Intermediate Microeconomics Equilibrium

Partial Equilibrium We have now derived both the market demand curve (Qd(p)) and market supply curve (Qs(p)) from first principles. Equilibrium price and quantity is determined by finding price that equates these two curves: Qd(p*) = Qs(p*) Ex: Consider the following demand and supply curves: Qd(p) = 55 – 5p Qs(p) = 0 if p < 5 = p/2 What is equilibrium price and quantity?

Comparative Statics Often we are interested in analyzing how changes in the market affect equilibrium price and quantity. Generally called “comparative statics” Given we know where our supply and demand functions come from, comparative statics are often straightforward. Changes in production technology, price of inputs, affect MC and therefore cause a shift in supply curve and cause movement along the demand curve. Changes in preferences, or prices of complements or substitutes, will shift the demand curve and cause movement along supply curve.

Comparative Statics (cont.) Examples: What will likely happen to price and quantity of manufactured goods as emissions regulations are tightened?

Comparative Statics – Short-run vs. Longer-run (cont.) Examples: How can we use these tools of analysis to think about the economics of something like “Fair-trade” coffee?

Consumer/Producer Surplus Equilbrium under perfect competition results in a given allocation of goods to consumers and revenue to firms (which are owned by still other consumers). How does this allocation compare to other ways of allocating resources? To answer this question, first consider what the area underneath the demand curve but above the equilibrium price tells us. How about area underneath the price but above supply curve?

Consumer/Producer Surplus (cont.) So we can think of the change in Consumers’ Surplus associated with an increase in price. (1) Loss in CS due to having to pay more for each unit consumed. (2) Loss in CS due to fewer overall units consumed. $ p’’ p’ 1 2 Qd(p) q” q’ q

Consumer/Producer Surplus (cont.) We can also think of the change in Producers’ Surplus associated with an increase in price. (1) Gain in PS due to higher profits for each unit sold. (2) Gain in PS due to more overall units sold. $ p” p’ Qs(p) 1 2 q” q’ q

Consumer/Producer Surplus and Comparative Statics We can think about changes in Consumer/Producer Surplus to think about who is affected by changes in economic environment. Impacts often depend on relative slopes of Supply and Demand Curves Examples: Price controls (e.g. a price ceiling of $3/gal on gasoline). Who benefits from change in technological efficiency? (e.g. costs of production and ease of entry into computer market over last 20 years). How does increase in drug enforcement affect drug market?

Net Surplus We often interested in Net Surplus in the economy, or simply the sum of consumer surplus plus producer surplus. This is some measure of how much value a market is creating As we will see, this relates to Pareto Efficiency (Pareto) Efficient Outcome: No one can be made better off without making someone else worse off.

Net Surplus Example: Consider the allocation of apartments. Suppose there are three types of people (20 of each) Type 1 – will pay up to $1000 for an apartment Type 2 – will pay up to $800 for an apartment Type 3 – will pay up to $600 for an apartment Type 4 – will pay up to $400 for an apartment Supply of apartments given by supply function Qs(p) = p/7.5

Net Surplus Consider rent control of $300 Total supply of apartments: Qs(300) = (300)/7.5 = 40 Demand exceeds supply at $300, so apartments randomly allocated, 10 to each type. Net Surplus Is this Pareto Efficient? $1000 $800 $600 $400 $300 Qs(p) 20 40 60 80 apartments

Net Surplus What if we kept rent control and random initial allocation, but let people trade apartments for cash after initial allocation? E.g. suppose a side market was enacted where apartments could be traded for $610. Is this Pareto Efficient? $1000 $800 $600 $400 $300 Qs(p) 20 40 60 80 apartments

Net Surplus What if market dictated apartments? Consider a price of $450 60 apartments demanded (Type 1s, Type 2s, Type 3s) Qs(450) = (450)/7.5 = 60 apartments supplied Net Surplus $1000 $800 $600 $400 $300 Qs(p) 20 40 60 80 apartments

Markets and Efficiency First Welfare Theorem: Under perfect competition, markets lead to Pareto Efficient outcomes. Generally it will be true that Pareto Efficient outcomes are outcomes that maximize net surplus (why is this true?) Markets achieve Pareto Efficiency by essentially performing two functions: Rations scarce resources to those who “value” goods the most (however, do note that value depends on income!) Provide allocative signals, telling those with capital how that capital will be valued in alternate uses.

Markets and Efficiency (cont.) Another way of saying this is that perfect markets mean that all mutually beneficial trades have been made. Not only between producers and consumers, but also between those with capital to invest and those who need capital for production. However, is it necessarily true that society is “better off” under market allocation than rent control allocation? How does this relate to “The Rise and Fall of the GDP”

Markets and Efficiency (cont.) This reveals a fundamental insight that comes out of studying economics. How do you weigh one person’s utility against another’s? What is the correct social welfare function? Therefore, economists tend to focus on evaluating how much efficiency might we have to give up to get more equality and/or achieve other social goals (This leads to Taxation)

Taxes and Tax Incidence Consider two ways of collecting taxes: From consumers (e.g. pay some amount t for each unit purchased) How would this affect equilibrium? From firms (e.g. pay some amount t for each unit sold)

Taxes and Tax Incidence Does who nominally pays tax really matter? How much of incidence is borne by consumers? How much is borne by producers?

Tax Incidence How does tax incidence depend on relative responsiveness of supply and demand?

Taxes and Net Surplus Besides tax incidence, what else do we notice happens when we impose a tax? Given this, what kind of goods are best to tax? How do income taxes fit into this?