1. AGEC/FNR 406 LECTURE 8 A rural market in the Philippines

2. Static Efficiency Lecture Goals: 1.Bring together supply and demand analysis 2. Identify equilibrium conditions and the key aspects of static efficiency

3. Markets What is a market? 1. A place where buyers and sellers interact (either physically or virtually) 4. A place where private decisions regarding optimality are made. 3. A place where producers (or sellers) reveal the cost of supplying goods 2. A place where consumers reveal their willingness (and ability) to pay

4. Part 1: Consumer Demand Consumers make tradeoffs. Why? 1. Different bundles of goods provide different levels of utility 2. Marginal utility is diminishing 3. Prices influence decision making 4. Choices depend on income

5. Key Point A consumer’s optimal consumption pattern occurs where the marginal utilities of consumption are equal to the ratio of prices, i.e. where the budget constraint is tangent to the indifference curve. The goods that consumers demand reflect the tradeoffs that consumers are willing to accept.

6. Demand curve Quantity Price A demand curve measures the amount of a particular good that a person would be willing to purchase at a range of prices, i.e. the marginal benefit. D = MB 20 1 25

7. Willingness to pay Quantity Price willingness to pay = area under demand curve D 1 Total willingness to pay = sum of willingness to pay for each and every unit of a good 25 2

8. Willingness to pay Quantity Price D Total willingness to pay = area under the demand curve, located to the left of the allocation of interest. Total willingness to pay is a measure of private benefits associated with consumption.

9. Importance of demand curves: Quantity of CDs purchased Price demand = willingness to pay willingness to pay is an indicator of private value to the individual Demand for CDs 5 4 20 1

10. Willingness to pay Total willingness to pay is a narrow definition: it measures what someone would be willing to pay. If no one is willing to pay, is the value zero? From an economic perspective, the answer is: YES

11. willingness to pay  price Quantity of CDs purchased Price willingness to pay = area under demand curve Demand for CDs 20 1 For 1 CD, individual pays $20 BUT... willingness to pay > price WTP = $20 x 1 + ($5 x 1)/2 = $22.5 25

12. willingness to pay  price Quantity of CDs purchased Price Demand for CDs 5 4 For 4 CDs, individual pays $5 x 4 = $20 BUT... WTP = $5 x 4 + ($20 x 4)/2 = $60 25

13. Can we be creative in assessing willingness to pay? YES Q:What is the value of an Oak Savannah Remnant? A: The price The Nature Conservancy is willing to pay to purchase and protect it.

14. Q:What is the value of having clean drinking water? A: The price of bottled water or the cost of a water filtration system. Can we be creative in assessing willingness to pay? YES

15. Consumer surplus Price 5 4 The excess of willingness to pay over the amount actually paid (i.e. the triangle in the graph) is called “consumer surplus”. 25

16. Part 2: Supply The supply curve is an incremental measure of the private cost of producing additional units of a good. To get more, a higher price must be paid. Q P S=MC

17. Producer surplus Price 5 4 The excess of price over the cost of production (i.e. the triangle in the graph) is called “producer surplus”. 25

18. Market Equilibrium A market will reach an equilibrium where the quantity demanded equals the quantity supplied. Q P S=MC D=MB P* Q*

19. Market Equilibrium At a given price... If supply exceeds demand: Price will fall and quantity demanded will increase. Q P S=MC D=MB QSQS QDQD

20. Market Equilibrium At a given price... If demand exceeds supply: Price will rise and quantity demanded will fall. Q P S D QDQD QSQS

21. Market Equilibrium When D=S, MB=MC Market achieves “Static Efficiency” Q P S=MC D=MB P* Q*

22. Calculating Net Benefit Total Benefit = area under the demand curve Q P S=MC D=MB Total Cost = area under the supply curve Net Benefit = Total Benefit - Total Cost

23. Static Efficiency Static Efficiency is obtained when Net Benefit is Maximized, i.e. when MB=MC Q P S=MC D=MB

24. Conditions satisfied by static efficiency 1. Factors paid marginal value product (MVP) 2. Price ratio = MRTS 3. Ratio of MUs = Ratio of prices As a result, opportunity costs in consumption equal opportunity costs in production

25. Static vs. dynamic efficiency The “model” discussed above is static, meaning it is concerned with maximization of net benefits for a single time period. Many economic decisions that occur over time are a series of static decisions. Example: Shopping for Food Choose groceries each week, consume them, then start over again next week.

26. Static vs. dynamic efficiency A dynamic decision is one in which today’s decision has some impact on the choices or outcomes available in the future. Many economy-environment decisions are inherently dynamic decisions. Example: Forestry If you choose to harvest trees this year, harvesting next year is no longer an option.