Week 3 Flashcards
What is a normal good?
A good whose demand increases with an increase in consumers income
What do we assume at market equilibrium
At market equilibrium, we assume ceteris paribus, i.e. prices in related markets (substitutes, complements and FOPs) are constant.
Equilibrium
: a situation where demand and supply have been brought into balance.
When does the equilibrium occur
In the competitive market, the equilibrium occurs at the price where Qd = Qs. This price clears the market such that no shortage nor surplus exists.
Equilibrium price and quantity
The equilibrium price balances the quantity supplied and the quantity demanded.
The equilibrium quantity is the quantity supplied and the quantity demanded at the equilibrium price.
Comparative statics
The equilibrium price and quantity depend on the position of the supply and demand curves. When some event shifts one of these curves, the equilibrium in the market changes, resulting in a new price and a new quantity exchanged between buyers and sellers. The analysis of such a change is called comparative statics because it involves comparing an old equilibrium and a new equilibrium.
Comparative static analysis
This analysis is done in three steps:
- Decide whether the event shifts the supply or demand curve (or perhaps both);
- Decide in which direction the curve shifts;
- Use the supply and demand diagram to see how the shift changes the equilibrium price and quantity.
Changes in demand
A change (rise/fall) in demand means that at every price, there is now a different (greater/smaller) quantity demanded. If demand rises the demand curve shifts to the right.
Factors that change demand
Price of substitutes in consumption
Price of compliments in consumption
Consumer income
Consumer tastes
Consumer expectations
Changes in population
Changes in supply
A change (rise/fall) in supply means that at every price, there is now a different (greater/smaller) quantity supplied. If supply rises the curve shifts to the right
Factors that change supply
Price of substitutes in production
Price of compliments in production
Taxes
FOP Prices
Technology
Firm entry/exit
Comparative statics short summary
We examine the effect of a change in the prevailing conditions on the (initial) equilibrium in the market. We find the new equilibrium and compare it to the previous one.
Pareto efficiency
A situation where resources cannot be re-allocated so as to make one person better off without making another worse off
Welfare economics
Welfare economic is the study of how the allocation of resources affects the economic wellbeing of society. Suppose a social planner (e.g. the Government) wants to maximise the economic wellbeing of everyone in society. To do this effectively, the planner must first decide how to measure the economic wellbeing of a society.
How we measure economic wellbeing?
Using the concepts of consumer surplus and producer surplus.
Consumer surplus
The difference between consumers willingness to pay and the amount they actually pay. It is the consumers gains from trade i.e. the benefit of consumers from participating in the market.
Consumer surplus is the area between the demand curve and the price line
Consumer value - amount paid = consumer surplus
Willingness to sell
the minimum price they are wiling to accept at every quantity supplied.
Producer surplus
The difference between producers willingness to sell and the amount they actually receive. It is the producers gains from trade, i.e. the benefit of producers from participating in the market.
Producer surplus is the area between the supply curve and the price line
Amount received - producer cost = producer surplus
Total surplus from trade
Measures the benefit of buyers and sellers from participating in the market, the total gains from trade. It is the sum of consumer and producer surplus.
Consumer surplus + producer surplus = total surplus
Conversely it is the value to buyers minus the cost to sellers
Consumer value - producer cost = total surplus
The total benefit to society
The total benefit to society is the value of consuming the product minus the cost of producing it
Total surplus from trade: how much should society produce?
Society should continue to produce more as long as the marginal consumer value is greater than the marginal cost of production
This will maximise total surplus and the gains from trade in the market
Maximised total surplus
At equilibrium (pq), the value to the marginal consumer = the cost of the marginal producer. Total surplus is maximised.
Hence, the free market at equilibrium allocates resources efficiently:
Hence, the free market at equilibrium allocates resources efficiently:
the supply of goods is allocated to the buyers who value them most highly;
the demand for goods is allocated to the sellers who can produce them at lowest cost;
the quantity of goods that is produced maximises the sum of consumer and producer surplus.
When does/should Government intervene in the market?
At equilibrium, the market outcome is efficient; total surplus is maximised. Policy makers/Government cannot improve on it.
However, as we will see:
Intervention by Government may be desirable if the efficient outcome is considered inequitable;
Or if Government wishes to disregard consumer preferences;
Sometimes, a market failure happens – where the market does not achieve efficient an outcome – in such cases,
intervention is warranted.
Analyse the following events diagrammatically and assess their economic impact on the markets likely to be affected.
Which curve will move?
Right or left?
What will the new equilibrium price be?
What will the new equilibrium quantity be?
