1. the analytics of constrained optimal decisions microeco nomics spring 2016 the perfectly competitive market ………….1demand and supply curves revisited ………….2 market mechanism and equilibrium session three ………….3market dynamics: shifting curves ………….5 market dynamics: long-run ………….8market dynamics: key points ………….9 consumer surplus ………11producer surplus ……….13 market efficiency analysis ………14price floor analysis ……….15 price ceiling analysis ……….16 consumer tax analysis ………17tax incidence analysis ……….18 key points

2. microeconomic s the analytics of constrained optimal decisions lecture 3 the perfectly competitive market & government intervention  2016 Kellogg School of Management lecture 3 page |1 demand and supply curves revisited ► Demand and supply curves revisited ► How does the market adjust to an equilibrium? demand curve The demand curve associates to each possible price level the utility maximizing consumption level. In particular, the optimal consumption satisfies the condition: MU ( Q *) = P supply curve The supply curve associates to each possible price level the profit maximizing output. In particular:  for P  P shut-down, Q * satisfies P = MC ( Q *) or Q * = Q max  for P < P shut-down, Q * satisfies Q * = 0 MU = 25 – 2 Q Figure 1. Demand curve MC = 3 Q Figure 2. Supply curve  The demand curve is identical with the marginal utility curve. For a given quantity consumed the marginal utility shows by how much the satisfaction increases for the last unit is consumed. That unit is actually bought only if the price paid is no more than the marginal utility obtained.  The height of the demand curve for a given quantity shows the maximum price the consumer is willing to pay for that quantity. quantity  The supply curve is identical with the marginal cost curve. For a given quantity produced the marginal cost shows by how much the cost increases if the last unit is produced. That unit is actually produced only if the price obtained is no less than the marginal cost incurred (for that unit).  The height of the supply curve for a given quantity shows the minimum price the producer is willing to accept for that quantity.

3. microeconomic s the analytics of constrained optimal decisions lecture 3 the perfectly competitive market & government intervention  2016 Kellogg School of Management lecture 3 page |2 demand and supply curves revisited ► Demand and supply curves revisited ► How does the market adjust to an equilibrium? the market mechanism A market mechanism is a set of rules through which agents (consumers, producers, government, market makers, etc.) organize the trade of goods by determining a price level at which the quantity demanded equals the quantity supplied: market equilibrium. P = 25 – 2 Q Figure 3. The market maker mechanism P = 3 Q  The market maker mechanism assumes that a benevolent individual (the market maker) receives from consumers and producers their demand and supply schedules (for each possible price what is the quantity demanded and supplied respectively). The market maker would simply match the two curves by finding the price at which the quantity demanded equals the quantity supplied at point ( M ) the market equilibrium P = 25 – 2 Q Figure 4. The web adjustment mechanism P = 3 Q  The web adjustment mechanism assumes the market will reach its equilibrium by successive adjustments of quantity supplied and demanded. Starting from point (0) at a price of $20 producers are willing to produce about 6.67 units at point (1). But for this output a maximum price of $11.33 at point (2) is paid by consumers which in turn prompts producers to reduce their output to 3.78 units at point (3) and so on unit point ( M ) – the market equilibrium – is reached. (M)(M) (M)(M) (0) (1) (2) (3)

4. microeconomic s the analytics of constrained optimal decisions lecture 3 the perfectly competitive market & government intervention  2016 Kellogg School of Management lecture 3 page |3 market dynamics: shifting curves ► Demand and supply curves shifts ► Long run dynamics (M1)(M1) (M2)(M2) D1D1 D2D2 S P1P1 P2P2 Q1Q1 Q2Q2 Figure 5. Shift in demand curve  A shift in demand curve from D 1 to D 2 moves the equilibrium from ( M 1 ) to ( M 2 ). The change in equilibrium is a movement along the supply curve in this case. The equilibrium price increases from P 1 to P 2 while the equilibrium quantity increases from Q 1 to Q 2. (M1)(M1) (M2)(M2) D1D1 S1S1 P1P1 P2P2 Q1Q1 Q2Q2 Figure 6. Shift in supply curve  A shift in supply curve from S 1 to S 2 moves the equilibrium from ( M 1 ) to ( M 2 ). The change in equilibrium is a movement along the demand curve in this case. The equilibrium price decreases from P 1 to P 2 while the equilibrium quantity increases from Q 1 to Q 2. S2S2

5. microeconomic s the analytics of constrained optimal decisions lecture 3 the perfectly competitive market & government intervention  2016 Kellogg School of Management lecture 3 page |4 market dynamics: shifting curves ► Demand and supply curves shifts ► Long run dynamics  Consider a firm serving two markets characterized by demand curves D 1 and D 2. They intersecting at point ( M 0 ) which is the initial equilibrium in both markets (the initial supply curve is S initial for both markets thus the same price P 0 and quantity Q 0 are initially seen in both markets).  The firm manages to decrease its marginal cost which result in a rotation downward in the supply curve to S new for each market.  In market one the new equilibrium is at point ( M 1 ) with price P 1 and quantity Q 1. In market two the new equilibrium is at point ( M 2 ) with price P 2 and quantity Q 2.  What explains the different reaction in the two markets (notice that P 1 > P 2 and Q 1 < Q 2 )? Which demand is more elastic at the initial point ( M 0 )?  A change in price will result in a higher change in quantity for a more elastic demand. In this case D 2 is more elastic than D 1 at the initial point ( M 0 ). (M0)(M0) (M1)(M1) D2D2 S initial P1P1 P2P2 Q2Q2 Q1Q1 Figure 7. Demand elasticity and shift in supply curve S new D1D1 (M2)(M2) Q0Q0 P0P0

6. microeconomic s the analytics of constrained optimal decisions lecture 3 the perfectly competitive market & government intervention  2016 Kellogg School of Management lecture 3 page |5 market dynamics: the long-run ► Demand and supply curves shifts ► Long run dynamics MC = S (1) Figure 8. Shut-down and entry price: one firm P shut-down ATC FRATC P entry MC = S (1) Figure 9. Shut-down and entry price: several firms P shut-down P entry S (N)  Start with one firm that has a simple marginal cost function, i.e. MC ( Q ) = c  Q. We already know that the shut-down price is the min ATC and the entry price is min FRATC. The interpretation of these two thresholds is simple: - if the market price is expected to be forever below P shut-down then the firm is better off to close - if the market price is expected to be forever above P entry then the investor should incur the investment costs and setup an operational firm  When several identical firms enter the market the shut-down and entry price thresholds have the same meaning.

7. microeconomic s the analytics of constrained optimal decisions lecture 3 the perfectly competitive market & government intervention  2016 Kellogg School of Management lecture 3 page |6 market dynamics: the long-run ► Demand and supply curves shifts ► Long run dynamics S initial Figure 10. Market exit P shut-down P entry  The market starts at point ( M 0 ). The market price P 0 is below the shut-down price P shut-down.  If the demand curve ( D ) is expected to remain the same forever then some firms will have to exit the market…  What is the market dynamics?  As firms et the market the supply curve starts to rotate to the left with the market price increasing as a result.  The market intermediate equilibrium points are all aligned along the demand curve.  The exit process ends when enough firms exit the market to bring the market price just equal to P shut-down.  At point ( M 1 ) the market settles in the new equilibrium with an obvious contraction of the total output offered and at a higher price. S new D (M0)(M0) P0P0 (M1)(M1) Q0Q0 Q1Q1 exit  Market output decreases as a result of firms exiting the market.

8. microeconomic s the analytics of constrained optimal decisions lecture 3 the perfectly competitive market & government intervention  2016 Kellogg School of Management lecture 3 page |7 market dynamics: the long-run ► Demand and supply curves shifts ► Long run dynamics S new Figure 11. Market entry P shut-down P entry  The market starts at point ( M 1 ) with initial demand curve ( D 1 ). The market price is exactly P shut-down.  Say market demand expands to a new curve ( D 2 ) and is expected to remain at this new schedule forever…  What is the market dynamics?  Obviously the new equilibrium is at point ( M 2 ) where the market price P 2 is above the entry price... we expect some entry to occur…  In the interim the existing firms will expand their output resulting in an increase in market output increase from Q 1 to Q 2.  The entry process begins with new firms entering the market which rotate the supply curve to the right…  The entry process ends when enough firms enter the market to bring the market price just equal to P entry. S initial D1D1 (M3)(M3) P2P2 (M1)(M1) Q2Q2 Q1Q1 entry (M2)(M2) D2D2 Q3Q3  In the first phase market output increases as a result of existing firms increasing their output.  The market output continues to increase as new firms enter the market.

9. microeconomic s the analytics of constrained optimal decisions lecture 3 the perfectly competitive market & government intervention  2016 Kellogg School of Management lecture 3 page |8 ► Demand and supply curves shifts ► Long run dynamics ► The market equilibrium will be found at the intersection of demand and supply curves… ► We can distinguish the short-run dynamics and the long-run dynamics : - the short-run refers to the adjustment from a current equilibrium to the new equilibrium through an adjustment of output for existing firms - the long-run refers to the adjustment from a current equilibrium to the new equilibrium through an adjustment in the number of firms operating in the market (exit or entry) ► The critical point in understanding the long-run adjustment is always to consider the shut-down and entry threshold prices in relation to a “hypothetical” forever price level… market dynamics: key points

10. microeconomic s the analytics of constrained optimal decisions lecture 3 the perfectly competitive market & government intervention  2016 Kellogg School of Management lecture 3 page |9 government intervention and market efficiency ► Consumer surplus, producer surplus and market efficiency ► Government intervention ► Consider a consumer who has to decide how much he values each additional unit he might consume. Arguably each additional unit brings a lower satisfaction. ► On the vertical axis we record the (hypothetical) amount the consumer is willing to give up for each unit… ► Suppose that actually he can buy any number of units at the same price $4 per unit. How many units is he going to buy? ► As long as his valuation of a certain unit is at least as high as the price he has to pay for it he will buy that unit ► Given the conditions in the diagram he will buy 4 units ► For the first unit he gets a surplus of $6 as: his valuation ($10) – price ($4) = surplus ($6) This is the area of the first vertical rectangle… ► For the second unit he gets a surplus of $4 as: his valuation ($8) – price ($4) = surplus ($4) This is the area of the second vertical rectangle… The total consumer surplus is the sum of all the per unit surpluses ( = own valuation – price) for each unit demanded. 12345678910 1 2 3 4 5 6 7 8 9 Q 0 11 12 value for 1 st unit value for 2 nd unit value for 3 rd unit value for 4 th unit value for 5 th unit value for 6 th unit units demanded (price) P = $4 consumer surplus consumer surplus Figure 12. Consumer surplus (I)

11. microeconomic s the analytics of constrained optimal decisions lecture 3 the perfectly competitive market & government intervention  2016 Kellogg School of Management lecture 3 page |10 government intervention and market efficiency ► Consumer surplus, producer surplus and market efficiency ► Government intervention ► If we consider now that the good can be divided in very small units we get a “smooth” demand curve for the good. ► Moreover aggregating demand over all consumers in the market we can talk about the market demand for the good and consumers’ surplus defined as ► The total consumer surplus is t he area under the demand curve and above the price charged. 12345678910 1 2 3 4 5 6 7 8 9 Q 0 11 12 value for 1 st unit value for 2 nd unit value for 3 rd unit value for 4 th unit value for 5 th unit value for 6 th unit units demanded (price) P = $4 price ($) market demand ► For the case shown in the diagram we get: Area = ½ ∙ (8) ∙ (4) = 16 consumer surplus Figure 13. Consumer surplus (II)

12. microeconomic s the analytics of constrained optimal decisions lecture 3 the perfectly competitive market & government intervention  2016 Kellogg School of Management lecture 3 page |11 government intervention and market efficiency ► Consumer surplus, producer surplus and market efficiency ► Government intervention ► Consider a producer who has to decide how much it costs her each additional unit he might produce. Arguably (under increasing marginal cost) each additional unit brings a higher cost. ► On the vertical axis we record the cost – the amount the producer is willing to give up for each unit produced… ► Suppose that actually she can sell any number of units at the same price $4 per unit. How many units is she going to sell? ► As long as her cost of a unit is at most as high as the price she receives for it she will produce and sell that unit ► Given the conditions in the diagram she will sell 4 units ► For the first unit she gets a surplus of $3 as: price ($4) – her cost ($1) = surplus ($3) This is the area of the first vertical rectangle… ► For the second unit she gets a surplus of $2 as: price ($4) – her cost ($2) = surplus ($2) This is the area of the second vertical rectangle… cost of 3 rd unit cost of 2 nd unit cost of 1 st unit units produced cost of 4 th unit cost of 5 th unit cost of 6 th unit 1 2 3 4 5 6 7 8 9 10 price ($) 0 11 12 12345678910 Q producer surplus (price) P = $4 The total producer surplus is the sum of all the per unit surpluses ( = price – cost for unit) for each unit sold. producer surplus Figure 14. Producer surplus (I)

13. microeconomic s the analytics of constrained optimal decisions lecture 3 the perfectly competitive market & government intervention  2016 Kellogg School of Management lecture 3 page |12 government intervention and market efficiency ► Consumer surplus, producer surplus and market efficiency ► Government intervention ► If we consider now that the good can be divided in very small units we get a “smooth” supply curve for the good. ► Moreover aggregating supply over all producers in the market we can talk about the market supply for the good and producers’ surplus defined as ► The total producer surplus is the area above the supply curve and below the price received. units produced ► For the case shown in the diagram we get: Area = ½ ∙ (4) ∙ (4) = 8 cost of 3 rd unit cost of 2 nd unit cost of 1 st unit cost of 4 th unit cost of 5 th unit cost of 6 th unit 1 2 3 4 5 6 7 8 9 10 price ($) 0 11 12 12345678910 Q producer surplus (price) P = $4 market supply Figure 15. Producer surplus (II)

14. microeconomic s the analytics of constrained optimal decisions lecture 3 the perfectly competitive market & government intervention  2016 Kellogg School of Management lecture 3 page |13 government intervention and market efficiency price ($) ► The quantity traded and trading price in a free-of-constraints market is obtained at the intersection of demand and supply curves. ► In this case (left diagram) the equilibrium price is P = $4 and 4 units are traded. Consumers’ surplus is the area below the demand curve and above the price paid. Producers’ surplus is the are above the supply curve and below the price received. ► The total surplus is the sum of the consumers’ and producers’ surpluses. consumers’ surplus (CS) light gray area producers’ surplus(PS) dark grey area total surplus(CS) + (PS) ► For the case shown in the diagram we get: Total surplus = 16 + 8 = 24 1235678910 1 2 3 4 5 6 7 8 9 Q 0 11 12 (price) P = $4 supply demand (CS) (PS) Defines the market outcome in terms of price and quantity. equilibrium Related to the possibility to obtain a total surplus at least as high (through a different pair of price and quantity) as the total surplus obtained through the market outcome. efficiency 4 Figure 16. Market equilibrium and total surplus

15. microeconomic s the analytics of constrained optimal decisions lecture 3 the perfectly competitive market & government intervention  2016 Kellogg School of Management lecture 3 page |14 government intervention: price floor ► Price floo r: a minimum price imposed in the market (the price in the market cannot be less than the price floor). ► For a binding case the floor has effect on the market: the floor becomes the transaction price. ► Whenever the price floor is binding the producers would like to produce more than what the consumers demand ( oversupply ). non-binding floorbinding floor price ($) left diagramright diagramchange consumers’ surplus A + B + CA– B – C producers’ surplus D + EB + D+ B – E total surplusA + B + C + D + EA + B + D– E – C deadweight loss A B C D E A B C D E 12345678910 1 2 3 4 5 6 7 8 9 Q 0 11 12 floor P F = $2 supply demand 12345678910 1 2 3 4 5 6 7 8 9 Q 0 11 12 floor P F = $8 supply demand market outcome oversupply 6 units Figure 17. Price floor analysis

16. microeconomic s the analytics of constrained optimal decisions lecture 3 the perfectly competitive market & government intervention  2016 Kellogg School of Management lecture 3 page |15 government intervention: price ceiling ► Price ceiling : a maximum price imposed in the market (the price in the market cannot be more than the price ceiling). ► For a binding case the ceiling has effect on the market: the ceiling becomes the transaction price. ► Whenever the price ceiling is binding the consumers would like to buy more than what the producers offer ( demand surplus ). left diagramright diagramchange consumers’ surplus A + B + CA + B + D + D – C producers’ surplus D + E + FF– D – E total surplusA + B + C + D + E + F A + B + D + F– E – C deadweight loss non-binding ceilingbinding ceiling price ($) A B C D E A B C D E F F 123456789 1 2 3 4 5 6 7 8 9 10 0 123456789 1 3 4 5 6 7 8 9 0 ceiling P C = $2 shortage 3 units ceiling P C = $8 market outcome 10 Q Q 11 12 supply demand 11 12 supply demand 2 Figure 18. Price ceiling analysis

17. market outcome microeconomic s the analytics of constrained optimal decisions lecture 3 the perfectly competitive market & government intervention  2016 Kellogg School of Management lecture 3 page |16 government intervention: taxes no taxes consumer tax of $6 per unit price ($) left diagramright diagramchange consumers’ surplusA + B + CA– B – C producers’ surplusD + E + FF – D – E government revenueB + D+ B + D total surplusA + B + C + D + EA + B + D + F– E – C deadweight loss A B C D E A B C D E 12345678910 1 2 3 5 6 7 8 9 Q 0 11 12 12345678910 1 2 3 4 5 6 7 8 9 Q 0 11 12 demand supply demand market outcome price paid by consumer PCPC price received by producer PDPD F F tax paid by consumer 4 Figure 19. Consumer tax analysis

18. microeconomic s the analytics of constrained optimal decisions lecture 3 the perfectly competitive market & government intervention  2016 Kellogg School of Management lecture 3 page |17 government intervention and market efficiency ► Tax on consumers consumer tax of $6 per unit price ($) A B C D E 12345678910 1 2 3 4 5 6 7 8 9 Q 0 11 12 supply demand market outcome price paid by consumer PCPC price received by producer PDPD F tax paid by consumer P* equilibrium price, no taxes tax burden on consumer tax burden on producer  For the consumer tax case the difference between the price paid by consumer ( P C ) and the price received by the producer ( P D ) is exactly the tax ( t ): P C – P D = t  Using the equilibrium price for “no taxes case” (P*), the above difference can be written as ( P C – P *) + ( P * – P D ) = t  The “tax burdens” ( TB ) for consumer and producer respectively are then:

19. microeconomic s the analytics of constrained optimal decisions lecture 3 the perfectly competitive market & government intervention  2016 Kellogg School of Management lecture 3 page |18 key points ► DEMAND: - shows the willingness to pay for each unit ► CONSUMER SURPLUS: - the difference between the willingness to pay and the actual payment for all units that the buyers ends buying - critical issues: clearly identify the price paid for each unit and the number of units that the consumer buys; the surplus is calculated only for the units actually bought ► SUPPLY: - shows the minimum price accepted by the producer for each unit to be produced ► PRODUCER SURPLUS: - the difference between the price received for each unit sold and the cost of producing those units - critical issues: clearly identify the price received for each unit and the number of units that the producer sells; the surplus is calculated only for the units actually sold ► APPLICATIONS: - represent the sum of consumer and producer surpluses (and other agents in economy) ► DEADWEIGHT LOSS:- the surplus that is lost as a result of a certain change in market conditions - it is important to remember that the deadweight loss is a relative measure : calculate the total surplus under scenario 1 and scenario 2 – the change in total surplus (if negative) gives you the deadweight loss – if the change is positive you obtained a surplus gain demand consumer surplus supply producer surplus total surplus deadweight loss