ECO 100: TEST 1 REVIEW

10/19/11

CONSUMER SURPLUS: NUMERICAL EXAMPLE Suppose that the market DD and SS determine an equilibrium price of $5. Your demand curve is as follows: Price $20 $15 $10 $5 Quantity 1st 2nd 3rd 4th Consumer Surplus $15 = (20 5) $10 = (15 5) $5 = (10 5) None

You will purchase 4 units and enjoy consumer surplus of $30 = ($15 + $10 + $5 + 0) The graph is a non-linear step function. Note: On test 1, students are not required to graph the step-like demand curve that arises in this case! ALLOCATIVE EFFICIENC Y OF COMPETITIVE MARKETS

Area = Gains from Trade (Total Surplus) SS

All possible prices resulting in gains from trade

DD 1
When total surplus is maximized, we have allocative efficiency.

QE

Definition: we have AE when the value to the buyer = cost to sellers of the last good sold (intersection of the demand & supply curve)

P SS

Q1: To the left of QE;

VALUE TO BUYER > COST TO SELLERS

efficient to increase output Q2: To the right of QE;

VALUE TO BUYER < COST TO SELLERS

efficient to reduce output

DD Q1 QE Q2 Q

Question: How much, in total, would consumers and producers pay to prevent this market from shutting down? Answer: CONSUMER SURPLUS + PRODUCER SURPLUS = TOTAL SURPLUS Key Result: If output of a good is less than output in a competitive market (ie equilibrium), output is too low and is allocatively inefficient because: 1) the value of the good to the buyers exceeds the cost to sellers of producing the good 2) the gains from trade the benefits of participating in the market are not fully realized

P Consumer Surplus

SS

CS = DD PE PS = PE SS AE focuses on maximizing total surplus. Distribution of total surplus is irrelevant.

PE Producer Surplus QE

DD Q

Implication: Government policies that prevent output from reaching the competitive level result in allocative inefficiency Price Ceiling: if beneath market price, produces shortage (as previously discussed) In more sophisticated framework (welfare analysis), also results in loss of total surplus

Consumer Surplus (larger)

Dead Weight Loss: loss in total surplus

SS

PC Producer Surplus (smaller) QC

1) 2) 3) 4)

DD Q QE

Price ceiling (Pc) is beneath equilibrium market price Consumer surplus increases, as producer surplus falls Total surplus decreases by shaded area Qc is allocatively inefficient: at Qc, value to buyer exceeds cost to sellers of producing additional output

MARGINAL COST/BENEFIT EXAMPLE Your brother gives you a frequent flyer coupon, which allows you to pay $200 less than the regular airfare on any airfare you choose to take. The coupon can be used any time, and you often fly. The cost of Toronto/Vancouver airfare is $500 for a regular ticket. You value the trip from Toronto to Vancouver at $400. Should you use the coupon, pay $300, and fly to Vancouver? Explain your answer.

Marginal benefit of trip: $400 Marginal cost of trip: $500 Why is marginal cost $500? $200 coupon has an opportunity cost of $200, since it can be used in other flights. Result: DO NOT take trip. Insight: if coupon could only be used on the Toronto/Vancouver trip, its opportunity cost would be zero and you should take the trip

TRUE, FALSE, UNCERTAIN QUESTIONS 1) A drought around the world raises the total revenue that farmers around the world receive from the sale of grain, but a drought only in Saskatchewan reduces the total revenue that Saskatchewan farmers receive. Could this be true?

Increase in TR in the World P

SS SS

P1 P0

DD

TR0 = P0 x Q0 TR1 = P1 x Q1

Q Q1 Q0 Even though P, TR has only increased if world demand is inelastic TR1 > TR0 if price elasticity 1

Saskatchewan Drought SS

SS P0 = world price (unchanged) TR (before drought)

P0

TR0 = P0 X Q0 TR (after drought) TR0 TR1 Q1 Q0 TR1 = P1 X Q1 TR1 < TR0 Q

Saskatchewan Drought: Saskatchewan production of grain is so small relative to world production that world supply is (Essentially) unaffected price remains at P0 Saskatchewan farmers produce less grain, sell at unchanged world price, so total revenue of Saskatchewan farmers declines a) It is uncertain that TR of farmers around the world would raise, only applicable if demand is elastic, where a rise in price results in an increase in TR. b) True, the TR of Saskatchewan farmers is reduced because price remains unchanged while the new quantity sold decreases. Since total revenue is defined as the product of price and quantity sold, a decrease in quantity also decreases the TR.

A PIZZA PUZZLE A local pizza parlour offers and all you can eat lunch for $3. You pay at the door, and then the waiter brings you as many slices of pizza as you like. A large number of students enter the pizza parlor. As they enter, one-half of these students are immediately awarded a prize a refund of $3 Which group of student will eat more pizza? Both will eat same amount of pizza. Price of pizza (marginal cost) is $0 in both situations, and the all students will consume pizza until their willingness to pay (marginal benefit) is equal to MC, or $0. This amount is the same for both parties of students.

MB

QE

MC = $0