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Test 1 Review.pdf

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James Pesando

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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 st $20 1 $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 P Area = Gains from Trade (Total Surplus) SS All possible prices resulting in gains from trade DD QE Q 1 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) P Q1: To the left oE Q ; SS VALUE TO BUYER > COST TO SELLERS  efficient to increase output Q2: To the right oE Q ; 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 CS = DD – PE P SS Consumer PS = PE – SS Surplus AE focuses on maximizing total surplus. Distribution of total surplus is irrelevant. PE Producer Surplus DD Q Q E 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 SS Dead Weight Loss: Consumer loss in total surplus Surplus (larger) PC Producer Surplus DD (smaller) Q QC Q E 1) Price ceiling (P ) is beneath equilibrium market price c 2) Consumer surplus increases, a
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