1. Extra Slides for Review (Slides 1-30) 1. Demand 1

2. Price of Coffee Quantity of Coffee 2 Tony’s Demand Schedule & Curve Price of coffee Quantity of coffee demanded $0.0016 1.0014 2.0012 3.0010 4.008 5.006 6.004

3. Market Demand versus Individual Demand The quantity demanded in the market is the sum of the quantities demanded by all buyers at each price. Suppose Tony and Dani are the only two buyers in the coffee market. (Q d = quantity demanded) 3 4 6 8 10 12 14 16 Tony’s Q d 2 3 4 5 6 7 8 Dani’s Q d + + + + = = = = 6 9 12 15 +=18 +=21 +=24 Market Q d $0.00 6.00 5.00 4.00 3.00 2.00 1.00 Price

4. P Q 4 The Market Demand Curve for Coffee P Q d (Market) $0.0024 1.0021 2.0018 3.0015 4.0012 5.009 6.006

5. Willingness to Pay (WTP) A buyer’s willingness to pay for a good is the maximum amount the buyer will pay for that good. WTP measures how much the buyer values the good. 5 nameWTP Flea$300 Anthony250 Chad175 John125 Example: 4 buyers’ WTP for an iPod

6. WTP and the Demand Curve Q:If price of iPod is $200, who will buy an iPod, and what is quantity demanded? 6 A:Flea & Anthony will buy an iPod, Chad & John will not. Hence, Q d = __ when P = $200. nameWTP Flea$300 Anthony250 Chad175 John125

7. WTP and the Demand Curve Derive the demand schedule: 7 4 John, Chad, Anthony, Flea 0 – 125 3 Chad, Anthony, Flea 126 – 175 2Anthony, Flea176 – 250 1Flea251 – 300 0nobody$301 & up QdQd who buys P (price of iPod) nameWTP Flea$300 Anthony250 Chad175 John125

8. WTP and the Demand Curve 8 PQdQd $301 & up0 251 – 3001 176 – 2502 126 – 1753 0 – 1254 P Q Q d =0 Q d =1 Q d =2 Q d =3 Q d =4 $175 $125

9. About the Staircase Shape… This D curve looks like a staircase with 4 steps. 9 P Q If there were a huge # of buyers, as in a competitive market, there would be a huge # of very tiny steps, and it would look more like a smooth curve.

10. Shifts of D Curve Economic variables held constant when specifying demand include income, wealth, prices of related goods, preferences, price expectations, the number of buyers… If one of the above variables change, the demand curve will shift. 10

11. P Q Suppose the number of buyers increases. Then, at each price, quantity demanded will increase (by 5 in this example). D curve shifts to the right. 11

12. 2. Supply 12

13. 13 Starbucks’ Supply Schedule & Curve Price of coffee Quantity of coffee supplied $0.000 1.003 2.006 3.009 4.0012 5.0015 6.0018 P Q

14. Market Supply versus Individual Supply The quantity supplied in the market is the sum of the quantities supplied by all sellers at each price. Suppose Starbucks and Jitters are the only two sellers in this market. (Q s = quantity supplied) 14 18 15 12 9 6 3 0 Starbucks 12 10 8 6 4 2 0 Jitters + + + + = = = = 30 25 20 15 +=10 +=5 +=0 Market Q s $0.00 6.00 5.00 4.00 3.00 2.00 1.00 Price

15. P Q The Market Supply Curve P Q S (Market) $0.000 1.005 2.0010 3.0015 4.0020 5.0025 6.0030 15

16. Cost and the Supply Curve Cost is the value of everything a seller must give up to produce a good (i.e., opportunity cost). Includes cost of all resources used to produce good, including value of the seller’s time. Example: Costs of 3 sellers in the lawn-cutting business. 16 namecost Angelo$10 Hunter20 Kitty35 A seller will only produce and sell the good if the price exceeds his/her cost. Hence, cost is a measure of willingness to sell.

17. Cost and the Supply Curve 17 335 & up 220 – 34 110 – 19 0$0 – 9 QsQs P Derive the supply schedule from the cost data: namecost Angelo$10 Hunter20 Kitty35

18. Cost and the Supply Curve 18 P Q PQsQs $0 – 90 10 – 191 20 – 342 35 & up3 $35

19. Shifts of S Curve Economic variables held constant when deriving a supply curve include production technology, input prices, taxes and subsidies, and price expectations 19

20. Examples of inputs: for coffee: milk, sugar, coffee machines, buildings… A fall in input prices makes production more profitable at each output price, so firms supply a larger quantity at each price, and the S curve shifts to the right. Example: input prices 20

21. P Q Suppose the price of milk falls. At each price, the quantity of coffee supplied will increase (by 5 in this example). Example: input prices 21

22. 3. Welfare Measures 22

23. (1) Consumer Surplus (CS) Consumer surplus is the amount a buyer is willing to pay minus the buyer actually pays. 23 nameWTP Flea$300 Anthony250 Chad175 John125 Suppose P = $260. Flea’s CS = $300 – 260 = $ __. The others get no CS because they do not buy an iPod at this price. Total CS = $ ___.

24. CS and the Demand Curve 24 P Q Flea’s WTP P = $260 Flea’s CS = $300 – 260 = ___ Total CS = ___

25. CS and the Demand Curve 25 P Q Flea’s WTPAnthony’s WTP Instead, suppose P = $220 Flea’s CS = $300 – 220 = ___ Anthony’s CS = $250 – 220 = ___ Total CS = ____

26. CS and the Demand Curve 26 P Q The lesson: Total CS equals the area below the demand curve & above the price.

27. P Q CS with Lots of Buyers & a Smooth D Curve Q: P = $30, CS=? A: CS is the area below the D curve and above the P. Recall: area of a triangle equals ½ x base x height So, CS=½ x 15 x $30 = _____ 27 The Demand for Shoes D h $ Price per pair 1000s of pairs of shoes

28. (2) Producer Surplus P Q Producer surplus (PS): the amount a seller is paid for a good minus the seller’s cost. 28

29. Producer Surplus and the S Curve P Q Suppose P = $25 Angelo’s PS = ___ Hunter’s PS = ___ Total PS = ____ Kitty’s cost Hunter’s cost Angelo’s cost Total PS equals the area below the price and above the supply curve. $25 29

30. P Q PS with Lots of Sellers & a Smooth S Curve The supply of shoes S Q: P=$40, PS=? A: PS is the area below the P and above the S curve. The height of this triangle is $40 – 15 = $25. So,PS= _____________ = $312.5 h Price per pair1000s of pairs of shoes $15 30

31. Modeling the Market Process: A Review of the Basics Chapter 2 31

32. 32 1. Market Models: Fundamentals Defining the Relevant Market – A market: the interaction between _________ & ___________ to exchange a well-defined commodity – Defining the market context is one of critical steps in economic analysis Specifying the Market Model – Qualitative and quantitative relationship

33. 33 2. Supply and Demand: An Overview Primary objective of the supply and demand model is to facilitate an analysis of market conditions and any observed change in price Sellers’ decisions are modeled through a _______ function and buyers’ decisions are modeled through a _______ function

34. 34 Competitive Market for Private Goods Private goods are commodities that have two characteristics: excludable and rival in consumption A competitive market is characterized by: – A large number of buyers and sellers with no control over price – The product is homogenous or standardized – The absence of entry barriers – Perfect information

35. Important Characteristics of Goods A good is excludable if a person can be prevented from using it if he does not pay for it. – excludable: fish tacos – not excludable: national defense A good is rival in consumption if one person’s use/ consumption of it diminishes others’ use/ consumption. – rival: fish tacos – not rival: national defense 35

36. Classic division of goods in economy Rival in consumption (consumption diminishes its value) Not rival Excludable (have to pay) private goodsprivate goods: food clothing natural monopolies (club goods): cable TV Not excludable common resourcescommon resources: fish in the sea public goodspublic goods: national defense tornado siren 36

37. 37 3. Demand Demand refers to the quantities of a good the consumer is willing and able to buy at a set of prices during some time period, ceteris paribus (c.p.) – The willingness to pay (WTP), or demand price, measures the marginal benefit (MB) from consuming another unit of the good Law of Demand says there is an _________ relationship between price (P) and quantity demanded of a good (q d ), c.p.

38. 38 Market demand captures the decisions of all consumers willing and able to purchase a good – For a private good, market demand is found by horizontally summing individual demands

39. 39 Market Demand Bottled Water Price Quantity P = –0.01Q D + 11.5 $11.50 D 1,150

40. 40 4. Supply Supply refers to the quantities of a good the producer is willing and able to bring to market at a given set of prices during some time period, c.p. Law of Supply – there is a direct relationship between price (P) and quantity supplied (q s ) of a good, c.p. – Rising marginal cost (MC) supports this positive relationship (willingness to sell should cover MC)

41. 41 Market Supply captures the combined decisions of all producers in a given industry – Derived by horizontally summing the individual supply functions

42. 42 Market Supply Bottled Water Price Quantity S P = 0.0025Q S + 0.25 0.25

43. 43 5. Market Equilibrium Supply and demand together determine a unique equilibrium price (P E ) and equilibrium quantity (Q E ), at which point there is no tendency for change – P E occurs where ____________ Model for bottled water – D:P = –0.01Q D + 11.5 – S:P = 0.0025Q S + 0.25 – Equilibrium found where –0.01Q D + 11.5 = 0.0025Q S + 0.25, or where Q E = 900 and P E = _________

44. 44 Market Equilibrium Bottled Water Price Quantity S 0.25 D 2.50 900 11.50 PEPE QEQE

45. 45 Market Adjustment to Equilibrium Disequilibrium occurs if the prevailing market price is at some level other than the equilibrium level – If actual price is below its equilibrium level, there will be a shortage Shortage = excess demand = Q D – Q S – If actual price is above its equilibrium level, there will be a surplus Surplus = excess supply = Q S – Q D Price movements serve as a signal that a shortage or surplus exists, whereas price stability suggests equilibrium

46. 46 6. Efficiency Criteria (1) Allocative Efficiency At the market level, allocative efficiency requires that resources be appropriated such that additional benefits to society are equal to additional costs incurred, i.e., _____________ – The value society places on the good is equivalent to the value of the resources given up to produce it At the firm level, this efficiency is achieved at a competitive market equilibrium, assuming firms are _________________________

47. 47 Profit Maximization Total Profit (  ) = Total Revenue (TR) - Total Costs (TC) – TR = P x Q – TC is all economic costs, explicit and implicit Profit is maximized where  TR/  Q =  TC/  Q, or where ________________ MR =  TR/  Q, additional revenue from producing another unit of Q MC =  TC/  Q, additional cost from producing another unit of Q

48. 48 Profit Maximization In competitive industries, firms face constant prices determined by the market, which means P = MR Therefore the competitive market equilibrium achieves allocative efficiency because: –  maximization requires:MR = MC – Competitive markets imply: P = MR – So  maximization in competition means: P = MC, which defines allocative efficiency

49. 49 Profit Maximization Bottled Water $ Quantity 2.50 0.25 MC P = MR q E = 36

50. 50 (2) Technical Efficiency Technical Efficiency refers to production decisions that generate _____________________given some stock of resources Market forces can achieve technical efficiency so long as competitive conditions prevail – Competitive firms must minimize costs to remain viable in the market because they cannot raise price to cover the added cost of inefficient production

51. 51 7. Welfare Measures (1) Consumer Surplus (CS) Consumer surplus is the net benefit to buyers estimated by the excess of marginal benefit (MB) of consumption over market price (P), aggregated over all units purchased Graphically measured as the triangular area above the price and below the demand curve up to the quantity sold

52. 52 Consumer Surplus Bottled Water Market CS = ___________________________ = ____________

53. 53 (2) Producer Surplus (PS) Producer surplus is the net gain to sellers of a good estimated by the excess of the market price (P) over marginal cost (MC), aggregated over all units sold Graphically measured as the triangular area above the MC curve up to the price level over all units sold

54. 54 Producer Surplus Bottled Water Market PS = ____________________________ = _____________

55. 55 (3) Deadweight Loss (DWL) Society’s welfare can be captured through the sum of CS and PS Comparing these measures before and after a market disturbance helps quantify how society is affected by that disturbance through Deadweight Loss (DWL) DWL is the net loss of consumer and producer surplus due to an allocatively inefficient market event

56. 56 DWL of Price Regulated above P E Bottled Water Policy forces price to $6.50 DWL = (C + E) = ____________________________________ =_____________

57. Refer to slide 46: Greg Mankiw, Principles of Economics, Ch7— An allocation of resources is efficient if it maximizes total surplus. The market equilibrium is efficient. 57