Economics 110 Introduction to Economic Theory Professor Tanya Rosenblat

1
Economics 110Introduction to Economic
TheoryProfessor Tanya Rosenblat
Perfectly Competitive Markets
2
Experiment (Session 1). Widget Market (48
participants)
Type of Agent Number of Agents Cost Value
Low-Cost Supplier 16 10
High-Cost Supplier 8 30
High-Value Demander 8 40
Low-Value Demander 16 20
3
Supply Schedule
Price Range Amount Supplied
Plt10 0
10ltPlt30 16
Pgt30 24
4
Demand Schedule
Price Range Amount Demanded
Pgt40 0
20ltPlt40 8
Plt20 24
5
Session 1 Supply and Demand for Widgets
40 30 20 10
P R I C E
8 16 24
Number of Bushels
6
Experimental Data

• Round 1 Average Price 18.3 (19.5)

7
Experimental Data

• Round 2 Average Price 17.4 (17.3)

8
A Demand Curve Can Be Thought of as a Schedule of
Buyers Maximum Willingnesses to Pay
Highest price at which individual is willing to
buy
Potential Buyer
per unit

• Only one buyer has a maximum willingness
• to pay greater than 5.75
• Thus at a price of 5.75, only one potential
  buyer (1)
• would buy.
• Quantity demanded at 5.75 1

1
6.00


6.50
2
5.50


3
5.00


6.00
5.75
4
4.50


5.50
5
4.00


6
3.50


5.00
7
3.00


4.50
8
2.50


9
2.00


4.00
10
1.50


3.50
11
1.00


12
0.50


3.00
2.50

• At a price of 2.25, eight potential buyers
• would buy (1 - 8).
• Quantity demanded at 2.25 8.

2.25
2.00
1.50
1.00
Demand Curve
0.50
Quantity
-
0
1
2
3
4
5
6
7
8
9
10
11
12
Notice that the demand curve also describes the
maximum willingness to pay of all potential
buyers in the market!
9
A Supply Curve Can Be Thought of as a Schedule of
Sellers Minimum Willingnesses to Sell
Supply Curve

• The price of 5.75 is greater than the
• minimum willingness to sell for 11
  potential sellers
• Thus quantity supplied at 5.75 11

per unit
6.50
6.00
5.75
Lowest price at which seller is willing to sell
5.50
Potential Seller


5.00
1
0.50


4.50


2
1.00


3
1.50


4.00
4
2.00


3.50
5
2.50


6
3.00


3.00
7
3.50


2.50
2.25
8
4.00


9
4.50


2.00
10
5.00


1.50
11
5.50


12
6.00


1.00
0.50
Quantity
-
0
1
2
3
4
5
6
7
8
9
10
11
12
10
Is There An Equilibrium in Our Market? Yes!
Supply Curve
per unit

• At any price above 3.00 but below 3.50, exactly
  6 potential buyers are willing to buy
• At a price above 3.00 but below 3.50, exactly 6
  potential sellers are willing to sell.
• For any price in this band, quantity supplied
  equals quantity demanded at this price.

6.50
6.00
5.50
5.00
4.50
4.00
3.50
equilibrium price band
3.00
2.50
2.00
1.50
1.00
Demand Curve
0.50
Quantity
-
0
1
2
3
4
5
6
7
8
9
10
11
12
11
How Much Do Buyers Gain at the Market Equilibrium?
Highest price at which individual is willing to
buy
Buyer 1 winning to pay as much as
6.00 actually pays 3.25 net gain (consumer
surplus) 2.75 (area A)
Potential Buyer
per unit
1
6.00


6.50
2
5.50


Buyer 2 winning to pay as much as
5.50 actually pays 3.25 net gain (consumer
surplus) 2.25 (area B)
3
5.00


6.00
A
4
4.50


5.50
5
4.00


B
6
3.50


5.00
Buyer 6 winning to pay as much as
3.50 actually pays 3.25 net gain (consumer
surplus) 0.25 (area F)
7
3.00


4.50
8
2.50


9
2.00


4.00
10
1.50


3.50
11
1.00


F
3.25
12
0.50


3.00
2.50
2.00
1.50
These buyers do not buy Their consumer surplus is
zero!
1.00
Demand Curve
0.50
Quantity
-
0
1
2
3
4
5
6
7
8
9
10
11
12
12
Consumer Surplus

• Consumer surplus the aggregate net gain to
  consumers from purchasing at a given market
  price.
• Equal to the area underneath the demand curve
  above the market price
• In our picture consumer surplus at a market
  price of 3.25 equals area ABCDEF.
• This number, which equals 9.00, is the
  aggregate
• difference between what consumers are willing
  to pay and what they actually pay.

per unit
6.50
6.00
A
5.50
B
5.00
C
4.50
D
4.00
E
3.50
F
3.25
3.00
2.50
2.00
Consumer Surplus Willingness to pay - Actual
payment
1.50
1.00
Demand Curve
0.50
Quantity
-
0
1
2
3
4
5
6
7
8
9
10
11
12
13
The Concept of Consumer Surplus Also Applies to
Smooth Demand Curves
P ( per liter)

• Consumers demand 4000 liters at 6 per unit.
• Consumers surplus difference between
• total willingness to pay and
• actual amount paid area A
• 8,000.

10
A
6
MARKET DEMAND CURVE
Q (liters per year)
4000
14
How Much Do Sellers Gain at the Market
Equilibrium?
Supply Curve
per unit
Seller 1 actually receives 3.25 must receive
at least 0.50 net gain (producer
surplus) 2.75 (area A)
6.50
6.00
Lowest price at which seller is willing to sell
5.50
Potential Seller
Seller 2 actually receives 3.25 must receive
at least 1.00 net gain (producer
surplus) 2.25 (area B)


5.00
1
0.50


4.50


2
1.00


3
1.50


4.00
4
2.00


3.50
5
2.50


3.25
A
B
F
6
3.00


3.00
7
3.50


2.50
8
4.00


Seller 6 actually receives 3.25 must receive
at least 3.00 net gain (producer
surplus) 0.25 (area F)
9
4.50


2.00
10
5.00


1.50
11
5.50


12
6.00


1.00
0.50
Quantity
-
0
1
2
3
4
5
6
7
8
9
10
11
12
15
Producer Surplus
Supply Curve
per unit
Producer Surplus Actual payment - required
payment
6.50
6.00
5.50


5.00
4.50



4.00

• Producer surplus the aggregate net gain to
  sellers
• from selling at a given market price.
• Equal to the area underneath the market price
• above the supply curve.
• In our picture producer surplus at a market
  price of
• 3.25 equals area ABCDEF.
• This number, which equals 9.00, is the
  aggregate
• difference between what sellers actually
  receive
• and the smallest amount they need to receive.

3.50
3.25
A
B
F
C
D
E
3.00
2.50
2.00
1.50
1.00
0.50
Quantity
-
0
1
2
3
4
5
6
7
8
9
10
11
12
16
Producer Surplus Also Applies to Smooth Supply
Curves
P ( per liter)
Market Supply Curve
6
A

• Firms supply 4000 liters at 6 per liter.
• Producer surplus is area A in the diagram
  8,000.

2
Q (liters per year)
4000
17
Total Economic Value Created in a Market
Consumer Surplus Producer Surplus
Supply Curve
per unit
6.50
6.00
5.50
5.00
4.50

• Total economic value created when
• market price is 3.25
• Consumer surplus at 3.25
• Producer surplus at 3.25
• 9.00 9.00
• 18.00

4.00
3.50
3.25
3.00
2.50
2.00
1.50
1.00
Demand Curve
0.50
Quantity
-
0
1
2
3
4
5
6
7
8
9
10
11
12
18
If The Market is Prevented From Reaching
Equilibrium, Economic Surplus is Not Realized
Supply Curve
per unit
6.50
6.00
5.50
5.00

• If, for some reason, potential buyers 3,4,5
• and potential sellers 3,4,5 were prevented
• from participating in the market,
• consumer and producer surplus would
• be lost.
• Gains from exchange would not be realized!
• We say there is a deadweight loss unrealized
• economic benefits.
• How could this happen?
• Government interventions!

4.50
4.00
3.50
3.00
2.50
2.00
1.50
1.00
Demand Curve
0.50
Quantity
-
0
1
2
3
4
5
6
7
8
9
10
11
12
19
The Economics of Price Controls
Price ( per unit)
Free market (no price control) Price controls Difference due to price controls
Producer surplus F C E F - C - E
Consumer surplus A B D A B C C D
Total surplus A B C D E F A B C F - E - D

A
S
B
D
2,000
E
C
1,400
F
D
QD
Q
QS
E D Deadweight loss
Quantity (units per period)
20
Elasticity

• Where is the Demand Curve coming from? How do we
  measure its slope?
• The Demand Curve tells us how much consumers will
  buy for different prices of the good
• From Consumer Behavior, we know how to deduce
  from tastes how much an individual consumer will
  buy at a given price. Summing over consumers, we
  get the Demand Curve
• The Demand Curve is (assumed to be) decreasing
  (The Law of Demand) The higher the price, the
  lower the consumption

21
How to measure elasticity?

• It is important to measure how sensitive Demand
  is to changes in Prices
• Preferably, this measure should not depend on
  units are we counting in dollars, cents, or
  euros? Pounds, Kilograms or Tons?
• The price elasticity of demand provides such a
  measure
• In words, it is the change in quantity for (or
  divided by) a given change in prices
• (sometimes, the elasticity is defined as the
  opposite number the precise convention does not
  matter, as long as one realizes that the law of
  demand applies)

22
The Importance of Elasticity

• The Concept of Elasticity is used for other
  concepts
• - Income elasticity of Demand
• - Price Elasticity of Supply
• What affects the Slope? When is it steep? It is
  steep when there is no good substitute

23
Using Calculus
24
Examples

• Linear Demand
• Q a bP
• Elasticity

25
Elasticity

• Elastic responsive to price changes
• Inelastic not responsive to price changes
• Examples
• - An unconscious bleeding man is brought to the
  hospital emergency room.
• - Among hospital patients whose insurance will
  pay all charges, what would the demand be like
  for nurse-administered propoxyphene (Darvon), a
  pain-killer?
• - Now suppose that the patients are in managed
  care plans that pressure physicians to use
  lower-price drugs. What might demand for the
  Darvon be?
• - A patient is given a presciption for a drug
  to control high blood pressure. The patient's
  insurance doesn't cover drugs, so the patient
  must pay out of pocket.

26
Elasticity

• Demand is more elastic if the decision-maker has
  an incentive to save money and if there is an
  adequate substitute for the product or service.

27
What Shifts Demand Curves?

• Change in income
• Change in a price of a substitute
• Change in a price of a complement
• Change in composition of population
• Change in tastes
• Change in information
• Change in availability of credit
• Change in expectations

28
What Shifts Supply Curve?

• Change in price of inputs
• Change in technology
• Change in natural environment
• Change in availability of credit
• Change in expectations