Transcript lecture_5

Lecture 5
Market Values and Social Values
Readings: Chapter 5
Recent Event
• Several years ago, Newfoundland
announced that gasoline prices would be
regulated by the government.
• The Newfoundland government judges
that market prices are not meeting
Newfoundland’s social objectives.
• They believe regulated prices will serve
the interests of Newfoundland society
better than unregulated market prices.
What questions does this raise?
• This action by the Newfoundland government is
unusual. Most governments prefer to let the
market determine the price for commodities.
• Q: Why do governments usually prefer to leave
market prices unregulated?
• A: Competitive markets generate prices that lead
to an efficient allocation of societies scarce
resources.
What is efficiency?
Economists understand efficiency to be a
social outcome in which society’s scarce
resources are used to produce the goods
and services that people value the most.
To find efficient social outcome recall
marginal analysis.
How is an efficient social outcome
found?
Marginal benefit
• is the benefit that a person receives from
consuming one more unit of a good or service.
• Measured as the maximum amount that a person is
willing to give up for one additional unit.
Principle of decreasing marginal benefit:
• Marginal
benefit decreases as consumption
increases.
How is an efficient social outcome
found?
Marginal cost
• is the opportunity cost of producing one more unit
of a good or service.
• Measured as the value of the best alternative
forgone.
Principle of increasing marginal cost:
• Marginal cost increases as the quantity produced
increases.
Efficiency and Inefficiency
• To determine whether an outcome is
efficient requires comparison of the
marginal cost (MC) and marginal benefits
(MB).
• Resources are efficiently utilized when
MB = MC
• If MB>MC then increase output.
• If MB<MC then decrease output.
Marginal cost and marginal benefit
(dollars worth of goods and services)
The Efficient Quantity of
Pizza
25
Pizza valued more
highly than it costs:
Increase production
MC
Pizza costs more
than it is valued:
Decrease
production
20
15
10
5
0
Efficient quantity
of pizza
5
10
15
MB
20
Quantity (thousands of pizzas per day)
How are value and price related?
• For economists, the value of one more
unit of a good or service is the same
thing as its marginal benefit.
• Marginal benefit can be expressed as
the maximum price people are willing to
pay for an additional unit.
• Willingness to pay determines
demand.
Demand, Willingness to Pay,
and Marginal Benefit
Price (dollars per pizza)
25
Price determines
quantity demanded
20
15
5
Quantity of
pizzas
demanded
at $15 a pizza
0
5
10
D
10
15
20
Quantity (thousands of pizzas per day)
Demand, Willingness to Pay,
and Marginal Benefit
Quantity determines
willingness to pay
Price (dollars per pizza)
25
20
15
Maximum price
willingly paid
for the 10,000th
pizza
10
5
0
5
D = MB
10
15
20
Quantity (thousands of pizzas per day)
Do market prices reflect the
total value of a good?
• Most goods purchased in the market are
valued more highly than the market price.
• Most people pay less for the good than they
value it, creating a consumer surplus.
Consumer surplus is the value of a good
minus the price paid for it.
Price (dollars per slice)
A Consumer’s Demand and
Consumer Surplus
Consumer
surplus
2.50
2.00
1.50
Lisa’s consumer
surplus from the
10th pizza
Market
price
Total
1.00
benefit
Amount
paid
0.50
0
10
20
30
D
40
Quantity (slices of pizzas per week)
What is marginal cost?
The cost of producing one more unit of a
good or service is its marginal cost.
• For a firm, it is the marginal value of the
resources used in the production of one more unit
applied to the next best activity.
• Therefore, the marginal cost is the minimum
price required by producers to produce another
unit of output.
What does Marginal Cost
look like?
• The supply curve in a competitive industry
can also be interpreted as the curve which
gives the minimum price required to
produce a certain level of output.
A supply curve is a marginal cost curve.
Price (dollars per pizza)
Supply, Minimum Supply
Price, and Marginal Cost
25
Price determines
quantity supplied
S
20
15
10
Quantity of pizzas
supplied at $15
a pizza
5
0
50
100 150
200
Quantity (thousands of pizzas per day)
Price (dollars per pizza)
Supply, Minimum Supply
Price, and Marginal Cost
S = MC
25
Minimum supply
price for 10,000th
pizza
20
15
10
Quantity determines
minimum supply price
5
0
5
10
15
20
Quantity (thousands of pizzas per day)
Producer Surplus
Producer surplus is the value of a good
minus the opportunity cost of producing it.
If a firm sells something for more that it
costs to produce, the firm obtains a
producer surplus.
Price (dollars per pizza)
A Producer’s Supply
and Producer Surplus
Max’s producer
surplus from the
50th pizza
25
20
S = MC
Market
price
Producer
surplus
15
10
Total
revenue
5
0
50
100
Cost
of production
150
200
Quantity (pizzas per day)
What does the market do?
• We already know that markets produce
equilibrium prices.
• When demand exceeds supply, the price will
increase
• When demand is less than supply, the price
will decrease
• An equilibrium price emerges that determines
what society produces, how much society
produces, and who gets society’s product.
Price (dollars per pizza)
An Efficient Market for Pizza
25
Consumer
surplus
S
Marginal cost
(opportunity cost)
of pizza
20
15
Consumer’s
Marginal benefit
(value) of pizza
10 expenditure
=
Producer
Efficient quantity
5 Producer’s
surplus
D
of pizzas
revenue
0
5
10
15
20
Quantity (thousands of pizzas per day)
Are market prices useful
social values?
At the competitive equilibrium, the
marginal benefit to consumers of last
unit purchased equals the marginal cost
to producers of supplying that last unit.
Resources are being used
efficiently.
Price (dollars per pizza)
An Efficient Market for Pizza
25
Consumer
surplus
S = MC
Marginal cost
(opportunity cost)
of pizza
20
15
Marginal benefit
(value) of pizza
10
5
0
Producer
surplus
5
Efficient quantity
of pizzas
10
15
D = MB
20
Quantity (thousands of pizzas per day)
Why is this efficient?
• At the competitive equilibrium, the sum of
consumer surplus and producer surplus is
maximized.
• By maximizing this net benefit, the total
benefit is maximized.
• Any alternative application of society’s
scarce resources would reduce the net
benefit and hence the total benefit.
Price (dollars per pizza)
Reducing Resource Used in
Pizza Production
S
Net Loss
25
20
15
10
5
0
D
5
10
15
20
Quantity (thousands of pizzas per day)
The Invisible Hand
Adam Smith first proposed the
idea that competitive markets
allocate resources efficiently
in his 1776 book, The Wealth
of Nations.
Each participant in a competitive
market is “led by an invisible hand to
promote an end [the efficient use of
resources] which was no part of his
intention.”
Implications
• Competitive markets generally do a good
job of efficiently allocating resources.
• Governments (like Newfoundland) have,
from time to time, intervened and impose
different values.
• In the next lecture we examine how
governments can intervene to impose
different values on the market and what the
social implications of such intervention can
be.