Microeconomic Tools

© Copyright Allen C. Goodman, 2015

Supply and Demand

• In microeconomics, we typically have suppliers reacting positively to price, and demanders reacting negatively.

• The two of them combine to provide an equilibrium, that indicates the market quantity and the market price.

100 200 300 400 500

2.50

5.00

7.50

10.00

Price

Apples

Demand for Apples

What affects demand?

• Price of the good

• Prices of other goods

• Consumer income

• Tastes

100 200 300 400 500

2.50

5.00

7.50

10.00

Price

Apples

Demand with higher income

Demand for Apples

Supply of Apples

100 200 300 400 500

2.50

5.00

7.50

10.00

Apples

What affects supply?

• Technological change

• Input prices

• Prices of Production-Related Goods – Examples?

• Size of the Industry

• Weather

Supply of Apples

100 200 300 400 500

2.50

5.00

7.50

10.00

Apples

Improved technology

Poor weather

Equilibrium of Demand and Supply

100 200 300 400 500

2.50

5.00

7.50

10.00

Apples

SupplyDemand

Equilibrium of Demand and Supply

100 200 300 400 500

2.50

5.00

7.50

10.00

Apples

SupplyDemand

Total Revenue,Total Expenditures

Equilibrium of Demand and Supply

100 200 300 400 500

2.50

5.00

7.50

10.00

Apples

SupplyDemand

Shift in Demand

Equilibrium of Demand and Supply

100 200 300 400 500

2.50

5.00

7.50

10.00

Apples

SupplyDemand Shift in Supply

Equilibrium of Demand and Supply

100 200 300 400 500

2.50

5.00

7.50

10.00

Apples

SupplyDemand Shift in SupplyShift in Demand

What Does Consumer Surplus Measure?

• Consumer surplus, the amount that buyers are willing to pay for a good minus the amount they actually pay for it, measures the benefit that buyers receive from a good as the buyers themselves perceive it.

How the Price Affects Consumer Surplus

Copyright©2003 Southwestern/Thomson Learning

Initialconsumer

surplus

Quantity

(b) Consumer Surplus at Price P

Price

0

Demand

A

BC

D EF

P1

Q1

P2

Q2

Consumer surplusto new consumers

Additional consumersurplus to initial consumers

PRODUCER SURPLUS

• Producer surplus is the amount a seller is paid for a good minus the seller’s cost.

• It measures the benefit to sellers participating in a market.

• Just as consumer surplus is related to the demand curve, producer surplus is closely related to the supply curve.

How the Price Affects Producer Surplus

Copyright©2003 Southwestern/Thomson Learning

Quantity

(b) Producer Surplus at Price P

Price

0

P1B

C

Supply

A

Initialproducersurplus

Q1

P2

Q2

Producer surplusto new producers

Additional producersurplus to initialproducers

D EF

MARKET EFFICIENCY

• Consumer surplus and producer surplus may be used to address the following question:

– Is the allocation of resources that is determined by free markets in any way desirable?

… or do economists just love them

… or do economists just love them

MARKET EFFICIENCY

CS = Value to buyers – Amount paid by buyers

and

PS = Amount received by sellers – Cost to sellers

MARKET EFFICIENCY

Total surplus

= Consumer surplus + Producer surplus

or

Total surplus

= Value to buyers – Cost to sellers

EFFICIENCY and EQUITY

• Efficiency is the property of a resource allocation of maximizing the total surplus received by all members of society.

• In addition to market efficiency, a social planner might also care about equity – the fairness of the distribution of well-being among the various buyers and sellers.

Consumer and Producer Surplus in the Market Equilibrium

Copyright©2003 Southwestern/Thomson Learning

Producersurplus

Consumersurplus

Price

0 Quantity

Equilibriumprice

Equilibriumquantity

Supply

Demand

A

C

B

D

E

MARKET EFFICIENCY Three Insights Concerning Market

Outcomes1. Free markets allocate the supply of goods to the

buyers who value them most highly, as measured by their willingness to pay.

2. Free markets allocate the demand for goods to the sellers who can produce them at least cost.

3. Free markets produce the quantity of goods that maximizes the sum of consumer and producer surplus.

The Efficiency of the Equilibrium Quantity

Copyright©2003 Southwestern/Thomson Learning

Quantity

Price

0

Costto

sellers

Costto

sellers

Valueto

buyers

Valueto

buyers

Value to buyers is greaterthan cost to sellers.

Value to buyers is lessthan cost to sellers.

Equilibriumquantity

Consumersurplus

ProducerSurplus

Efficiency is all about quantity!

Efficiency is all about quantity!

Demand

Supply

Using Calculus

DefineW = Total Value (ftn of Quantity) – Total

Costs (ftn of Quantity)

W = V (Q) – TC (Q)

dW/dQ = V′ – TC′ = 0

V′ is marginal benefits

TC′ is marginal costs!

So Welfare W is maximized with MB = MC.

Utility Analysis?

• In principles courses we often measure utility -- sometimes use “utils” ...

• which is lame (like … who thinks about “utils”).

• For several analyses in public economics, we’ll want to use more modern analysis ...

• Ordinal utility

Indifference Curves

Pounds of Spam

Sq.

Fee

t of

hou

s ing

20 40 60 80 100

500

1000

1500

2000

Indifference Curves

Pounds of Spam

Sq.

Fee

t of

hou

s ing

20 40 60 80 100

500

1000

1500

2000 Higher level of utility

How much is bought?

Pounds of Spam

Sq.

Fee

t of

hou

s ing

20 40 60 80 100

500

1000

1500

2000In a monthHousing = $1.00/sq.footSpam = $10/poundIncome = $1500

If price of Spam doubles?

Putting them together

Pounds of Spam

Sq.

Fee

t of

hou

s ing

20 40 60 80 100

500

1000

1500

2000In a monthHousing = $1.00/sq.footSpam = $10/poundIncome = $1500

Putting them together

Pounds of Spam

Sq.

Fee

t of

hou

s ing

20 40 60 80 100

500

1000

1500

2000In a monthHousing = $1.00/sq.footSpam = $10/poundIncome = $1500

U1

U2

Mkt gives you this

You onlyneed this

Putting them together

Pounds of Spam

Sq.

Fee

t of

hou

s ing

20 40 60 80 100

500

1000

1500

2000In a monthHousing = $0.75/sq.footSpam = $10/poundIncome = $1500

U increases

More housing

More Spam

Why?

A close look at the tangency

Pounds of Spam

Sq.

Fee

t of

hou

s ing

20 40 60 80 100

500

1000

1500

2000

In a monthHousing = $1.00/sq.footSpam = $10/poundIncome = $1500

U2

ΔU/Δh = - Mgl. utility of housing

ΔU/Δs =Mgl. utilityof Spam

phΔh

+psΔs

A close look at the tangency

Pounds of Spam

Sq.

Fee

t of

hou

s ing

20 40 60 80 100

500

1000

1500

2000

U2

ΔU/Δh = - Mgl. utility of housing

ΔU/Δs =Mgl. utilityof Spam

phΔh

+psΔs

phΔh + psΔs = 0

Δh/Δs = -ps/ph

Now, for utility

-MUs/Muh = (ΔU/Δs)/(ΔU/Δh)

= Δh/Δs

-ps/ph = Δh/Δs = -MUs/Muh

or

Muh /ph = MUs/ ps

In a monthHousing = $1.00/sq.footSpam = $10/poundIncome = $1500

MU/p = Utility/$ = Bang for the Buck!

MU/p = Utility/$ = Bang for the Buck!

Using Calculus - Utility

Utility = g [housing (h), Spam (s)]

DU = gh dh + gs ds.

On an indifference curve, DU = 0.

So:

0 = gh dh + gs ds

dh/ds = -gs/gh

Using Calculus - Income

Y = ph h + ps s

dY = ph dh + ps ds

On the budget constraint, dY = 0.

0 = ph dh + ps ds

dh/ds = -ps/ph

Using Calculus - Equilibrium

Slopes are equal

Marginal utilities

dh/ds = -gs/gh

Income trade-off

dh/ds = -ps/ph

Therefore:

-gs/gh = -ps/ph gs/gh = ps/ph