Download Chapter 3

Chapter 3
Supply and demand:
an introduction
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
3-1
Supply and demand: an introduction
• How do consumers get the goods and services they
want in the right quantities and qualities?
– Some goods and services are allocated by the market forces
of supply and demand.
• Why do some goods and services have shortages or
surpluses and others do not?
– Some goods and services are regulated by government.
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
3-2
What, how and for whom? Central planning
versus the market
• Three problems all economic systems must address
– What should be produced?
– How should it be produced?
– For whom will it be produced?
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
3-3
What, how and for whom? Central planning
versus the market
• Centralised economic organisations
–
–
–
–
–
–
Agrarian society
Former Soviet Union
Cuba
North Korea
China
Bureaucracy
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
3-4
What, how and for whom? Central planning
versus the market
• Central planning means a small number of individuals
address
– What
 Establish production targets for factories and farms.
– How
 Plan how to achieve the goals.
– For whom
 Distribute the goods and services produced.
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
3-5
What, how and for whom? Central planning
versus the market
• Free-market or capitalist economic systems
– Individual choices determine:




Which careers to pursue
Which products to produce or buy
When to start and shut down a business
Who gets what, which is decided by individual preferences and
purchasing power
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
3-6
Buyers and sellers in markets
• The market for any good or service consists of all the
buyers and sellers of that good or service.
– In the market for pizza:
 sellers comprise the individuals and firms that sell pizza,
 buyers include all individuals who buy, or might buy pizza.
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
3-7
Buyers and sellers in markets
• The demand curve
– A representation of the relationship between the amount of a
particular good or service that buyers want to purchase and
the price of the good or service.
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
3-8
Buyers and sellers in markets
– A property of demand is that as the price of a good or service
goes down, the quantity consumers wish to buy will
increase. Therefore, the demand curve is downward sloping.
– Determinants of a downward-sloping demand curve
 Substitution effect
 Income effect
 Buyer’s reservation price
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
3-9
The daily demand curve for pizza in
Perth
Price
($ per slice)
4
3
2
Demand
8
12
16
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
Quantity
(1000s of slices per day)
3-10
Buyers and sellers in markets
• The substitution effect
– The change in the quantity demanded of a good or service
caused by a change in price, which results because the
good or service becomes more or less expensive relative to
other goods and services.
• The income effect
– The change in the quantity demanded of a good or service
caused by a change in price, which results because of a
change in purchasing power of a buyer’s income.
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
3-11
Buyers and sellers in markets
• The income effect
– The change in the quantity demanded of a good that results
because a change in the price of a good changes the
buyer’s purchasing power.
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
3-12
Buyers and sellers in markets
• The reservation price
– Based on the cost-benefit principle, if the reservation price
(benefit) exceeds the market price (cost) the consumer will
purchase the good.
– At higher prices, benefit will exceed cost for a smaller
quantity than at lower prices.
– When the good sells for a high price, it will satisfy the costbenefit test for fewer buyers than when it sells for a lower
price.
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
3-13
Buyers and sellers in markets
Price
($ per slice)
The buyer’s reservation price:
The largest dollar amount the
buyer would be willing to pay for
a good.
4
3
2
Demand
8
12
16
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
Quantity
(1000s of slices per day)
3-14
Buyers and sellers in markets
Horizontal interpretation
Price
($ per slice)
Price determines
quantity demanded.
4
3
2
Demand
8
12
16
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
Quantity
(1000s of slices per day)
3-15
Buyers and sellers in markets
Vertical interpretation
Price
($ per slice)
Quantity measures the
marginal buyer’s
reservation price.
4
3
2
Demand
8
12
16
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
Quantity
(1000s of slices per day)
3-16
Buyers and sellers in markets
• The supply curve
– A representation of the relationship between the amount of a
particular good or service that sellers want to supply and the
price of the good or service.
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
3-17
Buyers and sellers in markets
• Will the opportunity cost of producing additional units
of pizza increase or decrease? (Hint: low-hangingfruit principle)
– Sellers must receive a higher price to produce additional
units of a product to cover the higher opportunity costs of
each additional unit.
– Seller’s reservation price: The smallest dollar amount for
which a seller would be willing to sell an additional unit,
generally equal to marginal cost.
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
3-18
The daily supply curve for pizza in
Perth
Price
($ per slice)
Supply
4
3
2
8
12
16
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
Quantity
(1000s of slices per day)
3-19
The daily supply curve for pizza in Chicago
Horizontal interpretation
Price
($ per slice)
Supply
4
Shows the
quantity produced
for each price.
3
2
8
12
16
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
Quantity
(1000s of slices per day)
3-20
The daily supply curve for pizza in Chicago
Vertical interpretation
Price
($ per slice)
Supply
4
Shows the marginal
cost (reservation
price) for producing
each additional unit.
3
2
8
12
16
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
Quantity
(1000s of slices per day)
3-21
Market equilibrium
• Equilibrium
– Any situation in which a system is at rest, for example where
neither price nor quantity of a good or service is changing.
• Market equilibrium
– Occurs in a market when all buyers and sellers are satisfied
with their respective quantities at the market price.
• Equilibrium price and equilibrium quantity
– The values of price and quantity for which quantity supplied
and quantity demanded are equal.
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
3-22
The equilibrium price and quantity of
pizza in Perth
Price
($ per slice)
Supply
Equilibrium at $3
Quantity demanded =
Quantity supplied
4
3
2
Demand
8
12
16
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
Quantity
(1000s of slices per day)
3-23
Market equilibrium
• What would happen if the price of pizza were $4 per
slice in the pizza example?
• What would happen if the price of pizza were $2 per
slice in the pizza example?
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
3-24
Excess supply
Excess supply = 8000 slices per day
Price
($ per slice)
Supply
4
3
2
Demand
8
12
16
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
Quantity
(1000s of slices per day)
3-25
Excess demand
Price
($ per slice)
Supply
4
Excess demand = 8000
slices per day
3
2
Demand
8
16
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
Quantity
(1000s of slices per day)
3-26
Points along the demand and supply
curves of a pizza market
Demand for pizza
Supply of pizza
Price
($/slice)
Quantity demanded
(1000s of slices/day)
Price
($/slice)
Quantity supplied
(1000s of slices/day)
1
8
1
2
2
6
2
4
3
4
3
6
4
2
4
8
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
3-27
Graphing supply and demand and
finding the equilibrium price and quantity
Price
($ per slice)
Supply
5
4
The equilibrium price = $2.50
The equilibrium quantity = 5
3
2.50
2
1
0
Demand
2
4
6
8
10
Quantity
(1000s of slices per day)
5
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
3-28
Market equilibrium
• What do you think?
– Is the market equilibrium always an ideal outcome for all
market participants?
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
3-29
An unregulated housing market
Monthly rent
($/apartment)
Supply
What do you think?
Is $1600 more than some
people can afford?
1600
Demand
2
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
Quantity
(1000s of apartment/ month)
3-30
Rent controls (price ceiling)
Monthly rent
($/apartment)
Supply
2400
Excess demand = 200 000
apartments/ month
1600
Controlled rent = 800
Demand
0
1
2
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
3
Quantity
(1000s of apartment/
month)
3-31
Market equilibrium
• Rent controls reconsidered
– Other consequences of rent controls





Maintenance will decline and housing quality will fall
Illegal payments
Creation of co-ops and conversion to condominiums
Reduction in household mobility
Discrimination
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
3-32
Market equilibrium
• Price ceiling
– A maximum allowable price, specified by law.
• Price floor
– A minimum allowable price, specified by law.
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
3-33
Price controls (price floor)
Price of sugar
($/kg)
Supply
$2
$1.70
$1.50
Excess supply
Demand
0
1
2
3
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
Quantity
(100 kg of sugar/day)
3-34
Market equilibrium
• Sugar price controls?
– Market responses to a sugar price floor




Stockpiles
Government purchase schemes
Production quotas
Producer buyout schemes
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
3-35
Predicting and explaining changes in
prices and quantities
• Distinguishing between
– A change in the quantity demanded
 A movement along the demand curve that occurs in response
to a change in price.
– A change in demand
 A shift of the entire demand curve.
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
3-36
An increase in quantity demanded vs. An
increase in demand
Price
($/can)
6
D
Increase in
quantity
demanded
5
4
3
2
1
0
D
2
4
12
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
Quantity
(1000s of cans/day)
3-37
An increase in quantity demanded vs. An
increase in demand
Price
($/can)
6
D’
D
5
4
Increase in demand
3
2
D’
1
0
D
12
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
Quantity
(1000s of cans/day)
3-38
Shifts in the demand curve
• Direction of the shifts
– Complements: Two goods are complements in consumption
if an increase (decrease) in the price of one causes a fall
(rise) in demand for the other, as shown by a leftward
(rightward) shift in the demand curve for the other.
– Substitutes: Two goods are substitutes in consumption if an
increase (decrease) in the price of one causes a fall (rise) in
demand for the other, as shown by a rightward (leftward)
shift in the demand curve for the other.
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
3-39
The effect on the market for tennis balls of a
decline in court rental fees
Price
($/ball)
S
1.40
1.00
D’
D
40
58
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
Quantity
(1000s of balls /month)
3-40
Effect on the market for overnight letter delivery
of a decline in the price of Internet access
Price
($/letter)
S
P
P’
D
D’
Q’
Q
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
Quantity
(letters/month)
3-41
Predicting and explaining changes in
prices and quantities
• Thinking as an economist
– As average income rises why does the price of premium
bottled wine go up?
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
3-42
Predicting and explaining changes in
prices and quantities
Price
($/bottle)
S
Wine is a normal good.
P’
P
D
Q
Q’
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
D’
Quantity
(bottles/month)
3-43
Predicting and explaining changes in
prices and quantities
• A change in income
– Normal good
 One whose demand increases (decreases) when the incomes
of buyers increase (decrease).
– Inferior good
 One whose demand decreases (increases) when the incomes
of buyers increase (decrease).
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
3-44
Predicting and explaining changes in
prices and quantities
• Change in the quantity supplied
– A movement along the supply curve that occurs in response
to a change in price.
• Change in supply
– A shift of the entire supply curve.
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
3-45
The effect on the plastic kayak market
of an increase in the price of plastic
Price
($/kayak)
S’
S
1600
1200
D
80 100
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
Quantity
(kayaks/month)
3-46
Predicting and explaining changes in
prices and quantities
• What do you think?
– Does the increase in the cost of plastic have any effect on
the demand curve for kayaks?
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
3-47
The effect on the market for new houses
of a decline in carpenters’ wage rates
Price
($1000/house)
S
S’
220
190
D
40
50
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
Quantity
(houses/month)
3-48
Why do students’ major assignments go
through so many more revisions today than in
the 1970s?
Price
($/revision)
S
55
S’
7.50
D
12
36
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
Quantity
(millions of revisions per year)
3-49
Predicting and explaining changes in
prices and quantities
• Other determinants of supply
– Weather
– Expectations
– Number of sellers
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
3-50
Four simple rules of the effects
of supply and demand shifts: I
An increase in demand will lead to an increase
in both the equilibrium price and quantity.
Price
S
P’
P
D
Q
D’
Q’
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
Quantity
3-51
Four simple rules of the effects of
supply and demand shifts: II
A decrease in demand will lead to a decrease
in both the equilibrium price and quantity.
Price
S
P
P’
D’
Q’
D
Quantity
Q
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
3-52
Four simple rules of the effects
of supply and demand shifts: III
An increase in supply will lead to a
decrease in the equilibrium price
and an increase in the equilibrium quantity.
Price
S
S’
P
P’
D
Q
Q’
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
Quantity
3-53
Four simple rules of the effects of
supply and demand shifts: IV
An decrease in supply will lead to
an increase in the equilibrium price
and a decrease in the equilibrium quantity.
Price
S’
S
P’
P
D
Q’
Quantity
Q
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
3-54
The effects of simultaneous shifts in supply
and demand (a)
The market for bottled water
Price
($/bottle)
S
S’
P
S’ after the price of bottles
falls.
D’ after the disclosure that
bottled water is no more pure
than ordinary tap water.
P’
D
D’
Q’
Q
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
Millions of
bottles/month
3-55
The effects of simultaneous shifts in supply
and demand (b)
The market for bottles
Price
($/bottles)
S
S’ after the price of bottles
falls.
S’
P
P’
D’
D
Q Q’
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
D’ after the disclosure that
bottled water is no more pure
than ordinary tap water.
Millions of bottles
per month
3-56
The effects of simultaneous shifts in supply
and demand
• Observations:
– (a) When demand falls and supply increases, the equilibrium
price falls and the equilibrium quantity falls if the demand
curve shifts more than the supply curve.
– (b) When demand falls and supply increases, the equilibrium
price falls and the equilibrium quantity rises if the demand
curve shifts less than the supply curve.
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
3-57
Predicting and explaining changes in
prices and demand
• Thinking as an economist
– Why do the prices of some goods, like airline tickets to Fiji,
go up during the months of heaviest consumption, while
other goods, such as cherries, go down?
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
3-58
Seasonal variation in air travel and cherry
markets
High consumption due to high demand
Price
($/ticket)
S
Pw
Ps
Dw
Ds
Qs
Qw
Copyright  2007 McGraw-Hill Australia Pty Ltd
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Slides prepared by Nahid Khan
1000s of
tickets/day
3-59
Seasonal variation in air travel and
cherry markets
High consumption due to high supply
Price
($/kg)
SW
SS
Pw
Ps
D
100s of kg/ day
QW
QS
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
3-60
Markets and social welfare
• What do you think?
– When are the prices and quantities determined in market
equilibrium socially optimal, in the sense of maximising total
economic surplus?
Copyright  2007 McGraw-Hill Australia Pty Ltd
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Slides prepared by Nahid Khan
3-61
Markets and social welfare
• Cash on the table
– Assume
 All exchange is purely voluntary.
– If so
 The buyer’s reservation price exceeds the seller’s reservation
price and both the buyer and seller receive an economic
surplus.
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
3-62
Markets and social welfare
• Cash on the table
– Buyer’s surplus
 The difference between the buyer’s reservation price and the
price she or he actually pays.
– Seller’s surplus
 The difference between the price received by the seller and his
or her reservation price.
– Total surplus
 The difference between the buyer’s reservation price and the
seller’s reservation price.
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
3-63
Price controls in the pizza market
Price
($ per slice)
Assume
• Buyer’s reservation P = $4
• Seller’s reservation P = $2
• Pizza sells for $3
S
4
• Buyer’s surplus: $4 - $3 = $1
• Seller’s surplus: $3 - $2 = $1
• Total surplus: $4 - $2 = $2
3
2
D
8
12
16
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
Quantity
(1000s of slices per day)
3-64
Price controls in the pizza market
Excess demand =
$8000 slices/day
Price
($ per slice)
Assume price controls = $2
• Quantity supplied falls to 8000.
• Buyer’s reservation price ($4) is
greater than seller’s ($2).
• Both would benefit from
additional production.
• There is CASH ON THE TABLE.
4
3
2
D
S
8
12
16
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
Quantity
(1000s of slices per day)
3-65
Markets and social welfare
• Cash on the table
– Economic metaphor for unexploited gains from exchange.
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
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Markets and social welfare
• Smart for one, dumb for all
– Socially optimal quantity: The quantity of a good that results
in the maximum possible economic surplus from producing
and consuming the good.
– The socially optimal quantity occurs when MC = MB.
– Economic efficiency occurs when all goods and services are
produced and consumed at their respective socially optimal
levels.
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
3-67
Markets and social welfare
– Achieving economic efficiency
 Maximises the economic surplus.
 Increases the economic pie.
– When is the market equilibrium efficient?
 When all costs of producing the good or service are borne
directly by the seller.
 When all benefits from the good or service accrue directly to
buyers.
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
3-68
Markets and social welfare
– Inefficient market equilibrium
 When some costs of production fall on people other than those
who sell the good or service.
 When some benefits from the good or service accrue to people
who did not buy the good or service.
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
3-69
Markets and social welfare
– Example: Pollution
 The market is in equilibrium: MC = MB
 MC however underestimates the cost to society of producing
the good.
 Therefore, the market produces more than the efficient amount
and there is no incentive for producers and consumers to alter
their behaviour.
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
3-70
Markets and social welfare
• Example: Vaccinations
 The market is in equilibrium: MC = MB.
 MB underestimates the benefits to society of consuming the
vaccinations.
 The market produces less than the efficient amount of
vaccinations and there is no incentive for producers and
consumers to alter their behaviour.
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
3-71
Markets and social welfare
• Smart for one, dumb for all
– In these markets




Buyers and sellers are behaving rationally.
Market equilibrium exists.
There are no unexploited opportunities for individuals.
Economic surplus is not maximised.
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
3-72