Transcript Chapter 2: A Review of Markets and Rational Behavior

Chapter 2: A Review of Markets
and Rational Behavior
“…while the law [of competition] may be sometimes hard for the individual, it is best for the race, because it ensures the
survival of the fittest in every department.” Andrew Carnegie
“Markets change, tastes change, so the companies and the individuals
who choose to compete in those markets must change.”
Attributed to An Wang (founder of Wang Laboratories, a defunct computer company)
“A commodity appears at first sight an extremely obvious, trivial thing. But its
analysis brings out that it is a very strange thing, abounding in
metaphysical subtleties and theological niceties.” Karl Marx
Perfect Competition
 Classical Assumptions for Perfect Competition:
 1. Many Buyers and Sellers: This assumption implies that no single producer or
consumer will influence prices through individual action. One case which
violates this assumption is a monopoly, or a single seller of a product.
 2. Perfect information: Every buyer and seller is aware of the price and quality
of the goods
 3. Homogeneous product: The output of each firm in the market is identical.
 4. Free entry and exit, or perfect mobility: Buyers or sellers can enter or leave a
market without restriction or cost.
 5. No Collusion: No group decision-making, including price fixing.

If the competitive assumptions are approximately true for a given market, both
buyers and sellers will be price takers, meaning that no buyer or seller will have
the power to influence the market price of the product.
Demand Shifts
If the variable is NOT on an axis, its effect appears
as a shift In the curve. If the variable IS on the axis
its effect appears in the slope of the curve.
Your Turn 2-2: In Figure 2-1 below, the initial demand curve for cola is D1. Label
the location of the demand curve after each of the following events. Is each
event below consistent with a new demand at D 1, D2, or D3?
a) Researchers find that Coke cures warts. ____
b) Papa Joe’s pizza goes on sale. ____
c) The population of caffeine addicts
Figure 2-1: Demand for Coke
Price
declines.___
d) Pepsi goes on sale.____
e) Coke goes on sale. ____
D3
D1
D2
Quantity
Supply Shifts
Your Turn 2-4: Possible supply shifts See Figure 2-3 below. Starting from
S1, will each event below lead to a new curve like S2, S3, or S1?
a) Bean beetles decimate the cola crop.____
b) Cola workers demand higher wages.____
c) Sugar prices tumble.____
d) New technology allows firms to transport
beans directly to the factory (beam them up,
Figure 2-3: Supply Shifts
Figure 3-3: The Supply of Cola
Price
S2
S1
S3
Scotty). ____
e) The demand for cola rises. ____
Quantity
Figure 2-4: Equilibrium and
Disequilibrium
Equilibrium with Numbers
Your Turn 2-5: Find the equilibrium price and quantity for the following sets of
equations.
Example A: Cola
Example B: Cola
Demand:
Pd = 100 -1/2 Qd
Qd = 200 - 2Pd
Supply:
Ps = 20 + ½ Qs
Qs = -40 + 2Ps
Equilibrium: Pd = Ps
Qd = Q s
Elasticity and the Minimum Wage
Q
(Qa  Qb )
(2-7) elasticity 
P
( Pa  Pb)
2
= ∆Q/average Q ÷ ∆P/average P
2
Your Turn 2-6: Assume that in the government of Amnesia recently increased
the minimum wage from $7 to $9. The Amnesian government knows that an
economist predicted that employment of Amnesian teens would drop from 101 to
99 as a result of the higher wage, but they don’t remember why this is important.
A. Using the midpoint formula, find the price elasticity of demand for
Amnesian teens. Is demand elastic, inelastic, or unit elastic over this price
range?
B. Another economist claims that teen employment would fall from 120 to 80
as a result of the same wage increase. Find her predicted elasticity of
demand. Is this elasticity elastic, inelastic, or unit elastic?
Elasticity and Total Spending
Your Turn 2-7: The total earnings of minimum wage teenage labor (per hour) in
Amnesia will equal the wage times the number of employees. Find the total
earnings for these teens before and after the wage increase for both sets of
employment predictions in Your Turn 2-6. Are the results consistent with the
elasticity of demand estimates for Amnesian teens?
The Total and Marginal Value of
Consumption
Definitions:
The Marginal Value of consumption is the maximum a person is willing to pay
for a particular unit of a good.
The Total Value of consumption is the sum of the marginal values for all units
actually consumed.
Your Turn 2-8: If Carrie consumes 5 mugs of coffee,
what is the marginal value of the last mug? ____
What is the total value of all 5 mugs combined? ____
Total Value with a
Linear Demand Curve
Your Turn 2-9: Find the total value for coffee
purchased given the demand curve in Figure 2-6
below. Hint: find areas A and B first.
Consumer Surplus
Definition: The net benefit of consumption, or the
difference between total value and total
spending, is called Consumer Surplus.
Your Turn 2-11: Carrie’s Consumer Surplus. See
Figure 2-7. Find the number of mugs Carrie will purchase
at a price of $3, and then find her total spending,
consumer surplus, and total value in dollars.
Consumer Surplus with Linear Demand
Your Turn 2-12: Calculate the consumer surplus,
total spending, and total value for Figure 2-6 below.
Your Turn: Equilibrium and Consumer
Surplus
Demand: Price = 12 - 2Q Supply: Price = 3 + Q
Find the equilibrium price and quantity, and sketch both demand and supply
curves including endpoints and equilibrium values.
Find the consumer surplus, total spending, and total value to the consumer of
this market.
Producer Surplus and Its Parts
 Definitions:
 Revenue = price x quantity sold
 Opportunity cost: The sum of the marginal costs of producing each unit,
and also the area under the supply curve and to the left of the quantity
produced.
 Producer Surplus equals the total revenue of producers minus the
opportunity cost of production. Graphically producer surplus is the area
between the market price and the height of the supply curve for a given
unit of a good.
Producer Surplus Graphs
 Figure 2-8: Costs and Benefits of Production
YOUR TURN 2-14: Calculate the total
spending, opportunity cost, and producer
surplus for Figure 2-8. Why won’t firms
produce the 7th unit?
Figure 2-9: Revenue, Opportunity Cost
and Producer Surplus
Your Turn 2-15: Calculate the producer surplus
and opportunity cost for Figure 2-9.
The Components of Producer Surplus:
Economic Rent vs. Economic Profit
 Economic Rent: Total Revenue minus opportunity cost for owners of inputs
such as land or resources.
 Economic Profit: Total Revenue minus the opportunity cost of production for
owners of capital goods such as factories, stores or machines.
An example of Economic Rent
In Figure 3-10, Jed can produce oil for $5 a barrel,
but oil sells at $40 per barrel. The difference will show up in the
Market price of Jed’s land and mineral rights. Therefore it is economic rent.
Long Run Equilibrium
A market is in long run equilibrium if
 (1) supply equals demand and
 (2) economic profits are zero.
 If both conditions exist, there is no incentive for firms to enter or exit the market.
Long Run Equilibrium and the
Components of Producer Surplus
 Economic Rent: Total Revenue minus opportunity cost for owners of inputs
such as land or resources.
 Economic Profit: Total Revenue minus the opportunity cost of production for
owners of capital goods such as factories, stores or machines.
 Long Run Equilibrium. A competitive market is in long run equilibrium if (1)
supply equals demand and (2) economic profits are zero. If both
conditions exist, there is no incentive for firms to enter or exit the market.
 If a competitive market is in long run equilibrium, economic profits equal
zero, so any producer surplus is made up of economic rent.
Net Gains for a Private Market:
Consumer plus Producer Surplus
Given the numbers on the axes, find the consumer surplus,
producer surplus and net gains for this market.
Rational Consumer
Choice and Incentives
The Budget Line: What is Affordable
with fixed income and prices?
The Budget:
(2-7) Income = PX•X + PY•Y = spending on X + spending on Y.
Budget Line Formulas:
slope of budget line =
Y endpoint =
Income
Py
Px
X
= 
Y
Py
Utility Functions and Indifference Curves
 (2-10) Utility = f(X,Y)
This utility function has three dimensions; the level of total utility, the quantity of
good X, and the quantity of good Y. The level of utility is determined by the
quantities of the two goods consumed.
Figure 2-13: Utility Function
Figure 2-14: Indifference Curves
Utility Maximization: Choosing quantities of X
and Y to reach the highest affordable level of
utility (U2 in figure 2-16)
Changes in Income Lead to Parallel
Shifts in the Budget Line
Example of Price and Income Changes
 Your Turn 2-19:
 A. Graph a budget line where income = $50 and the prices of X and Y both
equal $10.
 B. Now graph a new line with the same prices but an income of $70.
 C. Now graph a third budget line with an income of $70 and prices of $ 7
for X and $10 for Y.
Note how the endpoints and slopes of the budget lines change in each case.
Income and Substitution Effects
of a Price Change
Substitution Effect: The change in the quantities of X and Y caused
by a change in their relative prices, holding utility constant.
Income Effect: The change in the quantities of X and Y consumed
caused by a change in income (or utility), holding prices constant at
their new level.
Example: Gasoline Tax
and Income Tax Rebate
A tax on petrol or gasoline will raise the price, discourage
consumption, and also lower utility. If income taxes are cut
by the same amount as the gas tax revenue, raising the
steeper budget line From point B to C, utility will probably
remain lower.
Free Goods
Consumers will consume a free good until they no longer gain
any utility for additional units (marginal utility =0).
An Inconsistency in Consumer Surplus
 Compensating Variation in income is the maximum amount a person is willing to
pay for a marketed or non-marketed good.
 Equivalent Variation in income is the minimum amount a person will accept in
order to face a marketed or non-marketed cost such as a price increase or an
increased non-monetary harm.
 The two are not necessarily equal.
Hicks and Marshall Demand Curves
 Concept: The Hicks Demand Curve measures the change in the quantity of
X associated with the substitution effect of a price change after any
change in utility is eliminated through a change in income.
 A normal demand curve is often named the Marshall demand curve.
An Illustration of the 2 Types of
Demand Curves
The 2 types of demands are equal if there is no
income effect on the quantity of X-Box games.
Figure 2-22: Equivalent Variation of a Price Increase
Y
Y
Biased Demand
Unbiased Demand
C’
C
A
B
A
B’
Xb Xc Xa
X box games
Px
Biased CS
true CS
P2
Pa
b
Xb=Xc Xa
X box games
Px
P2
b=c
c
a
Pa
Marshall Demand
Hicks Demand
Xb Xc Xa X box games
a
Marshall Demand
=Hicks Demand
Xb=Xc Xa
X box games
Conclusion
 This chapter provides a review of microeconomic models of the competitive market
and the rational consumer.
 Concepts such as consumer surplus, producer surplus, and consumer choice
provide the basis for comparing the efficiency dimension of public policy.
 These models will be the cornerstone of much of the remainder of the book