1

Economics 110Introduction to Economic Theory

Professor Tanya Rosenblat

Perfectly Perfectly Competitive MarketsCompetitive Markets

2

Experiment (Session 1). Widget Market (48 Experiment (Session 1). Widget Market (48 participants)participants)

Type of Agent Number of Agents

Cost Value

Low-Cost Supplier

16 10

High-Cost

Supplier

8 30

High-Value Demander

8 40

Low-Value Demander

16 20

3

Supply ScheduleSupply Schedule

Price Range Amount Supplied

P<10 0

10<P<30 16

P>30 24

4

Demand ScheduleDemand Schedule

Price Range Amount Demanded

P>40 0

20<P<40 8

P<20 24

5

Session 1: Supply and Demand for WidgetsSession 1: Supply and Demand for Widgets

8 16 24

40

30

20

10

P

R

I

C

E

Number of Bushels

6

Experimental DataExperimental Data

• Round 1 – Average Price 18.3 (19.5)

Round 1 Prices

0

10

20

30

40

0 10 20 30

Transactions

Pri

ce

7

Experimental DataExperimental Data

• Round 2 – Average Price 17.4 (17.3)

Round 2 Prices

05

101520253035

0 5 10 15 20

Transactions

Pric

e

8

A Demand Curve Can Be Thought of as a Schedule A Demand Curve Can Be Thought of as a Schedule of Buyers’ Maximum Willingnesses to Payof 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

$6.50

0 1 2 3 4 5 6 7 8 9 10 11 12Quantity

$ per unit#1 6.00$ #2 5.50$ #3 5.00$ #4 4.50$ #5 4.00$ #6 3.50$ #7 3.00$ #8 2.50$ #9 2.00$ #10 1.50$ #11 1.00$ #12 0.50$

PotentialBuyer

Highest priceat which individualis 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

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$-

$0.50

$1.00

$1.50

$2.00

$2.50

$3.00

$3.50

$4.00

$4.50

$5.00

$5.50

$6.00

$6.50

0 1 2 3 4 5 6 7 8 9 10 11 12Quantity

$ per unit

A Supply Curve Can Be Thought of as a Schedule of A Supply Curve Can Be Thought of as a Schedule of Seller’s Minimum Willingnesses to SellSeller’s Minimum Willingnesses to Sell

#1 0.50$ #2 1.00$ #3 1.50$ #4 2.00$ #5 2.50$ #6 3.00$ #7 3.50$ #8 4.00$ #9 4.50$ #10 5.00$ #11 5.50$ #12 6.00$

PotentialSeller

Lowest priceat which selleris 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

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Is There An Equilibrium in Our Market? Yes!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

$6.50

0 1 2 3 4 5 6 7 8 9 10 11 12Quantity

$ 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

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How Much Do How Much Do BuyersBuyers Gain at the Market Gain at the Market Equilibrium?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

$6.50

0 1 2 3 4 5 6 7 8 9 10 11 12Quantity

$ per unit#1 6.00$ #2 5.50$ #3 5.00$ #4 4.50$ #5 4.00$ #6 3.50$ #7 3.00$ #8 2.50$ #9 2.00$ #10 1.50$ #11 1.00$ #12 0.50$

PotentialBuyer

Highest priceat which individualis willing to buy

$3.25

Demand Curve

Buyer #1:winning to pay as much as: $6.00actually pays: $3.25net gain (consumer surplus): $2.75 (area A)

AB

F

Buyer #2:winning to pay as much as: $5.50actually pays: $3.25net gain (consumer surplus): $2.25 (area B)

Buyer #6:winning to pay as much as: $3.50actually pays: $3.25net gain (consumer surplus): $0.25 (area F)

These buyers do not buyTheir consumer surplus is zero!

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Consumer SurplusConsumer 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

$6.50

0 1 2 3 4 5 6 7 8 9 10 11 12Quantity

$ per unit

$3.25

Demand Curve

AB

CD

EF

• 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

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The Concept of Consumer Surplus Also Applies to The Concept of Consumer Surplus Also Applies to “Smooth” Demand Curves“Smooth” Demand Curves

P ($ per liter)

Q (liters per year)4000

$6A

• Consumers demand 4000 liters at $6 per unit.• Consumers surplus = difference between total willingness to pay andactual amount paid = area A = $8,000.

$10

MARKETDEMAND CURVE

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$-

$0.50

$1.00

$1.50

$2.00

$2.50

$3.00

$3.50

$4.00

$4.50

$5.00

$5.50

$6.00

$6.50

0 1 2 3 4 5 6 7 8 9 10 11 12Quantity

$ per unit

How Much Do Sellers Gain at the Market How Much Do Sellers Gain at the Market Equilibrium?Equilibrium?

#1 0.50$ #2 1.00$ #3 1.50$ #4 2.00$ #5 2.50$ #6 3.00$ #7 3.50$ #8 4.00$ #9 4.50$ #10 5.00$ #11 5.50$ #12 6.00$

PotentialSeller

Lowest priceat which selleris willing to sell*

$3.25

Supply Curve

Seller #1:actually receives: $3.25must receive at least: $0.50net gain (producer surplus): $2.75 (area A)

AB

F

Seller #2:actually receives: $3.25must receive at least: $1.00net gain (producer surplus): $2.25 (area B)

Seller #6:actually receives: $3.25must receive at least: $3.00net gain (producer surplus): $0.25 (area F)

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$-

$0.50

$1.00

$1.50

$2.00

$2.50

$3.00

$3.50

$4.00

$4.50

$5.00

$5.50

$6.00

$6.50

0 1 2 3 4 5 6 7 8 9 10 11 12Quantity

$ per unit

Producer SurplusProducer Surplus

$3.25

Supply Curve

AB

F

CD

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

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Producer Surplus Also Applies to “Smooth” Supply Producer Surplus Also Applies to “Smooth” Supply CurvesCurves

$6

$2

4000

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

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Total Economic Value Created in a Market = Total Economic Value Created in a Market = Consumer Surplus + Producer SurplusConsumer 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

$6.50

0 1 2 3 4 5 6 7 8 9 10 11 12Quantity

$ per unitSupply Curve

Demand Curve

$3.25

• Total economic value created whenmarket price is $3.25= Consumer surplus at $ 3.25 + Producer surplus at $3.25= $9.00 + 9.00= $18.00

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If The Market is Prevented From Reaching If The Market is Prevented From Reaching Equilibrium, Economic Surplus is Not RealizedEquilibrium, 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

$6.50

0 1 2 3 4 5 6 7 8 9 10 11 12Quantity

$ per unitSupply 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!

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The Economics of Price ControlsThe Economics of Price Controls

Price($ per unit)

Quantity (units per period)

$2,000

$1,400

A

B D

C E

F

QS Q*

D

S

QD

Free market (no price control)

Price controls

Difference due to price controls

Producer surplus

F + C+ E F - C - E

Consumer surplus

A + B + D A + B + C C – D

Total surplus

A + B + C + D + E + F

A + B + C + F

- E - D

E + D = Deadweight loss

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ElasticityElasticity

• 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

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How to measure elasticity?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)

PPQQ

EDD

p //

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The Importance of Elasticity 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

PPQQ

ESS

S //

IIQQ

EDD

I //

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Using CalculusUsing Calculus

dI

dQ

Q

I

IdI

QdQ

incomeinchange

demandedquantityinchange

/

/

%

%

%

%

/

/

change in quantity demanded

change in price

dQ Q

dP P

P

Qx

dQ

dP

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ExamplesExamples

• Linear Demand• Q = a – bP• Elasticity =

abP

bPb

Q

P

dP

dQ

Q

P

PdP

QdQ

)(

/

/

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ElasticityElasticity• 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.

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ElasticityElasticity

• 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.

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What Shifts Demand Curves?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

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What Shifts Supply Curve?What Shifts Supply Curve?

• Change in price of inputs

• Change in technology

• Change in natural environment

• Change in availability of credit

• Change in expectations