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Directions: Please provide an initial discussion based on the assignment below. I will provide you responses from select peers to respond back to one Peer only, upon submitting initial post. I will provide additional documents for Module 4, upon Tutor accepting bid. Thanks.Assignment: Please post a clear question regarding the material in Module 1. If you can, note exactly where in the notes/video lecture the relevant area is located. Be sure that you do NOT ask about the questions on the problem set directly – that is not the intention of the discussion board.
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Module 4: Part 2
Last time we discussed the notions of productive and allocative efficiency. We are
concerned with whether free markets essentially make the best use of society’s scarce
resources. Are free markets a good way to manage economic activity?
We now focus on a different notion of efficiency.
Meaning of good outcomes, part 2:
Another (related) way of thinking about this is to realize that all economic activity
generates “well-being” in society.
So, we could ask:
“Do markets generate the greatest possible economic well-being?”
To answer this we need to:
1. determine where well-being comes from
2. figure out how to measure it
3. see if our measures of well-being are greatest when we let markets manage our
economy
Let’s tackle 1 first:
Let’s use an example to help clarify our thoughts.
Suppose I have a car I want to sell, and you’d like to buy it.
Here is a potential economic activity, and we first want to see where well-being could
come from.
Well, when I sell my car to you there are two people who could benefit – me and you.
That is, we have:
Well-being of the consumer: Let’s call this “consumer surplus” or CS
Well-being of the producer: let’s call this “producer surplus” or PS
Now, there will be cases when people not directly involved in the transaction may be
impacted by it, but generally it’s the case that the producer and consumer are the prime
potential beneficiaries of the transaction.
So….
Total economic well –being (total surplus or TS) = CS + PS
Module 4: Part 3
Recal we are thinking about whether markets are efficient, and we introduced the idea of
well being for consumers (CS) and producers (PS) as a way to measure efficiency.
Let’s start to incorporate the ideas of efficiency into a market supply and demand graph.
The supply and demand graph shows you how markets work and what outcome will
result. We want to see if this outcome is efficient in terms of generating the greatest
economic well-being (TS).
To do this – we will first define some concepts more formally, and then define them
within the context of a market graph.
Consumer Surplus:
The basic intuition of consumer surplus is: whenever a buyer purchases something they
were most likely willing to pay more than the price they actually paid. Anytime the price
you pay is less than what you were willing to pay you gain. The bigger the difference,
the bigger the gain.
Back to our example: Suppose we agree on a price of $2000 for the car, but you were
willing to pay $3000 for it. Then, your gain, your CS is $1000.
So, we have the following definition:
CS = willingness to pay – price paid
Or,
CS = Value to buyer – price paid.
Producer Surplus:
The basic story here is more complicated than consumer surplus. I’ll start with the most
straightforward explanation, and then get into the details…
Back to our example: I’m selling my car, and I probably have in my mind the lowest
price I’d be willing to accept. Suppose that this lowest price is $1000.
So, if I were willing to sell for $1000 and I received a price of $2000, then my PS is
$1000.
So, we have the following definition:
PS = price received – lowest price willing to sell
Or,
PS = price received – willingness to sell
For a minute, let’s think about this willingness to sell value. How low of a price am I
willing to sell it for? Well, it could be that my friend has agreed to buy it for $1000 if I
get no takers, or it could be that at a price less than $1000 I’d rather have the car then the
money. Either way, what I am doing is essentially using the notion of opportunity cost –
the next best alternative to the offer at hand. If the offer you make me is less than my
next best alternative, then I’ll choose the alternative rather than your offer.
In short, willingness to sell equals cost (roughly speaking….)
Total Surplus:
Total surplus will measure the total economic well being derived from economic activity.
We define TS as:
TS = CS + PS
In the car example, you earned $1000 of CS and I obtained $1000 of PS, as a result, we
have:
TS = $1000 + $1000 = $2000
Intuition: think about it: I have a car that is only worth $1000 to me. How do I know?
Because if I could sell the car for as little as $1000 I’d rather have the money than the car,
but any price below $1000 then I’d prefer to keep the car. The car gives me a $1000
worth of value. For you, the car is worth $3000 – that is how much money you would be
willing to give up in order to purchase the car. Anything more than $3000 and you’d
pass on the car, but any price less than $3000 then you’d prefer the car to the money.
For society, the car should be in your hands, not mine. Why? Because the transaction
would be mutually beneficial – your economic well being would increase and so would
mine.
Impact of a price change:
Suppose you are a better negotiator than I am, and the price we agree on is $1500 rather
than $2000.
Question: Has total surplus changed in society? Nope. It has just been redistributed
more towards you and less towards me, but overall well being stays the same.
Price changes, by themselves, do not impact overall well being.
As an example – think about scalping: is that economic activity efficient? Does it
improve TS? The answer is yes – scalping involves trade that is mutually beneficial:
both CS and PS improve.
Module 4: Part 4
Now, let’s take apply the ideas of efficiency to markets as a whole rather than a single
transaction.
Demand and Consumer Surplus:
Consider the following demand curve for oysters:
So, think about what this demand curve says: it says that if price is $10 an oyster I won’t
eat any – the price is too high. So, at a price of $10 I am “priced out of the market.”
But, at a price of $9 my Qd is 1 oyster, $8 my Qd is 2 oysters, and so on.
From previous work, we know that the actual price I’ll face is determined by the market
supply and demand curves: suppose the market price is $7. Then, we have:
Question: How much CS do I get from this market?
Well, I was willing to pay $9 for the 1st oyster but only had to pay $7 – so the first oyster
gave me CS of $2. The second oyster I would have paid $8 for but only actually paid $7,
so I received another $1 of CS. The third oyster I received 0 CS for.
So, in total, I received $3 worth of CS from this oyster market.
Graphically, we have:
The demand curve shows the buyers willingness to pay.
CS = area below demand and above price
PS and the Supply curve:
Now we can show PS by using the supply curve.
As a starting point, think about Supply: it shows combinations of price and how much a
firm will supply.
For example,
In this case, at a price of $10 we have 10 units being supplied, but if price were to drop to
$9 then firms will wish to sell only 9 units.
Why? How low of a price is a firm willing to accept and still produce? The answer is
that I will sell a good for as little as it cost me, but I won’t accept a price that is less than
my cost to produce that item.
So, suppose that the equilibrium price is $7. Then, we have:
How much PS is in this market? Well, we have 7 units being produced in the market.
The first unit I was willing to sell for as little as $1 but I received a price of $7, so my PS
for that first unit is $6. Continuing through all units sold, we have a total PS of
6+5+4+3+2+1+0 = $21.
Supply shows the firms willingness to sell (their cost)
PS = area below price and above supply.
TS and the Market:
Now, let’s put these two together and see what TS looks like?
TS = PS + CS.
Module 4: Part 5
Now, our question is: could we have produced a different amount of this good and
increased total economic well-being (TS)?
Well, let’s consider a level of output that would be greater than the equilibrium output
(Qhigh) and an output that is below the equilibrium output (Qlow):
Qhigh:
The last unit at Qhigh has a willingness to sell and a willingness to buy attached to it. As
we see, the willingness to buy (the value to the buyer) is LESS than the willingness to sell
(the cost to the seller).
Thus, if we were to produce the Qhigh unit it would cost society more to make this unit
than the value received from consuming it! Not a good decision – it would create
NEGATIVE TS!
Qlow:
Suppose, instead, we decided to stop short of the equilibrium output – the last output
produced is Qlow. Was this a good stopping point?
Well, suppose we decided to produce just a little bit more than Qlow – say to Qlow+1:
Qlow+1 would indeed be a valuable good to produce for society because it generates
more value to the buyer than cost to the seller.
Thus, when we think about it:
The market is allocatively efficient: it does produce the right amount of the product: it
does maximize TS in the market.
Intuitively, markets are great because they ensure that the most valued goods are the ones
produced, and things that cost more to produce than what we value them at are not
produced. A very nice outcome indeed….
What about productive efficiency – are the units produced made at the lowest possible
cost?
Well, we will dig into this more deeply later, but you can see that the folks on the supply
curve are firms that have the lowest costs. Put simply, markets ensure that the firms that
can produce the produce at the lowest cost are the ones who get to use our scarce
resources. Again, I very nice outcome indeed….
So consider a good – say pickleball – that has seen an increase in demand. Does the
market respond efficiently?
YES! Before the demand growth we maximized TS and after we have maximized TS
given the new preferences. We really like something more and as a result the market
produces more – and not just more but exactly the right amount of more!
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