AGEC 608 Lecture 03, p. 1 AGEC 608: Lecture 3 Objective: Review microeconomic foundations of CBA Readings: –Boardman, Chapter 3 –Kankakee, Section III (pp ) Homework #1: Chapter 1, problem 1 Chapter 2, problem 2 Chapter 2, problem 4 due: next class Homework #2: Chapter 3, problem 1 Chapter 3, problem 2 Chapter 4, problem 3 due: March 13

AGEC 608 Lecture 03, p. 2 Demand Demand arises as the combination of two forces: 1. an individual’s desire to acquire something 2. the purchasing power to acquire it Patterns of demand are used by economists to infer the value of goods by individuals and society (e.g. cars, national parks, clean water). Demand is the desire for a good or service plus the willingness and ability to acquire it.

AGEC 608 Lecture 03, p. 3 Demand Curve Decreasing marginal utility combined with substitution between goods leads to a demand curve that slopes downward. Q P As price falls, quantity demanded increases. Conversely, as price rises, demand falls. D

AGEC 608 Lecture 03, p. 4 Demand Curve A demand curve measures marginal values based on an individual’s willingness to pay for additional units of a good. Each point on the curve represents the PRIVATE value of a unit to a consumer. Q P D

AGEC 608 Lecture 03, p. 5 Features of demand curves Q P 1. Downward sloping. D 2. A function of price, income, and tastes.

AGEC 608 Lecture 03, p. 6 Changes in demand Q P 1. A price change induces a movement along the demand curve D

AGEC 608 Lecture 03, p. 7 Changes in demand Q P D 2. A shift of the demand curve represents a change in some other factor. The change might be a change in the price of a substitute, a change in income, or a change in tastes.

AGEC 608 Lecture 03, p. 8 Example: sunscreen Q P Q: Suppose the price of sunscreen falls from P 1 to P 2. What happens? D P1P1 P2P2 Q1Q1 Q2Q2 A: The price reduction leads to greater demand, so the quantity goes up from Q 1 to Q 2.

AGEC 608 Lecture 03, p. 9 Example: sunscreen Q P Q: Now suppose it is reported that a hole in the ozone has appeared over West Lafayette. What happens? D P1P1 Q1Q1 Q2Q2 A: The news leads to a shift in the demand curve. More sunscreen is demanded at the old price.

AGEC 608 Lecture 03, p. 10 Market demand curve A market demand curve is a horizontal summation of individual demand curves: Q P D Individual 1 Q Q D D 123 Individual 2 Market (1 unit)(2 units)(3 units)

AGEC 608 Lecture 03, p. 11 Demand Curve Summary Important properties: downward slope (diminishing marginal utility) indicator of total benefits (area under curve) indicator of marginal benefit (point on curve) measure of WTP combined w/price, determines consumer surplus

AGEC 608 Lecture 03, p. 12 Willingness to pay Quantity Price D Total willingness to pay = area under the demand curve, located to the left of the allocation of interest. Total willingness to pay is a measure of private benefits associated with consumption.

AGEC 608 Lecture 03, p. 13 Consumer surplus Price 5 4 The excess of willingness to pay over the amount actually paid (i.e. the triangle in the graph) is called “consumer surplus”. 25

AGEC 608 Lecture 03, p. 14 Change in consumer surplus The price of a product rises from P 2 to P*: The price rise leads to less demand, so the quantity consumed goes down from Q* to Q 2. The change in consumer surplus (benefit in excess of price paid) is the area ABC. Q P D P2P2 P* Q2Q2 Q* A C B

AGEC 608 Lecture 03, p. 15 Calculating consumer surplus If demand schedule is linear and change in price and change in quantity are both known, then… ΔCS=(ΔP)Q* + 1/2 (ΔQ)(ΔP) Q P D P2P2 P* Q2Q2 Q* A C B

AGEC 608 Lecture 03, p. 16 Calculating consumer surplus If change in quantity is not known but price elasticity is known, then… ΔCS=(ΔP)Q* + ΔP(Q*)[1+1/2(ΔP/P*)ε d ] Q P D P2P2 P* Q2Q2 Q* A C B

AGEC 608 Lecture 03, p. 17 Supply Curve The supply curve is the upward sloping portion of the marginal cost curve, above the average cost curve. It measures the incremental private cost of producing additional units of the good. Q P S=MC

AGEC 608 Lecture 03, p. 18 Supply Curve The upward slope reflects diminishing returns to input use. The shape of the supply curve is determined by the technology of production. The area under the supply curve is the measure of the total cost of resources used to produce that level of output. Q P S

AGEC 608 Lecture 03, p. 19 Changes in supply Q P S A shift in supply can result from either: 1. A change in input prices 2. Technological innovation 3. A project or policy change

AGEC 608 Lecture 03, p. 20 Producer surplus Price 5 4 The excess of price over the cost of production (i.e. the triangle in the graph) is called “producer surplus”. 25

AGEC 608 Lecture 03, p. 21 Calculating Net Benefit total benefit = area under demand curve Q P S=MC D=MB total cost = area under supply curve net benefit = total benefit - total cost

AGEC 608 Lecture 03, p. 22 Allocative efficiency revisited NB = TB – TC “Social Surplus” = CS + PS Shifts in S or D typically result in a deadweight loss (“leakage”), neither producer nor consumer surplus