Lecture 4(i) Announcements Aplia Experiment Thur or Friday: 3 rounds (around 10 minutes) If participate, add 1.5 bonus to HW4 Choose between 4 different times: Thur 9am, 6pm, 10pm Friday 4pm (Only participate once!) Evening Midterm in two weeks! Mon Oct 6 7:00-8:00 pm If you have conflict, you need to register with [email protected] makeup Wed 4-5pmMakeup Registration Deadline (for no penalty) Mon Sept 29, 4pm Lecture 1. Review Consumer Surplus and Producer Surplus in Market Allocation 2. Pareto Efficiency 3. Link between efficiency and the market allocation.AofAfter fextmidterntermnalitim wilies.ll intPayroduy atteuce centioconcon tocepto theteLast class we figured out what happens when Econland has a market economy Q = 5 P = 5 S1, S2, S3, S4, S5 produce D1, D2, D3, D4, D5 consume Market determines the P, Q, and who.Gains from Trade? We calculated: Consumer surplus of particular buyer = reservation price – price paid Producer surplus of seller = price received – cost Fill table in to get….Q Res. Price price paidCS Pricerec.Cost PS 1 9 5 4 5 1 4 2 8 5 3 5 2 3 3 7 5 2 5 3 2 4 6 5 1 5 4 1 5 5 5 0 5 5 0 6 4 - 0 - 6 0 7 3 - 0 - 7 0 8 2 - 0 - 8 0 9 1 - 0 - 9 0 10 0 - 0 - 10 0 Total 10 10 TS = CS + PS20 = 10 + 10 Consumer Surplus and Producer Surplus in Competitive Equilibrium 01234567891001234567891QuantityDollarsDSSee in graph Consumer Surplus Area between demand curve and price line Producer Surplus Area between price line and supply curve In Econland, demand and supply curves look like steps In economy with lots of people, we won’t notice the steps, things will smooth out. CS = Area of Triangle = ½×5 ×5 = 12.5 PS = ½×5 ×5 = 12.5 TS = CS + PS = 25 012345678910012345678910QuantityDollarsSDSo that is market allocation And the social surplus (or “pie”) And the division of the surplus (“who get’s what slice”) The next step is to examine the efficiency of the market. Need a concept of efficiency. The standard concept is Pareto Efficiency AfesosoorsocageAn aleasibomeomer...Tomean oettinVilfrlocable aeoneeoneThe Peoneonly ng a redoationand e bete woPie ie is tcomsmao Pa is Pthertter orse s bigto geme frallerretoParere is off woff. g aset a om slic184eto Eno wwithos it cabiggsomce.)48-1Efficiway out man bger smeon923entto mmakibe. (slicene elif it imakeing (If , it lse is eConcept is easy to understand if pies are the only thing in the economy Pretty simplistic view of the world that there is a fixed pie out there and the only economic question is how the pie is divided up. Somebody has to bake the pie.Redistribution policies could very well affect how many pies are baked! This brings us back to Econland. Widgets are NOT scattered about on the ground waiting to be picked up. they have to be produced. In Econland there are dollars and widgets. The S people can produce widgets and the D people can consume them. Everyone likes dollars! The fundamental economic questions that need to be addressed: How many widgets should be produced? Who should produce widgets? Who should consume widgets? How many dollars does each person get?Reservation Prices and Costs for Widgets Name Res.Price Cost Name D1 9 1 S1 D2 8 2 S2 D3 7 3 S3 D4 6 4 S4 D5 5 5 S5 D6 4 6 S6 D7 3 7 S7 D8 2 8 S8 D9 1 9 S9 D10 0 10 S10 The following allocation is not Pareto efficient. An allocation where D8 consumes a widget but D2 does not can not be Pareto efficient. Because... D8 gives widget D2 D2 gives $5 to D8 D8 better off (get $5 for widget he values at $2) D2 better off (pays $5 dollars for widget he values at $8.) (And no one worse off)Note this is just one possible trade that can make some people better off with no one worse off. Other possibilities? General Principle 1 Efficient Allocation of Consumption In any efficient allocation, consumers with highest willingness to pay consume.Reservation Prices and Costs for Widgets Name Res.Price Cost Name D1 9 1 S1 D2 8 2 S2 D3 7 3 S3 D4 6 4 S4 D5 5 5 S5 D6 4 6 S6 D7 3 7 S7 D8 2 8 S8 D9 1 9 S9 D10 0 10 S10 Next consider an allocation where S7 produces a widget but S3 does not. Is this Pareto efficient?General Principle 2 Efficient Allocation of Production In any efficient allocation, producers with the lowest cost produce. What about quantity? Let's see what we can learn from the next two examples. Next consider an allocation where 3 widgets are produced (by S1, S2, S3) and 3 widgets are consumed (by D1, D2, and D3). Pareto efficient?Next consider an allocation where 8 widgets are produced (by S1 through S8) and 8 widgets are consumed (by D1 through D8). Let’s say S8 is supposed to deliver a widget to D8. Pareto efficient? Relative to the initial allocation, S8 can give $5 instead of a widget. Paying $5 is cheaper for S8 than making a widget. D8 would rather have $5 than a widget. So both better off, no one worse off. So what do we learn from these last two examples?General Principle 3 Efficient Quantity In any efficient allocation, the quantity is where the marginal valuation of the last unit consumed equals the marginal cost of the last unit produced. Principles 1, 2, and 3 imply that in an efficient allocation for the widget industry in Econ land: Q = 5 S1, S2, S3, S4, S5 produce D1, D2, D3, D4, D5 consume 012345678910012345678910QuantityDollarsMarginal CostMarginal reservation priceQefficient = 5, Social Surplus equals: 8+6+4+2+0 = 20 All of this should look familiar. Let’s link this to the market