Appendix Tools of Microeconomics. 1. The Marginal Principle Simple decision making rule We first...

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Appendix Tools of Microeconomics

Transcript of Appendix Tools of Microeconomics. 1. The Marginal Principle Simple decision making rule We first...

Page 1: Appendix Tools of Microeconomics. 1. The Marginal Principle Simple decision making rule We first define: Marginal benefit (MB): the benefit of an extra.

Appendix

Tools of Microeconomics

Page 2: Appendix Tools of Microeconomics. 1. The Marginal Principle Simple decision making rule We first define: Marginal benefit (MB): the benefit of an extra.

1. The Marginal Principle

Simple decision making rule We first define:

Marginal benefit (MB): the benefit of an extra unit of an activity

Marginal cost (MC): the cost of an extra unit of an activity

RULE: Do more of an activity if its MB exceeds its MC. If possible, pick the level of activity at which MB=MC

Page 3: Appendix Tools of Microeconomics. 1. The Marginal Principle Simple decision making rule We first define: Marginal benefit (MB): the benefit of an extra.

1. Marginal Principle

When undertaking an activity the objective is to maximize the net benefit.

This will be achieved when choosing the level of activity where MB=MC

Page 4: Appendix Tools of Microeconomics. 1. The Marginal Principle Simple decision making rule We first define: Marginal benefit (MB): the benefit of an extra.

Total v. Net Benefits

Benefit of a unit of the activity

(MB)

-Its cost (MC)

Net MarginalBenefit

Page 5: Appendix Tools of Microeconomics. 1. The Marginal Principle Simple decision making rule We first define: Marginal benefit (MB): the benefit of an extra.

Total Benefit

1 2 3 4

Marginal benefit of the first unit

Marginal benefit of the second unit

Marginal benefit of the third unit

Marginal benefit of the fourth unit

Page 6: Appendix Tools of Microeconomics. 1. The Marginal Principle Simple decision making rule We first define: Marginal benefit (MB): the benefit of an extra.

Total Benefit and Net Benefit

Rational self interested agents (consumers/ firms) maximize their net benefit (utility / profit)

The objective is to make a choice to maximize net benefit.

Page 7: Appendix Tools of Microeconomics. 1. The Marginal Principle Simple decision making rule We first define: Marginal benefit (MB): the benefit of an extra.

Total vs. Net Benefits

Marginal cost of unit 1

Net Marginal Benefit of unit 1

Marginal cost of unit 2

Net Marginal Benefit of unit 2

Marginal cost of unit 3

Net Marginal Benefit of unit 3

Marginal cost of unit 4

Net loss of unit 4

1 2 3 4

Page 8: Appendix Tools of Microeconomics. 1. The Marginal Principle Simple decision making rule We first define: Marginal benefit (MB): the benefit of an extra.

Net Benefit or Net Surplus

Net Benefit of 3 units

1 2 3 4

Undertake only 3 units of the activity. The net benefit is the light blue area

Page 9: Appendix Tools of Microeconomics. 1. The Marginal Principle Simple decision making rule We first define: Marginal benefit (MB): the benefit of an extra.

2. Equilibrium in a product market

The model of supply and demand determines the equilibrium price and quantity

Page 10: Appendix Tools of Microeconomics. 1. The Marginal Principle Simple decision making rule We first define: Marginal benefit (MB): the benefit of an extra.

Buyers determine demand.

Sellers determine supply.

What is a Market?

Page 11: Appendix Tools of Microeconomics. 1. The Marginal Principle Simple decision making rule We first define: Marginal benefit (MB): the benefit of an extra.

The Equilibrium of Supply and DemandPrice of

Ice-CreamCone

0 1 2 3 4 5 6 7 8 9 10 11 12Quantity of Ice-Cream Cones

13

Equilibriumquantity

Equilibrium price Equilibrium

Supply

Demand

P*2.00

Page 12: Appendix Tools of Microeconomics. 1. The Marginal Principle Simple decision making rule We first define: Marginal benefit (MB): the benefit of an extra.

Shifting the curves: hot weather

Price ofIce-Cream

Cone

0 Quantity of Ice-Cream Cones

Supply

Initialequilibrium

D

D

3. . . . and a higherquantity sold.

2. . . . resultingin a higherprice . . .

1. Hot weather increasesthe demand for ice cream . . .

2.00

7

New equilibrium$2.50

10

Page 13: Appendix Tools of Microeconomics. 1. The Marginal Principle Simple decision making rule We first define: Marginal benefit (MB): the benefit of an extra.

Shifting the curves: Higher price of sugar

Price ofIce-Cream

Cone

0 Quantity of Ice-Cream Cones

Demand

Newequilibrium

Initial equilibrium

S1

S2

2. . . . resultingin a higherprice of icecream . . .

1. An increase in theprice of sugar reducesthe supply of ice cream. . .

3. . . . and a lowerquantity sold.

2.00

7

$2.50

4

Page 14: Appendix Tools of Microeconomics. 1. The Marginal Principle Simple decision making rule We first define: Marginal benefit (MB): the benefit of an extra.

3. Market Surplus

It is a measure of the total value to consumers and producers from a market

The area between the marginal cost and the marginal benefit represents the market surplus, the gains to consumers and producers from trade.

Market surplus=Consumer surplus + Producer surplus

Supply curve is a marginal cost curve

Demand curve is a marginal benefit curve

Page 15: Appendix Tools of Microeconomics. 1. The Marginal Principle Simple decision making rule We first define: Marginal benefit (MB): the benefit of an extra.

CONSUMER SURPLUS

Willingness to pay is the maximum amount that a buyer will pay for a good.

It measures how much the buyer values the good or service.

Consumer surplus is the buyer’s willingness to pay for a good minus the amount the buyer actually pays for it.

Page 16: Appendix Tools of Microeconomics. 1. The Marginal Principle Simple decision making rule We first define: Marginal benefit (MB): the benefit of an extra.

Four Possible Buyers’ Willingness to Pay

Page 17: Appendix Tools of Microeconomics. 1. The Marginal Principle Simple decision making rule We first define: Marginal benefit (MB): the benefit of an extra.

The Demand Schedule and the Demand Curve

Page 18: Appendix Tools of Microeconomics. 1. The Marginal Principle Simple decision making rule We first define: Marginal benefit (MB): the benefit of an extra.

The Demand CurvePrice of

Album

0 Quantity ofAlbums

Demand

1 2 3 4

$100 John’s willingness to pay

80 Paul’s willingness to pay

70 George’s willingness to pay

50 Ringo’s willingness to pay

Page 19: Appendix Tools of Microeconomics. 1. The Marginal Principle Simple decision making rule We first define: Marginal benefit (MB): the benefit of an extra.

Measuring Consumer Surplus with the Demand Curve

(a) Price = $80

Price ofAlbum

50

70

80

0

$100

Demand

1 2 3 4 Quantity ofAlbums

John’s consumer surplus ($20)

Page 20: Appendix Tools of Microeconomics. 1. The Marginal Principle Simple decision making rule We first define: Marginal benefit (MB): the benefit of an extra.

Measuring Consumer Surplus with the Demand Curve

(b) Price = $70Price of

Album

50

70

80

0

$100

Demand

1 2 3 4

Totalconsumersurplus ($40)

Quantity ofAlbums

John’s consumer surplus ($30)

Paul’s consumersurplus ($10)

Page 21: Appendix Tools of Microeconomics. 1. The Marginal Principle Simple decision making rule We first define: Marginal benefit (MB): the benefit of an extra.

How the Price Affects Consumer Surplus

Consumersurplus

Quantity

(a) Consumer Surplus at Price PPrice

0

Demand

P1

Q1

B

A

C

The area below the demand curve and above the price measures the consumer surplus in the market

Page 22: Appendix Tools of Microeconomics. 1. The Marginal Principle Simple decision making rule We first define: Marginal benefit (MB): the benefit of an extra.

PRODUCER SURPLUS

Producer surplus is the amount a seller is paid for a good minus the seller’s cost.

It measures the benefit to sellers participating in a market.

Page 23: Appendix Tools of Microeconomics. 1. The Marginal Principle Simple decision making rule We first define: Marginal benefit (MB): the benefit of an extra.

The Costs of Four Possible Sellers

Page 24: Appendix Tools of Microeconomics. 1. The Marginal Principle Simple decision making rule We first define: Marginal benefit (MB): the benefit of an extra.

The Supply Curve

Page 25: Appendix Tools of Microeconomics. 1. The Marginal Principle Simple decision making rule We first define: Marginal benefit (MB): the benefit of an extra.

The Supply Curve

Page 26: Appendix Tools of Microeconomics. 1. The Marginal Principle Simple decision making rule We first define: Marginal benefit (MB): the benefit of an extra.

Measuring Producer Surplus

Quantity ofHouses Painted

Price ofHouse

Painting

500

800

$900

0

600

1 2 3 4

(a) Price = $600

Supply

Grandma’s producersurplus ($100)

Page 27: Appendix Tools of Microeconomics. 1. The Marginal Principle Simple decision making rule We first define: Marginal benefit (MB): the benefit of an extra.

Measuring Producer Surplus with the Supply Curve

Quantity ofHouses Painted

Price ofHouse

Painting

500

800

$900

0

600

1 2 3 4

(b) Price = $800

Georgia’s producersurplus ($200)

Totalproducersurplus ($500)

Grandma’s producersurplus ($300)

Supply

Page 28: Appendix Tools of Microeconomics. 1. The Marginal Principle Simple decision making rule We first define: Marginal benefit (MB): the benefit of an extra.

How the Price Affects Producer Surplus

Producersurplus

Quantity

(a) Producer Surplus at Price P

Price

0

Supply

B

A

C

Q1

P1

The area below the price and above the supply curve measures the producer surplus in a market.

Page 29: Appendix Tools of Microeconomics. 1. The Marginal Principle Simple decision making rule We first define: Marginal benefit (MB): the benefit of an extra.

Consumer and Producer Surplus

Producersurplus

Consumersurplus

Price

0 Quantity

Equilibriumprice

Equilibriumquantity

Supply

Demand

A

C

B

D

E

Does the market system maximize market (social) surplus?• Point E gives the

maximum surplus• Any other point would

result in a lower surplus• Therefore, the market is

efficient. The market is a good way to organize economic activity

Page 30: Appendix Tools of Microeconomics. 1. The Marginal Principle Simple decision making rule We first define: Marginal benefit (MB): the benefit of an extra.

4. Externalities and market inefficiency

An externality refers to benefits or costs borne by a third party.

Who is the first or second party? The first and second parties are the buyers and

sellers of a good. The third party is, therefore, someone not

involved in the transaction.

Page 31: Appendix Tools of Microeconomics. 1. The Marginal Principle Simple decision making rule We first define: Marginal benefit (MB): the benefit of an extra.

Positive vs. Negative Externalities

When the impact on the bystander is adverse (beneficial), i.e. when costs are imposed on a third party, the externality is called a negative (positive) externality.

Page 32: Appendix Tools of Microeconomics. 1. The Marginal Principle Simple decision making rule We first define: Marginal benefit (MB): the benefit of an extra.

EXTERNALITIES AND MARKET INEFFICIENCY

Negative Externalities Automobile exhaust Cigarette smoking Barking dogs (loud

pets) Loud stereos in an

apartment building

Page 33: Appendix Tools of Microeconomics. 1. The Marginal Principle Simple decision making rule We first define: Marginal benefit (MB): the benefit of an extra.

EXTERNALITIES AND MARKET INEFFICIENCY

Positive Externalities Immunizations Restored historic buildings Education

Page 34: Appendix Tools of Microeconomics. 1. The Marginal Principle Simple decision making rule We first define: Marginal benefit (MB): the benefit of an extra.

EXTERNALITIES AND MARKET INEFFICIENCY

Externalities cause markets to fail, i.e., fail to produce the quantity that yields the maximum social surplus.

Positive (Negative) externalities lead markets to produce a smaller (Larger) quantity than is socially desirable.

In the presence of externalities markets do not work well, i.e. they are inefficient

Page 35: Appendix Tools of Microeconomics. 1. The Marginal Principle Simple decision making rule We first define: Marginal benefit (MB): the benefit of an extra.

Example: Aluminum Production The Market for Aluminum

Assume that aluminum production results in emission of toxic wastes that are dumped in a nearby river. The factory does not bear the clean up cost.

The full cost of producing aluminum is not borne by the seller, i.e., there is an external cost.

How does the externality affect social welfare?

Page 36: Appendix Tools of Microeconomics. 1. The Marginal Principle Simple decision making rule We first define: Marginal benefit (MB): the benefit of an extra.

Pollution and the Social Optimum

Equilibrium

Quantity ofAluminum

0

Price ofAluminum

DemandMarginal Benefit

Supply(marginal private cost)

Marginal Social cost =marginal private cost

+external cost

QWELFARE

Social Optimum

External Cost

QMARKET

Page 37: Appendix Tools of Microeconomics. 1. The Marginal Principle Simple decision making rule We first define: Marginal benefit (MB): the benefit of an extra.

Social Welfare in the absence of the externality

Equilibrium

Quantity ofAluminum

0

Price ofAluminum

Demand(marginal private benefit=marginal social benefit)

Supply(marginal private cost)

Marginal Social cost =marginal private cost

+external cost

QWELFARE

Social Optimum

QMARKET

If QWELFARE was produced+

Page 38: Appendix Tools of Microeconomics. 1. The Marginal Principle Simple decision making rule We first define: Marginal benefit (MB): the benefit of an extra.

Social Welfare with the externality

Equilibrium

Quantity ofAluminum

0

Price ofAluminum

Demand

Supply

Marginal Social cost =

QWELFARE

Social Optimum

QMARKET

- When QMARKET is produced+