Principles of Microeconomics 09.Welfare and Market Efficiency* Juan Pablo Chauvin August 4, 2011 * Slide content principally sourced from N. Gregory Mankiw “Principles of Economics” Premium PowePoint

Contents 1.Review of previous lecture 2.An auction 3.Prices and consumer surplus

1. Review

Taxes 1.What shifts? If imposed on buyers, it is equivalent to a decrease in income, shifts the demand curve left If imposed on sellers, it is equivalent to an increase in input costs, shifts the supply curve left 2.What is the size of the shift? The amount of the tax 3.Tax incidence (who pays for the tax burden) Whether the tax is charged to the producers or to the sellers is irrelevant – the tax incidence is the same in both cases What matters is the elasticity of Supply and Demand If Supply is more inelastic, the larger share of the burden falls on the sellers. If Demand is more inelastic, the larger share of the burden falls on the buyers

Willingness to pay and CS Willingness to Pay (WTP): the maximum price a buyer is willing to pay for a given good. At any Q, the height of the Demand Curve is the WTP of the marginal buyer. Consumer Surplus (CS): is the amount a buyer is willing to pay minus the amount the buyer actually pays. To get the market CS you add-up the individual CS. P Flea’s WTPAnthony’s WTP

Costs and PS Cost is the value of everything a seller must give up to produce a good ( i.e., opportunity cost). At any Q, the height of the Supply Curve is the cost of the marginal seller. Producer Surplus (PS): is the amount a seller is paid for a good minus the seller’s cost To get the market PS you add-up the individual PS. P Q Janet’s cost Jack’s costChrissy’s cost

2. An auction

Product: Hand-made picture frames

Rules There is 6 buyers and 7 sellers in this classroom Buyers’ goal is to get as many picture frames as they can Sellers’ goal is to sell as many picture frames as they can The instructor will serve as the auctioneer Each buyer at a time makes an offer price (e.g. “I pay $ XX per picture frame”). The sellers that wish to sell at that price make it known and close the transaction. The auction may have up to 6 rounds.

The Buyers’ WTP and the Demand Schedule PriceWho buysQDQD $ and upNobody Rosalia Rosalia, Seeye Rosalia, Seeye, Mehnaz Rosalia, Seeye, Mehnaz, Rachel Rosalia, Seeye, Mehnaz, Rachel, Monica Rosalia, Seeye, Mehnaz, Rachel, Monica, Ellen 6 BuyerWTP Rosalia20 Seeye18 Mehnaz16 Rachel14 Monica12 Ellen10

Demand Schedule and Demand Curve Q P D PriceQDQD $ and up

The Sellers’ costs and the Supply Schedule SellerCost Kirk6 Golib8 Rebeca10 Chandrika12 Elisa14 Marina16 Valery18 PriceWho sells (write names) QSQS $ 0 – 5.99Nobody0 6 – 7.99Kirk1 8 – 9.99Kirk, Golib2 10 – 11.99Kirk, Golib, Rebeca3 12 – Kirk, Golib, Rebeca, Chandrika 4 14 – Kirk, Golib, Rebeca, Chandrika, Elisa 5 16 – Kirk, Golib, Rebeca, Chandrika, Elisa, Marina and up Kirk, Golib, Rebeca, Chandrika, Elisa, Marina, Valery 7

Supply Schedule and Supply Curve Q P S PriceQSQS $ 0 – – – – – – – and up7

Q P Equilibrium Q* P* D S Equilibrium Q = 4 picture frames Equilibrium price range = from $12.01 to $13.99

3. Prices and Consumer Surplus

Q P Student’s Turn: What is the CS at Price $13? Q* D S P*

Q P The CS at Price $13 Q* D S P* Rosalia: = 7 Seeye: 18 – 13 = 5 Mehnaz: 16 – 13 = 3 Rachel: 14 – 13 = 1 Total CS = 16

P Q $ CS with Lots of Buyers & a Smooth D Curve The demand for shoes D 1000s of pairs of shoes Price per pair At Q = 5(thousand), the marginal buyer is willing to pay $50 for pair of shoes. Suppose P = $30. Then his consumer surplus = $20.

P Q Calculating CS with a Smooth D Curve The demand for shoes D CS is the area between P and the D curve, from 0 to Q. Recall: Area of a triangle equals ½ x base x height Height = $60 – 30 = $30. So, CS = ½ x 15 x $30 = $225. h $

Q P How a higher price reduces CS in our example… Q* D S P* 1 P* 2 In the Price raises from $13 to $15, total CS decreases from $16 to $ 9. From the $7 loss in CS: $ 6 are because each of the 3 buyers remaining pays $2 more per frame. $ 1 is because one buyer left the market

P Q How a Higher Price Reduces CS in a smooth Demand Curve D If P rises to $40, CS = ½ x 10 x $20 = $100. Two reasons for the fall in CS. 1. Fall in CS due to buyers leaving market 2. Fall in CS due to remaining buyers paying higher P

P Q demand curve A. Find marginal buyer’s WTP at Q = 10. B. Find CS for P = $30. Suppose P falls to $20. How much will CS increase due to… C. buyers entering the market D. existing buyers paying lower price $ STUDENTS’ TURN: Consumer surplus

Answers P $ Q demand curve A. At Q = 10, marginal buyer’s WTP is $30. B. CS = ½ x 10 x $10 = $50 P falls to $20. C. CS for the additional buyers = ½ x 10 x $10 = $50 D. Increase in CS on initial 10 units = 10 x $10 = $100

Principles of Microeconomics 09. Market Efficiency and Welfare* Juan Pablo Chauvin August 4, 2011 * Slide content principally sourced from N. Gregory Mankiw “Principles of Economics” Premium PowePoint