Economics 1: Fall 2010 J. Bradford DeLong, Michael Urbancic, and a cast of thousands... hAp://delong.typepad.com/econ_1_fall_2010/

Economics 1: Fall 2010: Supply and Demand II J. Bradford DeLong October 18, 2010, 12-­‐1 Wheeler Auditorium, U.C. Berkeley

Ladies and Gentlemen, to Your iClickers... •  The second essay was... –  A. A pointless waste of Sme you could have spent beAer on other classes –  B. A pointless waste of Sme you could have spent beAer on leisure acSviSes –  C. A somewhat-­‐useful exercise of your prose-­‐ wriSng muscles so that they do not completely atrophy –  D. A useful intellectual exercise

Fundamentals of Supply and Demand

EvaluaSng AllocaSons: The Market AllocaSon •  Set the price at \$19/lesson, and supply balances demand with 30 students and 3 teachers •  Let us look at the surplus: –  \$270 of producer surplus –  \$90 of consumer surplus –  \$360 of total surplus

Consumer Surplus

Producer Surplus

PDC Enters the Picture

Last Time I Asked... •  Suppose PDC—ProducSon and DistribuSon CoordinaSon—decided that we were going to oﬀer four yoga classes at a price of \$20/lesson for each student and \$200/lesson for each teacher. Now it ﬁnds that there are only 25 students and 4 teachers. What should PDC do?

–  A. Split up the students among the four teachers and announce that the teachers will only be paid \$120/lesson –  B. Split up the students among the four teachers and announce that the students will each have to pay \$32/lesson –  C. Pick one of the teachers by lot and send him or her home, and then go drac 5 passers-­‐by and force them to take the class, charging each student \$20/ lesson and paying each teacher \$200/lesson –  D. Drac 15 passers-­‐by and force them to take the class, charging each student \$20/lesson and paying each teacher \$200/lesson –  E. Lower the price charged to \$19/lesson and the price paid to \$190/lesson, and see if any more students are willing to pay that price and if any of the teachers say they would rather go do something else.

•  I got 76%

–  Is that good? –  This is one of the four things I want to be sure is engraved onto your neuronal circuitry when you leave this course..,

EvaluaSng AllocaSons: (D) Drac 15 Students •  Suppose PDC—faced with 25 students and 4 teachers—decides on (D): –  D. Drac 15 passers-­‐by and force them to take the class, charging each student \$20/lesson and paying each teacher \$200/lesson

•  Let us look at the surplus –  The four teachers have a disuSlity of -­‐\$50 -­‐ \$100 -­‐ \$150 -­‐ \$200 = -­‐\$500 –  Willing students have average valuaSon of (\$25 + \$20)/2 = \$22.50, and there are 25 of them, and \$22.50 • 25 = \$562.50 –  What about the unwilling students?

Valuing the Experience of the Unwilling Students •  PDC agents have just received instrucSons to go drac 15 passers-­‐by and force them to (i) take yoga classes and (ii) pay \$20/ lesson •  What do they think of this?

–  Do they say: “Losing the cash was unrighteous, but I actually enjoyed the yoga lesson—maybe \$5 worth...”? –  Or do they say: “Jeebus. I would have paid serious, serious money to avoid that experience!”?

Valuing the Whole AllocaSon •  I say count the experience as worth -­‐\$5 to each of the unwilling students... •  So we have -­‐\$500 + \$562.50 -­‐ \$5 • 15 = -­‐\$12.50

–  The students pay the teachers \$800, but that nets out—a plus for the teachers, a minus for the students

•  You would have been beAer oﬀ not to have started the yoga lesson business in the ﬁrst place •  AllocaSon of surplus: –  Teachers: \$300 –  Willing students: \$62.50 –  Unwilling students: -­‐\$375

EvaluaSng AllocaSons: (A) Cut Teachers’ Wages •  Suppose PDC—faced with 25 students and 4 teachers —decides on (A):

–  A. Split up the students among the four teachers and announce that the teachers will only be paid \$120/lesson

•  Let us look at the surplus:

–  Students have average valuaSon of (\$25 + \$20)/2 = \$22.50 –  There are 25 of them, and \$22.50 • 25 = \$562.50 –  The four teachers have a total valuaSon of -­‐\$50 -­‐\$100 -­‐ \$150 -­‐\$200 = -­‐\$500 –  Total surplus of \$62.50

•  Yes, the students pay the teachers—but that nets out to zero since teachers’ earnings and students’ costs •  Teachers get \$70 + \$20 -­‐ \$30 -­‐\$80 = -­‐\$20 of surplus •  Students get \$82.50 of surplus

EvaluaSng AllocaSons: (B) Raise Student Fees •  Suppose PDC—faced with 25 students and 4 teachers —decides on (B): –  B. Split up the students among the four teachers and announce that the students will each have to pay \$32/ lesson

•  Let us look at the surplus:

–  Students have average valuaSon of (\$25 + \$20)/2 = \$22.50 –  There are 25 of them, and \$22.50 • 25 = \$562.50 –  The four teachers have a total valuaSon of -­‐\$50 -­‐\$100 -­‐ \$150 -­‐\$200 = -­‐\$500 –  Total surplus of \$62.50

•  Yes, the students pay the teachers—but that nets out to zero since teachers’ earnings and students’ costs •  Teachers get \$150 + \$100 +\$50 +\$0 = \$300 of surplus •  Students get -­‐\$237.50

EvaluaSng AllocaSons: (C) Let One Teacher Go and Drac 5 Students •  Suppose PDC—faced with 25 students and 4 teachers —decides on (C): –  C. Pick one of the teachers by lot and send him or her home, and then go drac 5 passers-­‐by and force them to take the class, charging each student \$20/lesson and paying each teacher \$200/lesson

•  Let us look at the surplus

–  The average teacher has a disuSlity of -­‐\$125. Since you let the teacher go at random the expected disuSlity of the teachers is -­‐\$375 –  Willing students have average valuaSon of (\$25 + \$20)/2 = \$22.50, and there are 25 of them, and \$22.50 • 25 = \$562.50 –  What about the unwilling students?

Valuing the Experience of the Unwilling Students •  PDC agents have just received instrucSons to go drac 5 passers-­‐by and force them to (i) take yoga classes and (ii) pay \$20/ lesson •  What do they think of this?

–  They might say: “Losing the cash was unrighteous, but I actually enjoyed the yoga lesson—maybe \$5 worth...” –  They might say: “Jeebus. I would have paid serious, serious money to avoid that experience!”

Valuing the Whole AllocaSon •  I say count the experience as worth -­‐\$5 to each of the unwilling students. •  So we have -­‐\$375 + \$562.50 -­‐ \$5 • 5 = \$162.50 •  The students pay the teachers, but that nets out •  AllocaSon of surplus:

–  Teachers: \$225 –  Willing students: \$62.50 –  Unwilling students: -­‐\$125

ProperSes of the Market Equilibrium •  It is where the supply and demand curves cross •  Nobody is raSoned out of the market

–  In the sense that they want to buy and are willing to pay the market price but cannot ﬁnd a seller –  People are raSoned out in the sense that they want to buy—but not at that price

•  It is stable •  It produces the maximum dollar-­‐value social surplus

–  No other possible arrangement produces more social surplus –  Other arrangements have •  •  •  •

Some of the wrong people teaching the classes Some of the wrong people taking the classes Too few classes being oﬀered Too many classes being oﬀered

•  Here we produce: –  \$90 of CS –  \$270 of PS

Other Arrangements Leave Side Deals: Who •  Some of the wrong people teaching the classes –  If Greg320 is assigned to teach one of the three classes and Greg305 is not, then—“Psst. Will you teach my class?” There’s \$150 of surplus for them to split

•  Some of the wrong people taking the classes –  If yogastudent#10 is not assigned to take a class and yogastudent#30 is, then—“Psst. Will you take my place?” There is \$4 of surplus for them to split

Other Arrangements Leave Side Deals: How Many •  Too few classes being oﬀered –  If only two classes are being oﬀered, then yogastudent#21 through yogastudent#30 meet Greg315 outside and if they set up a class then there is \$100 of surplus for them to split

•  Too many classes being oﬀered –  If four classes are oﬀered, then when yogastudent#31 through yogastudent#40 meet Greg320 for their class, they look at each other and say: “Let’s just pretend we did this”—and in so doing they split \$20 of surplus

A CompeSSve Market in Equilibrium Leaves No Side Deals •  No group of students can get together with a teacher and agree to just pretend that they did this •  No group of non-­‐students can get together with a non-­‐teacher and gain surplus by engaging in a transacSon •  No student can swap places with any non-­‐student in such a way that they can make a side-­‐payment that makes both happy •  No teacher can swap places with any non-­‐teacher in such a way that they can make a side-­‐payment that makes both happy

Ladies and Gentlemen, to Your i&gt;Clickers... •  But is a compeSSve market equilibrium fair? Should we impose an excess proﬁts tax on Greg305 and Greg310, and an excess educaSon fee on yogastudent#1 through yogastudent#20? –  A. Yes, on both the teachers and the students, because it is unfair to the rest of us that they like yoga so much –  B. Yes on the teachers because they are gevng a job they really, really like, but not on the students because it is not their fault that they like yoga and they should not be penalized. –  C. Yes on the students because it is not fair that they get to pay so liAle for something so valuable to them, but not on the teachers because it is not their fault that they are good at teaching and enjoy what they do and they should not be penalized. –  D. No on both: we cannot help how we are made, or what we like and dislike. –  E. What is this “fair”? And once you start taxing people not for what they do but for how they feel, don’t you create a huge problem of decepSon and lies that you will not be able to untangle as everybody claims to really hate teaching and not to like taking yoga lessons very much? The task here is to ﬁgure out what maximizes the total value we create, rather than trying fruitlessly to ensure that nobody is enjoying themselves too much.

Why We Economists Don’t Like Supply RestricSon

A Non-­‐Market Equilibrium Mechanism: Average ValuaSon

A Non-­‐Market Equilibrium Mechanism: QuanSty RestricSon

A Non-­‐Market Equilibrium Mechanism: Consumer Surplus

A Non-­‐Market Equilibrium Mechanism: Producer Surplus

Market Equilibrium vs. Price Ceiling •  Price ceiling:

–  Consumer surplus: (\$17.5 – \$10) • 20 = \$150 –  Producer surplus: \$50 –  Total surplus: \$200

•  Market equilibrium:

–  Consumer surplus: \$6 • 30 • ½ = \$90 –  Producer surplus: \$40 + \$90 + \$140 = \$270 –  Total surplus: \$360

•  Where did it go?

–  Lost producer surplus due to quanSty restricSon: \$40 –  Lost consumer surplus due to quanSty restricSon: \$10 –  Lost consumer surplus due to misallocaSon: \$110 = (\$23 -­‐ \$17.5) • 20

•  And the price ceiling transfers \$180 from producers to consumers

Market Equilibrium vs. Price Ceiling

What To Do If You Really Don’t Want More than 20 Yoga Lessons Given? •  Impose a tax on yoga lessons instead... •  \$11 per lesson would do it... •  The 20 who are then taking yoga lessons are the ones who value them the most... •  The two who are teaching are the two who are most willing to teach...

What To Do If You Really Don’t Want More than 20 Yoga Lessons Given?

What To Do If You Really Don’t Want More than 20 Yoga Lessons Given? •  The government has raised money it can use to achieve its other social objecSves •  The loss of social surplus—producer and consumer surplus—is least •  Why would anybody object to using taxes and bounSes?

What To Do If You Really Don’t Want More than 20 Yoga Lessons Given?

Ladies and Gentlemen, to Your i&gt;Clickers... •  What is the big reason to impose taxes (or bounSes) rather than use command-­‐and-­‐control to limit quanSSes (or drac parScipants)? –  A. Market signals allow people to choose what they want to do –  B. Command-­‐and-­‐control may put the wrong people in places they should not be –  C. Command-­‐and-­‐control will greatly reduce consumer plus producer surplus –  D. Command-­‐and-­‐control will create a favored group that would lose from reversion to the market outcome —even though social surplus would be increased

Working with Demand and Supply Curves •  Now let’s pracSce a liAle bit more with supply and demand curves... •  Suppose supply (or demand) should change... –  Bad harvests... –  Good invenSons... –  Growth of consumer (or producer) complements... –  Growth of consumer (or producer) subsStutes...

Working with Demand and Supply Curves

Working with Demand and Supply Curves: In-­‐Up Shic in Supply Curve

Working with Demand and Supply Curves: In-­‐Down Shic in Demand Curve

Working with Demand and Supply Curves

Slopes of Demand and Supply Curves: Rule-­‐of-­‐Thumb ImplicaSons for Equilibrium

•  When supply is inelasSc—when the supply curve is steep:

–  Most of the eﬀect of a shic in the demand curve will be on price –  LiAle of the eﬀect of a shic in the demand curve will be on quanSty

•  When supply is elasSc—when the supply curve is ﬂat:

–  Most of the eﬀect of a shic in the demand curve will be on quanSty –  LiAle of the eﬀect of a shic in the demand curve will be on price

•  And similarly for demand...

Working with Demand and Supply Curves: Supply Becomes Less ElasSc

Slopes of Demand and Supply Curves: Rule-­‐of-­‐Thumb ImplicaSons for Welfare

•  When supply is inelasSc—when the supply curve is steep:

–  LiAle of the eﬀect of a shic in the demand curve will be on the total volume of surplus –  Most of the eﬀect of a shic in the demand curve will be on the distribuSon of surplus between producers and consumers

•  When supply is elasSc—when the supply curve is ﬂat:

–  Most of the eﬀect of a shic in the demand curve will be on the total volume of surplus –  LiAle of the eﬀect of a shic in the demand curve will be on the distribuSon of surplus between producers and consumers

•  And similarly for demand...

Working with Demand and Supply Curves: Less ElasSc Supply Gets a Greater Share of Surplus

Working with Demand and Supply Curves: But If Supply Is Less ElasSc There Is Less Surplus to Share

A Monopolist Would Choose to Act as Though the Supply Curve Were VerScal at That Point That Maximized Producer Surplus

Transferring a Good Deal of What Had Been Consumer Surplus to Producers, at the Cost of Throwing Away Some Producer and Consumer Surplus

The Welfare Economics of Non-­‐Market AllocaSon Mechanisms I: The Market Outcome: Price

The Welfare Economics of Non-­‐Market AllocaSon Mechanisms II: The Market Outcome: Consumer Surplus

The Welfare Economics of Non-­‐Market AllocaSon Mechanisms II: The Market Outcome: Producer Surplus

The Welfare Economics of Non-­‐Market AllocaSon Mechanisms II: A Price Ceiling

The Welfare Economics of Non-­‐Market AllocaSon Mechanisms II: A Price Ceiling and Consumer Surplus

The Welfare Economics of Non-­‐Market AllocaSon Mechanisms II: A Price Ceiling and Producer Surplus

The Welfare Economics of Non-­‐Market AllocaSon Mechanisms II: A Price Ceiling: What’s Lec on the Table

Test Your Knowledge •  Why does a market equilibrium allocaSon maximize the total societal surplus? •  What are “side deals”? •  Why doesn’t a compeSSve market equilibrium leave open side deals? •  What happens to the market equilibrium price and quanSty when the supply curve moves up and inward? •  What happens to the market equilibrium price and quanSty when the demand curve moves in and downward? •  Why do economists prefer taxes and bounSes to command-­‐ and-­‐control when we want to move away from the market equilibrium for some good reason?

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