Supply, Demand, and the Virtues of the Market1. Why a Market Maximizes Total Surplus2. Two Things Needed for Markets to Work Well3. Two Things that Cause Markets to Not Work Well4. Why Governments Sometimes Want to Manipulate Markets5. Maximum Prices or Price Ceilings6. Minimum Prices or Price Floors7. Production Quotas8. Taxes and Subsidies9. The Case for the Gas Tax1Announcements• Ben Friedman will speak in class on March 23 on his book The MoralConsequences of Economic Growth– Thesis is that economic growth (or lack of it) affects the moral char-acter of a society. In particular, economic growth leads to moreopenness of opportunity, tolerance, economic and social mobility,fairness and democracy.• This thesis faces considerable skepticism these days. See David Brooks’2/19/2006 NY Times column.• This is one of thebig questions facing society today.• On a different topic, we are skipping section 9.52Why a Market Maximizes Total Surplus• Recall that we have discussed the concepts of consumer surplus andproducer surplus.– Consumer surplus is the difference between what buyers are willingto pay for the good and what they actually pay; it measures thegains to consumers from participating in the market.– Producer surplus is the difference between the price that sellers of agood receive and their cost; it measures the gains to producers fromparticipating in the market.• Total surplus is the sum of consumer and producer surplus and mea-sures the gains from trade: the total benefit to buyers and sellers fromparticipating in the market.• The equilibrium for a perfectly competitive market – a market in whichboth buyers and sellers are price takers – is usually efficient.• The market maximizes total surplus despite (or is it because of?)– buyers are maximizing their own utility without direct concern forsellers.– sellers are maximizing profits without direct concern for buyers.3• Consider figure 9.1• So how do we know total surplus is maximized at the equilibrium priceand quantity determined by the intersection of the supply and demandcurves?– Goods go the “right” buyers: every consumer who buys the goodhas a willingness to pay at or above the equilibrium market price.– Every potential consumer who does not buy the good has a willing-ness to pay less than the equilibrium market price.– The good is produced by the “right” suppliers. Every seller whosupplies the good has a cost at or below the market price.– Every potential seller who does not supply the good has a cost ofmore than the market price.4• Finally, the right quantity of goods are bought and sold.– Any additional units of the good would cost more to produce thanthe market price but would be worth less than the market price tothe consumers who receive them.– If fewer units of the good were bought and sold, some consumerswould be willing to pay more than it costs to supply additionalquantities of the good.• Many people are skeptical that markets maximize total surplus or wel-fare. Try the following:– reallocate consumption– reallocate production– change the level of production5Needed for Markets to Work Well: Property Rights• Property rights are the rights of owners of valuable items, whetherresources or goods, to dispose of those items as they choose.• Property rights are what make the mutually beneficial transactions ina market possible.• Well-defined property rights are crucial for a well functioning market.– Suppose that students do not have full property rights to theirPindyck and Rubinfeld textbook. In particular, suppose you arenot allowed to resell the book back to the Yale Bookstore or to nextyear’s crop of Econ 115b victims (er ... I mean students).– This restriction on property rights would prevent many mutuallybeneficial trades.– Some students would be stuck with textbooks they do not plan toreread and would be happier receiving cash instead. Other studentswould be forced to pay full price for shiny new books when theywould be happier getting slightly battered copies at a lower price.6• Property rights are at the center of some of the most contentious issuesof the day ...• So who controls your body (i.e. your labor)?– In general you are free to sell your time (labor) to whomever youwant.– But with some exceptions:∗ cannot sell your labor when you are under 16∗ cannot sell your labor for less than the minimum wage∗ cannot engage in risky endeavors (such as mining) without gov-ernment dictated safety and health restrictions.∗ cannot engage in prostitution, sell body parts, ...7Why Markets Work so Well: Prices as Economic Signals• An economic signal is any piece of information that helps people makebetter economic decisions.• Prices are far and away the most important economic signal.• Prices convey the essential information about other’s people costs andwillingness to pay.• The market price announces to the world that there are consumerswilling to pay a given amount for a good and producers who can producethe good for less than (or at) that price.• Any consumer not willing to pay the market price should stay out ofthe market.• Any producer who cannot produce the good for less than the marketprice should find another business.• But any consumer willing to pay the market price and any firm whocan produce the good for less than the market price will find it in theirbest interest to consume and produce.8Why Markets Sometimes Don’t Work Well: Market Failure1. Asymmetric Information: when one side of the transaction knows a lotmore about the good than the other.• buying an used car• life insurance• a company’s stock2. Externalities: when there are side-effects to a transaction that are notproperly taken into account.• pollution• smoking9Why Governments Sometimes Want to Manipulate Markets• Buyers would always like to pay less for a good. As we saw whenderiving the demand curve, consumers have higher utility when theprice of a good is lower.– Sometimes can make a strong moral argument, sometimes not ...– Rent control• Sellers would always like to receive a higher price than the marketprovides.– Sometimes can make a strong moral argument, sometimes not ...– Minimum wages– Farm subsidies10• Sometimes there are pressures to increase or decrease the quantity con-sumed of a good– Sometimes arguments based on externalities– The U.S. is “addicted to foreign oil”– Reduce