Professional Documents
Culture Documents
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Willingness to Pay (WTP)
A buyer’s willingness to pay for a good is the
maximum amount the buyer will pay for that good.
WTP measures how much the buyer values the good.
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WTP and the Demand Curve
Q: If price of iPod is $200, who will buy an iPod, and
what is quantity demanded?
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WTP and the Demand Curve
Derive the
P (price
demand who buys Qd
of iPod)
schedule:
$301 & up nobody 0
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WTP and the Demand Curve
P
$350
P Qd
$300
$250 $301 & up 0
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CS and the Demand Curve
P
Flea’s WTP P = $260
$350
Flea’s CS =
$300 $300 – 260 = $40
$250 Total CS = $40
$200
$150
$100
$50
$0 Q
0 1 2 3 4
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CS and the Demand Curve
P
Flea’s WTP Instead, suppose
$350 P = $220
$300 Anthony’s WTP
Flea’s CS =
$250 $300 – 220 = $80
$200 Anthony’s CS =
$250 – 220 = $30
$150
Total CS = $110
$100
$50
$0 Q
0 1 2 3 4
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CS and the Demand Curve
P
$350 The lesson:
Total CS equals
$300
the area under
$250 the demand curve
$200 above the price,
from 0 to Q.
$150
$100
$50
$0 Q
0 1 2 3 4
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CS with Lots of Buyers & a Smooth D Curve
At Q = 5(thousand),
Price P The demand for shoes
the marginal buyer
per pair
$ 60
is willing to pay $50
for pair of shoes. 50
Suppose P = $30. 40
Then his consumer 30
surplus = $20. 1000s of pairs
20 of shoes
10
D
0 Q
0 5 10 15 20 25 30
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CS with Lots of Buyers & a Smooth D Curve
CS is the area b/w The demand for shoes
P
P and the D curve,
from 0 to Q. $ 60
Recall: area of 50
h
a triangle equals 40
½ x base x height
30
Height =
$60 – 30 = $30. 20
So, 10
D
CS = ½ x 15 x $30 0 Q
= $225. 0 5 10 15 20 25 30
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How a Higher Price Reduces CS
If P rises to $40,
P
CS = ½ x 10 x $20 1. Fall in CS
60
= $100. due to buyers
50 leaving market
Two reasons for the
fall in CS. 40
30
2. Fall in CS due to 20
remaining buyers 10
D
paying higher P 0 Q
0 5 10 15 20 25 30
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ACTIVE LEARNING 1
Consumer surplus
demand curve
P
50
A. Find marginal
buyer’s WTP at $45
Q = 10. 40
B. Find CS for 35
P = $30. 30
Suppose P falls to $20. 25
How much will CS 20
increase due to… 15
C. buyers entering 10
the market 5
D. existing buyers 0
paying lower price 0 5 10 15 20 Q
25
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ACTIVE LEARNING 1
Answers
demand curve
P
50
A. At Q = 10, marginal
$45
buyer’s WTP is $30.
40
B. CS = ½ x 10 x $10 35
= $50
30
P falls to $20. 25
C. CS for the 20
additional buyers 15
= ½ x 10 x $10 = $50 10
D. Increase in CS 5
on initial 10 units 0
= 10 x $10 = $100 0 5 10 15 20 Q
25
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Cost and the Supply Curve
Cost is the value of everything a seller must give
up to produce a good (i.e., opportunity cost).
Includes cost of all resources used to produce
good, including value of the seller’s time.
Example: Costs of 3 sellers in the lawn-cutting
business.
name cost A seller will produce and sell
the good/service only if the
Jack $10 price exceeds his or her cost.
Janet 20 Hence, cost is a measure of
Chrissy 35 willingness to sell.
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Cost and the Supply Curve
P Qs
Derive the supply schedule
from the cost data: $0 – 9 0
10 – 19 1
20 – 34 2
name cost
35 & up 3
Jack $10
Janet 20
Chrissy 35
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Cost and the Supply Curve
P
$40 P Qs
$0 – 9 0
$30
10 – 19 1
$20
20 – 34 2
$10 35 & up 3
$0 Q
0 1 2 3
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Cost and the Supply Curve
P
At each Q,
$40
Chrissy’s the height of
the S curve
$30 cost is the cost of the
Janet’s marginal seller,
$20 cost the seller who
would leave
$10 Jack’s cost the market if
the price were
$0 Q any lower.
0 1 2 3
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Producer Surplus
P PS = P – cost
$40 Producer surplus (PS):
the amount a seller
$30 is paid for a good
minus the seller’s cost
$20
$10
$0 Q
0 1 2 3
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Producer Surplus and the S Curve
P PS = P – cost
$40 Suppose P = $25.
Chrissy’s
Jack’s PS = $15
$30 cost
Janet’s PS = $5
Janet’s
$20 cost Chrissy’s PS = $0
Total PS = $20
$10 Jack’s cost
2. Fall in PS due to 20
remaining sellers 10
getting lower P
0 Q
0 5 10 15 20 25 30
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ACTIVE LEARNING 2
Producer surplus
supply curve
P
50
A. Find marginal
45
seller’s cost
at Q = 10. 40
35
B. Find total PS for
P = $20. 30
25
Suppose P rises to $30.
20
Find the increase
in PS due to: 15
C. selling 5 10
additional units 5
D. getting a higher price 0
on the initial 10 units 0 5 10 15 20 Q25
26
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ACTIVE LEARNING 2
Answers
supply curve
P
50
A. At Q = 10, 45
marginal cost = $20
40
B. PS = ½ x 10 x $20 35
= $100 30
P rises to $30. 25
C. PS on 20
additional units 15
= ½ x 5 x $10 = $25 10
D. Increase in PS 5
on initial 10 units 0
= 10 x $10 = $100 0 5 10 15 20 Q25
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CS, PS, and Total Surplus
CS = (value to buyers) – (amount paid by buyers)
= buyers’ gains from participating in the
market
PS = (amount received by sellers) – (cost to sellers)
= sellers’ gains from participating in the market
Total surplus = CS + PS
= total gains from trade in a market
= (value to buyers) – (cost to sellers)
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The Market’s Allocation of Resources
In a market economy, the allocation of resources
is decentralized, determined by the interactions
of many self-interested buyers and sellers.
Is the market’s allocation of resources desirable?
Or would a different allocation of resources make
society better off?
To answer this, we use total surplus as a measure
of society’s well-being, and we consider whether
the market’s allocation is efficient.
(Policymakers also care about equality, though
our focus here is on efficiency.)
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Efficiency
Total
surplus = (value to buyers) – (cost to sellers)
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Evaluating the Market Equilibrium
Market eq’m: P
P = $30
60
Q = 15,000
50 S
Total surplus
= CS + PS 40 CS
Is the market eq’m 30
efficient? PS
20
10
D
0 Q
0 5 10 15 20 25 30
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Which Buyers Consume the Good?
Every buyer P
whose WTP is
60
≥ $30 will buy.
50 S
Every buyer
whose WTP is 40
< $30 will not. 30
So, the buyers 20
who value the
good most highly 10
D
are the ones who 0 Q
consume it. 0 5 10 15 20 25 30
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Which Sellers Produce the Good?
Every seller whose P
cost is ≤ $30 will
60
produce the good.
50 S
Every seller whose
cost is > $30 will 40
not.
30
So, the sellers with
20
the lowest cost
produce the good. 10
D
0 Q
0 5 10 15 20 25 30
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Does Eq’m Q Maximize Total Surplus?
At Q = 20,
P
cost of producing
60
the marginal unit
is $35 50 S
value to consumers 40
of the marginal unit
is only $20 30
Hence, can increase 20
total surplus
by reducing Q.
10
D
This is true at any Q 0 Q
greater than 15. 0 5 10 15 20 25 30
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Does Eq’m Q Maximize Total Surplus?
At Q = 10,
P
cost of producing
60
the marginal unit
is $25 50 S
value to consumers 40
of the marginal unit
is $40 30
Hence, can increase 20
total surplus
by increasing Q.
10
D
This is true at any Q 0 Q
less than 15. 0 5 10 15 20 25 30
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Does Eq’m Q Maximize Total Surplus?
The market P
eq’m quantity 60
maximizes 50 S
total surplus:
At any other 40
quantity, 30
can increase
20
total surplus by
moving toward 10
D
the market eq’m 0 Q
quantity. 0 5 10 15 20 25 30
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Adam Smith and the Invisible Hand
Passages from The Wealth of Nations, 1776
“Man has almost constant occasion
for the help of his brethren, and it is
vain for him to expect it from their
benevolence only. He will be more
likely to prevail if he can interest their
self-love in his favor, and show them
that it is for their own advantage to do
for him what he requires of them…
It is not from the benevolence of the
butcher, the brewer, or the baker that
Adam Smith,
we expect our dinner, but from their
1723-1790
regard to their own interest….
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Adam Smith and the Invisible Hand
Passages from The Wealth of Nations, 1776
“Every individual…neither intends to
promote the public interest, nor knows
how much he is promoting it….
He intends only his own gain, and he is
in this, as in many other cases, led by
an invisible hand to promote an end
which was no part of his intention.
Nor is it always the worse for the society
that it was no part of it. By pursuing his
own interest he frequently promotes
Adam Smith,
that of the society more effectually than
1723-1790
when he really intends to promote it.”
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The Free Market vs. Govt Intervention
The market equilibrium is efficient. No other
outcome achieves higher total surplus.
Govt cannot raise total surplus by changing the
market’s allocation of resources.
Laissez faire (French for “allow them to do”):
the notion that govt should not interfere with the
market.
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The Free Market vs. Central Planning
Suppose resources were allocated not by the
market, but by a central planner who cares about
society’s well-being.
To allocate resources efficiently and maximize total
surplus, the planner would need to know every
seller’s cost and every buyer’s WTP for every good
in the entire economy.
This is impossible, and why centrally-planned
economies are never very efficient.
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CONCLUSION
This chapter used welfare economics to
demonstrate one of the Principles:
Markets are usually a good way to
organize economic activity.
Important note:
We derived these lessons assuming
perfectly competitive markets.
In other conditions we will study in later
chapters, the market may fail to allocate
resources efficiently…
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CONCLUSION
Such market failures occur when:
a buyer or seller has market power—the ability to
affect the market price.
transactions have side effects, called externalities,
that affect bystanders. (example: pollution)
We’ll use welfare economics to see how public policy
may improve on the market outcome in such cases.
Despite the possibility of market failure, the analysis
in this chapter applies in many markets, and the
invisible hand remains extremely important.
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S U M MA RY
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S U M MA RY
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S U M MA RY
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