1. Supply and demand Part 3

2. Underlying assumptions in economic theory The underlying value judgement Individual (Homo oeconomicus hypothesis) sovereignty: Resources should be allocated according to what people want. (Pareto-efficiency) The underlying concept Opportunity costs: In order to consume more of good 1 (e.g., boats) you have to give up some consumption of good 2 (e.g., environmental quality or leisure).

3. Let’s go deeper into demand Individuals have preferences over goods & services including the environment. It’s all based on UTILITY The individual preferences can be translated into an willingness to pay (WTP), reflecting the individual benefits from consumption. Generally, the marginal willingness to pay declines with the amount consumed. Let us ignore the environment for the time being. From individual needs to an aggregated demand curve !

4. law of diminishing returns Gossen's First Law is the “law” of diminishing marginal utility: that marginal utilities are diminishing across the ranges relevant to decision-making. Gossen's Second Law, which presumes that utility is at least weakly quantified, is that in equilibrium an agent will allocate expenditures so that the ratio of marginal utility to price (marginal cost of acquisition) is equal across all goods and services.

5. example

6. Marginal WTP Quantity 1 Benefits and Costs 50 Aggregated demand curve

7. Marginal WTP Quantity 1 Benefits and Costs 50 42 2 Aggregated demand curve

8. Marginal WTP Quantity Benefits and Costs 50 42 35 WTP 10 Aggregated demand curve

9. Marginal WTP Quantity Benefits and Costs 50 42 35 WTP 10 Aggregated demand curve

10. Marginal WTP Quantity Benefits and Costs 50 42 35 WTP 10 Aggregated demand curve

11. Marginal WTP Quantity Benefits and Costs 50 42 35 WTP 10 Aggregated demand curve Question: How do we get to know the marginal willingness to pay of somebody?

12. Benefits and Costs WTP Quantity 10 Linear relationship  This makes it easier for us to handle! Aggregated demand curve Marginal WTP

13. Benefits and Costs Summing up individual WTP yields total WTP. Total willingness to pay is equal to total benefits from consumption. Total (marginal) WTP provides a measure of a society’s benefits from consumption.

14. Benefits and Costs The production side: The available technologies determine the production possibilities. Producing goods/services implies (opportunity) costs Marginal cost curve shows the costs of producing one additional unit. Marginal costs are non-decreasing with output. Total costs are the sum of marginal costs.

15. Benefits and Costs Marginal Costs Relationship of marginal to total costs Total Costs Quantity 20 Marginal Costs

16. Socially Optimal Outcome Calculation of net benefits: total (aggregate) net benefits = total (aggr.) benefits – total costs Efficiency: An allocation is efficient if this allocation maximises net benefits. Optimality condition: Net benefits are maximised if marginal benefits equal marginal costs. Source: Tietenberg (2006), p. 23.

17. Socially Optimal Outcome Net Benefit Marginal WTP/Costs Quantity Q* Derivation of net benefits Total Costs Maximum price

18. Additional reading for those interested: Duncan Kennedy, Cost-Benefit Analysis of Entitlement Problems: A critique; Stanford Law Review, Vol. 33, No. 3 (Feb., 1981), pp. 387-445 Stable URL: http://www.jstor.org/stable/1228354

19. Why is the market economy best in theory? Both consumers and producers are better off because there is a market in this good, i.e. there are gains from trade. The maximum possible total surplus (highest possible gain to society) is achieved at market equilibrium. In the market equilibrium there is no way to make some people better off without making others worse off  markets are efficient. (no pareto optimum possible)

20. The benifits of the market system Example: Market for books

21. Two cases It’s all about books Situation No. 1 “Demand”: We have a market for books. Imagine we would take an economics book from Mia (who bought it) and give it to Bob, who thought it is too expensive. What are the effects?

22. Reallocating consumption lowers consumer surplus

23. Case No. 2 Situation No. 2 “Supply”: Two booksellers (Yvonne & Xavier) are competing on the market. Imagine Yvonne would be forced to sell her book instead of Xavier. What would be the effect?

24. Reallocating Sales Lowers Producer Surplus

25. The market performs 4 important functions It allocates consumption of the good to the potential buyers who value it the most. It allocates sales to the potential sellers who most value the right to sell the good. It ensures that every consumer who makes a purchase values the good more than every seller who makes a sale. It ensures that every potential buyer who doesn’t make a purchase values the good less than every potential seller who doesn’t make a sale.

26. Freakonomics blog What problems to exist if we deal with supply and demand ? Refer to problems mentioned in the articles

27. Links to articles http://www.freakonomics.com/2012/02/01/are-super- bowl-ads-too-cheap/http://www.freakonomics.com/2012/02/01/are-super- bowl-ads-too-cheap/ http://www.freakonomics.com/2012/01/12/the- economics-of-prostitution-belle-epoque-edition/http://www.freakonomics.com/2012/01/12/the- economics-of-prostitution-belle-epoque-edition/ http://www.freakonomics.com/2011/12/02/why-does- a-caucasian-dollhouse-cost-nearly-70-more-than-an- african-american-dollhouse/http://www.freakonomics.com/2011/12/02/why-does- a-caucasian-dollhouse-cost-nearly-70-more-than-an- african-american-dollhouse/

28. Defining and Measuring Elasticity The price elasticity of demand is the ratio of the percent change in the quantity demanded to the percent change in the price as we move along the demand curve.

29. Different values for elasticity

32. Interpreting the Price Elasticity of Demand: How Elastic Is Elastic? Demand is: elastic if the price elasticity of demand is greater than 1, inelastic if the price elasticity of demand is less than 1, and unit-elastic (or iso-elastic) if the price elasticity of demand is exactly 1.

33. Price Elasticity of Supply …and nearly the same, just the other way around… The price elasticity of supply is a measure of the responsiveness of the quantity of a good supplied to the price of that good.

34. Quick review of demand Review: Demand curve illustrates relationship between price & quantity demanded The „law of demand“ asserts that demand curves normally slope downward  higher price, fewer quantity Increase in demand  right-shift of the curve Decrease in demand  left-shift of the curve 4 main factors that can shift the curve: (1) price of a related good: substitute or complement (2) income (3) tastes and (4) expectations

35. Quick review of supply Review: supply curve illustrates relationship between price and quantity supplied The supply curves are normally sloping upwards  higher price, more quantity offered Increase in supply  right-shift of the curve Decrease in supply  left-shift of the curve 3 main factors that can shift the curve: (1) input prices (2) technology and (3) expectations

36. A different view on supply & demand

37. Any questions left ?