Recap of the last class

• Anecdotes to the elasticity of demand.

• The concept of willingness to pay and willingness to sell are
analyzed.
– Relationship to demand and supply.
• Consumer and producer surplus are introduced.

7-1
 Changing the distribution of total surplus
When an artificial price is imposed on a market, surplus is
transferred between consumers and producers.
Price ($) Price ($)
600 600

500 500

400 400
1
S S
300 300 1
2
4 4
200 200 5
5
2
3
100 100
3
D D
0 5 10 15 20 25 30 35 40 45 50 0 5 10 15 20 25 30 35 40 45 50
Quantity of cameras (millions) Quantity of cameras (millions)
When the price is raised above $200, consumer When the price is lowered below $200, producer
surplus area 2 is transferred to producers. surplus area 2 is transferred to consumers.

5-2
 Deadweight loss
When an artificial price is imposed on a market, a
deadweight loss occurs.
Price ($) The deadweight loss is the loss of
600 total surplus that results when
the quantity of a good that is
500 bought and sold is below the
market equilibrium quantity.
400 Deadweight loss • Reduction in cameras sold by
S
10 million.
300
• Reduces consumer and
200 Transactions producer surplus.
that no longer
take place at the • Deadweight loss is the gray
new price
100 triangle.
D
0 5 10 15 20 25 30 35 40 45 50 55 60 65
Quantity of cameras (millions)

5-3
 From autarky to free trade
When an economy decides to engage in trade, the
domestic price and quantity change.

Price ($) • If the world price is less than

Domestic supply autarky domestic price:
– Domestic price decreases to
equal the world price.
25 Autarky domestic price – Excess demand occurs.
15 World price
• Imports make up the
Imports difference between domestic
Domestic demand
supply and demand,
0 180 300 420
Quantity of shirts (millions)
eliminating the shortage.

17-4
 From autarky to free trade
Consumer and producer surpluses are affected.
Surplus under autarky Surplus after trade
Price ($) Price ($)
Domestic Domestic
supply supply

A A
Producer surplus
25 25
B Consumer surplus B C
15 World price
D D Imports
Domestic Domestic
demand demand
0 300 0 180 420
Quantity of shirts (millions) Quantity of shirts (millions)

Under autarky: After trade:

• Consumer surplus is A. • Consumer surplus increases to A + B
+ C.
• Producer surplus is B + D. • Producer surplus decreases to D.
• Total surplus increases by C.

17-5
 From autarky to free trade
• Producers export their goods and services
when the world price is greater than the
domestic price.
Price ($)

Domestic supply • If the world price is greater

Exports than autarky domestic price:
260 World price
– Domestic price increases to
200
equal the world price.
Autarky domestic price
– Excess supply occurs.
• Exports make up the
difference between domestic
Domestic demand supply and demand,
eliminating the surplus.
0 40 60 80
Quantity of wheat (millions of tons)

17-6
 From autarky to free trade
Consumer and producer surpluses are again affected.
Price ($) Price ($)

Domestic supply Domestic

Exports supply
A A
260 World price
B B D
C Producer surplus C
200 200
F Consumer surplus F
E E
Domestic
demand
Domestic demand

0 60 0 40 60 80
Quantity of wheat (millions of tons) Quantity of wheat (millions of tons)

Under autarky: After trade:

• Consumer surplus is A + B + C. • Consumer surplus decreases to A.
• Producer surplus increases to B + C
• Producer surplus is E + F. + D + E + F.
• Total surplus increases by D.

17-7
 Tariffs
• A tariff is a tax targeted at certain imports.
• The purpose is to reduce the quantity of imports to
protect domestic producers.
Price ($)

Domestic supply
• A tariff has two effects:
Imports with – Increases the world price
tariff for domestic consumers.
– Decreases the amount of
325 World price + $75 tariff
shortage made up by
250 World price imports.
Imports Domestic demand
without
tariff

0 8 14 25 30
Quantity of steel (tons)

17-8
 Domestic welfare effects of a tariff
There are substantial welfare effects of imposing a tariff.
Price ($) Price ($)
Producer surplus Government revenue

Read this Consumer surplus Deadweight loss

piece 400
A
B
A
B
325 World price + $75 tariff
C D E F Old world C D E F
250 G price 250 G Old world price
Imports Imports

0 8 30 0 8 14 25 30
Quantity of steel (millions of tons) Quantity of steel (millions of tons)

Under trade without a tariff on imports: Under trade with a tariff on imports:
• Quantity of imports decreases.
• Consumer surplus is A + B + C +D +
• New world price is higher.
E+ F. • Consumer surplus is A + B.
• Producer surplus is G. • Producer surplus is C + G.
• Government tax revenue is E.
• Deadweight loss is D + F.
17-9
 Active Learning: Restrictions to trade
A tariff of $t per unit is imposed on foreign copper.
• Complete the welfare table.
Price ($)

Measure Before After Change

CS
A

B
Pw + t
C D E F
New world price
PS
Pw Old world price
G
Imports Gov’t Rev
DWL
0 8 14 25 30
Quantity of copper (millions of tons)

17-10
Consumers’ Preferences (Back to the main track!)

17-11
 Utility functions
• The principle of revealed preferences isn’t feasible for analyzing
how people make choices.
• Instead, a more formal method is required.
• Utility functions aid in systematically analyzing choices.
– A utility function is a formula for calculating the total utility that a
particular person derives from consuming a combination of goods and
services.
• A bundle is a unique combination of goods and services that a
person could choose to consume.

17-12
 Utility functions
• Utility functions quantify preferences.
• Utility measurements are relative, not absolute.
• For example, suppose Sarah receives a utility of 3 for each
serving of mac-n-cheese she eats, 2 for broccoli, and 8 for ice
cream.
• If she eats 1 serving of mac-n-cheese, 2 servings of broccoli,
and 2 of ice cream, then:
total utility = (3 x 1) + (2 x 2) + (8 x 2) = 23

17-13
 Marginal utility
• When individuals continue to engage in an activity or consume
more of one good or service, the utility from the next unit is not
as great as the last unit.
– Marginal utility is the change in total utility from consuming an
additional unit of a good or service.
– The principle of diminishing marginal utility is that the additional
utility gained from consuming successive units of a good or service
tends to be smaller than the utility gained from the previous unit or
service.
• Sometimes, marginal utility becomes negative.

17-14
 Diminishing marginal utility
The utility function and the marginal utility can be plotted. An individual
maximizes utility when total utility is greatest or marginal utility is zero.
Total utility Marginal utility per scoop
25 7
A
6
20
5
15 4
3
10
2
5
1
A
0
0 1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8
-1
Scoops of ice cream Scoops of ice cream
Total utility increases with each scoop of Marginal utility measures the per
ice cream until point A, the seventh unit utility from each scoop of ice
scoop, at which total utility is maximized. cream.
7-15