Micro Economics- The Power of Prices-1

8/3/2019 Micro Economics- The Power of Prices-1

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MicroeconomicsProf. Rushen Chahal

The Power of PricesThe Power of Prices

2/12/2012 Prof. Rushen Chahal


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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



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So Far This Semester

Weve began looking at some concepts centralto microeconomics, especially supply anddemand

We understand that supply is upwards slopingand demand is downwards sloping

We saw that market equilibrium occurs where

supply and demand intersect



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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



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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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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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Marginal Benefit

I like dumplings

Every time I eat a dumpling, I get a certainamount of value out of it

We can call the value that I get fromconsuming one additional dumpling (ONEUNIT!!!) my marginal benefit

Marginal benefit the incremental value of anadditional unit of a good.



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Marginal Benefit

However, the value of eating each dumpling is notthe same

The first dumpling I eat gives me the most value

Im 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 Im still hungry, but its not as good

as the first dumpling



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Marginal Benefit

So we see that as I consume more and more of aproduct (like dumplings) the value of each additionaldumpling, or marginal benefitI get from each

additional unit decreases

Marginal benefit decreases for a certain period oftime.

I will get zero benefit from dumplings once I am full. Butafter a few hours I will be hungry again and want moredumplings.



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Marginal Benefit

We can think of the demand curve as arepresentation of my marginal benefit

The first dumpling I consume gives me the most

value, so Id be willing to pay the most for that firstdumpling

The second dumpling gives me less value, so Iwouldnt be willing to pay as much for it as the first

And so on . . .



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1 2 3 4 5 6 70

0.

5

1

1.

5

2

2.

5

3

Demand = Marginal Benefit

Price

Quantity

The first dumpling gives me the mostsatisfaction, so Im willing to pay more

for it

The second dumpling gives me lesssatisfaction than the first, so Imwilling to pay less

The 6th dumpling gives me nosatisfaction, so I wouldnt bewilling to pay anything for it



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Marginal Benefit

So marginal benefit is the additional value thatconsumers get from buying one more unit of theproduct

The demand curve is going to represent marginalbenefit

As quantity increases, price decreases, just asincreased consumption of a product leads to

decreasing marginal benefit Lets look at another example



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Marginal Benefit

PricePrice QuantityQuantity

$20$20 11

$15$15 22

$10$10 33

QuantityQuantityMarginalMarginalBenefitBenefit

TotalTotalBenefitBenefit

11 $20$20 $20$20

22 $15$15 $35$35

33 $10$10 $45$45

Dwights demandDwights demand

for blue jeans.for blue jeans.

Dwights benefits from buyingDwights benefits from buying

blue jeans.blue jeans.



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Consumer Surplus

Consumer surplusConsumer surplus -- consumersconsumerstotal benefit minus cost; graphically,total benefit minus cost; graphically,demand minus market price.demand minus market price.

Consumer Surplus = DemandConsumer Surplus = Demand -- Market PriceMarket Price



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Consumer Surplus


$20$20 11

$15$15 22

$10$10 33

TotalTotalBenefitBenefit

Total PaidTotal PaidConsumerConsumer

SurplusSurplus

$20$20 $20$20 $0$0

$35$35 $30$30 $5$5

$45$45 $30$30 $15$15

Dwights demandDwights demand

for blue jeans.for blue jeans.

Dwights benefits from buyingDwights benefits from buying




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Consumer Surplus

1 2 3

DemandDemand

$

Quantity

Price

=$10

Consumer surplusConsumer surplus

in general.in general.

TheThe consumerconsumer

surplussurplus is theis the

area under thearea under thedemand curve anddemand curve and

above the marketabove the market

price. It is whatprice. It is what

consumers gainconsumers gain

from their purchasesfrom their purchases

after deducting theafter deducting the

cost.cost.



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Consumer Surplus

1 2 3

DemandDemand

$

Quantity

Price

=$10

At a price of $10 perAt a price of $10 per

pair of jeans, Dwightpair of jeans, Dwight

buys three pair, andbuys three pair, and

receives $15 worth ofreceives $15 worth ofconsumer surplus.consumer surplus.

His consumerHis consumer

surplus equals thesurplus equals the

sum of the consumersum of the consumer

surplus from the 1st,surplus from the 1st,

2nd, and 3rd pair of2nd, and 3rd pair of

jeans.jeans.

$10 +$5 + $0 =$15.$10 +$5 + $0 =$15.

$10

$5

$0



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Consumer Surplus

We can talk about individual consumer surplus,

as with Dwight and blue jeans

We can also talk about consumer surplus foran entire market

Consider the demand curve for SHE tickets in

Beijing



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Consumer Surplus

PricePerTicket

Tickets sold(thousands)

1 2 3 4 5 6 7 8 9 10 11 12 13

70

65

60

5550

45

40

75

35

80

30

25

85

Market Price

If the price were $80, there would be1000 fans who would still buy tickets

If the price were $60, there would be5,500 fans who would still buy tickets

But regardless of what differentfans would be willing to pay, theyall will pay the market price of $45



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Consumer Surplus

PricePerTicket

Tickets sold(thousands)

1 2 3 4 5 6 7 8 9 10 11 12 13

70

65

60

5550

45

40

75

35

80

30

25

85

Market Price

ConsumerSurplus

Consumer surplus is then, the areaabove the market price line andbelow demand

In this example, CS = X ($85 $45) X 9000= $180,000



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Consumer Surplus

Consumer surplus measures the aggregatebenefit that consumers obtain from buyinggoods 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 consumersurplus



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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)



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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



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Marginal cost and Supply

This minimum price that producers would bewilling to accept for each quantity sold isgoing to be their marginal cost

This represents the additional cost ofproducing each additional unit

We see according to the supply curve that

marginal cost is increasing



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Marginal Cost

Supply = Marginal CostSupply = Marginal Cost

$$

QuantityQuantity11 22 33

Marginal cost increasesMarginal cost increases

as quantity producedas quantity produced

rises.rises.



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Marginal Cost

What causes marginal cost to increase?

Why is it going to be more expensive to produce the500th 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 thesecond is cheaper than the third, and so on



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Marginal Cost

Because the cost of producing eachsuccessive unit becomes more expensive,

the minimum price suppliers will accept fora 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 becharged



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Marginal Cost


$5$5 11

$7.50$7.50 22

$10$10 33

QuantityQuantityMarginalMarginalCostCost

Total CostTotal Cost

11 $5$5 $5$5

22 $7.50$7.50 $12.50$12.50

33 $10$10 $22.50$22.50

Buddys supplyBuddys supply

of blue jeans.of blue jeans.

Buddys cost of producingBuddys cost of producing




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Producer Surplus

The Producer Surplus producers revenue

minus production cost; graphically, market

price minus supply.

Producer Surplus = Market PriceProducer Surplus = Market Price -- SupplySupply



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Producer Surplus

PricePriceQuantityQuantity

SoldSold

$5$5 11

$7.50$7.50 22

$10$10 33

Total CostTotal CostTotalTotal

RevenueRevenueProducerProducerSurplusSurplus

$5$5 $5$5 $0$0

$12.50$12.50 $15$15 $2.50$2.50

$22.50$22.50 $30$30 $7.50$7.50

Buddys supplyBuddys supply

of blue jeans.of blue jeans.

Buddys cost of producingBuddys cost of producing




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Producer Surplus

SupplySupply

$$


TheTheproducer surplusproducer surplusis the area above theis the area above the

supply curve andsupply curve and

under the marketunder the market

price. It is whatprice. It is what

the producers gainthe producers gain

from their salefrom their sale

after deductingafter deducting

their cost.their cost.

PricePrice$10$10

Producer SurplusProducer Surplus



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Producer Surplus

SupplySupply

$$


At a price of $10 perAt a price of $10 per

pair of jeans, Buddy sells 3pair of jeans, Buddy sells 3pair and receivespair and receives

$7.50 worth of$7.50 worth ofproducer surplus.producer surplus.

His producer surplus equals theHis producer surplus equals the

sum of his producer surplussum of his producer surplus

from the 1from the 1stst, 2, 2ndnd and 3and 3rdrd pairs,pairs,

which is $5 + $2.50 +$0which is $5 + $2.50 +$0

equals $7.50equals $7.50

PricePrice$10$10

$5$5$2.50$2.50

$0$0



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Marginal Benefit and Marginal Cost

Marginal Benefit (to consumers): The value

of each additional unit of the good.

Marginal Cost (to producers): The cost ofresources used to produce each additional

unit.

The efficient outputoccurs when societys

marginal benefit equals marginal cost.



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Market Efficiency

Supply = Marginal Cost

D

emand = MarginalB

enefit

$

QuantityEfficient

Quantity

Equilibrium

Price

ConsumerConsumer

SurplusSurplus

Social Surplus =Social Surplus =

consumer surplusconsumer surplus

+ producer surplus+ producer surplus

ProducerProducer

SurplusSurplus



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Market Efficiency

The market equilibrium price

leads to the efficient quantity.

No other quantity would generate a larger total of

consumer and producer surplus.



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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.



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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.



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Deadweight Loss



$

QuantityEfficient

Quantity

Deadweight Loss

High PriceHigh Price

Producer

surplus =

price -supply

Consumer surplus = demand - price

InefficientInefficient

QuantityQuantity2/12/2012 Prof. Rushen Chahal


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Deadweight Loss



$

QuantityEfficient

Quantity

Deadweight Loss

Producer

surplus =

price -

supply

Low PriceLow Price

Consumer surplus = demand - price

InefficientInefficient

QuantityQuantity2/12/2012 Prof. Rushen Chahal


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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 leavethe free market alone, and in this way we can avoid

any deadweight loss

But this may not always be the case



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Market Failure

Market failure instances in which the market outcome failsto achieve efficiency.

In other words: The market does not maximize social surplus.

Market failure happens ONLY if the market is not able to getto equilibrium

Causes include public goods, common property resources,externalities, monopoly.

Market failure will cause a deadweight loss.



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Imports and Exports

Lets 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 were starting to see a trend here) in

economics, trade is generally considered to be good



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Imports and Exports

If a country doesnt engage in international trade,prices within the country reflect the domesticdemand 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 tointernational producers and consumers

Prices are going to tend towards world prices

These prices are determined by the supply anddemand from all countries



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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



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Imports and Exports

Regardless of if it is above or below the worldprice, international trade means the domesticprice 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



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Imports and Exports

Lets take a look at an example where the domesticprice 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



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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!!



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Efficiency OfImports

Supply

Demand

$

QuantityQuantityProduced

World Price

Quantity

Consumed

Imports

Market Equilibrium

with trade

Added Social surplus

From imports



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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



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Imports and Exports

Because the price is now above the domesticmarket price, we would normally experience asurplus

But this excess product is now going to beexported and sold abroad

This will also increase social surplus to a level

higher than it would have been had therebeen no trade



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Efficiency Of Exports

Supply

Demand

$

QuantityQuantity

consumed

World Price

Quantity

produced

Exports

Market Equilibrium

with trade

Added Social surplus

from Exports



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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



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Imports and Exports

What should you remember from this section?:

International trade increases total social surplus!!

2/12/2012 Prof Rushen Chahal

Micro Economics- The Power of Prices-1

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