The Basics of the Economic Approach
- See: Field and OlewilerCh. 3 (Model of Supply and Demand), Ch. 4
(Efficiency)
- Three basic questions any economic system must answer:
- What to produce?
- How to produce it?
- Who gets the output?
- Market economy:
- Decision-making is decentralized: millions of individual
decision-makers interacting with one another.
- Household decisions:
- work or not, what type of work? how much to work?
- spend income or save it?
- what to buy and how much?
- Business decisions:
- What products should they produce? How much?
- How should they produce them? What technology?
How many workers and other inputs?
- Interactions:
- Buying and selling: trades and prices.
- Adam Smith’s puzzle (Wealth of Nations 1776):
- Why does this system work as well as it does? (as if guided by
an “invisible hand”)
- it seems too decentralized to work well.
- How are decisions of buyers and sellers coordinated?
- Explaining this is a key task of microeconomics -- the model
of supply and demand provides some insights.
- General idea:
- People responding rationally to incentives can result in
reasonably coordinated results.
- Examples:
- A trivial example: lineups at grocery store
checkouts.
- Markets are they anotherexample?
- Working assumption: economic decision-makers act rationally with the
objective of making themselves as well off as
possible.
Households: spend their income to maximize “well-being”
(utility).
Businesses: operate so as to maximize profits.
- Modeling decision-maker behavior:
- Decision-maker compares benefits and costs of a particular action
- Take the action if:
Benefit > Cost
- such an action will make the decision-maker better off.
(gain or surplus: Benefit – Cost )
The Model of Supply and Demand
- Basic model of a “market”
i.e. of interactions of buyers and sellers.
- Outcomes:
- Quantity of the good or service bought and sold.
- Price of the good or service.
- Usefulness:
- a simple economic model: framework for analyzing and predicting
outcomes.
- useful for thinking about how to measure economic value.
- Weaknesses and limitations:
- A special case: competitive market (many buyers and sellers)
- focus is on a market for a single good or service (a market economy
is a set of interconnected markets)
Demand and Willingness to Pay: the Buyer’s Decision
Individual Demand Curve: shows the quantity of some good (Qd) that a
person is willing to buy at different prices (P).
- Where does it come from?
- Rooted in a benefit-cost comparison.
- Benefit of buying a unit of the good:
- some measure of the value (pleasure, utility) the person places
on it.
(marginal value, marginal benefit or willingness-to-pay)
Note: marginal = incremental = from an extra unit.
- this value will depend upon factors such as:
- personal preferences: what do you like and how much?
- income: this affects willingness and ability to pay.
- prices of other goods: affects ability to pay and the
cost of alternative uses for income.
- imagine that a person can state the maximum amount they
would be willing to pay for each unit of a good.
- this is willingness-to-pay (WTP) or marginal benefit
(MB) of each extra unit.
e.g. Example in text:
Quantity ofWillingness-to-pay ($)
Apples (Kg)(Marginal value, Marginal Benefit)
14.50
24.00
33.50
43.00
52.50
62.00
71.50
81.00
90.50
10 0
- willingness-to-pay for the first Kilo is $4.50. for the second it is
$4.00 etc.
- as in the example typically expect WTP to fall as the person gets
more of the good.
- WTP reflects the benefit from buying extra units of the good.
- Cost of deciding to buy more is just the price of the good (P).
- To be as well off as possible the person should:
Buy more if:
WTP > Price
i.e. benefit > cost
Don’t buy units for which:
WTP < Price
i.e. benefit < cost
- So at a given price (P) the person roughly buys up to the point where:
Price = WTP on the last unit bought
Price = Marginal value or marginal benefit of the last unit
bought.
(note: suggests prices can provide good measures of the
marginal value of the good to consumers)
e.g. at a price of $2.25/Kg. 5 Kg. would be bought.
- An implication of this is that our graph of WTP is the demand curve!
- at each price the quantity demanded (Qd) is where Price (P) hits the
demand curve.
i.e. to left of this Qd WTP > P so buy more
to right of this Qd WTP < P so buy less.
(Aside: typically we will draw this as a smooth downward sloping curve
i.e. as if each ‘step’ is infinitely small – this is for convenience)
Market Demand Curve (Aggregate Demand Curve in text):
For each price it shows the sum of the quantities demanded across all
individuals.
i.e. horizontal sum of the individual demand curves.
(see: Fig 3-4 for example)
- Link between willingness-to-pay and the demand curve provides a way of
measuring the benefits buyers obtain from consuming the good.
- sum of the willingness-to-pay across all units bought.
- equivalently: area under the demand curve from Qd=0 to the
quantity actually bought.
- this is the “total benefit” of consuming the good.
- Location of the Market Demand curve depends on:
- Number of people in the market;
- Income levels of those in the market (typically more income, more is
bought)
- Tastes, preferences of those in the market.
- Prices of other goods or services.
- Policies, like taxes and subsidies, can also shift the demand curve.
Supply and Marginal Cost: The Producer’s Decision
Individual Firm’s Supply curve: shows the quantity of output supplied
(Qs) by the producer at each price.
- Where does it come from?
- Comparison of the benefits and costs to the firm of producing extra
output.
- Benefit to the firm of producing an extra unit of output:
- Price received for the output (P)
i.e. extra revenue it brings in.
- Cost of producing extra output is “Marginal Cost” (MC):
- The relevant measure is the least-cost way of producing the
extra output.
(a profit maximizing business will choose this way)
- Marginal Cost depends on:
- technology (determines which and how many extra
inputs are required to produce extra output);
- prices of the inputs:
- these reflect what the firm must pay if it is to
obtain the inputs rather than some other
firm.
i.e. reflects value of these inputs to competing
firms.
- Typically draw MC as eventually rising as output rises.
i.e. eventually due to a limited amounts of a fixed factor,
organization and management costs etc. MC rises.
( practical importance of rising MC:
- limits the size of a firm so there is not just one supplier - most markets have multiple suppliers. )
Text example (Firm 1 in Table 3-2):
Quantity of Apples (kg)Marginal Cost
1 $1.67
2 $2.00
3 $2.33
4$2.67
5$3.00
6$3.33
- so if price is $2.25 the firm supplies 2 Kg. (P>MC only for
units 1 and 2).
Market Supply Curve: shows the quantity of output all firms in the market
supply at each price.
i.e. horizontal sum of the individual firm supply curves.
- Location of the supply curve depends upon:
- Technology: determines types and quantities of inputs needed to
produce extra output at least cost.
(note: environmental regulation may disallow certain
technologies or inputs and shift the MC curve)
- Input prices: determine the cost of producing output in any given
way via changing the cost of inputs.
- Number of business firms in the market (how many individual
supply curves are we summing over?)
- Policies: taxes or subsidies – can view them as increasing or
offsetting costs.
Market outcome: Equilibrium
- So far:
Market Demand Curve: shows the quantities buyers will wish to buy
at each price.
Market Supply Curve: shows the quantities sellers will wish to sell at
each price.
- Price will adjust until: quantity demanded = quantity supplied.
- until price is at the level where the Supply and Demand
curves cross.
- this is the “equilibrium price” (call it Pe).
- Why does the price move to this level?
- reflects the actions of individual buyers and sellers.
- say the price > Pe:
- suppliers want to supply more than people want to buy.
- suppliers response?
- those faced with having unsold output cut their
price in order to sell the unsold output.
- those that can profit by selling more at a lower
price offer to do so.
- buyers response?
- they are in a strong bargaining position: offer to
buy only at reduced prices.
- prices fall toward the equilibrium level.
- thenconsumers want to buy more, suppliers want to
supply less: gap between supply and demand
shrinks.
- say price < Pe:
- buyers wish to buy more than sellers supply.
- faced with more demand than output sellers can raise
their price and still sell everything.
- faced with getting no output, some buyers offer to pay
more (but still less than WTP).
- price rises toward Pe.
- the price rise reduces quantity demanded and raises
quantity supplied: closes the gap between them.
- Once price is at Pe it stays there.
- no unsold supply to force prices down.
- no unsatisfied demand to bid prices up.
- Characteristics of market equilibrium:
- quantity supplied = quantity demanded.
- buyers willingness-to-pay on the last unit = marginal cost of
producing that unit of output.
- all units supplied and sold:
willingness-to-pay (WTP) > MC
marginal benefit to buyer > marginal cost to seller
- units not supplied and sold: MC > WTP.
- equilibrium price = MC = marginal benefit to buyer (MB,
WTP).
- Decentralized coordination?
- Supply-Demand model outcome reflects decisions of many
individual buyers and sellers.
- Good is supplied and sold if someone’s WTP > marginal cost.
- Supply = Demand in equilibrium.
- Notice: who gets the good? - those with highest WTP
who supplies the good? – producers with the lowest MC.
Predictions from the Model of Supply and Demand
- The model says that the market will settle at the price and quantity where: Supply=Demand
- If variables that determine the position and shape of the Supply and Demand curves change this equilibrium outcome will change.
Demand: changes in income, prices of other goods, consumer preferences, number of people all shift the demand curve.
Supply: changes in input prices, technology, the number of businesses in the market all shift the supply curve.
Evaluating Economic Outcomes: Economic Efficiency
- A key criterion:Economic efficiency or ‘Pareto Efficiency’
An outcome is efficient if it is not possible to change the outcome and
make someone better off without making someone worse off.
- changing an efficient outcome either creates winners and losers or
just losers;
- moving from an inefficient to an efficient outcome: everyone may be able to gain (at least no one loses!)
- efficiency is an attractive attribute of an economic outcome:
there are no missed opportunities to make people better off
without creating harm.
- Pareto efficiency is an attempt to avoid making comparisons
between gains and losses going to different people.
i.e. avoid the problem of interpersonal comparisons.
- Market equilibrium and efficiency:
- Say quantity of output bought and sold is below market equilibrium:
- then MB > MC on the last unit of output produced and sold.
- raising output and selling it at a price between MB and MC
will make both the buyer and seller better off.
i.e. both parties to the exchange are better off so raising
output is “potentially” efficient.
- a surplus is created that can be split between buyer and
seller.
- that is why exchange occurs: both party’s agree
to buy/sell since both benefit.
- Say output bought and sold is above the market equilibrium
quantity:
- then MB < MC on the last unit sold.
- lowering output saves more in costs than the fall in benefits to
the consumers.
- reducing output can potentially make both parties better off.
- a surplus is created from lowering output that can make both
buyers and sellers better off.
- At market equilibrium: MB = MC = P on the last unit sold.
- no surplus can be created by raising or lowering output.
- raising or lowering output means someone must lose.
- the outcome is efficient.
- In other words: market equilibrium maximizes economic surplus.
Components of surplus:
Consumer surplus (CS): measures the net gain to buyers from
purchasing and consuming a good.
- equals the difference between MB (willingness-to-
pay) and the price actually paid.
- geometrically: area between the demand curve and the
equilibrium price.
Producer Surplus (PS): measures the net gain to sellers from
producing and selling a good.
- equals the difference between the Price received (P) and
MC.
- a measure of the extra profit from producing output.
- geometrically: area between the price of the good and
the height of the supply curve (MC).
Total Economic Surplus from the Market:
- Is just: PS + CS
- Note that this total surplus is as large as possible at the
market equilibrium.
(buyers and sellers have incentives to trade as long
as there is surplus to split)
- An “invisible hand” result!
- This total surplus is a measure of the well-being generated by this market.
- This argument identifies efficiency with the size of the total surplus
generated in the market.
- thisidentification involves making an additional assumption about
how to evaluate outcomes.
- assumes that $1 in one person’s hands is worth the same as $1 in
someone else’s hands
(otherwise you can’t just sum up surpluses that go to different people)
e.g. say output is less than equilibrium (Qsmall) and the price is greater
thanPe (so price is where Qd = Qsmall at PHigh )
- lowering the price to Pe raises total surplus;
- those supplying Qsmall at the old, higher price lose by the move
to equilibrium:
- price fall redistributes some of the surplus from sellers
to buyers even as it raises total surplus.
- move is not efficient in Pareto’s original sense.
- Text treats this as efficient but this involves the “$1 is a $1”
assumption.
- a much bigger assumption than saying Pareto efficiency is
good.
- some such assumption is needed to make comparisons
between most “real world” outcomes:
- there are usually gainers and losers in moving between
outcomes.
- alternatives? Should we weight $1 in the hands of a poor
person more heavily than $1 in the hands of a rich person?
Aside:
- Discussion above: product or output market.
- Model of an input market works much the same way.
Difference in who is on the demand and supply side:
- Demand for input: business not household.
- buy input if benefit > cost
- cost = input price
- benefit: value of (revenue from) extra output the
input produces.
- Supplier: could be business or household
- if business the supplier acts as in the product
market.
- if household e.g. selling labour time
- benefit of sale: price
- cost: value of the input to the household.
Supply and Demand and Environmental Policy: Preview
- Environmental policy may aim to change the quantity bought and sold of
some good.
e.g. lower the quantity of some good that creates pollution.
raise the quantity of some good with environmental benefits.
- How?
- Shift supply and demand curves.
e.g. say you want to reduce the quantity:
- lower demand (shift demand curve left):
- change preferences: education, green alternatives.
- use subsidies to make substitute goods cheaper.
- uses taxes to make the good more expensive at
each price.
- lower supply (shift supply left):
- raise MC of producing the good
e.g. tax inputs, restrict input use or technologies used in producing the good.
- lower revenues: tax business revenues.
- these measures lower total surplus generated by this market.
- seems desirable that a good policy should generate a
larger, offsetting gain.
i.e. for a good policy the gains from reduced
environmental damage should exceed lost surplus.
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