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Chapter 7

Chapter 7 Notes, Economics Surplus and Exchange (ECO100Y) 4th Canadian Edition

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Department
Economics
Course
ECO101H1
Professor
Robert Gazzale
Semester
Fall

Description
Chapter 7 Notes: Economic Surplus and Exchange (Market Interventions) 7.1 – Pre-Conditions for Markets Invisible Hand  Metaphor by Adam Smith that under carefully specified circumstances, the actions of independent buyers and sellers will result in the largest possible economic surplus Economic Surplus  The benefit of any action minus its costs An example of economic surplus: Suppose you are willing to pay a maximum of $40 for a sweatshirt. You go shopping and discover another sweatshirt priced at $30 that meets your specifications. If I pay $30 for the sweatshirt, I realize an economic surplus of $10.  Buyer aspect: my willingness to pay $40 reveals that the value of the sweatshirt to me is $40  Seller aspect: Suppose that the seller is willing to sell the sweatshirt at $25. If the seller receives $30 for the sweatshirt, the seller will realize an economic surplus of $5. This transaction is mutually beneficial because both the buyer and seller realize an economic profit. The “right” competition circumstances include competition among a large number of small participants in markets (therefore market price is unaffected). Therefore, societies need laws and courts to enforce “right” competition to ensure competition takes legitimate forms 1 Perfectly competitive markets  A market in which no individual supplier has significant influence on the market price of the product  A firm cannot charge more than a rival firm nor does the incentive to charge less exist Perfectly competitive firms are price takers because of their inability to influence market price. Price Taker  A firm that has no influence over the price at which it sells its product. Four conditions are needed to satisfy the assumption of a perfectly competitive market: 1. All firms sell the same standardized product. This condition implies that buyers are willing to switch sellers if it allows them to buy at a lower price. 2. The market has many buyers and sellers, and each buys or sells only a small fraction of the total quantity exchanged. This implies that individual buyers and sellers are price takers, regarding the market price of the product as fixed and beyond their control. 3. Productive resources are mobile; that is, both buyers and sellers are able to move their resources freely between markets in pursuit of business opportunities. 4. Buyers and sellers know the market price and quality of the standardized product. 2 Three good reasons to study perfect competition: 1. Some markets (e.g., foreign exchange, many agricultural products) are closer to perfect competition than to other market types. 2. It is easier to first analyze perfect competition and then proceed to other market types than it is to do the reverse. 3. When individuals make mutually beneficial transactions in a perfectly competitive market, their self-interested behaviour is harmonized with the common good. Therefore, perfect competition provides a benchmark against which the outcomes of other market types can be compared. For an example that approximates perfect competition, consider how well the market faced by a wheat farmer in Manitoba meets the criteria: 1. The different grades of wheat are highly standardized with very specific criteria for each. 2. Each farmer's crop is only a fraction of Canadian and world wheat production. Even when the Canadian Wheat Board acted for many years as sole sales agent for Canadian wheat exports, it had no control of world wheat market prices. 3. Some farmers can choose to produce other crops even if they are unwilling to leave farming, which provides a degree of mobility of resources. All buyers and sellers can be well informed because the Internet provides access to information about prices and grades of wheat as published by the Canadian Wheat Board and others. 3 A) Shows the market demand and supply curves intersecting to determine a market price of P 0 B) Shows the product demand curve as faced by any individual firm in this market that is a horizontal line at P0. Since the market is perfectly competitive, firms must accept the price at which they sell their goods and services. The firm has only one decision to make: the output level is chosen that enables the largest possible profit. 7.2 – Market Equilibrium and Mutually Beneficial Exchange Suppose the supply and demand curves for milk are as shown in Figure 7.2, and the current price of milk is $1/litre. Describe an unrealized transaction that would benefit both buyer and seller. At a price of $1, sellers offer 2000 litres of milk per day. At this quantity, buyers value an extra litre of milk at $2 (the buyers’ willingness to pay for an additional litre). The cost of producing an extra litre of milk is only $1 (the price that corresponds to 2000 litres/day on the supply curve, which is equal to the marginal cost). Therefore, a price of $1/litre leads to excess demand of 2000 litres/day.  Suppose a supplier sells an extra litre of milk to the most eager of these potential buyers at $1.25… FIGURE 7.3 How Excess Demand Creates an Opportunity for a Surplus-Enhancing Transaction At a market price of $1/litre, the most intense potential buyer is willing to pay $2 for an additional litre, which a seller can produce at a cost of only $1. If this buyer pays the seller $1.25 for the extra litre, the potential buyer gains an economic surplus of $0.75 and the seller gains an economic surplus of $0.25. 4 If compensating payments can be made to those who lose when the price of milk rises, it is possible for additional buyers and sellers to be better off while no one is worse off. Therefore, selling milk at $1 does not provide the largest possible economic surplus. It prevents mutually beneficial exchange. If milk sells at a price below its equilibrium price, we can design a transaction in which each participant’s benefit exceeds cost. QUESTION: Suppose that milk initially sells for 50 cents per litre. Describe a transaction that will create additional economic surplus for both buyer and seller without causing harm to anyone else. A Market in Which Price is Below the Equilibrium Level In this market, milk is currently selling for $1/litre, $0.50 below the equilibrium price of $1.50/litre. ANSWER: At a price of 50 cents per litre, there is excess demand of 4000 litres/day. Suppose a seller produces an extra litre of milk (MC = $0.50) and sells it to the buyer who would value it most (reservation price = $2.50) for $1.50. Both buyer and seller will gain an additional economic surplus of $1, and no other buyers or sellers will be hurt by the transaction. 5 FIGURE 7.4 How Excess Supply Creates an Opportunity for a Surplus-Enhancing Transaction At a market price of $2/litre, buyers are only willing to purchase 2,000 litres. At that quantity of total production, sellers can produce an additional litre of milk at a cost of only $1, which is $1 less than the marginal buyer would be willing to pay for it. If the buyer pays the seller $1.75 for that extra litre, the buyer gains an economic surplus of $0.25 and the seller gains an economic surplus of $0.75. j If exchange is voluntary, neither the buyer nor the seller can be compelled to purchase or sell more than is optimal for them given the going price.  Prices read from the supply and demand curves thus make it clear why opportunities for additional mutually beneficial exchanges cease only if the equilibrium price pertains in a market.  When the price is either higher or lower than the equilibrium price, the quantity exchanged in the market will always be lower than the equilibrium quantity. If the price is below equilibrium, the quantity sold will be the amount that sellers offer. The price on the demand curve at the quantity exchanged (the value of an extra unit to buyers) must be larger than the seller's reservation price on the supply curve (the marginal cost of producing that unit). 7.3 – Economic Surplus Total economic surplus is the sum of all economic surpluses attributable to participation in that market by buyers and sellers. It is a measure of the total amount by which buyers and sellers benefit from their participation in the market. A perfectly competitive market maximizes its economic surplus when it reaches equilibrium price and quantity 6 Supplier’s reservation price is the lowest price a supplier will accept in return for providing a service. Demander’s reservation price is the highest price a demander will offer in order to obtain a good or service. Consumer and Producer Surplus Consumer surplus (blue area) is the cumulative difference between the most that buyers are willing to pay for each unit and the price they actually pay. Producer surplus (green area) is the cumulative difference between the price at which producers sell each unit and the smallest amounts they would be willing to accept. When the potential purchasers are arranged from highest to lowest reservation price, demand forms the staircase-shaped demand curve. The supply and demand curves of this figure can be thought of as discrete counterparts of the traditional continuous supply and demand curves. Consumer surplus:  the total economic gain of the buyers of a product as measured by the cumulative difference between their respective reservation prices and the price they actually paid.  the cumulative difference between what buyers would have been willing to pay for the product and the price they actually do pay. Graphically, it is the area between the demand curve and the market price. 7 Producer surplus:  the total economic gain of the sellers of a product as measured by the cumulative difference between the price received and their respective reservation prices  the cumulative difference between the market price and the reservation prices at which producers would have been willing to make their sales. Graphically, it is the area between market price and the supply curve. The surplus received by buyers and sellers will generally not be the same dollar value. The total economic surplus for a market is the sum of consumer surplus and producer surplus. Total economic surplus in a perfectly competitive market is maximized when exchange occurs at the equilibrium price. How much do buyers and sellers benefit from their participation in the market for milk? OR How much total economic surplus do the participants in this market reap? Total economic surplus = Producer Surplus + Consumer Surplus = Area of Green Triangle + Area of Blue Triangle = $6000/day  The last unit exchanged generates no surplus at all for both buyers and sellers.  For sellers, the surplus is the cumulative difference between market price and marginal cost.  For buyers, the surplus is the cumulative difference between the most they would be willing to pay for milk and the price they actually pay. 8  Another way to think about surplus is to ask, what is the highest amount consumers and producers would pay, for the right to continue participating in the market? For buyers, it is $2000/day. This is the amount by which their combined benefits exceed their combined costs. For sellers, it is $4000/day, since that is the amount by which their combined benefits exceed their combined reservation prices. The equilibrium price and quantity serve to maximize the total economic surplus created by a market. The prices and quantities that we observe as equilibrium outcomes in markets are conditional on tastes and the distribution of wealth. Whenever a perfectly competitive market is out of equilibrium, it is always possible to generate additional economic surplus. A larger economic surplus means that, at least potentially, it is possible to make at least some people better off without making anyone worse off. 7.4 – The Cost of Preventing Price Adjustments: Price ceiling: a maximum allowable price, specified by law or regulation (e.g. rent control) How much is an economic surplus reduced by price control? 9 And suppose that legislators pass a law setting the maximum price at $10/bbl. How much lost economic surplus does this policy cost society? For the supply and demand curves shown, the equilibrium price of oil is $14/bbl, and the equilibrium quantity is 3000 bbl/day. Consumer surplus is the area of the blue triangle ($9000/day). Producer surplus is the area of the green triangle (also $9000/day). Total economic surplus in this market will be $18 000/day. If the price of oil is kept at $10/bbl, only 1000 bbl/day will be sold, and the total economic surplus will be reduced by the area of the lined triangle. Since the height of this triangle (lost economic surplus) is $8/bbl and its base is 2000 bbl/day, its area is (½)(2000 bbl/day)($8/bbl) = $8000/day. Producer surplus falls from $9000/day in the unregulated market to the area of the green triangle, or (½)(1000 bbl/day)(2/bbl) = $1000/day, which is a loss of $8000/day. Note that consumer surplus under controls is the area of the blue figure, which is again $9000/day. (Hint: To compute this area, first split
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