $15 worth of consumer surplus. His consumer surplus equals the sum of the consumer surplus from the 1st, 2nd, and 3rd pair of jeans. $10 +$5 + $0 =$15.

Prof. Rushen Chahal

Consumer Surplus
We can talk about individual consumer surplus, as with Dwight and blue jeans We can also talk about consumer surplus for an entire market Consider the demand curve for SHE tickets in Beijing

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Prof. Rushen Chahal

Consumer Surplus
Price Per 85 Ticket 80
75 70 65 60 55 50 45 40 35 30 25
1
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If the price were $80, there would be 1000 fans who would still buy tickets If the price were $60, there would be 5,500 fans who would still buy tickets But regardless of what different fans would be willing to pay, they all will pay the market price of $45
Market Price

6 7

8 9

10 11 12 13 Tickets sold (thousands)

Prof. Rushen Chahal

Consumer Surplus
Price Per 85 Ticket 80
75 70 65 60 55 50 45 40 35 30 25
1
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Consumer surplus is then, the area above the market price line and below demand In this example, CS = X ($85 $45) X 9000 = $180,000
Market Price

Consumer Surplus

6 7

8 9

10 11 12 13 Tickets sold (thousands)

Prof. Rushen Chahal

Consumer Surplus
Consumer surplus measures the aggregate benefit that consumers obtain from buying goods in a market Consumer Surplus varies inversely with price:
The lower the price, the higher the consumer surplus The higher the price, the lower the consumer surplus

2/12/2012

Prof. Rushen Chahal

Marginal Cost and Supply

We saw that we can look at demand in two different ways:
1. The different quantities of a product that people are willing to buy at different prices 2. The maximum price the consumer would pay for each quantity that might be purchased (marginal benefit)

2/12/2012

Prof. Rushen Chahal

Marginal Cost and Supply

We can also then, look at supply in two different ways:
1. The different quantities of a product that producers will be willing to make and sell at different prices 2. The minimum price that producers would be willing to accept for each quantity offered

2/12/2012

Prof. Rushen Chahal

Marginal cost and Supply

This minimum price that producers would be willing to accept for each quantity sold is going to be their marginal cost This represents the additional cost of producing each additional unit We see according to the supply curve that marginal cost is increasing

2/12/2012

Prof. Rushen Chahal

Marginal Cost
$ Supply = Marginal Cost

Marginal cost increases as quantity produced rises.

1 2 3 Quantity

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Prof. Rushen Chahal

Marginal Cost
What causes marginal cost to increase? Why is it going to be more expensive to produce the 500th unit of a product than the 100th unit? This has to do with the law of diminishing returns For now, just accept the fact that producing the first unit is cheaper than the second, producing the second is cheaper than the third, and so on

2/12/2012

Prof. Rushen Chahal

Marginal Cost
Because the cost of producing each successive unit becomes more expensive, the minimum price suppliers will accept for a unit increases as production increases The more of a good that must be produced, the more expensive each unit is to make, thus the higher the price that must be charged
2/12/2012 Prof. Rushen Chahal

Marginal Cost
Buddys supply of blue jeans. Price Quantity Buddys cost of producing blue jeans. Quantity Marginal Cost $5 Total Cost

$5

$5

$7.50

$7.50

$12.50

$10

$10

$22.50

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Prof. Rushen Chahal

Producer Surplus
The Producer Surplus producers revenue minus production cost; graphically, market price minus supply.

Producer Surplus = Market Price - Supply

2/12/2012

Prof. Rushen Chahal

Producer Surplus
Buddys supply of blue jeans. Price Quantity Sold 1 Buddys cost of producing blue jeans. Total Cost Total Revenue $5 Producer Surplus $0

$5

$5

$7.50

$12.50

$15

$2.50

$10

$22.50

$30

$7.50

2/12/2012

Prof. Rushen Chahal

Producer Surplus
$ Price $10 Producer Surplus Supply

Quantity

The producer surplus is the area above the supply curve and under the market price. It is what the producers gain from their sale after deducting their cost.

2/12/2012

Prof. Rushen Chahal

Producer Surplus
$ $5 Price $10 $2.50 Supply $0 At a price of $10 per pair of jeans, Buddy sells 3 pair and receives $7.50 worth of producer surplus. His producer surplus equals the sum of his producer surplus from the 1st, 2nd and 3rd pairs, which is $5 + $2.50 +$0 equals $7.50

Quantity

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Prof. Rushen Chahal

Marginal Benefit and Marginal Cost

 Marginal Benefit (to consumers): The value of each additional unit of the good.  Marginal Cost (to producers): The cost of resources used to produce each additional unit.  The efficient output occurs when society s marginal benefit equals marginal cost.

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Prof. Rushen Chahal

Market Efficiency
$ Social Surplus = consumer surplus + producer surplus Supply = Marginal Cost

Consumer Equilibrium Surplus Price Producer Surplus Demand = Marginal Benefit

Efficient Quantity
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Quantity

Market Efficiency
The market equilibrium price
leads to the efficient quantity. No other quantity would generate a larger total of consumer and producer surplus.

2/12/2012

Prof. Rushen Chahal

Deadweight Loss
If the price is less than the equilibrium price, quantity supplied will be less than the equilibrium quantity. If the price is greater than the equilibrium price, quantity demanded will be less than the equilibrium quantity.

2/12/2012

Prof. Rushen Chahal

Deadweight Loss
Deadweight Loss reduction in social surplus caused by inefficient price (any price that is NOT the equilibrium price); shown graphically as a triangular area.

2/12/2012

Prof. Rushen Chahal

Deadweight Loss
Consumer surplus = demand - price $
High Price

Deadweight Loss

Supply = Marginal Cost

Producer surplus = price supply Efficient Quantity

Prof. Rushen Chahal

Demand = Marginal Benefit

Quantity

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Inefficient Quantity

Deadweight Loss
Consumer surplus = demand - price $ Deadweight Loss Supply = Marginal Cost

Low Price

Demand = Marginal Benefit Producer surplus = price supply

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Inefficient Quantity

Efficient Quantity
Prof. Rushen Chahal

Quantity

Deadweight Loss
It seems in general that if we leave the market to itself, prices will adjust to equilibrium price (as we saw last week) and social surplus will be maximized The argument would be that we should always leave the free market alone, and in this way we can avoid any deadweight loss But this may not always be the case

2/12/2012

Prof. Rushen Chahal

Market Failure
Market failure instances in which the market outcome fails to achieve efficiency. In other words:
The market does not maximize social surplus.

Market failure happens ONLY if the market is not able to get to equilibrium
Causes include public goods, common property resources, externalities, monopoly.

Market failure will cause a deadweight loss.

2/12/2012 Prof. Rushen Chahal

Imports and Exports

Let s bring trade into the picture Does trade serve to increase or decrease social surplus? If you had to guess, what would you guess? Is trade good or bad for social surplus? Yes, (and we re starting to see a trend here) in economics, trade is generally considered to be good

2/12/2012

Prof. Rushen Chahal

Imports and Exports

If a country doesn t engage in international trade, prices within the country reflect the domestic demand and supply for goods These are what we would call domestic prices If we open our economy to international trade, however, we now are subjecting ourselves to international producers and consumers Prices are going to tend towards world prices These prices are determined by the supply and demand from all countries
2/12/2012 Prof. Rushen Chahal

Imports and Exports

Countries that trade can import goods, export goods, or do both Whether a country imports or exports a good is going to depend upon whether the domestic price is above or below the world price

2/12/2012

Prof. Rushen Chahal

Imports and Exports

Regardless of if it is above or below the world price, international trade means the domestic price will come to be equal to the world price If the domestic price is below the world price, the country will export the good If the domestic price is above the world price, the country will import the good

2/12/2012

Prof. Rushen Chahal

Imports and Exports

Let s take a look at an example where the domestic price is above the world price In this case we would expect the country to import the good Domestic consumers are unwilling to purchase the good for higher than the world price Producers will also not sell for less than the world price

2/12/2012

Prof. Rushen Chahal

Imports and Exports

Because the price is now below the domestic market price, we would normally experience a shortage But the difference between quantity demanded and quantity supplied is made up for by imports This will actually increase social surplus to more than it would have been had there been no trade!!

2/12/2012

Prof. Rushen Chahal

Efficiency Of Imports
$
Added Social surplus From imports

Supply

World Price

Market Equilibrium with trade

Imports
Quantity Produced
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Demand

Quantity Consumed
Prof. Rushen Chahal

Quantity

Imports and Exports

What about a situation where the domestic price was below the world price In this case we would expect the country to export the good Producers would be unwilling to sell their good for less than the world price Consumers are unwilling to purchase the good for more than the world price

2/12/2012

Prof. Rushen Chahal

Imports and Exports

Because the price is now above the domestic market price, we would normally experience a surplus But this excess product is now going to be exported and sold abroad This will also increase social surplus to a level higher than it would have been had there been no trade

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Prof. Rushen Chahal

Efficiency Of Exports
Market Equilibrium with trade

$ Exports
World Price

Supply

Added Social surplus from Exports

Demand

Quantity consumed
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Quantity produced
Prof. Rushen Chahal

Quantity

Imports and Exports

To Put It Simply:
When a country imports a good, consumer surplus increases and producer surplus decreases
Which changes more?
Consumer surplus!

When a country exports a good, producer surplus increases and consumer surplus decreases
Which changes more?
Producer surplus!

In either situation, social surplus increases

2/12/2012

Prof. Rushen Chahal

Imports and Exports

What should you remember from this section?:
International trade increases total social surplus!!

2/12/2012

Prof. Rushen Chahal