a rational decision maker makes choices so as best to achieve a clear goal. rational behavior most...
TRANSCRIPT
A rational decision maker makes choices so as best to achieve a clear goal.
• Rational behavior most often requires marginal analysis
in which the marginal benefit and marginal cost of a
incremental action are compared.
• Economists assume that consumers take actions so as to
maximize their satisfaction or utility.
• An implication of rationality on the part of consumers is
that their demand curves for a good reflect their marginal
benefit from the good.
Willingness to pay is the maximum amount that a
buyer is willing to pay for a good.
Marginal willingness to pay (marginal benefit) is the maximum amount a buyer is willing to pay for an incremental unit.
Total willingness to pay (total benefit) is the maximum amount a buyer is willing to pay for the total number of units received.
What if the price of movies tickets is $7.00 each?
A consumer seeking to maximize satisfaction will choose the number of movies that maximizes her net gain or consumer surplus (for the given price).
The consumer surplus associated with a particular quantity is the total one is willing to pay for that quantity of the good minus what one actually pays.
In maximizing total net benefit (i.e., consumer surplus), the individual will buy each units having a marginal benefit that is at least as great as the marginal cost.
2
4
6
8
10
12
14
1 2 3 4 5 6 7 8 movies
$ per movie
2
4
6
8
10
12
14
1 2 3 4 5 6 7 8 movies
$ per movie
P = $7.00
$7
$5$3
$1
P = $4.00
2
4
6
8
10
12
14
1 2 3 4 5 6 7 8 movies
$ per movie
$7
$5$3
$1
$3 $3 $3 $3 $2
2
4
6
8
10
12
14
1 2 3 4 5 6 7 8 movies
$ per movie
P = $4.00
$8$6
$4
$10
$2
10
60
D
Q
P
20
40
40 a
b c
)040()2040(400$21
consumer surplus when P = $20(area abc):
m n r
)060()1040(900$21
consumer surplus when P = $10(area amr):
$400
initial surplus
$400
increase in surplus due to price reduction on initial quantity $400 = (20-10)40
$100
increase in surplus from purchase of additional units of Q
A supply curve reflects the marginal opportunity cost of sellers making the good available.
Quantity ofHouses Painted
Price ofHouse
Painting
500
800
$900
0
600
1 2 3 4
Grandma’s cost
Georgia’s cost
Frida’s cost
Mary’s cost
Supply
Measuring Producer Surplus with the Supply Curve...
Quantity ofHouses Painted
Price ofHouse
Painting
500
800
$900
0
600
1 2 3 4
SupplyPrice = $800
Georgia’s producersurplus ($200)
Totalproducersurplus ($500)
Grandma’s producersurplus ($300)
Quantity ofHouses Painted
Price ofHouse
Painting
500
800
$900
0
600
1 2 3 4
SupplyPrice = $800
Producer surplus is the total amount sellers receive in payment for a good minus the sellers’ (total) opportunity cost.
The area below the price and above the supply curve measures the producer surplus in a market.
P2
Q2
How Price Affects Producer Surplus...
Quantity
Price
0
Supply
Q1
P1
A
BCInitial
Producersurplus
Additional producersurplus to initialproducers
D EF
Producer surplusto new producers
The diamond-water paradox refers to the puzzling observation that markets place a very high value on diamonds at the same time that water is cheap.
•Market prices reflect marginal values and marginal costs.•When a good is abundant, the marginal value of the last unit can be quite low even though the total net benefit (i.e., consumer surplus) is quite large.
D
S
Q
P
P1
Q1
However, in reality there is no paradox of value.
Welfare Economics
Welfare economics is the study of how the allocation of resources affects economic well-being.
Buyers and sellers receive benefits from taking part in the market.
Consumer surplus measures economic welfare on the buyer’s side.
Producer surplus measures economic welfare on the seller’s side.
Total Surplus
consumer surplus = value to buyers - amount paid
producer surplus = amount paid - costs to sellers
total surplus = consumer surplus + producer surplus
= value to buyers - costs to sellers
Welfare economics is concerned with both efficiency and equity.
Efficiency is concerned with maximizing the total surplus received by all members of society.
Equity is concerned with the fairness of the distribution of well-being among the members of society.
For an allocation of resources to be efficient, each of the following is needed:
• Efficiency in production: Any given level of output must be produced in the least costly manner.
• Efficiency in exchange: Any given level of output must be consumed by those individuals who value it the most.
• Efficiency in the mix and levels of goods and services
Q
D
SP
Q0
P0
qa
saP
P0
q0a qb
sbP
P0
q0b qe
seP
P0
q0eqc
scP
P0
q0c
Free markets result in the total output produced, here Q0, being produced by the sellers who can produce at the least cost.
In this way, the given level of output is produced in the least costly manner.
Q
D
SP
Q0
P0
qh
dh
P
P0
q0h qi
di
P
P0
q0i qj
dj
P
P0
q0j
Free markets result in the total output produced, here Q0, being allocated to buyers who value the good most highly.
In this way, for the given level of output the total benefit to buyers is maximized.
qk
P
P0
q0k
dk
Free markets produce the quantity of goods, here Q0, that maximize the sum of producer and consumer surplus.
Q
D
S
P
Q0
P0
consumer surplus
producer surplus
Q
D
SP
Q0
P0
Producing any units of Q greater than Q0, will result in a fall in total surplus since the marginal cost to sellers exceed the marginal value to buyers.
Q2
a
b
ce
f
Q
D
SP
Q0
P0
Reducing Q to a level below Q0 would result in a reduction in total surplus since the marginal cost of those units to sellers is less than the marginal value of those units to buyers.
Q1
a
b
c
m
n
Even though buyers and sellers are only concerned about their own (individual) welfare, demand and supply forces in competitive markets operate like an “invisible hand,” leading to
the total benefit to buyers and sellers being maximized.
Quotes from Adam Smith in The Wealth of Nations
“It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest.”
“Every individual … by pursuing his own interest .. promotes that of society. He is led … by an invisible hand to promote an end which was no part of his intention.”
Problems impeding the functioning of markets:
Lack of competition: Competition in markets often is less than perfect.
Externalities: when the actions of either buyers or sellers affect third parties, maximizing the total benefits to buyers and sellers is not not the same as maximizing the total surplus or net benefit to society.
In general, there is market failure when unregulated markets fail to allocate resources efficiently.