Ec1661/API135 Jan 28, 2011 Avinash Kishore

Outline Rationality – Opportunity Cost – Marginal Principle Demand, Supply and the Competitive Equilib. Consumer and Producer Surplus, Deadweight loss Externality Coase Theorem

Basic Principles Economic actors are rational. Being rational = Optimizing = Doing the very best they can with available resources Rational people think in terms of opportunity cost: the value of the best foregone alternative – Not just the financial outlay – Cost of your college education is not just the tuition fee you pay (Total Cost = Money Cost + Opportunity Cost)

Basic Principles Rational people think at the margin Not averages AC = C(Q)/Q MC = ΔC(Q)/ ΔQ Marginal Cost (MC) is the cost of producing the last unit, or Change in total cost from increasing output by one unit Similarly for marginal benefit (MB)

Optimal Rule: Produce till MC = Price

Demand: The Steel Mill Example Price ($) Qty. (tons) Q = 300 – P MB Height of demand curve: marginal willingness to pay (WTP) Total WTP =  marginal WTP = Area under the Demand Curve

Supply Price ($) Qty. (tons) MC = Q Supply Curve = MC Curve = Additional Cost of producing one more unit Total Cost of Production/ Supply = Area under the Supply Curve

Market Equilibrium Algebraically, We have Q = 300 – P and MC = Q Optimization Rule: P = MC So, Q = 300 – Q or, 2Q = 300 Q = 150; P = 150

Consumer Surplus CS = Area of the blue triangle = ½ Q*( ) = $11250

Producer Surplus

CS +PS = Social Welfare = $22500 Welfare is maximum when MB = MC. MB = MC in competitive markets.

Let’s try some other point DWL

What if there is an externality? Externality is the effect of buyers’ or sellers’ actions on bystanders. Impact on any party not involved in a given economic transaction. Can be positive (a beautiful garden) or negative externality (pollution) MB = MC does not maximize total welfare if there is an externality

Assume there is a laundry nearby – s.t. MD = 0.5Q Remember: MB = 300 –Q and MPC = Q New term: MSC = MPC + MD = 1.5Q

Now, Social Welfare is maximized by : – MSC = MB – 300 – Q = 1.5Q or 2.5Q = 300 – Q* = 120; P* = 300 – 120 = $ 180

Loss to steel firm of moving to Q * is the shaded red triangle – This is the area between the MB and MPC curve going from Q to Q *. ½ (Q-Q*)X (MB – MPC) Q* ½ (Q-Q*)X (MDq – MDq*) ½ (Q-Q*)X (MSC – MB) Q Laundry gains the trapezoid area under the MD curve going from Q to Q* = = shaded (blue + red) triangle area. DWL from producing Q 1 instead of Q * = Area (blue triangle) What if the Mill Still Chooses MB = MPC?

Numerical Example Steel mill’s loss if Q* instead of Q = ½ (Q-Q*)X (MB – MPC) Q* = ½ (30)*( ) = $ 900 Laundry’s gain if Q* instead of Q = ½ (30)X (60+75) = $2025 Q = ½ (Q-Q*)X(MSC– MB) Q = ½ (30)*( ) = $1125

Coase Theorem: Property rights to laundry Qty, Q Steel Mills π = (MB – MPC) Q = $ = $ = $ = $58 L‘s Damage = MD = 0.5Q $10$40$ 60$ 60.5 MB – MPC = MD or, MB = MD + MPC Or MB = MSC

CT: Property right to the Mill Once Again MB – MPC = MD or, MB = MD + MPC Or MB = MSC