Microeconomic Tools © Copyright Allen C. Goodman, 2015

Supply and Demand In microeconomics, we typically have suppliers reacting positively to price, and demanders reacting negatively. The two of them combine to provide an equilibrium, that indicates the market quantity and the market price.

Price Apples Demand for Apples

What affects demand? Price of the good Prices of other goods Consumer income Tastes

Price Apples Demand with higher income Demand for Apples

Supply of Apples Apples

What affects supply? Technological change Input prices Prices of Production-Related Goods – Examples? Size of the Industry Weather

Supply of Apples Apples Improved technology Poor weather

Equilibrium of Demand and Supply Apples Supply Demand

Equilibrium of Demand and Supply Apples Supply Demand Total Revenue, Total Expenditures

Equilibrium of Demand and Supply Apples Supply Demand Shift in Demand

Equilibrium of Demand and Supply Apples Supply Demand Shift in Supply

Equilibrium of Demand and Supply Apples Supply Demand Shift in Supply Shift in Demand

What Does Consumer Surplus Measure? Consumer surplus, the amount that buyers are willing to pay for a good minus the amount they actually pay for it, measures the benefit that buyers receive from a good as the buyers themselves perceive it.

How the Price Affects Consumer Surplus Copyright©2003 Southwestern/Thomson Learning Initial consumer surplus Quantity (b) Consumer Surplus at Price P Price 0 Demand A B C DE F P1P1 Q1Q1 P2P2 Q2Q2 Consumer surplus to new consumers Additional consumer surplus to initial consumers

PRODUCER SURPLUS Producer surplus is the amount a seller is paid for a good minus the seller’s cost. It measures the benefit to sellers participating in a market. Just as consumer surplus is related to the demand curve, producer surplus is closely related to the supply curve.

How the Price Affects Producer Surplus Copyright©2003 Southwestern/Thomson Learning Quantity (b) Producer Surplus at Price P Price 0 P1P1 B C Supply A Initial producer surplus Q1Q1 P2P2 Q2Q2 Producer surplus to new producers Additional producer surplus to initial producers D E F

MARKET EFFICIENCY Consumer surplus and producer surplus may be used to address the following question: –Is the allocation of resources that is determined by free markets in any way desirable? … or do economists just love them

MARKET EFFICIENCY CS = Value to buyers – Amount paid by buyers and PS = Amount received by sellers – Cost to sellers

MARKET EFFICIENCY Total surplus = Consumer surplus + Producer surplus or Total surplus = Value to buyers – Cost to sellers

EFFICIENCY and EQUITY Efficiency is the property of a resource allocation of maximizing the total surplus received by all members of society. In addition to market efficiency, a social planner might also care about equity – the fairness of the distribution of well-being among the various buyers and sellers.

Consumer and Producer Surplus in the Market Equilibrium Copyright©2003 Southwestern/Thomson Learning Producer surplus Consumer surplus Price 0 Quantity Equilibrium price Equilibrium quantity Supply Demand A C B D E

MARKET EFFICIENCY Three Insights Concerning Market Outcomes 1.Free markets allocate the supply of goods to the buyers who value them most highly, as measured by their willingness to pay. 2.Free markets allocate the demand for goods to the sellers who can produce them at least cost. 3.Free markets produce the quantity of goods that maximizes the sum of consumer and producer surplus.

The Efficiency of the Equilibrium Quantity Copyright©2003 Southwestern/Thomson Learning Quantity Price 0 Cost to sellers Cost to sellers Value to buyers Value to buyers Value to buyers is greater than cost to sellers. Value to buyers is less than cost to sellers. Equilibrium quantity Consumer surplus Producer Surplus Efficiency is all about quantity! Demand Supply

Using Calculus Define W = Total Value (ftn of Quantity) – Total Costs (ftn of Quantity) W = V (Q) – TC (Q) dW/dQ = V′ – TC′ = 0 V′ is marginal benefits TC′ is marginal costs! So Welfare W is maximized with MB = MC.

Utility Analysis? In principles courses we often measure utility -- sometimes use “utils”... which is lame (like … who thinks about “utils”). For several analyses in public economics, we’ll want to use more modern analysis... Ordinal utility

Indifference Curves Pounds of SpamSpam Sq. Feet of housing

Indifference Curves Pounds of Spam Sq. Feet of housing Higher level of utility

How much is bought? Pounds of Spam Sq. Feet of housing In a month Housing = $1.00/sq.foot SpamSpam = $10/pound Income = $1500 If price of Spam doubles?

Putting them together Pounds of Spam Sq. Feet of housing In a month Housing = $1.00/sq.foot Spam = $10/pound Income = $1500

Putting them together Pounds of Spam Sq. Feet of housing In a month Housing = $1.00/sq.foot Spam = $10/pound Income = $1500 U1U1 U2U2 Mkt gives you this You only need this

Putting them together Pounds of Spam Sq. Feet of housing In a month Housing = $0.75/sq.foot Spam = $10/pound Income = $1500 U increases More housing More Spam Why?

A close look at the tangency Pounds of Spam Sq. Feet of housing In a month Housing = $1.00/sq.foot Spam = $10/pound Income = $1500 U2U2 ΔU/Δh = - Mgl. utility of housing ΔU/Δs = Mgl. utility of Spam phΔhphΔh +p s Δs

A close look at the tangency Pounds of Spam Sq. Feet of housing U2U2 ΔU/Δh = - Mgl. utility of housing ΔU/Δs = Mgl. utility of Spam phΔhphΔh +p s Δs p h Δh + p s Δs = 0 Δh/Δs = -p s /p h Now, for utility -MU s /Mu h = (ΔU/Δs)/(ΔU/Δh) = Δh/Δs -p s /p h = Δh/Δs = -MU s /Mu h or Mu h /p h = MU s / p s In a month Housing = $1.00/sq.foot Spam = $10/pound Income = $1500 MU/p = Utility/$ = Bang for the Buck! MU/p = Utility/$ = Bang for the Buck!

Using Calculus - Utility Utility = g [housing (h), Spam (s)] DU = g h dh + g s ds. On an indifference curve, DU = 0. So: 0 = g h dh + g s ds dh/ds = -g s /g h

Using Calculus - Income Y = p h h + p s s dY = p h dh + p s ds On the budget constraint, dY = 0. 0 = p h dh + p s ds dh/ds = -p s /p h

Using Calculus - Equilibrium Slopes are equal Marginal utilities dh/ds = -g s /g h Income trade-off dh/ds = -p s /p h Therefore: -g s /g h = -p s /p h  g s /g h = p s /p h