Krugman and Wells Chapter 4OverviewWillingness to Pay and DemandCalculating consumer surplusGraphical representation of CSChanges in CS: textbook exampleChanges in CS: textbook exampleNOTE: Common MistakeChanges in CS: iPad exampleAnd now the producer side…Willingness to Sell and SupplyCalculating PSMore generally, PS is…Changes in PSGains from trade in a marketCompetitive Markets Are EfficientEfficiency of Competitive EquilibriumAnother example: muffinsAnother example: muffinsView of efficiency from bookAnother view of efficiencyAnother view of efficiencyA few commentsWhy do markets tend to work so well?Krugman and Wells Chapter 4 Steven J. Haider EC201 Spring 2015p2 Overview  Chap. 2: the US and Brazil could benefit from trade  They each specialized in producing the good in which they had a comparative advantage  Both gained from trade, even though the US had an absolute advantage in producing both goods  Chap. 3: we learned how competitive markets work  Participating in the market is trading: you use money, perhaps earned from your job, to buy (trade for) other goods  This chapter  Measure the benefits from the existence of markets (a type of trade): Consumer, Producer, and Total Surplus  Markets are efficient Caution: we’re now using our supply/demand model, which will only make sense if you know how the model works. Do problems!p3 Willingness to Pay and Demand  Willingness to pay: maximum price a person is willing to pay for a good  Example: willingness to pay for a used textbook  Assume individuals are willing to buy only one  Assume individuals buy when price ≤ willingness to pay (= by convention), and then derive a market demand curve  We did this for the muffin market already!  Note: step “function” because there are only five consumersp4 Calculating consumer surplus  If the price were $30, only Aleisha, Brad and Claudia would buy Individual consumer surplus: WtP – P for each individual  Market consumer surplus: sum of individual CSp5 Graphical representation of CS  CS: the area between the demand curve and the price  Fig 4-2: graphical representation of textbook example  Fig 4-3: graphical representation of CS more generally  Note: you will need to know how to calculate the area of triangles and squares. See Chap 2 appendix for refresher…p6 Changes in CS: textbook example  Suppose price drops from $30 to $20. How does CS change?  We could do this with a table: New CS: $39 + $25 + $15 + $5 = $84  Change in CS: $84 - $49 = $35  NOTE: there are gains to original buyers and new buyer(s) 39 25 15 5 --- 20 20 20 20 ---p7 Changes in CS: textbook example  Suppose price drops from $30 to $20. How does CS change?  But we’ll generally work with the graph  Change: [(30-20) x 3] + [(25-20) x 1] = 30 + 5 = 35p8 NOTE: Common Mistake  “Change in CS” is the blue area  Refers to the difference between CS in two situations  This use of English is standard: “Change in CS” vs. “New CS” vs. “CS Changes to…”Changes in CS: iPad example  Suppose iPad prices dropped from $2000 to $500  Gains to original buyers  Area of a rectangle (2000-500) x 200,000 = $300m  Gains to new buyers  Area of a triangle (2000-500) x 800,000 x ½ =$600m  Total change in CS with price drop: $900m p9p10 And now the producer side… Consumer Surplus vs. Producer Surplus Willingness to pay vs. Willingness to sell Market/individual demand vs. Market/individual supply Individual CS vs. Individual PS Area below demand vs. Area above supply  Every component has a direct analog, so I will go a little more quickly for these definitionsp11 Willingness to Sell and Supply  Willingness to sell: minimum price a seller is willing to accept for a good  The book defines this as “cost”, but I prefer WtS  Example: willingness to sell a used textbook  Assume individuals sell when price≥willingness to sell We can use this information to derive a market supply curve  We did this with the muffin example as well!  There are few individuals, so we again have a step function Willingness to sellp12 Calculating PS  Calculating PS  We can use a table or the graph  Andrew, Betty, and Carlos are willing to sell, but not Donna and Engelbert  Market PS is sum of individual PS  For graph, calculate area between price and supply curvep13 More generally, PS is…  …the area between price and the supply curvep14 Changes in PSp15 Gains from trade in a market  Total surplus = CS + PS  Total surplus: the total gains from trade The existing picture is the gains from a competitive marketp16 Competitive Markets Are Efficient  The much celebrated result…  Key word: competitive  Suppose markets are competitive, then the equilibrium outcome is efficient  Efficiency: no one can be made better off without someone being made worse off  In case at hand, efficiency maximizes total surplus  Three thought experiments to see why the competitive equilibrium is efficient  Try to reallocate consumption among consumers  Try to reallocate sales among sellers  Try to change quantity transactedp17 Efficiency of Competitive Equilibrium  Try to change the quantity transacted  Total surplus will decline if you move in either direction  Try to reallocate among consumers  Move book from A to B… Consumer surplus declines  Try to reallocate among sellers  Producer surplus declines Bottom line: no trades can be made to make anyone better offAnother example: muffins  Producer surplus  Value to the producers for participating in the market  Only those who’s minimum price is less than equilibrium price will sell  For individual, price - WtS p18 Player S’s willingness to sell Equilibrium price S’s individual PS 1 1.00 2.50 1.50 2 3.69 2.50 -- 3 1.99 2.50 .51 4 4.75 2.50 -- 5 2.75 2.50 -- Total 2.01Another example: muffins  Consumer surplus  Value to the consumers for participating in the market  Only those who’s maximum price is more than equilibrium price will buy  For individual, WtP - price p19 Player D’s willingness to pay Equilibrium price D’s Individual CS 1 1.50 2.50 -- 2 2.25 2.50 -- 3 2.75 2.50 0.25 4 4.25 2.50 1.75 5 1.00 2.50 -- Total 2.00View of efficiency from book  Trading 2 muffins at a