micro economics- the power of prices-1
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MicroeconomicsProf. Rushen Chahal
The Power of PricesThe Power of Prices
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Today
Marginal benefit and consumer surplus
Marginal cost and producer surplus
The efficiency of the marketplace Deadweight loss and market failure
The efficiency of imports and exports
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So Far This Semester
Weve began looking at some concepts centralto microeconomics, especially supply anddemand
We understand that supply is upwards slopingand demand is downwards sloping
We saw that market equilibrium occurs where
supply and demand intersect
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So Far This Semester
We see that at equilibrium, the price charged
is equilibrium price, and the quantity
bought/sold is equilibrium quantity
We have seen that a shift in demand or supply
will then lead to a new equilibrium price and
quantity
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Price Signals
Price signals help consumers decide how
much to buy and help producers decide how
much to sell.
In other words:
Buyers buy. Sellers sell. Prices tell them how
much to buy or sell.
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Prices:
When prices rise, consumers will buy less and
suppliers will sell more When prices fall, consumers will buy more and
suppliers will sell less
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Marginal Benefit
I like dumplings
Every time I eat a dumpling, I get a certainamount of value out of it
We can call the value that I get fromconsuming one additional dumpling (ONEUNIT!!!) my marginal benefit
Marginal benefit the incremental value of anadditional unit of a good.
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Marginal Benefit
However, the value of eating each dumpling is notthe same
The first dumpling I eat gives me the most value
Im eating it on an empty stomach The taste is new and refreshing to me
The second dumpling gives me a little less value
It still tastes good, and Im still hungry, but its not as good
as the first dumpling
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Marginal Benefit
So we see that as I consume more and more of aproduct (like dumplings) the value of each additionaldumpling, or marginal benefitI get from each
additional unit decreases
Marginal benefit decreases for a certain period oftime.
I will get zero benefit from dumplings once I am full. Butafter a few hours I will be hungry again and want moredumplings.
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Marginal Benefit
We can think of the demand curve as arepresentation of my marginal benefit
The first dumpling I consume gives me the most
value, so Id be willing to pay the most for that firstdumpling
The second dumpling gives me less value, so Iwouldnt be willing to pay as much for it as the first
And so on . . .
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1 2 3 4 5 6 70
0.
5
1
1.
5
2
2.
5
3
Demand = Marginal Benefit
Price
Quantity
The first dumpling gives me the mostsatisfaction, so Im willing to pay more
for it
The second dumpling gives me lesssatisfaction than the first, so Imwilling to pay less
The 6th dumpling gives me nosatisfaction, so I wouldnt bewilling to pay anything for it
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Marginal Benefit
So marginal benefit is the additional value thatconsumers get from buying one more unit of theproduct
The demand curve is going to represent marginalbenefit
As quantity increases, price decreases, just asincreased consumption of a product leads to
decreasing marginal benefit Lets look at another example
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Marginal Benefit
PricePrice QuantityQuantity
$20$20 11
$15$15 22
$10$10 33
QuantityQuantityMarginalMarginalBenefitBenefit
TotalTotalBenefitBenefit
11 $20$20 $20$20
22 $15$15 $35$35
33 $10$10 $45$45
Dwights demandDwights demand
for blue jeans.for blue jeans.
Dwights benefits from buyingDwights benefits from buying
blue jeans.blue jeans.
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Consumer Surplus
Consumer surplusConsumer surplus -- consumersconsumerstotal benefit minus cost; graphically,total benefit minus cost; graphically,demand minus market price.demand minus market price.
Consumer Surplus = DemandConsumer Surplus = Demand -- Market PriceMarket Price
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Consumer Surplus
PricePrice QuantityQuantity
$20$20 11
$15$15 22
$10$10 33
TotalTotalBenefitBenefit
Total PaidTotal PaidConsumerConsumer
SurplusSurplus
$20$20 $20$20 $0$0
$35$35 $30$30 $5$5
$45$45 $30$30 $15$15
Dwights demandDwights demand
for blue jeans.for blue jeans.
Dwights benefits from buyingDwights benefits from buying
blue jeans.blue jeans.
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Consumer Surplus
1 2 3
DemandDemand
$
Quantity
Price
=$10
Consumer surplusConsumer surplus
in general.in general.
TheThe consumerconsumer
surplussurplus is theis the
area under thearea under thedemand curve anddemand curve and
above the marketabove the market
price. It is whatprice. It is what
consumers gainconsumers gain
from their purchasesfrom their purchases
after deducting theafter deducting the
cost.cost.
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Consumer Surplus
1 2 3
DemandDemand
$
Quantity
Price
=$10
At a price of $10 perAt a price of $10 per
pair of jeans, Dwightpair of jeans, Dwight
buys three pair, andbuys three pair, and
receives $15 worth ofreceives $15 worth ofconsumer surplus.consumer surplus.
His consumerHis consumer
surplus equals thesurplus equals the
sum of the consumersum of the consumer
surplus from the 1st,surplus from the 1st,
2nd, and 3rd pair of2nd, and 3rd pair of
jeans.jeans.
$10 +$5 + $0 =$15.$10 +$5 + $0 =$15.
$10
$5
$0
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Consumer Surplus
We can talk about individual consumer surplus,
as with Dwight and blue jeans
We can also talk about consumer surplus foran entire market
Consider the demand curve for SHE tickets in
Beijing
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Consumer Surplus
PricePerTicket
Tickets sold(thousands)
1 2 3 4 5 6 7 8 9 10 11 12 13
70
65
60
5550
45
40
75
35
80
30
25
85
Market Price
If the price were $80, there would be1000 fans who would still buy tickets
If the price were $60, there would be5,500 fans who would still buy tickets
But regardless of what differentfans would be willing to pay, theyall will pay the market price of $45
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Consumer Surplus
PricePerTicket
Tickets sold(thousands)
1 2 3 4 5 6 7 8 9 10 11 12 13
70
65
60
5550
45
40
75
35
80
30
25
85
Market Price
ConsumerSurplus
Consumer surplus is then, the areaabove the market price line andbelow demand
In this example, CS = X ($85 $45) X 9000= $180,000
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Consumer Surplus
Consumer surplus measures the aggregatebenefit that consumers obtain from buyinggoods in a market
Consumer Surplus varies inversely with price: The lower the price, the higher the consumer
surplus
The higher the price, the lower the consumersurplus
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Marginal Cost and Supply
We saw that we can look at demand in two
different ways:
1. The different quantities of a product that
people are willing to buy at different prices
2. The maximum price the consumer would pay
for each quantity that might be purchased
(marginal benefit)
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Marginal Cost and Supply
We can also then, look at supply in two
different ways:
1. The different quantities of a product that
producers will be willing to make and sell at
different prices
2. The minimum price that producers would be
willing to accept for each quantity offered
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Marginal cost and Supply
This minimum price that producers would bewilling to accept for each quantity sold isgoing to be their marginal cost
This represents the additional cost ofproducing each additional unit
We see according to the supply curve that
marginal cost is increasing
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Marginal Cost
Supply = Marginal CostSupply = Marginal Cost
$$
QuantityQuantity11 22 33
Marginal cost increasesMarginal cost increases
as quantity producedas quantity produced
rises.rises.
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Marginal Cost
What causes marginal cost to increase?
Why is it going to be more expensive to produce the500th unit of a product than the 100th unit?
This has to do with the law of diminishing returns For now,just accept the fact that producing the first
unit is cheaper than the second, producing thesecond is cheaper than the third, and so on
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Marginal Cost
Because the cost of producing eachsuccessive unit becomes more expensive,
the minimum price suppliers will accept fora unit increases as production increases
The more of a good that must be produced,the more expensive each unit is to make,
thus the higher the price that must becharged
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Marginal Cost
PricePrice QuantityQuantity
$5$5 11
$7.50$7.50 22
$10$10 33
QuantityQuantityMarginalMarginalCostCost
Total CostTotal Cost
11 $5$5 $5$5
22 $7.50$7.50 $12.50$12.50
33 $10$10 $22.50$22.50
Buddys supplyBuddys supply
of blue jeans.of blue jeans.
Buddys cost of producingBuddys cost of producing
blue jeans.blue jeans.
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Producer Surplus
The Producer Surplus producers revenue
minus production cost; graphically, market
price minus supply.
Producer Surplus = Market PriceProducer Surplus = Market Price -- SupplySupply
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Producer Surplus
PricePriceQuantityQuantity
SoldSold
$5$5 11
$7.50$7.50 22
$10$10 33
Total CostTotal CostTotalTotal
RevenueRevenueProducerProducerSurplusSurplus
$5$5 $5$5 $0$0
$12.50$12.50 $15$15 $2.50$2.50
$22.50$22.50 $30$30 $7.50$7.50
Buddys supplyBuddys supply
of blue jeans.of blue jeans.
Buddys cost of producingBuddys cost of producing
blue jeans.blue jeans.
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Producer Surplus
SupplySupply
$$
QuantityQuantity11 22 33
TheTheproducer surplusproducer surplusis the area above theis the area above the
supply curve andsupply curve and
under the marketunder the market
price. It is whatprice. It is what
the producers gainthe producers gain
from their salefrom their sale
after deductingafter deducting
their cost.their cost.
PricePrice$10$10
Producer SurplusProducer Surplus
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Producer Surplus
SupplySupply
$$
QuantityQuantity11 22 33
At a price of $10 perAt a price of $10 per
pair of jeans, Buddy sells 3pair of jeans, Buddy sells 3pair and receivespair and receives
$7.50 worth of$7.50 worth ofproducer surplus.producer surplus.
His producer surplus equals theHis producer surplus equals the
sum of his producer surplussum of his producer surplus
from the 1from the 1stst, 2, 2ndnd and 3and 3rdrd pairs,pairs,
which is $5 + $2.50 +$0which is $5 + $2.50 +$0
equals $7.50equals $7.50
PricePrice$10$10
$5$5$2.50$2.50
$0$0
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Marginal Benefit and Marginal Cost
Marginal Benefit (to consumers): The value
of each additional unit of the good.
Marginal Cost (to producers): The cost ofresources used to produce each additional
unit.
The efficient outputoccurs when societys
marginal benefit equals marginal cost.
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Market Efficiency
Supply = Marginal Cost
D
emand = MarginalB
enefit
$
QuantityEfficient
Quantity
Equilibrium
Price
ConsumerConsumer
SurplusSurplus
Social Surplus =Social Surplus =
consumer surplusconsumer surplus
+ producer surplus+ producer surplus
ProducerProducer
SurplusSurplus
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Market Efficiency
The market equilibrium price
leads to the efficient quantity.
No other quantity would generate a larger total of
consumer and producer surplus.
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Deadweight Loss
If the price is less than the equilibrium price,
quantity supplied will be less than the
equilibrium quantity.
If the price is greater than the equilibrium
price, quantity demanded will be less than
the equilibrium quantity.
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Deadweight Loss
Deadweight Loss reduction in social surplus
caused by inefficient price (any price that is
NOT the equilibrium price); shown graphically
as a triangular area.
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Deadweight Loss
Supply = Marginal Cost
Demand = Marginal Benefit
$
QuantityEfficient
Quantity
Deadweight Loss
High PriceHigh Price
Producer
surplus =
price -supply
Consumer surplus = demand - price
InefficientInefficient
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Deadweight Loss
Supply = Marginal Cost
Demand = Marginal Benefit
$
QuantityEfficient
Quantity
Deadweight Loss
Producer
surplus =
price -
supply
Low PriceLow Price
Consumer surplus = demand - price
InefficientInefficient
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Deadweight Loss
It seems in general that if we leave the market to
itself, prices will adjust to equilibrium price (as we
saw last week) and social surplus will be maximized
The argument would be that we should always leavethe free market alone, and in this way we can avoid
any deadweight loss
But this may not always be the case
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Market Failure
Market failure instances in which the market outcome failsto achieve efficiency.
In other words: The market does not maximize social surplus.
Market failure happens ONLY if the market is not able to getto equilibrium
Causes include public goods, common property resources,externalities, monopoly.
Market failure will cause a deadweight loss.
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Imports and Exports
Lets bring trade into the picture
Does trade serve to increase or decrease social
surplus?
If you had to guess, what would you guess? Is trade
good or bad for social surplus?
Yes, (and were starting to see a trend here) in
economics, trade is generally considered to be good
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Imports and Exports
If a country doesnt engage in international trade,prices within the country reflect the domesticdemand and supply for goods
These are what we would call domestic prices If we open our economy to international trade,
however, we now are subjecting ourselves tointernational producers and consumers
Prices are going to tend towards world prices
These prices are determined by the supply anddemand from all countries
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Imports and Exports
Countries that trade can import goods, export
goods, or do both
Whether a country imports or exports a good
is going to depend upon whether the
domestic price is above or below the world
price
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Imports and Exports
Regardless of if it is above or below the worldprice, international trade means the domesticprice will come to be equal to the world price
If the domestic price is below the world price,the country will export the good
If the domestic price is above the world price,
the country will import the good
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Imports and Exports
Lets take a look at an example where the domesticprice is above the world price
In this case we would expect the country to import
the good Domestic consumers are unwilling to purchase the
good for higher than the world price
Producers will also not sell for less than the world
price
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Imports and Exports
Because the price is now below the domestic market
price, we would normally experience a shortage
But the difference between quantity demanded and
quantity supplied is made up for by imports
This will actually increase social surplus to more than
it would have been had there been no trade!!
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Efficiency OfImports
Supply
Demand
$
QuantityQuantityProduced
World Price
Quantity
Consumed
Imports
Market Equilibrium
with trade
Added Social surplus
From imports
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Imports and Exports
What about a situation where the domestic price
was below the world price
In this case we would expect the country to export
the good
Producers would be unwilling to sell their good for
less than the world price
Consumers are unwilling to purchase the good for
more than the world price
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Imports and Exports
Because the price is now above the domesticmarket price, we would normally experience asurplus
But this excess product is now going to beexported and sold abroad
This will also increase social surplus to a level
higher than it would have been had therebeen no trade
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Efficiency Of Exports
Supply
Demand
$
QuantityQuantity
consumed
World Price
Quantity
produced
Exports
Market Equilibrium
with trade
Added Social surplus
from Exports
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Imports and Exports
To Put It Simply:
When a country imports a good, consumer surplus
increases and producer surplus decreases
Which changes more? Consumer surplus!
When a country exports a good, producer surplus
increases and consumer surplus decreases
Which changes more?
Producer surplus!
In either situation, social surplus increases
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Imports and Exports
What should you remember from this section?:
International trade increases total social surplus!!
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