ECON 100 Lecture 15 Monday, November 10

Announcements MIDTERM #1: Wednesday November 19, starts at 7 P.M. Only material covered in lectures will be on the midterm. Solutions to old midterm exams (Spring 2014, 2013, and 2012) are posted on webpage. Announcements section. Solutions to PS #6 are posted on webpage. PS#7 (to be posted later in the week) will be the last exercise set before the exam. Webpage : https://ais.ku.edu.tr/course/25089/Default.html

Problem Session / KOLT tutors PS1: FRIDAY B4 (at 13:00) in room SOS B21 PS2: FRIDAY B5 (at 14:30) in room SOS B08 No attendance is taken at the PSs. Econ 100 KOLT tutors: Sonkurt, Jülide, and Ilgaz

Please turn off your phones. Class participation You must attend the section where you are registered. Your in-class exercise is your participation record. I collect them at the end of the lecture. Please turn off your phones.

We concluded our discussion of elasticity Last week on Wednesday We concluded our discussion of elasticity

Competitive markets and welfare Today’s lecture Competitive markets and welfare

SUPPLY AND DEMAND II: MARKETS AND WELFARE 3 SUPPLY AND DEMAND II: MARKETS AND WELFARE

Consumers, Producers, and the Efficiency of Markets

The equilibrium in the competitive market means “demand = supply” Price Supply Demand Pe Equilibrium price Qe Quantity Equilibrium quantity

Questions about the competitive market equilibrium 1 Do the equilibrium price and quantity maximize the total welfare of buyers and sellers? Market equilibrium reflects the way markets allocate scarce resources. 2 Is the market allocation desirable? This issue is addressed by welfare economics.

Welfare Economics Welfare economics is the study of how the allocation of resources affects economic well-being. Buyers and sellers receive benefits from taking part in the market. In today’s lecture we will learn that the equilibrium in a competitive market maximizes the total welfare of buyers and sellers.

Let’s get to work

How do we measure (quantify) the producers’ welfare? The welfare of the producers is measured by the producers’ surplus, PS. Producers’ Surplus ≈ profit (profit is total revenue – cost)

How do we measure (quantify) the producers’ welfare? The welfare of the producers is measured by the producers’ surplus, PS. Producers’ Surplus ≈ profit (profit is total revenue – cost) ≈

Consumers (more difficult) How do we measure the consumers’ welfare?

How do we measure the consumers’ welfare? The welfare of the consumers is measured by the consumers’ surplus, CS. CS = willingness to pay – actual price paid.

Consumer surplus, Consumer’s surplus, Consumers’ surplus Willingness to Pay (WtP): the maximum amount (of money) a buyer will pay for a good. Economist believe that WtP is a good measure of how much the buyer values the good (i.e., how large a benefit she receives from consuming the good).

Consumer surplus, Consumer’s surplus, Consumers’ surplus Example: WTP for a small reduction in risk of death If Cansın is willing to pay an extra 450TL for a safety feature on her new car that will reduce the probability that she will die by 1/10,000, then she values her life (at least) at 4.5 million TL.

Consumer surplus, Consumer’s surplus, Consumers’ surplus In general … If I am willing to pay $10 (but not more) for one unit of some good X, this means that the benefit/value/satisfaction (I think) I am getting from consuming this one unit of good X is $10.

Consumer surplus, Consumer’s surplus, Consumers’ surplus Consumer surplus is the buyer’s WtP for a good minus the amount the buyer actually pays for it. Example continued: If my WtP is $10 and I actually pay only $7 for one unit of good X, then my consumer surplus is $10 – $7 = $3. ????

Learning Activity #1

The table shows the willingness to pay numbers of four buyers The table shows the willingness to pay numbers of four buyers. If P = $15, who will buy the product? a. Mike b. Mike and Sandy c. Mike, Sandy, and Jonathan d. Mike, Sandy, Jonathan, and Hal BUYER WILLINGNESS TO PAY MIKE $50.00 SANDY $30.00 JONATHAN $20.00 HAL $10.00

At P = $18, what is the total consumer surplus. a. $38. b. $42. c. $46 At P = $18, what is the total consumer surplus? a. $38. b. $42. c. $46. d. $72. BUYER WILLINGNESS TO PAY MIKE $50.00 SANDY $30.00 JONATHAN $20.00 HAL $10.00

At P = $30 what is the total consumer surplus. a. $-10. b. $-6. c. $20 At P = $30 what is the total consumer surplus? a. $-10. b. $-6. c. $20. d. $30. BUYER WILLINGNESS TO PAY MIKE $50.00 SANDY $30.00 JONATHAN $20.00 HAL $10.00

WtP is a good measure of how much the buyer values the good (i. e WtP is a good measure of how much the buyer values the good (i.e., how much benefit she receives from consuming the good). Is it really so?

The willingness to pay may not always show who values a good most highly! Michael Sandel

Tickets to sporting events Those who pay the most for tickets may not value the experience very highly at all. . . 

Tickets to sporting events Those who pay the most for tickets may not value the experience very highly at all. . . The people sitting in the expensive seats at the stadium often show up late and leave early. Do they really care about the game?

Tickets to sporting events Their ability to afford the best seats has more to do with the depth of their pockets than their passion for the game. . . . This casts doubt on the claim that the price mechanism is the best way of getting goods to those who value them most highly.

Anyways, let’s consider a simple set-up

Four buyers; willingness to pay for a haircut

Four buyers; willingness to pay for a haircut John’s consumer surplus will be $100 – $60 = $40 Paul’s consumer surplus will be $80 – $60 = $20 George’s consumer surplus will be $70 – $60 = $10 Total consumer surplus will be $40 + $20 + $10 = $70 This is the total welfare of the consumers when the market price of haircut is P = $60. Suppose the market price is P = $60. Who will buy? John, Paul, and George will buy.

Allocating a limited supply of haircuts Suppose we use the price mechanism to allocate the available amount of haircuts. Which of the four consumers gets a haircut? John and Paul. The price mechanism allocates the limited supply of goods to consumers who are willing to pay the most for the goods. (who value them highly) Suppose only 2 haircuts can be provided. What is the lowest price at which the quantity demanded is 2? It is $70+

Is this good or bad?

All scarce goods must be rationed That means some consumers will go without. There are also other ways to ration/allocate: Beauty Seniority “First come, first served” Lottery Equal shares for all “Might makes right”

Price mechanism: A necessary evil? Allocating the limited supply of goods to consumers who are willing to pay the most for the goods is an attractive result when individuals have similar incomes.

Price mechanism: A necessary evil? What if that is not the case? We know that individuals don’t have similar incomes. What about issues of inequality, or fairness in that case? Rich people will get more haircuts (and more other goods) than poor people.

Sandel vs. Becker

Two short readings: Michael Sandel: If I ruled the world, I would rewrite the economics textbooks. “It is time to restore the distinction between gold and good”. Gary Becker: What limits to using money prices to buy and sell? “I do believe, however, that in the US and other economies, the bigger problem is not excessive use of prices and markets but insufficient use. ”

If I ruled the world, I would rewrite the economics textbooks If I ruled the world, I would rewrite the economics textbooks. This would be a big step toward a better civic life. Today, we confuse market reasoning for moral reasoning. We think that economic efficiency—getting goods to those with the greatest willingness and ability to pay for them—defines the common good. But this is a mistake.

Michael Sandel Michael Sandel is a political philosopher at Harvard University. He is best known for the course "Justice" which is one of the most popular courses in Harvard’s history. 

Michael Sandel Economics presents itself as a value-neutral science of human behavior. Increasingly, we accept this way of thinking and apply it to all manner of public policies and social relations. But the economistic view of the world is corrosive of democratic life.

Gary Becker Gary Becker (University of Chicago) won the Nobel prize in 1992. He died in 2014.  His Nobel prize acceptance speech is titled THE ECONOMIC WAY OF LOOKING AT LIFE: “My research uses the economic approach to analyze social issues that range beyond those usually considered by economists.”

Gary Becker Allowing kidneys to be purchased for transplant use would reduce the typical wait for a kidney to no more than a few months, and would eliminate all the deaths because of the time consuming queue to get a kidney. United States: about 90,000 individuals are waiting for a kidney transplant, and the average wait is about 6 years.

Gary Becker In light of these considerations, I do not understand how anyone who is knowledgeable of the great cost imposed by the present system on the many individuals who need kidneys could oppose allowing kidneys to be purchased and sold, even after taking full account of “repugnance” and the other alleged costs of allowing a market in kidneys.

Now the producers

Four sellers and their costs Hair designer Cost David $20 Ted 50 Serge 60 Hiro 90

Four seller and their costs David’s producer surplus will be $70 – $20 = $50 Ted’s producer surplus will be $70 – $50= $20 Serge’s producer surplus will be $70 – $60 = $10 Total producer surplus will be $50 + $20 + $10 = $80 This is the total welfare of the producers when the price is P = $70. Suppose the market price is P = $70. Who will sell? David, Ted, and Serge will sell.

Allocating a limited demand of haircuts Suppose we use the price mechanism to choose the sellers. Which of the four sellers will produce a haircut? David and Ted. The price mechanism ensures that the required quantity is produced by those sellers with the lowest cost. Suppose only 2 haircuts are needed. What is the lowest price at which the quantity supplied is 2? It is $50+

return to the haircut market. Different buyers with different WtPs. We will now return to the haircut market. Different buyers with different WtPs.

Peter, Paul, Mary, Jack and Jill

The buyers and their WtPs for a haircut Name ( = value/benefit of a haircut to the buyer) Peter $20 Paul 15 Mary 10 Jack 5 Jill 5

The producers and their costs Name Cost of haircut to sellers: Firm V $5 Firm W 5 Firm X 10 Firm Y 15 Seville Berberi 20

Market for haircuts: demand and supply WtP (value of a haircut) of buyers: Peter $20 Paul $15 Mary $10 Jack $5 Jill $5 Cost of haircut to sellers: Firm V $5 Firm W $5 Firm X $10 Firm Y $15 Seville Berberi $20 20 15 10 5 Price haircuts Peter Paul Jack and Jill V and W X Y SB Mary 0 1 2 3 4 5

The equilibrium in the market for haircuts Equilibrium Price = $10 Peter, Paul and Mary buy one haircut each, Firms V, W and X supply one haircut each. Gains to consumers Peter = $20 - $10 = $10 Paul = $15 - $10 = $5 Mary = $10 - $10 = $0 Gains to producers V = $10 - $5 = $5 W = $10 - $5 = $5 SB = $10 - $10 = $0 Total Gain: $25 20 15 10 5 Price haircuts Peter Paul Jack and Jill Consumer Surplus V and W X Y SB Mary Producer Surplus 0 1 2 3 4 5

We use the demand curve to measure consumers’ surplus The area below the demand curve and above the price line measures the consumers’ surplus.

Consumers’ surplus: the area under the demand curve above the price line Q1 Quantity

We use the demand curve to measure consumers’ surplus Consumers’ surplus is the measure of consumers’ welfare. The bigger this area, the larger the consumers’ welfare.

Consumers’ surplus: the area under the demand curve above the price line Initial consumer surplus Consumer surplus to new consumers P1 Q1 D E F P2 Q2 Additional consumer surplus to initial consumers Quantity

Multiple choice questions

When the price is P1, consumer surplus is a. A. b. A + B. c. A + B + C When the price is P1, consumer surplus is a. A. b. A + B. c. A + B + C. d. A + B + D.

When the price is P2, consumer surplus is a. A. b. B. c. A + B. d When the price is P2, consumer surplus is a. A. b. B. c. A + B. d. A + B + C.

When the price rises from P1 to P2, consumer surplus a When the price rises from P1 to P2, consumer surplus a. increases by an amount equal to A. b. decreases by an amount equal to B + C. c. increases by an amount equal to B + C. d. decreases by an amount equal to C.

When the price rises from P1 to P2, which statements is NOT TRUE. a When the price rises from P1 to P2, which statements is NOT TRUE? a. The buyers who still buy the good are worse off because they now pay more. b. Some buyers leave the market because they are not willing to buy the good at the higher price. c. Buyers place a higher value on the good after the price increase. d. Consumer surplus in the market falls.

We use the supply curve to measure producers’ surplus The area above the supply curve and below the price line measures the producers’ surplus in the market.

How the price increase affects producers’ surplus Supply B P1 C Producer surplus A Q1 Quantity

We use the supply curve to measure producers’ surplus Producers’ surplus is the measure of producers’ welfare. The bigger this area, the larger the welfare of the producers.

How the price increase affects producers’ surplus Additional producer surplus to initial producers Supply D E F P2 Q2 Producer surplus to new producers B P1 C Initial producer surplus A Q1 Quantity

Consumers’ and producers’ surplus in the competitive equilibrium Price A C B D E Consumer surplus Demand Supply Equilibrium price quantity Producer surplus Quantity

More MC questions

At the equilibrium, total consumer surplus is represented by the area a. A. b. A + B + C. c. D + E + F. d. A + B + C + D + E + F.

In equilibrium, the total producer surplus is represented by the area F. F + G. D + E + F. D + E + F + G + H.

In equilibrium, the total surplus is represented by the area A + B + C. A + B + D + F. A + B + C + D + E + F. A + B + C + D + E + F + G + H.

End of the lecture