Transcript demand price

We’ve seen that competitive markets bring “order” -price adjusts to balance supply and demand.
Any other desirable properties of competitive markets?
Do competitive markets provide the “right” quantity?
What about price?
(Of course, buyers always want a lower price; sellers
always want a higher price.)
Is there a “right” price?
These questions bring us to the topic of
Welfare economics: The study of how the allocation of
resources affects economic well-being.
Both buyers and sellers benefit from their participation
in the market. (Remember “basic principle #5”!)
We will need to develop tools for measuring, in dollar
terms, buyers’ and sellers’ benefits from market
participation.
“consumer and producer surplus”
Willingness to pay (WTP): The maximum amount that
a consumer will pay for a particular unit of a good.
For a given consumer, WTP varies among units of a
good (higher WTP for first unit than for second, etc.).
WTP also varies across consumers (some have “high”
WTP; some “low” WTP).
WTP is a measure, in dollar terms, of the value to the
consumer of that unit of the good.
Consumer surplus: A consumer’s willingness to pay
minus the amount the consumer actually pays
= “value” to consumer minus amount paid.
Consumer surplus and demand curves?
An example: The market for gizmos. Assume:
. . . people differ in their WTP for the first gizmo
of the day,
. . . but everyone has zero WTP for the second, third,
fourth, etc. gizmo each day.
(Gizmos are nice to have, but nobody needs
more than one per day!)
Suppose there are five consumers who differ in their
WTP for a gizmo:
Consumer
WTP for first gizmo
($/gizmo)
Al
1.00
Betty
0.80
Carl
0.70
Doug
0.50
Emily
0.30
The market demand curve for gizmos:
Start off with price above $1.00/gizmo, and gradually
reduce price.
As price falls below 1.00, Al’s
demand “kicks in.”
($/gizmo)
1.00
As price falls below 0.80,
Betty’s demand “kicks in.”
0.80
0.70
0.50
And so on . . . quantity
demanded increases by 1
as each level of WTP is
reached.
0.30
1
2
3
4
5
(gizmos/day)
Here’s that demand curve again:
Suppose that the price of a gizmo is $0.60/gizmo.
Quantity demanded is 3 gizmos/day. (Al, Betty, and Carl demand;
Doug and Emily don’t.)
($/gizmo)
1.00
0.60
Al’s C.S. = WTP - p = 1.00 - 0.60
= 0.40.
Betty’s C.S. = 0.80 - 0.60
= 0.20.
Carl’s C.S. = 0.70 - 0.60
= 0.10.
(gizmos/day)
3
5
Total C.S. ($0.70/day) = area below demand, above mkt. price.
Now in terms of a more “conventional” demand curve:
($/unit)
With price at the level p1 . . .
. . . and quantity purchased
and consumed
at Q1 . . .
p1
Demand
Q1
(units/day)
. . . consumer surplus is the (shaded) area below
the demand curve and above market price, over
the range of quantity purchased and consumed.
One more thing to notice from this construction of
demand:
The demand price at any quantity measures the
willingness to pay (“value”) for the marginal
consumer (the first consumer who would leave the
market if price were to increase).
For this reason, the demand curve is sometimes
described as a graph of “marginal value.”
Consumer surplus gives a measure (in dollar terms) of
buyers’ benefits from market participation.
What about sellers?
Opportunity cost: The value of what must be given up
to produce a particular unit of the good.
As such, opportunity cost is the minimum amount that a
seller would be willing to accept for that unit.
For a given seller, opportunity cost can vary across units
of a good.
Opportunity cost can also vary across sellers (some
might be “high” cost sellers; others “low” cost
sellers.)
Producer surplus: The amount a seller is paid for a
good minus the seller’s opportunity cost of producing
it.
Producer surplus and supply curves?
Gizmos again. Assume:
. . . suppliers differ in their opportunity cost of the
first gizmo produced per day.
. . . but all producers have infinite opportunity cost
for the second, third, etc. gizmo each day.
(It’s impossible to produce more than one
gizmo per day.)
Suppose there are five suppliers who differ in their
opportunity cost of a gizmo:
Supplier
Opportunity cost for first
gizmo ($/gizmo)
Arliss
0.25
Bob
0.50
Cindy
0.70
Denise
1.00
Edgar
1.25
The market supply curve for gizmos:
Start off with price at zero and gradually increase it.
($/gizmo)
As price rises above 0.25,
Arliss’ supply “kicks in.”
1.25
As price rises above 0.50,
Bob’s supply “kicks in.”
1.00
0.70
And so on . . . quantity
supplied increase by 1
as each level of
opportunity cost is
reached.
0.50
0.25
1
2
3
4
5
(gizmos/day)
Here’s that supply curve again:
Suppose that the price of a gizmo is $0.75/gizmo.)
($/gizmo)
Quantity supplied is 3 gizmos/day. (Arliss, Bob, and
Cindy supply; Denise and Edgar don’t.)
1.25
Arliss’ P.S. = p - opp. cost
= 0.75 - 0.25
= 0.50
0.75
Bob’s P.S. = 0.75 - 0.50
= 0.25
Cindy’s P.S. = 0.75 - 0.70
= 0.05
0.25
3
5
(gizmos/day)
Total P.S. ($0.80/day) = area above supply, below mkt. price.
Now in terms of a more “conventional” supply curve:
($/unit)
Supply
p1
With price at
the level of p1 . . .
. . . and quantity
produced and sold
at Q1 . . .
Q1
(units/day)
. . . producer surplus is the (shaded) area above
the supply curve and below market price, over the
range of quantity produced and sold.
One more thing to notice from this construction of
supply:
The supply price at any quantity measures the
opportunity cost for the marginal producer (the first
producer who would leave the market if price were to
decrease).
For this reason, it’s legitimate to think of the supply
curve as a graph of “marginal cost.”
Consumer and producer surplus measure, in dollar
terms, consumers’ and producers’ benefits from
market participation.
Consumer surplus measures an implicit benefit -- it
doesn’t really show up as dollars in our pocket.
Instead, it’s the difference between the maximum
amount we would have willingly paid, for all units
purchased, and the amount we actually do pay.
Producer surplus is more explicit -- it’s closely related to
the concept of “profit.” (More later.)
Consumer
surplus
=
Producer
surplus
Total
surplus
=
=
=
Value to
buyers
Amount paid
by buyers
-
Amount received
by sellers
Consumer
surplus
Value to
buyers
+
-
-
Cost to
sellers
Producer
surplus
Cost to
sellers
If total surplus is maximized, we say that “efficiency”
is achieved.
Some conditions for efficiency:
The total quantity of goods supplied must be allocated
to the buyers who value them most highly.
(Otherwise, total value to buyers could be increased
by a transfer from one buyer to another.)
The total quantity of goods demanded must be
allocated to sellers who can produce them at least
cost.
(Otherwise, total cost to sellers could be decreased
by a transfer from one seller to another.)
Let’s see if these conditions are met in competitive
market equilibrium.
($/unit)
A
Supply
The “price rationing”
mechanism of competitive
markets achieves these
conditions.
Only buyers who value the
good higher than p* . . .
E
p*
(those on AE)
C
Demand
Q*
. . . will buy.
(units/day)
(those on CE)
Only sellers whose cost is lower than p* . . .
. . . will sell.
Rationing by price achieves the “right”
allocations on both sides of the market.
There’s one more condition that must be satisfied for
efficiency (maximization of total surplus):
We must have production, trade, and consumption of all
units for which marginal value exceeds marginal cost
...
. . . (all units for which WTP of the marginal buyer
exceeds opportunity cost of the marginal seller) . . .
. . . so that all potential gains from trade will be
realized.
Is this condition achieved in competitive equilibrium?
At output Q1 (less than Q*),
marginal value . . .
($/unit)
marginal value
p*
Supply
marginal
cost
Demand
Q1
Q2 (units/day)
Q*
marginal cost
marginal value
. . . exceeds marginal
cost.
At output Q2 (greater
than Q*), marginal
value . . .
. . .is less than
marginal cost.
Efficiency requires trade of all units up to Q* . . . none beyond.
The equilibrium quantity is the “right” quantity in this sense.
So in competitive market equilibrium, efficiency is
achieved (total surplus is maximized).
The “right” quantity of output is produced, traded,
and consumed . . .
. . . and it’s allocated (by the price rationing
mechanism) in the “right” way.
(Buyers with the highest values buy.
Sellers with the lowest costs sell.)
Remember basic principle #6: “Markets are usually a
good way to organize economic activity”?
One very (!) important caveat to all of this:
Efficiency -- maximization of total surplus -- has to do
with the size of the “pie.”
We can (and should!) still worry about how the pie is
divided among society’s members.
These are “equity” issues.