# Class Agenda. Note: As you hand-in your quiz, pick-up graded HWK #1 and HWK #2 (due next Tuesday).

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1 Class 7

2 Class Agenda 1. Finish discussion on consumer and producer surplus (welfare theory). 2. Elasticity problems (individual/group work to prep for quiz). 3. Quiz #1. Note: As you hand-in your quiz, pick-up graded HWK #1 and HWK #2 (due next Tuesday). 9-2 Copyright 2012 Pearson Addison-Wesley. All rights reserved

5 p, \$ per trading card p, \$ per magazine Figure 9.2 Consumer Surplus (a) David s Consumer Surplus a 5 b 4 CS 1 = \$2 CS 2 = \$1 3 c Price = \$3 2 E 1 = \$3 E 2 = \$3 E 3 = \$3 Demand (b) Steven s Consumer Surplus q, Magazines per week Consumer surplus, CS p 1 Expenditure, E Demand Marginal willingness to pay for the last unit of output q 1 q, Trading cards per year 9-5 Copyright 2012 Pearson Addison-Wesley. All rights reserved

6 Consumer Surplus Consumer surplus (CS) - the monetary difference between what a consumer is willing to pay for the quantity of the good purchased and what the good actually costs. 9-6 Copyright 2012 Pearson Addison-Wesley. All rights reserved

7 Producer Surplus Producer surplus (PS) - the difference between the amount for which a good sells and the minimum amount necessary for the seller to be willing to produce the good 9-7 Copyright 2012 Pearson Addison-Wesley. All rights reserved

9 Competition Maximizes Welfare One commonly used measure of the welfare of society, W, is the sum of consumer surplus plus producer surplus: W = CS + PS. 9-9 Copyright 2012 Pearson Addison-Wesley. All rights reserved

10 Deadweight Loss (DWL) Deadweight loss (DWL) - the net reduction in welfare from a loss of surplus by one group that is not offset by a gain to another group from an action that alters a market equilibrium. The deadweight loss results because consumers value extra output by more than the marginal cost of producing it Copyright 2012 Pearson Addison-Wesley. All rights reserved

11 p, \$ per unit Figure 9.5 Why Reducing Output from the Competitive Level Lowers Welfare A Supply e 2 p 2 MC 1 = p 1 B D C E MC 2 e 1 Demand F Q 2 Q 1 Q, Units per year 9-11 Copyright 2012 Pearson Addison-Wesley. All rights reserved

13 Why Producing More than the Competitive Output Lowers Welfare Increasing output beyond the competitive level also decreases welfare because the cost of producing this extra output exceeds the value consumers place on it Copyright 2012 Pearson Addison-Wesley. All rights reserved

14 Why Producing More than the Competitive Output Lowers Welfare (cont). The reason that competition maximizes welfare is that price equals marginal cost at the competitive equilibrium. Market failure - inefficient production or consumption, often because a price exceeds marginal cost 9-14 Copyright 2012 Pearson Addison-Wesley. All rights reserved

15 Solved Problem 9.3 Show that increasing output beyond the competitive level decreases welfare because the cost of producing this extra output exceeds the value consumers place on it Copyright 2012 Pearson Addison-Wesley. All rights reserved

17 Example Elasticity Problems (work in small groups or individually. I ll work them out on the board after a few minutes) 9-17 Copyright 2012 Pearson Addison-Wesley. All rights reserved

19 ANSWER: Example #1 Step (1): Use initial points to solve for Y. Get Y=648. Step (2): Use income elasticity of demand formula. Get ξ=0.18. As income increases by 1%, demand for gas increases by 0.18% Copyright 2012 Pearson Addison-Wesley. All rights reserved

20 Example #2 (Q.19 from Perloff) According to Borjas (2003), immigration into the U.S. increased the labor supply of working men by 11.0% from and reduced the wage of the average native worker by 3.2%. From these results, can we make any inferences about the elasticity of supply or demand? Which curve changed, and why? 9-20 Copyright 2012 Pearson Addison-Wesley. All rights reserved

21 ANSWER: Example #2 The increase in immigration shifts the supply curve to the right by 11%. The relatively large percentage change in supply, which resulted in a relatively small decrease in the wage, would suggest that demand is elastic relative to supply. The situation is depicted in the figure to the right Copyright 2012 Pearson Addison-Wesley. All rights reserved

22 ANSWER: Example #3 (Q.21 from Perloff) The more elastic the demand at equilibrium, holding supply elasticity constant, the less the cost increase can be passed on to the consumer. Since there are many close substitutes for oranges, the demand for oranges is relatively elastic (the demand curve is relatively flat). The supply curve is relatively inelastic but not vertical. Therefore, when the cost increase shifts the supply curve up and to the left, the equilibrium price will rise but by much less than the cost increase Copyright 2012 Pearson Addison-Wesley. All rights reserved

23 ANSWER: Example #4 (Q.7 from Perloff) The price elasticity of overall demand for smoking in the United States is inelastic: % change in quantity demanded ε = % change in price = 8.3% 21% = Copyright 2012 Pearson Addison-Wesley. All rights reserved

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