1 Model: Nonmarginal Pricing Today in class, we will examine a model of one type of distorted market: nonmarginal pricing. This variation of the basic model represents a pattern common to many resource-related utilities (e.g., water, electricity), as well as other markets. Assumptions An economic model is basically a set of equations and rules that we use to describe a situation. Some of the most important rules (or assumptions) are those that describe how people perceive those situations and act in response. The nonmarginal pricing model is a variation of the basic model (short-term equilibrium in a perfectly competitive market). The key assumptions of the models are listed below. Note that the assumptions in bold differ between the two models. Standard (neoclassical) economics assumptions Rational consumers who maximize utility Rational producers who maximize profits (basic model) Producers who set price by some other standard (nonmarginal pricing) Perfect competition Consumers are price-takers Producers are price-takers (basic model) Producers set prices (nonmarginal pricing) Short-term equilibrium Some factors of production are fixed No entry or exit Other No market failure No government intervention (basic model) Government policy may affect pricing (nonmarginal pricing) Any model is effective only as far as its assumptions describe the situation of interest. You should view an economic model as only a rough approximation of reality, rather than an attempt to capture it precisely and completely. Even as a rough approximation, using a particular model makes sense only if you think that the assumptions are reasonable for describing the situation. Problem Setup Consider the following market for widgets:
2 The aggregate marginal benefit curve for widget consumers is P = 100 Q, where Q is quantity demanded. The aggregate marginal cost curve for widget producers is P = 20 + Q, where Q is quantity supplied. Questions to Discuss Scenario A Basic Model Suppose that all the assumptions of the basic model apply. Thus, the demand curve will be based on the consumers marginal benefit curve above. Likewise, the supply curve will be based on the producers marginal cost curve. Answer the following questions: Find the market equilibrium quantity (Q) and price (P). Draw a graph showing the demand and supply equations and the market equilibrium. (Blank figure below) Find the consumer surplus (CS) and producer surplus (PS) for this equilibrium outcome. Find the joint surplus (JS) and deadweight loss (DWL) associated with this outcome. Is this outcome efficient? Why or why not? Note: This scenario is sometimes called marginal cost pricing, since the market price equals the producers marginal cost of production. Scenario B Nonmarginal Pricing Suppose that producers are not rational, profit-maximizing price-takers (equating marginal cost to market price as assumed in the basic model). Instead, assume that producers decide to supply widgets at a price of P = 40. Thus, that equation is the horizontal supply curve. As before, assume that consumers are rational, utility-maximizing price-takers, so that the demand curve will be based on the consumers marginal benefit curve. Answer the following questions: What are the equilibrium market price (P) and quantity (Q), where the demand and supply curves intersect? Draw a graph showing the relevant equations and the market equilibrium. (Blank figure below) What is the marginal cost of widgets at the equilibrium quantity [MC(Q)]? What is the quantity at which marginal cost equals price (MC = P)? Find the consumer surplus (CS) and producer surplus (PS) for this equilibrium outcome. Find the joint surplus (JS) and deadweight loss (DWL) associated with this outcome. Is this outcome efficient? Why or why not?
3 You can draw your figures here: Scenario A Basic Model
4 Scenario B Nonmarginal Pricing
5 You can record your answers to the mathematical questions here: Basic Model (Scenario A) Nonmarginal Pricing (Scenario B) Quantity (Q) Market price (P) Marginal cost [MC(Q)] N/A Quantity where MC = P N/A Consumer surplus (CS) Producer surplus (PS) Joint surplus (JS) Deadweight loss (DWL)