MACROECONOMICS EXAM 1 STUDY GUIDES CH. 1, 2, 4, 5, 6.1, 7, 15.1
MACROECONOMICS EXAM 1 STUDY GUIDES CH. 1, 2, 4, 5, 6.1, 7, 15.1 ECON2015
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Chapter 4 —The Market Forces of Supply & Demand Supply & Demand are the forces that make market economies work o They determine the quantity of each good produced and the price at which its sold o Determines how buyers and sellers interact with each other Market—group of buyers and sellers of a particular good or service o Buyers as a group determine the demand for the product o Sellers as a group determine the supply of the product Competitive Market—market where there are so many buyers & so many sellers that each has a negligible impact on the market price o Ex: ice cream seller has limited control over price bc other sellers offer similar products o Seller has little reason to charge less & charging more makes buyers go elsewhere Monopoly—markets with only one seller, and this seller sets the price Assumptions o That there is perfect competition among markets Perfectly competitive market = easy to analyze bc people take the price given by market For perfect competition: goods for sale must all be exactly the same and buyers & sellers are so numerous that no single buyer/seller has influence over the market (price takers) o Many buyers & sellers are ‘price takers’ meaning that: o At the market price, buyers can buy all they want, sellers can sell all they want o That we have perfect information available o That goods are homogeneous (all exactly the same) o No market failure o Fixed period of time P MB= Marginal Benefit D = WTP (Buyers willingness to pay) Q coke/day Law of Demand— claim that, other things being equal, quantity demanded of a good falls when the price of the good rises. Ceteris Paribus (all else same) (price falls = quantity demand rises) o Price of a good/service , Quantity demanded Demand means the entire curve! “Quantity demanded” is what you normally what you think of for the word Demand P Decrease in P quantity demanded Q Demand Curve—graph of the relationship between the price of a good and the quantity demanded o Demand curve slopes downward bc, other things being equal, a lower price = greater QD Quantity Demanded—of goods is the amount of good that buyers are willing & able to purchase Market Demand—the sum of all individual demand for a particular good or service o The sum of quantities demanded by all buyers at each price, found by adding individual demand curves horizontally Shifters/ Changers (Δ) in Demand Curve (not Q quaDtity demand) Increase in demand– any change increasing quantity demanded at every price shifts demand curve right Decrease in demand—any change reducing quantity demanded at every price shifts the demand curve left Things that cause demand curve shifts: 1) Income a) Normal Goods o Income , Demand o Income , Demand Ex: cars, restaurants, meals b) Inferior Goods o Income , Demand o Income , Demand Ex: education, ramen college, used cars, bus tickets 2) P other goods (orP related goods) Compliments—people consume complementary goods Px, Q D, D together y Ex: Ink + Printer Cereal + Milk Gas + Car Pb + Jelly Shampoo + Conditioner Substitutes—2 goods where increase price of one = increase in demand for the other (interchangeable) Px, Q D D y o Ex: iPhone + Android Starbucks + Jittery Joe Brand + Generic Gatorade + PowerAde 3) Preferences & Tastes (self-explanatory. People who have a particular preference buy that) 4) # Buyers , D (more people wanting the same good = less supply to go around = higher demand) 5) Expectations—Buyers expect gas is going to go up tomorrow … Tomorrow , D today Summary: Variables that influence buyers o Price of the good itself represents a movement along the demand curve o Income shifts the demand curve o Price of related goods shifts the demand curve o Tastes shifts the demand curve o Expectations shifts the demand curve o Number of buyres shifts the demand curve Quantity Supplied—the amount of a good that sellers are willing & able to sell Law of Supply—claim that, other things equal, quantity supplied of good rises when price of good rises (when price falls, quantity supplied falls) Supply Schedule—table showing relationship between price of a good & quantity supplied, holding constant everything else influencing how much producers of the good want to sell Supply Curve— graph of relationship between price of a good & quantity supplied o Slopes upward bc, other things equal, higher price = greater quantity supplied o Based off of MC (marginal cost) (supply curve is also called marginal cost curve) Market Supply—sum of all supplies of all sellers. Sum of two individual supplies (horizontal) Bc market supply curve holds other things constant, when 1 of these factors change, supply curve shifts Psugar falls (sugar = input of ice cream): Psugar fall = ice cream sale more profitable Increase in supply—any change raising quantity supplied at each price (fall of sugar) shift right Decrease in supply—any change reducing quantity supplied at each price, shifts curve left Variables that can shift a supply curve (NOT quantity!!): Input Prices—the price of a good is negatively related to the price of the inputs used to make the good (think: price of sugar falls, so selling ice cream is more profitable) o P input S Goods (left shift) Increase in Supply + Demand shift right (visa versa) Technology— (technology= ‘how to’ or ‘method of production’) technological advances reduce the amount of labor necessary to produce goods. Reducing firms’ costs raises supply ‘ o Technological advances = SGood # Sellers— S Goods,think, if Ben & Jerry’s went out of business, supply in market would fall Weather & Crops—unpredictable!! Expectations – only sellers of a gas expect P Tomorrow so S (so they can today make more when the gas goes up) firms may put some of their supply into storage to sell when market goes up Number of Sellers—market supply depends on # of sellers (Ben & Jerry quit = market supply falls) Summary of Variables Influencing Sellers o Price of good itself represents a movement along the supply curve o Input prices shifts the supply curve o Technology shifts the supply curve o Expectations shifts the supply curve o Number of sellers shifts the supply curve Equilibrium—when market price reaches the level that: quantity supplied = quantity demanded o Situation in which various forces are in balance Equilibrium price—price at intersection, price balancing quantity supplied & quantity demanded o The quantity of the good that buyers are willing and able to buy exactly balances the quantity that sellers are willing and able to sell o Sometimes called the market-clearing price because at this price everybody is satisfied Equilibrium quantity—the quantity supplied & the quantity demanded at the equilibrium price Surplus—when quantity supplied is greater than quantity demanded (excess supply) o Sellers respond to surplus by cutting prices= quantity demanded, quantity supplied ^^ This represents movements along supply and demand curves (NOT shifts!!) Shortage—when quantity demanded is greater than quantity supplied (excess demand) o Sellers respond to shortage by prices without sales demand ^^ represents movements along supply and demand curves (NOT shifts!!) Law of Supply and Demand—claim that price of any good adjusts to bring the quantity supplied & quantity demanded for that good into balance. 3 steps for analyzing changes in equilibrium: 1) Decide whether the event shifts the supply or demand curve (or both) 2) Decide in which direction the curve shifts 3) Use supply & demand diagram to see how theshift changes the equilibrium price & quantity Increase in demand causes equilibrium price to rise, causing quantity supplied to rise o Change in supply is a shift in the supply curve o Change in quantity supplied is a movement along a fixed supply curve o Change in demand is a shift in the demand curve o Change in quantity demanded is a movement along a fixed demand curve What happens to price & quantity when supply or demand shifts? Chapter 5: Elasticity and its Application * See graphs * Chapter 6-1 and 15-1a Price ceiling— legal maximum on price at which goods can be sold Non-binding— price balancing supply & demand (equilibrium) is below the ceiling Market forces naturally move economy towards equilibrium so, price ceiling doesn’t effect price or quantity sold Binding constraint— forces of supply & demand tend to move the price towards the equilibrium price … But when market price hits the ceiling, it can’t (by law) raise further market price = the price ceiling At this price, the quantity of ice cream demanded exceeds the quantity supplied = shortage In response to this shortage, mechanisms for rationing ice cream will naturally develop o Ex: long lines (buyers willing to arrive early and wait in line get ice cream, others don’t) o Or sellers could ration them to people of their choice (friends, family, etc) o Intended to help buyers, yet only some actually benefit while most cant get ice cream Rationing mechanisms that develop from price ceilings are rarely desirable So… When the government imposes a binding price ceiling on a competitive market, a shortage of the goods arises, and seller must ration the scarce goods among the large number of potential buyers Example: Gas Market w Price Ceiling Panel A- gas market when price ceiling isn’t binding (bc price of equilibrium P 1elow ceiling) Panel B- gas market after Pcrude oilnput to gas)shifts curve left from 1 to S2 - Unregulated market would rise from P 1o P 2. But, price ceiling prevents this…. - Consumers willing to buy Q D but gas producers only will sell Q s - Difference in Quantity Demanded & Quantity Supplied = gas shortage (Q D Q =Sgas shortage) Example: Rent Control in Short Run & Long Run Panel A short run effects of rent control Because supply & demand curves for apts are relatively inelastic, the price ceiling imposed by rent-control laws cause only a small shortage of housing Panel B long run effects of rent control Because supply & demand curves for apts are more elastic, rent control causes a large shortage Long run is very different bc buyers & sellers respond to more market conditions as time passes Supply: landlords respond to low rents by not building new apts & not maintaining existing ones Demand: low rent encourages buying more apts (rather than rooming or living w parents) and induces more people to move into a city When rent control depresses rents below equilibrium, the quantity of apartments supplied , quantity of apartments demanded Result: large shortage of housing o Therefore, both supply & demand are more elastic in the long run Price floor— a legal minimum on the price at which a good can be sold When equilibrium price is above the floor, the price floor is not binding Market forces naturally move the economy to the equilibrium, and the price floor has no effect Market with a Price Floor Panel A- equilibrium above price floor, so price floor has no effect Market price adjusts to balance supply & demand Panel B- equilibrium below price floor, Surplus 40 cones (120 supplied, only 80 demanded) Bc equilibrium is below price floor, price floor is a binding constraint on the market Forces of supply & demand tend to move the price towards equilibrium price, but when market price hits the floor, it can’t fall any further market price = price floor Binding price floor causes surplus Example: How Minimum Wage Affects the Labor Market Panel A- labor market where wage adjusts to balance labor supply & labor demand Panel B- impact of a binding minimum wage Bc min wage is a price floor, causes surplus (quantity of labor > quantity demanded) Result unemployment Min wage raises incomes of workers with jobs, but lowers incomes of workers without jobs Min wage is binding more often for teenagers than other people in labor force bc they intern more Evaluating Price Controls Economists agree price ceilings & price floors are bad for markets Though gov tries to help, it often has unintended consequences Chapter 15 – Unemployment BLS (Bureau Labor Statistics) places each adult (16 and older) into 3 categories: o Employed—paid employees, business owners, unpaid family business staff, full & part time workers, or people with jobs but they’re temporarily absent (vacation, ill, maternity) o Unemployed—not job but, able & looking to work o Not in labor force—full students, homemakers, retirees, kids Labor Force— total # of able workers, both employed & unemployed Natural Rate of Unemployment: The normal rate of unemployment that the unemployment rate fluctuates around Cyclical Unemployment: Deviation of unemployment from its natural rate Chapter 15 – Unemployment BLS (Bureau Labor Statistics) places each adult (16 and older) into 3 categories: 1) Employed—paid employees, business owners, unpaid family business staff, full & part time workers, or people with jobs but they’re temporarily absent (vacation, ill, maternity) 2) Unemployed—not job but, able & looking to work 3) Not in labor force—full student, homemaker, retiree, kids Labor Force— total # of able workers, both employed & unemployed Natural Rate of Unemployment: The normal rate of unemployment that the unemployment rate fluctuates around Cyclical Unemployment: Deviation of unemployment from its natural rate Graph shows… Blue line = normal rate Red line = cyclical rate (unemployment) More than 1/3 of the unemployed are recent entrants to the labor force (young workers, or old workers who are returning to the work force & are now looking for a job) Discouraged Workers— individuals who would like to work but have given up looking for a job o Do not show up in unemployment statistics (even though they are workers without jobs) Chapter 2—Thinking Like an Economist Economist —“Social Scientist” that uses the scientific method to study human behavior Scientific Method 1 Observe Something (People who quit smoking gain weight) 2 Create Hypothesis 3 Collect Data (only relevant data) (price of cigarettes, taxes, food prices, exercise) 4 Create a Model A model is simplified representation of the real world (assumptions simplify = good thing!) The supply & demand model represent equations! A good model is….. Useful General Clear 5 Test Hypothesis 6 Reject or fail to reject hypothesis Assumptions— used by economists to simply the complex world and make it easier to understand. Ex: Study effects of international trade we assume world consists of only 2 countries each producing 1 good By considering a world of only 2 countries & 2 goods, we can focus our thinking on the essence of the problem. Think about the assumption that newspaper prices at a street stand do not change often. When studying the effects of policy change over time, we can assume shortterm and longterm effects. o ShortRun Effects—studying short run effects of the policy, we assume prices do not change most. We also assume (extremely & artificially) that all prices are completely fixed. o LongTerm Effects—studying longer term effects, we assume all prices are completely flexible Model 1: The CircularFlow Diagram o Visual model of the economy showing how dollars flow through markets among households & firms Model simplifies economy into only 2 type of decision makers: households & firms Firms – produce goods & services using inputs (labor, land, capital (tools + machines), buildings) Inputs are called the factors of production Households— own factors of production & consume all goods & services that firms produce Households & Firms interact in market for goods & services where… Households = buyers Firms = sellers And they interact in market for the factors of productions Firms = buyers Households = sellers Inner Loops—represents the flows of inputs and outputs Households sell use of their labor, land, & capital to firms in the markets for factors of production Firms then use these factors to produce goods & services, which in turn are sold to households in markets for goods & services. Outer Loops – represents the corresponding flows of dollars Households spend money to buy goods & services from the firms Firms use some of the revenue from these sales to pay the factors of production (workers wages) o What’s left: profit of the firm owners, who themselves are members of households Model 2: Production Possibilities Frontier o Graph showing the various combinations of output that the economy can possibly produce given the available factors of production & available production technology firms use to make factor output o Consider economy produces 2 goods: cars & computers (use all of economy’s factors of production) Assumptions: 1) 1 country 2) Produces only 2 goods 3) No government 4) Resources specialized = OC Production o Outputs in this case: cars & computers o If economy uses all its resources in car industry = 1,000 cars, 0 computers o If economy uses all resources in computer industry = 3,000 computers, 0 cars o The 2 endpoints of the production possibilities frontier represent these extreme possibilities o Points outside the frontier not feasible given the economy’s resources Slope of the production possibilities frontier measures the O.C. of a car in terms of computers This opportunity cost varies, depending on how much of the 2 goods the economy is producing o Because resources are scarce, not every conceivable outcome is feasible. Ex: No matter how resources are allocated between the 2 industries, the economy cannot produce the amount of cars & computers represented by point C. Given tech available for manufacturing cars & computers, the economy does not have enough of the factors of production to support that level of output o With the resources it has, the economy can produce at any point on or inside the production possibly frontier, but cannot produce points outside the frontier o Outcome = efficient if the economy is getting all it can from the scarce resources it has available o Points ON the production possibilities frontier (not inside) = efficient levels of representation Look at point A… no way to produce more of one good without producing less of the other Point D = inefficient outcome (producing less than it could given the resources available) Tradeoff efficient frontier point only way to produce more of 1 good = produce less of other Production possibilities frontier shows opportunity cost of 1 good measured in terms of the other Point APoint B: gives up 200 comps for 100 more cars (@p A, OC of 100 cars is 200 comps) Put another way – opportunity cost of each car = 2 computers OC of a car = the slope of the production possibilities frontier Linear PPF = Constant OC Technology advances = shifts outwards Production possibilities frontiers often have this bowed shape. Bowed out = increase OC Field of economics is traditionally divided into 2 broad subfields: o Microeconomics—study of how households & firs make decisions and how they interact in specific markets. o Macroeconomics—study of economywide phenomena. Chapter 1—Introduction to Economics Economy—Greek word oikonomis “one who manages the household” Economics—the study of how society allocates its scarce resources Economists study how people make decisions, how much they work, what/how much they buy/save and how people interact with each other (buyer vs. seller). Study/analyzes trends that affect the economy Scarcity—society has limited resources and therefore cannot produce all the goods and services people want Principles of Economics (14 how individuals make decisions, 57 how people interact with each other) How Individuals Make Decisions (Principles #1—4) Principle 1: People Face Tradeoffs o “No such thing as a free lunch” – making decisions requires trading off one goal against another o Tradeoff—to get more of one thing, people must give up other thing Ex: health care vs. war on terror (economic value of each against each other) o Common tradeoff ex equality & efficiency … so more equal distribution = less efficient o Efficiency—getting the maximum benefits out of scarce resources Tax labor increases = less workers = less productions = distribution to lower income Therefore, as equality increases, efficiency decreases (less efficient bc less workers) o Equality—those benefits are distributed uniformly among society’s members Principle 2: The Cost of Something is What You Give Up To Get It o Making decisions requires comparing the costs and benefits of alternative courses of action o Opportunity cost—what you give up to get an item. The value of the best thing given up… can be time and/or money. Stuff we can do preference Class #1 Sleep #2 Eating #3 } Tradeoffs Opportunity cost of being in class sacrifices/foregoes the value of sleep You pay $40 to go to concert o OC ~~ forego value of the $40 and what else you would have spent it on o OC ~~ forego value of next best thing you would do with that time Land in NYC has a higher OC than land in Athens College costs: Included in OC: Tuition, books Not included in OC: housing and food… bc you would have to buy food/shelter anyways, however the additional expense of these factors at college = OC Principle 3 & 4: Rational People Think at the Margin & People Respond to Incentives o Rational people—systematically and purposefully do the best they can to achieve their objectives, given the available opportunities. o Marginal change—small incremental adjustment to an existing plan of action. Margin = edge Decisions are made by comparing marginal benefits and marginal costs o Incentive—something (prospect of a punishment or reward) that induces a person to act (ex: tax on gasoline causes people to drive smaller, more fuel efficient cars) o Margin—small or additional to cost, break up a decision into the smallest possible parts Marginal benefit—additional benefit in money Marginal cost—additional cost in money o *** Different from average! **** FDIC—Federal deposit insurance corp. Guarantees $250,000 in checking How people interact with each other (Principles # 5—7) Principle 5: Trade Can Make Everyone Better Off o Trade between two countries can make each country better off. Promotes ‘friendly competition’ o Isolation would mean you would have to do everything on your own, grow food, make clothes o Trade allows each person to specialize in the activities they do best trade allows specialization Therefore, we can consume more than we produce o Voluntary trade can make society as a whole better off Autarky—no trade, economically independent or selfsufficient Individuals, states, and international Principle 6: Markets Usually Allocate Resources Efficiently Market efficiency—resources go to their highest valued uses first and they are produced by the lowest cost producers first Ex: ice cream market ice cream in the summer… Demand increases sellers increase ice cream production price increases Principle 7: Government Can Sometimes Increase Market Efficiency Market failure—when market fails to allocate resources efficiency by itself… 3 big causes: Externalities: (difficult for others to avoid cost) Negative externalities—when a person/firm imposes an external/spillover cost on another (ex: smoking, second hand smoke = pollution (firms/cars) o Qmarket > Qeffecicent = Gov. can tax Positive externalities—when someone’s behavior causes external/spillover benefits to others; benefits difficult to recap (ex: garden/landscaping house o Qmarket < Qefficient = Gov. can subsidize Market Power (monopoly) – the ability of a single person or firm to unduly influence market prices (ex: if a town had only one well, owner can charge water at high price) Price monopoly > Price competition Antitrust law Qmono < Qcompetition ( most effeicent) Equality— with equal income, market system doesn’t work. Meaning, if under provision of merit goods (education, vacation, museum—positive externality)& over provision of demerit goods (goods that harms consumers; smoking, drugs—negative externality) The Workings of the Economy as a Whole (Principles # 810) Principle 8: Growth Rate of a Nations Productivity Determines the Growth Rate of Avg. Income o A Country’s Standard of Living Mostly Depends on its Productivity Productivity is the amount of goods & services produced by each unit of input labor o Gov. can increase the well being of their citizens by… 1) R+D (research + development, technology) 2) Saving? And Investment 3) Education = most productive 4) Structure of government (communism vs. democracy) 5) Common law vs. Civil law Common law old laws & court cases set precedents that we have adapted to Civil law stricter interpretation of laws, not adaptable o Common law economic growth = 30% higher w/ time = more productive! Principle 9: Prices Rise When Government Prints More Money (inflation) o True in the long run o Inflation—increase in the overall level of prices in the economy. Low level inflation = goal for policy makers o Hyperinflation = way too much money printed so it becomes essentially useless o Why continue printing more money 1) money in economy stimulates overall spending levels = demand goods & services 2) demand eventually may lead to prices, but short run: encourages companies to hire more people in order to produce more goods & services 3) hiring = lower levels of unemployment (more employed = more spending) Principle 10: Society Faces a Shortrun Tradeoff Between Inflation & Unemployment o Shortrun Tradeoff between Inflation (π ) and Unemployment (U) o ShortRun—when the economy is ‘sticky’ or the economy doesn’t fully adjust o LongRun—when all things vary, the economy fully adjusts o Business Cycle—the irregular and largely unpredictable fluctuations in economic activity as measured by the production of goods & services or the # of people employed *See graph* Chapter 7 – Consumers, Producers, and the Efficiency of Markets Simple economics: Buyers always want to pay less, and sellers always want to be paid more Welfare economics—the study of how the allocation of resources affects economic well being Examine the benefit that buyers and sellers receive from market transactions... Conclusion: In any market, equilibrium of supply & demand maximizes total benefits of buyers & sellers combined Willingness to pay—buyer’s maximum willingness to pay or their value of a certain good Consumer surplus—amount buyer is willing to pay for a good – (minus) amount the buyer actually pays Measures the benefit buyers receive from participating in a market Table: demand schedule Graph: agreeing demand curve ** Demand curve height reflects buyer’s willingness to pay** Graph used to measure consumer surplus Marginal Buyer—buyer who would leave the market first if price were any higher (in this case Ringo) Measuring consumer surplus w/ demand curve: Use the area of what doesn’t overlap Consumer Surplus = WTP – Market Price The area below demand curve & above price Market w many buyers, so many ‘steps’ = smooth looking curve forms Panel A – Price: P1, Quantity demanded Q 1 so consumer surplus = area of ABC Panel B – Price falls from P1 to P2, so quantity demanded rises from Q to Q 1 2 - Initial consumer surplus rises - New customers pay less (Because they enter the market at lower price) Increase in consumer surplus has 2 factors: Increase in consumer surplus of exiting buyers = reduction in amount they pay (Rectangle BCED) Some new buyers enter the market because they’re WTP less for the good o Result Q Din the market from Q to Q1 2 CS of newcomers = Triangle CEF Goal of developing CS: to make judgments about the desirability of market outcomes CS measures the benefit that buyers receive from a good as the buyers themselves perceive it Thus, CS is good measure of economic well-being if policymakers do respect buyers preferences Cost— the value of everything a seller must give up to produce a good (think acct: price of inventory) Producer surplus = (amount a seller is paid– cost of production)… measures benefit sellers receive Example: need to paint a house, so you ask 4 different workers to try to get lowest price (a,b,c,d) Each painter is willing to work if the price they receive exceeds the cost of doing the work Here, cost is interpreted as painter’s opportunity cost: includes painter’s out-of- pocket expenses (paint, brushes, etc) & the value that painters place on their own time They give the lowest price they would accept, also called their willingness to sell services Example of PS: 2 houses need painting, but no painter will complete both jobs o Buyers WTP the same amount for each house paint job, so price falls until 2 painters are left o ^ this is binding… when binding stops there are 2 painters left (c, d) o The lowest the other painters would work for: $800. o Originally, painter C would have done it for $500 & painter B would for $600 o Therefore, C receives producer surplus of $300 and B receives producer surplus of $200 Total producer surplus in the market: $500 d , Supply Curve measures Producer Surplus— CS related to demand curve, PS related to supply curve Table – shows how much painters want to be paid as willing to do the job Quantity supplied = how many painters are willing to do the job Graph: supply curve height = sellers’ costs Marginal Seller—price given by the supply curve showing costs of seller who would leave market first if price were any lower, at any quantity (in this case Mary) Measuring Producer Surplus with Supply Curve— area below the price & above the supply curve = PS Using same example…. Panel A: Grandma’s PS is $100 Panel B: Price good = $800 (paint job) Grandma & Georgia both had PS, added together it is $500 In markets with lots of sellers, there is an upwards-sloping supply curve Producer Surplus = area below the price and above the supply curve Panel A: o At P Q1antity demanded is Q1 o PS = area of triangle ABC Panel B: o Price rises from P to P so... 1 2 o Qsupplied rises from Q to1Q 2 so… o Producer surplus rises to and is now the area of triangle ADF o Increase in PS (area BCFD) is result of (2): Producers receiving more (BCED) New producers enter market at higher price (CEF) Increased producer surplus has 2 parts: Initial sellers of 1 who sold at lower price P1, now better off as they get more for what they sell, Increase in PS for existing sellers = area of rectangle BCED Some new sellers enter market as they’re willing to produce the good at a higher price, resulting in: increase in quantity supplied form Q 1o Q 2 PS of newcomers = area CEF Total surplus—sum of consumer surplus + producer surplus Total surplus is a measure of society’s economic well-being overall Consumer surplus = Value to buyers – Amount paid by buyers Producer surplus = Amount received by sellers – Cost to sellers Total Surplus = Consumer Surplus + Producer Surplus Amount paid by buyers & amount received by buyers cancel out so… Total Surplus = Value to Buyers – Cost to Sellers Efficiency—property of a resource allocation of maximizing total surplus received by all of society An allocation is inefficient if: Good is not being produced at lowest cost If its not being consumed by the buyers who value it most highly Consumer and Producer Surplus in Market Equilibrium Total surplus = area between supply & demand curve up to equilibrium quantity Market outcomes: Free markets allocate supply of goods to buyers that value it most highly (measured by their WTP) Free markets allocate the demand for goods to sellers who can produce them at the lowest cost Free markets produce quantity of goods that maximizes the sum of consumer & producer surplus Thus, benevolent social planner cannot increase economic well-being by changing allocation of consumption among buyers or the allocation of production among sellers, or by changing the quantity of the good Efficiency of Equilibrium Quantity—quantities less than equilibrium quantity (Q1) value to buyers exceeds cost to sellers - Quantities greater than equilibrium quantity (Q2) cost to sellers exceeds value to buyers (value to buyers is less than cost to sellers) - Therefore, market equilibrium maximizes the sum of PS and CS
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