Chapter 7 Efficiency of Market

26 & 27 March, 2020 (Tutorial 4) Chapter 7 Efficiency of Market  Employ the demand and supply model and develop consumer surplus and producer surplus as a measure of Welfare and Efficiency 1. Demand, willingness to pay and value  Marginal benefit shows the value/ the maximum price that people are willing to pay for another unit of a good or service  Demand curve shows the maximum amount the person is willing to pay for a given quantity  Demand curve = MB curve  Price decreases, CS increases (for a lower price paid and a higher quantity purchased) 2. Supply, willingness to sell and cost  Marginal cost is the minimum price that producers must receive to induce them to produce another unit of the good or service.  Supply curve shows the minimum acceptable price the seller needs to be paid for given quantities.  Supply curve = MC curve  Price rises, PS increases (for a higher price received and additional unit sold) Consumer surplus = Value to buyers – Amount paid by buyers Producer surplus = Amount received by sellers – Cost to Sellers Total Surplus = Consumer Surplus + Producer Surplus Total Surplus is maximized at the equilibrium (assume perfectly competitive market and no externalities) Underproduction Overproduction  The free market allocates the supply of a good to the buyers who value it most highly (WTP) and allocates the demand for goods to the sellers who can produce it at the lowest cost - Underproduction - the value of the product to the marginal buyer is greater than the cost to the marginal seller so total surplus would rise if output increases. Overproduction- the value of the product to the marginal buyer is less than the cost to the marginal seller so total surplus would rise if output decreases. -   Efficiency: the property of a resource allocation of maximizing the total surplus received by all members of society. Equality: the property of distributing economic prosperity uniformly the members of society. 1 Example: Chapter 6, Q7 The cost of producing flat-screen TVs has fallen over the past decade. Let’s consider some implications of this fact. (a) Draw a supply and demand diagram to show the effect of falling production costs on the price and quantity of flat-screen TVs sold. (b) In your diagram, show what happens to consumer surplus and producer surplus. (c) Suppose the supply of flat-screen TVs is very elastic. Who benefits most from falling production costs --- consumers or producers of these TVS? (a) The supply curve of flat-screen TVs shifts to the right. In the new equilibrium, equilibrium price declines and equilibrium quantity increases. (b) Consumer surplus: changes from A to (A + B + C + D). An increase of (B+ C + D). Producer surplus: changes from (B + E) to (E + F + G). A change of (F + G – B) which could be positive or negative. Total surplus rises by (B + C + D) + (F + G – B) = (C + D + F + G) (c) If the supply of flat-screen TVs is very elastic, then the shift of the supply curve benefits consumers most. To take the most dramatic case, suppose the supply curve were horizontal, then there is no producer surplus at all. Consumers capture all the benefits of falling production costs, with consumer surplus rising from A to (A + B). Example: Chapter 6, Q9 One of the largest changes in the economy over the past several decades is that technological advances have reduced the cost of making computers. (a) Draw a supply-and-demand diagram to show what happened to price, quantity, consumer surplus, and producer surplus in the market for computers. (b) Forty years ago, students used typewriters to prepare papers for their classes; today they use computers. Does that make computers and typewriters complements or substitutes? Use a supply-and-demand diagram to show what happened to price, quantity, consumer surplus, and producer surplus in the market for typewriters. (c) Are computers and software complements or substitutes? Draw a supply-and-demand diagram to show what happened to price, quantity, consumer surplus, and producer surplus in the market for software. Should software producers have been happy or sad about the technological advance in computers? 2 (a) Supply curve shifts to the right. The equilibrium price of computers declines and the equilibrium quantity increases. Consumer surplus increases from A to (A + B + C + D). Producer surplus increases by F + G – B (From B + E to E + F + G) (b) As typewriters are substitutes for computers, the decline in the price of computers shifts the demand for typewriters to the left and it results in a decline in both the equilibrium price and equilibrium quantity of typewriters. Consumer surplus in the typewriter market changes by C – B (From A + B to A + C). Producer surplus changes drops by C + D (From C + D + E to E). (c) As software and computers are complements, the decline in the price and increase in the quantity of computers increases the demand for software and results in a higher price and quantity of software. Consumer surplus in the software market changes by A – C (From B + C to A + B). Producer surplus changes by C + D (From E to C + D + E). 3