ECO101H1 Study Guide - Midterm Guide: Opportunity Cost, Marginal Cost, Marginal Utility

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Published on 12 Jun 2012
School
Department
Course
Professor
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
Quantity
Consumer Surplus
$20
1st
$15 = (20 5)
$15
2nd
$10 = (15 5)
$10
3rd
$5 = (10 5)
$5
4th
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 EFFICIENCY OF COMPETITIVE MARKETS
When total surplus is maximized, we have allocative efficiency.
P
SS
DD
QE
Q
1
Area = Gains from Trade (Total Surplus)
All possible prices
resulting in gains
from trade
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Definition: we have AE when the value to the buyer = cost to sellers of the last good sold (intersection of the demand & supply
curve)
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
DD
SS
Q
P
QE
Q1
Q2
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
SS
Q
P
PE
QE
Consumer
Surplus
Producer
Surplus
CS = DD PE
PS = PE SS
AE focuses on maximizing total surplus.
Distribution of total surplus is irrelevant.
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Document Summary

Suppose that the market dd and ss determine an equilibrium price of . You will purchase 4 units and enjoy consumer surplus of = ( + + + 0) Note: on test 1, students are not required to graph the step-like demand curve that arises in this case! All possible prices resulting in gains from trade. When total surplus is maximized, we have allocative efficiency. Definition: we have ae when the value to the buyer = cost to sellers of the last good sold (intersection of the demand & supply curve) Answer: consumer surplus + producer surplus = total surplus. 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.

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