Overview Of Course

1
Lesson 3

• The Meaning of Price, Value, and Economic
  Efficiency.
• Consumer and Producer Surplus.
• Diamond Water Paradox.
• Efficiency of Competitive Market equilibrium
• Efficiency Implications of Price Controls and
  Taxes.

2
Area under demand total value of that output
1
P1
2
3
Pe
5
4
D
Qe
Q1
Total Value of Q1 Units 124
Total Value of Qe Units 12345
3
Area under supply total cost (net of fixed
costs)
P1
Pe
1
2
Q1
Qe
Increase in Total Cost when output increases from
Q1 to Qe 12
4
Role of Price

• Mechanism for Allocating Goods in Markets
  willingness to pay.
• What are alternative mechanisms?
• First come, first served
• Strongest and most Powerful
• Random Selection
• Friends and relatives

5
Meaning of Price

• What is the meaning of price when it is used to
  allocate goods? What does a high, or a low, price
  tell us about the product?
• Diamond-Water paradox why are diamonds expensive
  when water is so cheap?

6
Meaning of Price (diamond-water Paradox
Average Value Water
PA
Dwater
Swater
Pw
Qw
Total Value of Water is entire area
Average value of water is mid value of water
used. So what does price measure?
7
Meaning of Price (continued)
Sdiamonds
Average Value Diamonds
Pd
Ddiamonds
QDiamonds
value of diamonds
8
Meaning of Price (continued)
Sdiamonds
Average Value Water
Average Value Diamonds
Pd
Dwater
Swater
Pw
Ddiamonds
Qw
QDiamonds
Total Value of Water
is greater than value of diamonds
Average value of water is also greater. So what
does price measure?
9
Meaning of Price in Markets

• Price Measures the value of the last unit sold,
  or marginal unit.
• Price, therefore, is unrelated to average or
  total value of a product.
• Salary, which is the price of labor, need not be
  related to the value of the worker or the work.
• How can one group of workers generate higher
  wages for themselves?

10
Consumer and Producer Surplus

• Consumer surplus is the difference between the
  price paid and the higher price that consumers
  would have been willing to pay for the product.
• Producer surplus is the difference between the
  payment received and the minimum payment that
  producers would have accepted.

11
Consumer and Producer Surplus
P1
1
3
Pe
4
2
Qe
Q1
CS 1 PS 2
DWL 34
12
Price Controls

• Artificial Government Restraint of Price
• Can be a floor, or a ceiling
• Popular during wars, or in non-market economies
• Simple view distortion in output
• More complete view wrong consumers get product.

13
Price Floor at P1
1
P1
7
2
3
Pe
8
5
4
6
Q1
Qe
CS Before Price Control 123 Ps Before Price
Control 456
CS After Price Control 1 PS After Price Control
246
14
Price Floor at P1 AND wrong producers
1
P1
7
2
3
8
Pe
5
4
6
Q1
Qe
Q0
Q2
CS Before Price Control 1238 Ps Before Price
Control 456
CS After Price Control 1 PS After Price Control
2
15
Rent Control (Price Ceiling)
1
2
3
Pe
5
4
transfer
7
Prc
6
Q1
Qe
CS Before Price Control 123 Ps Before Price
Control 456
CS After Price Control 124 PS After Price
Control 6
16
Government guarantees price at P1 and and sells
output at market clearing price
S
1
P1
7
2
3
Pe
8
5
4
10
6
Pclearing
Revenue from Consumers
9
D
Q1
Qe
Q2
CS After Price Control 12345610 PS After
Price Control 234579
CS Before Price Control 123 Ps Before Price
Control 459
Taxpayers 234567810
17
Government guarantees price at P1 and burns any
output it can not sell at that price
1
P1
7
2
3
Pe
8
5
4
10
6
Pclearing
9
11
12
Q1
Qe
Q2
CS After Price Control 1 PS After Price Control
234579 Taxpayers 35678101112
CS Before Price Control 123 Ps Before Price
Control 459
18
Who Pays For A Tax?

• Terminology in Book is not exactly correct.
• Two forms of analysis decreasing supply or
  decreasing demand.
• Tax burden is shared depending on slope of both
  curves.

19
Tax from consumers vantage
St
S
amount of tax
P1
Pe
Price Paid by Consumer
D
Qe
Q1
20
Tax from producers vantage
S
P1
Pe
Price received by Producer
P0
amount of tax
D
Qe
Q1
Dt
21
Distortion from Tax
St
S
amount of tax
P1
Price Paid by Consumer
Pe
P0
D
Qe
Q1
22
Instance of Tax borne by Producer
S1
P
S
P1
Price Paid by Consumer
D with infinite elasticity
Q1
Q2
Q
23
Instance of Tax borne by Consumer
D with zero elasticity
S1
P
S
P1
Price Paid by Consumer
P0
Q0
Q
24
Instance of Tax borne by Consumer
P
S with infinite elasticity
P0
Price Received by Producer
D
Dt
Q1
Q0
Q
25
Instances of Tax borne by producer
S with zero elasticity
P
P0
Price Received by Producer
P1
D
Dt
Q0
Q