1 Economics 110 Introduction to Economic Theory Professor Tanya Rosenblat Perfectly Competitive Markets

2 Experiment (Session 1). Widget Market (48 participants) Type of AgentNumber of Agents CostValue Low-Cost Supplier 1610 High-Cost Supplier 830 High-Value Demander 840 Low-Value Demander 1620

3 Supply Schedule Price RangeAmount Supplied P< <P<30 16 P>30 24

4 Demand Schedule Price RangeAmount Demanded P> <P<40 8 P<20 24

5 Session 1: Supply and Demand for Widgets PRICEPRICE Number of Bushels

6 Experimental Data Round 1 – Average Price 18.3 (19.5)

7 Experimental Data Round 2 – Average Price 17.4 (17.3)

8 A Demand Curve Can Be Thought of as a Schedule of Buyers’ Maximum Willingnesses to Pay $- $0.50 $1.00 $1.50 $2.00 $2.50 $3.00 $3.50 $4.00 $4.50 $5.00 $5.50 $6.00 $ Quantity $ per unit #16.00$ #25.50$ #35.00$ #44.50$ #54.00$ #63.50$ #73.00$ #82.50$ #92.00$ #101.50$ #111.00$ #120.50$ Potential Buyer Highest price at which individual is willing to buy Only one buyer has a maximum willingness to pay greater than $5.75 Thus: at a price of $5.75, only one potential buyer (#1) would buy. Quantity demanded at $5.75 = 1 At a price of $2.25, eight potential buyers would buy (#1 - #8). Quantity demanded at $2.25 = 8. $5.75 $2.25 Notice that the demand curve also describes the maximum willingness to pay of all potential buyers in the market! Demand Curve

9 $- $0.50 $1.00 $1.50 $2.00 $2.50 $3.00 $3.50 $4.00 $4.50 $5.00 $5.50 $6.00 $ Quantity $ per unit A Supply Curve Can Be Thought of as a Schedule of Seller’s Minimum Willingnesses to Sell #10.50$ #21.00$ #31.50$ #42.00$ #52.50$ #63.00$ #73.50$ #84.00$ #94.50$ #105.00$ #115.50$ #126.00$ Potential Seller Lowest price at which seller is willing to sell* The price of $5.75 is greater than the minimum willingness to sell for 11 potential sellers Thus: quantity supplied at $5.75 = 11 $5.75 $2.25 Supply Curve

10 Is There An Equilibrium in Our Market? Yes! $- $0.50 $1.00 $1.50 $2.00 $2.50 $3.00 $3.50 $4.00 $4.50 $5.00 $5.50 $6.00 $ Quantity $ per unit equilibrium price “band” At any price above $3.00 but below $3.50, exactly 6 potential buyers are willing to buy At a price above $3.00 but below $3.50, exactly 6 potential sellers are willing to sell. For any price in this band, quantity supplied equals quantity demanded at this price. Supply Curve Demand Curve

11 How Much Do Buyers Gain at the Market Equilibrium? $- $0.50 $1.00 $1.50 $2.00 $2.50 $3.00 $3.50 $4.00 $4.50 $5.00 $5.50 $6.00 $ Quantity $ per unit #16.00$ #25.50$ #35.00$ #44.50$ #54.00$ #63.50$ #73.00$ #82.50$ #92.00$ #101.50$ #111.00$ #120.50$ Potential Buyer Highest price at which individual is willing to buy $3.25 Demand Curve Buyer #1: winning to pay as much as: $6.00 actually pays: $3.25 net gain (consumer surplus):$2.75 (area A) A B F Buyer #2: winning to pay as much as: $5.50 actually pays: $3.25 net gain (consumer surplus):$2.25 (area B) Buyer #6: winning to pay as much as: $3.50 actually pays: $3.25 net gain (consumer surplus):$0.25 (area F) These buyers do not buy Their consumer surplus is zero!

12 Consumer Surplus $- $0.50 $1.00 $1.50 $2.00 $2.50 $3.00 $3.50 $4.00 $4.50 $5.00 $5.50 $6.00 $ Quantity $ per unit $3.25 Demand Curve A B C D E F Consumer surplus: the aggregate net gain to consumers from purchasing at a given market price. Equal to: the area underneath the demand curve above the market price In our picture: consumer surplus at a market price of $3.25 equals area A+B+C+D+E+F. This number, which equals $9.00, is the aggregate difference between what consumers are willing to pay and what they actually pay. Consumer Surplus: Willingness to pay - Actual payment

13 The Concept of Consumer Surplus Also Applies to “Smooth” Demand Curves P ($ per liter) Q (liters per year) 4000 $6 A Consumers demand 4000 liters at $6 per unit. Consumers surplus = difference between total willingness to pay and actual amount paid = area A = $8,000. $10 MARKET DEMAND CURVE

14 $- $0.50 $1.00 $1.50 $2.00 $2.50 $3.00 $3.50 $4.00 $4.50 $5.00 $5.50 $6.00 $ Quantity $ per unit How Much Do Sellers Gain at the Market Equilibrium? #10.50$ #21.00$ #31.50$ #42.00$ #52.50$ #63.00$ #73.50$ #84.00$ #94.50$ #105.00$ #115.50$ #126.00$ Potential Seller Lowest price at which seller is willing to sell* $3.25 Supply Curve Seller #1: actually receives:$3.25 must receive at least:$0.50 net gain (producer surplus):$2.75 (area A) A B F Seller #2: actually receives:$3.25 must receive at least:$1.00 net gain (producer surplus):$2.25 (area B) Seller #6: actually receives:$3.25 must receive at least:$3.00 net gain (producer surplus):$0.25 (area F)

15 $- $0.50 $1.00 $1.50 $2.00 $2.50 $3.00 $3.50 $4.00 $4.50 $5.00 $5.50 $6.00 $ Quantity $ per unit Producer Surplus $3.25 Supply Curve A B F C D E Producer surplus: the aggregate net gain to sellers from selling at a given market price. Equal to: the area underneath the market price above the supply curve. In our picture: producer surplus at a market price of $3.25 equals area A+B+C+D+E+F. This number, which equals $9.00, is the aggregate difference between what sellers actually receive and the smallest amount they need to receive. Producer Surplus: Actual payment - required payment

16 Producer Surplus Also Applies to “Smooth” Supply Curves $6 $ P ($ per liter) Q (liters per year) A Firms supply 4000 liters at $6 per liter. Producer surplus is area A in the diagram = $8,000. Market Supply Curve

17 Total Economic Value Created in a Market = Consumer Surplus + Producer Surplus $- $0.50 $1.00 $1.50 $2.00 $2.50 $3.00 $3.50 $4.00 $4.50 $5.00 $5.50 $6.00 $ Quantity $ per unit Supply Curve Demand Curve $3.25 Total economic value created when market price is $3.25 = Consumer surplus at $ Producer surplus at $3.25 = $ = $18.00

18 If The Market is Prevented From Reaching Equilibrium, Economic Surplus is Not Realized $- $0.50 $1.00 $1.50 $2.00 $2.50 $3.00 $3.50 $4.00 $4.50 $5.00 $5.50 $6.00 $ Quantity $ per unit Supply Curve Demand Curve If, for some reason, potential buyers #3,4,5 and potential sellers #3,4,5 were prevented from participating in the market, consumer and producer surplus would be lost. Gains from exchange would not be realized! We say there is a deadweight loss: unrealized economic benefits. How could this happen? Government interventions!

19 The Economics of Price Controls Price ($ per unit) Quantity (units per period) $2,000 $1,400 A B D C E F QSQS Q* D S QDQD Free market (no price control) Price controls Difference due to price controls Producer surplus F + C+ EF- C - E Consumer surplus A + B + DA + B + CC – D Total surplus A + B + C + D + E + F A + B + C + F - E - D E + D = Deadweight loss

20Elasticity Where is the Demand Curve coming from? How do we measure its slope? The Demand Curve tells us how much consumers will buy for different prices of the good From Consumer Behavior, we know how to deduce from tastes how much an individual consumer will buy at a given price. Summing over consumers, we get the Demand Curve The Demand Curve is (assumed to be) decreasing (The “Law of Demand”): The higher the price, the lower the consumption

21 How to measure elasticity? It is important to measure how sensitive Demand is to changes in Prices Preferably, this measure should not depend on units: are we counting in dollars, cents, or euros? Pounds, Kilograms or Tons? The price elasticity of demand provides such a measure: In words, it is the % change in quantity for (or divided by) a given % change in prices (sometimes, the elasticity is defined as the opposite number: the precise convention does not matter, as long as one realizes that the law of demand applies)

22 The Importance of Elasticity The Concept of Elasticity is used for other concepts: - Income elasticity of Demand: - Price Elasticity of Supply: What affects the Slope? When is it steep? It is steep when there is no good substitute

23 Using Calculus

24 Examples Linear Demand Q = a – bP Elasticity =

25Elasticity Elastic – responsive to price changes Inelastic – not responsive to price changes Examples: - An unconscious bleeding man is brought to the hospital emergency room. - Among hospital patients whose insurance will pay all charges, what would the demand be like for nurse-administered propoxyphene (Darvon), a pain-killer? - Now suppose that the patients are in managed care plans that pressure physicians to use lower-price drugs. What might demand for the Darvon be? - A patient is given a presciption for a drug to control high blood pressure. The patient's insurance doesn't cover drugs, so the patient must pay out of pocket.

26 Elasticity Demand is more elastic if the decision-maker has an incentive to save money and if there is an adequate substitute for the product or service.

27 What Shifts Demand Curves? Change in income Change in a price of a substitute Change in a price of a complement Change in composition of population Change in tastes Change in information Change in availability of credit Change in expectations

28 What Shifts Supply Curve? Change in price of inputs Change in technology Change in natural environment Change in availability of credit Change in expectations