This week:
Review on Chapter 5 and 6
Chapter 5 Efficiency of Market
Employ the demand and supply model and develop consumer surplus and
producer surplus as a measure of Welfare and Efficiency
1. Demand, willingness to pay and value
MB: Marginal benefit is the value of one more unit of a good or service.
WTP: We measure marginal benefit by using the maximum price that people are
willing to pay for one more unit of a good or service.
Demand curve: Demand curve shows the maximum amount the person is willing
to pay for a given quantity
Demand curve = MB curve
Consumer Surplus: Consumer Surplus is the excess of benefit received from a
good over the amount paid for it
Consumer surplus = Value to buyers – Amount paid by buyers
Price decreases, CS increases (for a lower price paid and a higher quantity
purchased)
2. Supply, willingness to sell and cost
MC: Marginal cost is the cost of producing one more unit of good or services.
Supply curve shows the minimum acceptable price the seller needs to be paid for
given quantities.
Supply curve = MC curve
Producer Surplus: Producer Surplus is the excess of the amount received from the
sale of a good or service over the cost of producing it.
Producer surplus = Amount received by sellers – Cost to Sellers
Price rises, PS increases (for a higher price received and additional unit sold)
Consumer surplus = Value to buyers – Amount paid by buyers
Producer surplus = Amount received by sellers – Cost to Sellers
Total Surplus = Consumer Surplus + Producer Surplus
Total Surplus is maximized at the equilibrium (assume perfectly
competitive market and no externalities)
Underproduction Overproduction
The free market allocates the supply of a good to the buyers who value it most
highly (WTP) and allocates the demand for goods to the sellers who can produce
it at the lowest cost
Underproduction - the value of the product to the marginal buyer is greater than
the cost to the marginal seller.
Underproduction - Total surplus would rise if output increased.
Overproduction- the value of the product to the marginal buyer is less than the
cost to the marginal seller.
Overproduction - Total surplus would rise if output decreased.
Efficiency: the property of a resource allocation of maximizing the total surplus
received by all members of society.
Equality: the property of distributing economic prosperity uniformly to the members
of society.
Example:
The cost of producing flat-screen TVs has fallen over the past decade. Let’s consider
some implications of this fact.
(a)Draw a supply and demand diagram to show the effect of falling production costs
on the price and quantity of flat-screen TVs sold. In your diagram, show what
happens to consumer surplus and producer surplus.
(b)Suppose the supply of flat-screen TVs is very elastic. Who benefits most from
falling production costs --- consumers or producers of these TVS?
(a) Consumer surplus: changes from A to (A + B + C + D). An increase of (B+ C +
D).
Producer surplus: changes from (B + E) to (E + F + G). A change of (F + G – B)
which could be positive or negative.
Total surplus rises by (B + C + D) + (F + G – B) = (C + D + F + G)
(b) If the supply of flat-screen TVs is very elastic, then the shift of the supply curve
benefits consumers most. To take the most dramatic case, suppose the supply
curve were horizontal, then there is no producer surplus at all. Consumers capture
all the benefits of falling production costs, with consumer surplus rising from A to
(A + B).
Chapter 6 Supply, Demand and Government Policies
Price ceiling
A legal maximum on the price at which a good
can be sold
The price ceiling is a binding constraint if it is
lower than the equilibrium price and a shortage is
created
Example: Rent control
Price floor
A legal minimum on the price at which a good can
be sold
The price floor is a binding constraint if it is
higher than the equilibrium price and a surplus is
created
Example: minimum wage
Taxes (Per unit tax)
Tax on sellers
If the government requires the seller to pay a
certain dollar amount for each unit of a good
sold, the supply curve will shift left by the exact
amount of the tax.
Tax on buyers
If the government requires the buyer to pay a
certain dollar amount for each unit of a good
purchased, the demand curve will shift left by
the exact amount of the tax.
In both cases, the quantity of the good sold will decline
Buyers and sellers will share the burden of the tax. Buyers pay more for the good
and sellers receive less.
The tax burden does not depend on whether the tax is imposed on buyers or
sellers.
CS & PS before the tax CS & PS after the tax
Elasticity and Tax Incidence
A tax burden falls more heavily on the side of the market that is less elastic.
