Consumer theory markets and economic welfare
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Consumer Theory, Markets and Economic Welfare. Topics. 1. Competitive consumer: preferences, budget sets, choices. Price and income effects. 2. Firms: transform multiple inputs into outputs.

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Consumer theory markets and economic welfare

Consumer Theory, Markets and Economic Welfare


Topics

Topics

1. Competitive consumer: preferences, budget sets, choices. Price and income effects.

2. Firms: transform multiple inputs into outputs.

3. Private ownership economy with initial ownership of goods and firms, markets, trades, prices, feasible allocation, compet. equilibrium.

4. Pareto efficiency.

5. Externalities: fundamental or not.

6. Two Fundamental Welfare Theorems, their limited relevance; other advantages of markets


Competitive consumer a model

Competitive Consumer (a model)

  • Price-taking, rational optimizer

  • Acts as if it cannot affect prices (no market power); pays for what it gets (no stealing).

  • Buys best affordable bundle of goods.

  • Best according to preferences represented by indifference sets.

  • Affordable bundles = bundles in budget set.


Competitive consumer a model1

Competitive Consumer (a model)

  • Bundles

  • Indifference Curves, abbreviated INDIFF

  • Budget Sets show affordable bundles

  • Optimal Choices


Consumer theory markets and economic welfare

Bundles of Goods: represented by points

showing amounts of any goods X and Y

Y

(4,20)

(5, 15)

(20,15)

(15, 5)

X

5

15

20


Consumer theory markets and economic welfare

Preferences: represented by indifference sets (curves), sets of bundles the consumer finds equally good.

Y

(4,20)

(5, 15)

(20,15)

(15, 5)

X

5

15

20


Budget set set of affordable bundles

Budget Set = Set of affordable bundles

Budget Set normally looks like a triangle.

Upper boundary is Budget Line, the set of barely affordable bundles, where whole budget is spent.

y

x


Optimal choice

Optimal Choice

Consumer buys best affordable bundle.

Optimal bundle is black pointin budget line, on

highest indifference curve touching budget set.

y

x


Optimal choice1

Optimal Choice

If preferences were different, a different point would be chosen, but best indiff curve would still be tangent to budget line: their slopes are equal at the optimal bundle.

y

x


Optimal choice2

Optimal Choice

If the budget were bigger but prices the same, the budget linewould be higher, parallel to the original line, and a different point would be chosen. Shift in choice is income effect.

y

x


Meaning of indiff curve shapes

Meaning of Indiff Curve Shapes

Negative slope of indiff curve corresponds to both goods being desired.

Curve shaped like  corresponds to preference for moderate amounts of all goods, not a large amount of one of them.

y

x


Consumer theory markets and economic welfare

Slope = vertical change / horizontal change

= (20−15) / (4 −5) =−5/1

(4,20)

(5, 15)

(20,15)

(15, 5)

5

15

20


Consumer theory markets and economic welfare

Y

(4,20)

(5, 15)

(20,15)

Slope = −10/10= −1= −Rate of Substitution: consumer is willing to give up 10 units of Y to get 10 units of X.

(15, 5)

X

5

15

20


Consumer theory markets and economic welfare

Y

(4,20)

(5, 15)

(20,15)

Diminishing Rate of Substitution: Rate from black to red bundle is bigger (5) than from red to blue bundle (1). Consumer's willingness to pay for more X falls as X rises.

(15, 5)

X

5

15

20


Consumer theory markets and economic welfare

Y

(4,20)

(5, 15)

(20,15)

Marginal Rate of Substitution (MRS)

= − limit of slopes = − slope of tangent line= rate of substitution for small change

(15, 5)

X

5

15

20


Consumer theory markets and economic welfare

Y

(4,20)

(5, 15)

(20,15)

Curve shape implies preference for moderation: average consumption (10, 10) is preferred to red and blue bundles.

(10, 10)

(15, 5)

X

5

15

20


Indifference curves

Indifference Curves

  • Assume at least one desirable good (Y)

    indiff sets are curves. Higher is better.

    Standard Indiff Curves (1) stop only at axes

    (2) All goods desirable  negative slopes

    (3) Preference for moderation

    Diminishing rate of substitution

    Less willing to pay for additional units

    Indiff curves shaped like: 


Consumer theory markets and economic welfare

Standard Indifference Curves

One through every point, but we can't draw them all.

Y

(4,20)

(5, 15)

(15, 5)

X

5

15

20


Consumer theory markets and economic welfare

NOT Standard Indifference Curves

WHY NOT?

Y

X

5

15

20


Consumer theory markets and economic welfare

NOT Standard Indifference Curves

All points in blue indifference set must be equally good, but blue point is better than green point.

Standard indifference curves don't cross each other.

Y

X

5

15

20


Consumer theory markets and economic welfare

NOT Standard Indifference Curves

Standard curves only stop at the axes. If the red curve is standard it must continue and cross the blue curve (then it is not standard)

Y

X

5

15

20


Consumer theory markets and economic welfare

NOT Standard Indifference Curves

Standard curves only stop at the axes. If the red curve is standard it must continue and cross the blue curve or go below it, but with the wrong curvature.

Y

X

5

15

20


Consumer theory markets and economic welfare

Standard Indifference Curves must be able to fit around each other and keep their  shape without crossing each other.

Y

X

5

15

20


Consumer theory markets and economic welfare

NONSTANDARD preferences are possible. This consumer does not prefer moderate consumption. Moving along an indiff curve to the right, substituting X for Y makes additional units of X MORE VALUABLE for the consumer.

Y

X

5

15

20


Consumer theory markets and economic welfare

NONSTANDARD preferences are possible. Moving from the blue point to the right (raising X, without reducing Y) makes this consumer WORSE OFF. At the blue point, the consumer is satiated in X.

Y

X

5

15

20


Consumer theory markets and economic welfare

NONSTANDARD preferences are possible. Moving from the blue point to the right (raising X, without reducing Y) makes this consumer WORSE OFF. At the blue point, the consumer is satiated in X.

Y

X

5

15

20


Consumer theory markets and economic welfare

NONSTANDARD preferences are possible. Moving from the blue point to the right (raising X, without reducing Y) makes this consumer WORSE OFF. At the blue point, the consumer is satiated in X.

Y

X

5

15

20


Why indifference curves

Why Indifference Curves?

Water+Diamond Paradox: Water necessary but free; diamonds unnecessary, expensive.

Prices depend on availability (supply), but why are consumers willing to pay so much more for diamonds?

Answer:Willingness to pay depends on how

much of ALL goods the consumer starts with.


Consumer theory markets and economic welfare

Diamonds

Slope = vertical change / horizontal change

= (20−15) / (4 −5) =−5/1

Starting at black point, with a lot of diamonds and little water, consumer is willing to pay a lot for one more unit of water.

(4,20)

(5, 15)

(15, 5)

Water

5

15

20


Consumer theory markets and economic welfare

Diamonds

(4,20)

Starting at red point, with more water, less diamonds than at black point, consumer is less willing to pay for more water.

Diminishing Rate of Substitution

(5, 15)

(15, 5)

Water

5

15

20


Consumer theory markets and economic welfare

Diamonds

(4,20)

Starting at blue point, with more water, less diamonds, consumer is willing to pay less for more water.

Diminishing Rate of Substitution

Beyond the blue point, additional water is almost worthless (willingness to pay for more is near 0).

(5, 15)

(15, 5)

Water

5

15

20


Finding budget line

Finding Budget Line

Example: price of X = px = 2,

price of Y = py = 3, income or budget = 12.

Find intercepts. What economic meaning?Maximum affordable amounts of Y and X.

y

x


Finding budget line1

Finding Budget Line

Example: price of X = px = 2,

price of Y = py = 3, income or budget = 12.

Find intercepts. How much Y is affordable when none of X is bought?

Whole budget spent on Y:

py∙y =12, 3y = 12, y = 12/3 = budget/py =4.


Finding budget line2

Finding Budget Line

Example: price of X = px = 2,

price of Y = py = 3, income or budget = 12.

Maximum affordable amount of X when no Y is bought: px x = 2x = 12, x = 12/2 = 6. Budget line joins points (0, 4) and (6, 0).

y

4

x

6


Finding budget line3

Finding Budget Line

Example: price of X = px = 2,

price of Y = py = 3, income or budget = 12.

Another way: Find one point on line (we found an intercept). Then find budget line slope.

Slope =−px/py. Why?

y

4

px

py

x


Finding budget line4

Finding Budget Line

Example: price of X = px = 2,

price of Y = py = 3, income or budget = 12.

Budget line slope =−px/py. Why?To move to right on budget line, sell Y, buy X.

What is cost of py = 3 units of X? pxpy = 2∙3.

To get that money, how many units of Y does consumer sell?2 units at price py =3.

Gives up 2 of Y to get 3 of X. Moves down 2 and 3 to right. Slope = −2/3 =−px/py


Finding budget line5

Finding Budget Line

Example: price of X = px = 2,

price of Y = py = 3, income or budget = 12.

Consumer stays on budget line giving up 2=px units of Y, getting 3=py units of X, moves down 2 and 3 to right.

Slope = −2/3 =−px/py

y

4

px

py

x


General budget line

General Budget Line

px=price of X, py=price of Y, I =income (budget)

Budget Line = set of barely affordable bundles

Cost = px x + py y = I = budget , py y = I −px x,

y = (I/ py)+ (−px /py)x budget line equation

vertical interceptslope = − (I/ py)(I/ px)= −px /py

y

I/ py

I/ px

x


Effects of income changes

Effects of Income Changes

I up, prices fixed: y = (I/ py)+ (−px /py)x

Vertical interceptrises, slope stays same. Income effects are changes in amounts of X and Y bought. This consumer moves from blue to red point, buys more of both goods.

y

I/ py

I/ px

x


Effects of income changes1

Effects of Income Changes

I up, prices fixed: This consumer moves from blue to blackpoint, buys more X, but less Y. A good is called inferiorover a range of incomes if the consumer buys less when income is higher. Over this income range, good Y is inferior for this consumer. Note: It is not possible for a good to be inferior at all income levels. Why not? If Y is inferior, the consumer buys more when income is lower. But on the black budget line, the consumer cannot afford as much Y as at the blue dot.

y

I/ py

I/ px

x


Effects of income changes2

Effects of Income Changes

I up, prices fixed: Income effects are changes in amounts of X and Y bought. A good is NORMAL over a range of incomes if it is not inferior. (Its consumption does not fall when income rises.) This consumer moves from blue to redpoint, buys more of both goods. Both goods are normal for the consumer over this income range.

y

I/ py

I/ px

x


Effects of price changes

Effects of Price Changes

pxup, py and I fixed: y = (I/ py)+ (−px /py)x

Vertical intercept stays same (same maximum amount of Y if no X bought).

slope = −px /pyrises in magnitude (absolute value)

Steeper budget line. Less X affordable for given Y.

y

I/ py

I/ px

x


Effects of price changes1

Effects of Price Changes

pxup, py and I fixed: y = (I/ py)+ (−px /py)x

Vertical intercept stays same (same maximum amount of Y if no X bought).

slope = −px /pyrises in magnitude (absolute value)

Steeper budget line. Less X affordable for given Y.

Budget set shrinks.

y

I/ py

I/ px

x


Effects of price changes2

Effects of Price Changes

Ifpxfalls, with py and I fixed:

Vertical intercept stays same (same maximum amount of Y if no X bought).

slope = −px /pyfalls in magnitude (absolute value)

Flatter budget line. More X affordable for given Y.

y

I/ py

I/ px

x


Effects of price changes3

Effects of Price Changes

Ifpxfalls, with py and I fixed:

Vertical intercept stays same (same maximum amount of Y if no X bought).

slope = −px /pyfalls in magnitude (absolute value)

Flatter budget line.More X affordable for given Y. Budget set expands.

y

I/ py

I/ px

x


Effects of price changes4

Effects of Price Changes

Ifpy falls (good Y cheaper) with px and I fixed:

Vertical intercept rises (more Y affordable).

slope = −px /py rises in magnitude (absolute value)

Steeper budget line.Budget set expands.

I/ py

I/ px

x


Effects of price changes5

Effects of Price Changes

Ifpy falls (good Y cheaper) with px and I fixed:

With these preferences, optimal bundle shifts from blue bundle to green. Amounts of both goods rise, Y more than X.

I/ py

I/ px

x


Effects of price changes6

Effects of Price Changes

Ifpy falls (good Y cheaper) with px and I fixed:

With other preferences, optimal bundle shifts from blue bundle to red. Amount of X rises, but Y falls. This can only happen if good Y is inferior over a range of incomes. The quantity demanded rarely falls when the price falls.

I/ py

I/ px

x


Main conclusion for welfare analysis

Main Conclusion for Welfare Analysis

Optimal choices are bundles where indiff curve is tangent to budget line, with same slope.

− budget line slope = px /py= −Indiff curve slope = MRS = willingness to pay Y per unit of X

In competitive markets, all consumers who buy the goods face the same prices, haveequal MRS (willingness to pay).

I/ py

I/ px

x


Kinked budget lines labor supply with tanf benefits

Kinked Budget Lines: Labor Supply with TANF Benefits

Indifference curves usually represent preferences for desirable goods. We use leisure (desirable) instead of labor to study labor supply. Consider a consumer who can work any number of hour up to full time in a year at wage rate $10/hour. Full time = 40 hours/week for 50 weeks = 2000 hours/yr.

Any hours out of the 2000 not spent working are counted as leisure consumption:

Work time + Leisure time = 2000 hrs.

We will consider the effect of TANF welfare benefits (Temporary Assistance for Needy Families) on a consumer's budget set and choice of labor supply.


Kinked budget lines labor supply with tanf benefits1

Kinked Budget Lines: Labor Supply with TANF benefits

A consumer who consumes 2000 hours of leisure at point A, with no TANF benefit, gets no money. A consumer who consumes no leisure at B (works all 2000 hours at $10/hr) gets $20000. From any intermediate point like C, a consumer can move along the budget line by moving left by 1 hour and up by $10. The slope of the line is the vertical change over horizontal change: $10/−1 hr = −10 $/hr. If TANF pays a benefit of $6000, but reduces the benefit by $1 for each $1 the consumer earns (100% benefit reduction rate), then the consumer gets $6000 without working and $6000 if working 600 hours or less. The budget set expands

$ for other goods

B

$20000

C

A

leisure

leisure

2000 hrs

work


Kinked budget lines labor supply with tanf benefits2

Kinked Budget Lines: Labor Supply with TANF benefits

A consumer who consumes 2000 hours of leisure at point A, with no TANF benefit, gets no money. A consumer who consumes no leisure at B (works all 2000 hours at $10/hr) gets $20000. From any intermediate point like C, a consumer can move along the budget line by moving left by 1 hour and up by $10. The slope of the line is the vertical change over horizontal change: $10/−1 hr = −10 $/hr. If TANF pays a benefit of $6000, but reduces the benefit by $1 for each $1 the consumer earns (100% benefit reduction rate), then the consumer gets $6000 without working and $6000 if working 600 hours or less. Black triangle is added to the budget set.

$ for other goods

B

$20000

A

leisure

leisure

2000 hrs

work


Kinked budget lines labor supply with tanf benefits3

Kinked Budget Lines: Labor Supply with TANF benefits

With 100% benefit reduction, a consumer with standard preferences either gets no TANF benefitor does not work.

$ for other goods

B

$20000

A

leisure

leisure

2000 hrs

work


Kinked budget lines labor supply with tanf benefits4

Kinked Budget Lines: Labor Supply with TANF benefits

With 100% benefit reduction, a consumer with standard preferences either gets no TANF benefit or does not work.

$ for other goods

B

$20000

A

leisure

leisure

2000 hrs

work


Kinked budget lines labor supply with tanf benefits5

Kinked Budget Lines: Labor Supply with TANF benefits

If TANF pays a benefit of $6000, but reduces the benefit by 60¢ for each $1 the consumer earns (60% benefit reduction rate), then the consumer gets $6000 without working and gains $4 for each hour of work (after TANF reduction). Budget line when leisure is high has slope −4$/hr. If consumer works H hours and earns $10 H, benefit falls by $6 H. Whole $6000 benefit eliminated if H = 1000.

$ for other goods

B

$20000

slope = −4

A

leisure

leisure

1000 hrs

2000 hrs

work


Kinked budget lines labor supply with tanf benefits6

Kinked Budget Lines: Labor Supply with TANF benefits

If TANF pays a benefit of $6000, but reduces the benefit by 60¢ for each $1 the consumer earns (60% benefit reduction rate), then the consumer gets $6000 without working and gains $4 for each hour of work (after TANF reduction). Budget line when leisure is high has slope −4$/hr. If consumer works H hours and earns $10 H, benefit falls by $6 H. Whole $6000 benefit eliminated if H = 1000. If TANF benefit falls to $4000, budget line shifts down; slope does not change.

$ for other goods

B

$20000

slope = −4

A

leisure

leisure

1000 hrs

2000 hrs

work


Agents and their trades

Agents and Their Trades

goods, services

Governments

taxes, fees

Firms

goods

services

payment $

$

taxes

fees

goods, services

$

payment $

Firms

Consumers

goods, services

Consumers’ possible trades lie in budget sets.

Firms’ possible trades determined by production possibilities (technology).


General equilibrium agents and trades

General Equilibrium agents and trades

goods, services

Firms

payment $

Consumers

goods, services

$

payment $

goods, services

Firms

Consumers’ possible trades lie in budget sets.

Firms’ possible trades determined by production possibilities (technology)

Govs are represented as consumers and/or firms..


Markets and efficiency

Markets and Efficiency

  • Model private ownership economy as a set of

  • firms with production possibilities

    (feasible input-output combinations),

  • consumers with preferences over bundles of goods and initial ownership of

    resources (endowments: including time for labor or leisure) and shares of firms' profits.

    Leon Walras (1874)


Consumer theory markets and economic welfare

Endowments and Trade: Consumer A's endowment is the red point (A initiallyowns this bundle of goods). Consumer B has the same preferences, is on the same indiff curve and owns the black point. Both consumers gain from a trade represented by two arrows. A moves to the tip of the red arrow, gives up Y, gets more X. B moves to the tip of the black arrow, gets the amount of Y that A gives up, gives up the amount of X that A gets. Both benefit.

Y

A

B

X

5

15

20


Consumer theory markets and economic welfare

Endowments and Trade: A trade is always represented by two parallel arrows with the same slope and equal length, pointing in opposite directions. WHY?

The consumers do not need to be on the same indiff curve or have the same preferences. One or both of the traders could be a firm. A firm's trade just needs to be feasible given its production possibilities.

Y

A

B

X

5

15

20


Consumer theory markets and economic welfare

  • Allocation: amount of each good for each consumer, and amount of each input and each output for each firm.

  • Feasible allocation:

    For eachgood,

    total demand by consumers and firms

    = total output + total (initial) endowment.

    = total supply.


Competitive equilibrium ce

Competitive Equilibrium (CE)

  • Prices for all goods

    (in single market, goods are identical);

  • Competitive behavior:

    Firms price-taking profit maximizers; Consumers price-taking optimizers,

    value of net trade equals profit share.

  • Feasible allocation: prices adjust so

    supply = demand for each good.


Graded homework 1 problem 1

Graded Homework 1, problem 1

Define "market" broadly enough to cover market for wheat, U.S. anesthesiologists, and for a particular stock.

  • Market changes when essential features change and only then. What is wrong with:

    A "collection of buyers and sellers that, through their actual or potential interactions, determine the price of a product or set of products." ?

    .


Consumer theory markets and economic welfare

Efficient allocation (W. Pareto, 1906):

Think first about what is inefficient.

  • An allocation is INEFFICIENT if some feasible allocation is better for some consumer and no worse for anyone.

    Pareto improvement makes at least one consumer better off without hurting anyone

  • Efficient = feasible and not inefficient.

  • A feasible allocation is (Pareto) efficient if

    no Pareto improvement is feasible. (It is impossible to make a consumer better off without hurting someone else.)


Consumer theory markets and economic welfare

  • We care only about consumer welfare.

  • Care about firms indirectly

    (care about their owners).

  • Efficient is NOT same as desirable.

    An efficient allocation may be very unfair.

  • Example: all goods to one person.


Consumer theory markets and economic welfare

  • Which allocations are efficient?

    Answer is related to

  • Fundamental Externality: effect of one agent’s actions on others’ welfare or production possibilities WITHOUT CHANGING THEIR PRIVATE OWNERSHIP OR CONSUMPTION.

    Oil spill makes fishing more difficult (need to sail farther). FUNDAMENTAL: affects production possibilities.


Consumer theory markets and economic welfare

  • Which allocations are efficient?

    Answer is related to

  • Fundamental Externality: effect of one agent’s actions on others’ welfare or production possibilities WITHOUT CHANGING THEIR PRIVATE OWNERSHIP OR CONSUMPTION.

    Plant flowers that neighbor likes. FUNDAMENTAL. Neighbor's ownership unaffected.


Consumer theory markets and economic welfare

  • Which allocations are efficient?

    Answer is related to

  • Fundamental Externality: effect of one agent’s actions on others’ welfare or production possibilities WITHOUT CHANGING THEIR PRIVATE OWNERSHIP OR CONSUMPTION.

    Apple introduces iPad, reducing Amazon Kindle profit. NOT FUNDAMENTAL.


Consumer theory markets and economic welfare

  • ASSUME

    NO FUNDAMENTAL EXTERNALITIES.

  • A. Consumers care only about own private consumption, and

  • B. Firms' technological possibilities don't depend on others' actions.

  • Then an allocation is inefficient if mutually beneficial trade is possible.

  • Traders benefit; others are not affected.


First welfare theorem

First Welfare Theorem

Competitive equilibrium allocation is efficient

IF

there is a market for every good including all possible forms of insurance;

there are no fundamental externalities; and

there is a divisible, desirable good for each consumer.


Why efficiency of ce

Why Efficiency of CE?

Agents face same prices. CE equates marginal rates of substitution across agents; no small mutually beneficial trades.

Proof has to cover big trades too.

Pareto improvement requires more expensive net trades by consumers. But the money value of consumers' total net trade = firms' total profit, so higher value net trade requires at least one firm to make more profit--impossible if it is already maximizing profit.


Welfare theorem does not say

Welfare Theorem does NOT say

free markets yield efficient allocation.

Potential Problems

Noncompetitive behavior

Inefficient externalities (fundamental or not).


Welfare theorem does not say1

Welfare Theorem does NOT say

free markets yield efficient allocation.

Potential Problems

1. Noncompetitive Behavior

Market power: Traders take account of their effect on prices (oligopoly, unions,...).

Theft, violence, sabotage, ...

Consumers do not stay in budget sets;

Firms break contracts, sabotage rivals.

Nonrational behavior or other goals.


Potential problems

Potential Problems

  • Fundamental Externalities

    environmental, technological,

    empathy, status concerns, envy, ... .

  • Asymmetric information about quality

    Theorem assumes identical goods in each market; BUT some firms sell junk;

    some workers shirk.

    Still can get efficiency if qualities differ, but agents don’t notice or don’t care.


First theorem does not say

First theorem does not say

If all producers and consumers act as perfect competitors and a market exists for every commodity, with no fundamental externalities, efficient allocation emerges.

WHY NOT?

a.Competitive equilibrium may not exist.

Can’t exist with significant increasing returns.

  • Equilibrium may not be reached:

    optimism, pessimism; prices overshoot.

    Anything possible in model, Sonnenschein '73


Sample exam problem 1

Sample Exam Problem 1

Suppose that every consumer in a private ownership economy prefers one feasible allocation A to another allocation B. We can draw the following conclusion(s):

a. A is Pareto efficient.

b. A is not Pareto efficient.

c. B is Pareto efficient.

d. B is not Pareto efficient.

e. None of the above.

.


Sample exam problem 2

Sample Exam Problem 2

The first fundamental welfare theorem states that under certain assumptions a competitive equilibrium allocation is Pareto efficient. Which of the following are NOT among the assumptions?

a. There is a market for every good.

b. The only externalities are fundamental ones.

c. Gov taxes negative externalities.

d. There are no increasing returns in consumption and production.


Increasing returns firms supply

Increasing returns + firms’ supply

C(Q) = total cost

C(0) = sunk cost (due even with no output)

V(Q) = C(Q) ─ C(0) = variable cost

A(Q) = C(Q)/Q = average cost, cost per unit

AVC(Q) = V(Q)/Q = average variable cost

MC(Q) =marginal cost, cost of next unit

when Q units are produced

Increasing returns to scale  A(Q)  as Q 

 A(Q) > MC(Q) marginal cost below ave.

Marginal cost pulls average down.


Competitive supply

Competitive Supply

price or cost per unit of output

AVC(Q) average variable cost

P

At output level Q,raising output raises profit since P > MC(Q)

MC(Q) marginal cost

output

Q

MC curvepasses throughlowest point of AVC curve. Output units are small, so curves look smooth.


Competitive supply1

Competitive Supply

price or cost per unit of output

AVC(Q) average variable cost

P

Raising output beyond Q* reduces profit:

P<MC(Q) if Q>Q*

MC(Q) marginal cost

output

Q

Q*

MC curvepasses throughlowest point of AVC curve. Output units are small, so curves look smooth.


Competitive supply2

Competitive Supply

price or cost per unit of output

AVC(Q) average variable cost

P

P'

At price P'

best output is Q'

P"

MC(Q) marginal cost

output

Q

Q'

Q*

MC curvepasses throughlowest point of AVC curve. Output units are small, so curves look smooth.


Competitive supply3

Competitive Supply

price or cost per unit of output

AVC(Q) average variable cost

P

P'

At price P"

best output is 0

P"<minimum ofAVC

P"

MC(Q) marginal cost

output

Q

Q'

Q*

MC curvepasses throughlowest point of AVC curve. Output units are small, so curves look smooth.


Competitive supply4

Competitive Supply

price or cost per unit of output

AVC(Q) average variable cost

P

P'

At price P"

best output is 0

P"<minimum ofAVC

P"

MC(Q) marginal cost

output

Q

Q'

Q*

MC curvepasses throughlowest point of AVC curve. Output units are small, so curves look smooth.


Competitive supply5

Competitive Supply

price or cost per unit of output

AVC(Q) average variable cost

P

Supply curve: part of MC curve, part of vertical axis. Supply = 0 at price < min AVC

P'

min AVC

P"

MC(Q) marginal cost

output

Q

Q'

Q*

MC curvepasses throughlowest point of AVC curve. Output units are small, so curves look smooth.


Competitive supply6

Competitive Supply

price or cost per unit of output

AVC(Q) average variable cost

P

Supply curve: part of MC curve, part of vertical axis. Supply = 0 at price < min AVC

P'

min AVC

MC(Q) marginal cost

output

Q

Q'

Q*

MC curvepasses throughlowest point of AVC curve. Output units are small, so curves look smooth.


Competitive supply7

Competitive Supply

price or cost per unit of output

AVC(Q) average variable cost

P

Supply curveis broken. Output levels 0< Q <Q" never chosen.

P'

min AVC

MC(Q) marginal cost

output

Q

Q"

MC curve passes through lowest point of AVC curve. Output units are small, so curves look smooth.


Competitive supply8

Competitive Supply

price or cost per unit of output

AVC(Q) average variable cost

P

With demand curve like this, there is no equilibrium price equating supply and demand.

P'

min AVC

MC(Q) marginal cost

output

Q

Q"

MC curve passes through lowest point of AVC curve. Output units are small, so curves look smooth.


Increasing returns and benefits of markets

Increasing Returns and Benefits of Markets

In competitive eq, firms cannot have increasing returns where they operate. If they have increasing returns where they operate, they could make more profit by moving in the direction of the increasing returns. They are not maximizing profit at current prices.

The fundamental welfare theorems do not apply.

But markets still contribute to efficiency even if full efficiency is not attained:

Markets allow firms to reach more customers and take advantage of increasing returns. Fewer firms survive, but their average costs are lower.


Competitive supply9

Competitive Supply

price or cost per unit of output

AVC(Q) average variable cost

P

Problem: competitive firm never produces where AVC is decreasing.

P'

min AVC

MC(Q) marginal cost

output

Q

Q'

Q*

MC curvepasses throughlowest point of AVC curve. Output units are small, so curves look smooth.


Producer surplus

Producer Surplus

price or cost per unit of output

AVC(Q) average variable cost

P

P

At price P, variable profit = producer surplus = area to left of supply curve below P

min AVC

MC(Q) marginal cost

output

Q*

Q'

Q

MC curvepasses throughlowest point of AVC curve. Output units are small, so curves look smooth.


Producer surplus1

Producer Surplus

price or cost per unit of output

AVC(Q) average variable cost

P

P

At P and Q*, variable profit = PQ*─ VC(Q*) =area of rectangle to left of Q* above min AVC, below P

min AVC

MC(Q) marginal cost

output

Q*

Q*

Q'

Q

MC curvepasses throughlowest point of AVC curve. Output units are small, so curves look smooth.


Producer surplus2

Producer Surplus

price or cost per unit of output

AVC(Q) average variable cost

P

P

Raising output above Q* raises variable profit by solid line: P─ MC

min AVC

MC(Q) marginal cost

output

Q*

Q*

Q'

Q

MC curvepasses throughlowest point of AVC curve. Output units are small, so curves look smooth.


Producer surplus3

Producer Surplus

price or cost per unit of output

AVC(Q) average variable cost

P

P

Keep raising output above Q* get more solid lines of variable profit.

min AVC

MC(Q) marginal cost

output

Q*

Q*

Q'

Q

MC curvepasses throughlowest point of AVC curve. Output units are small, so curves look smooth.


Producer surplus4

Producer Surplus

price or cost per unit of output

P

P

At price P, and output Q, variable profit = area to left of supply curve below P = producer surplus

min AVC

MC(Q) marginal cost

output

Q*

Q'

Q

MC curvepasses throughlowest point of AVC curve. Output units are small, so curves look smooth.


Consumer surplus

Consumer Surplus

price or cost per unit of output

Height of demand curve is marginal benefit (willingness to pay for last unit). Net benefit of each unit is difference between demand curve height and price P. Sum of these differences is consumer surplus = area to left of demand curve above P.

AVC(Q) average variable cost

P

P'

output

Q

MC curve passes through lowest point of AVC curve. Output units are small, so curves look smooth.


Consumer surplus1

Consumer Surplus

price or cost per unit of output

Height of demand curve is marginal benefit (willingness to pay for last unit). Net benefit of each unit is difference between demand curve height and price.Sum of these differences is consumer surplus = area to left of demand curve above P.

AVC(Q) average variable cost

P

P'

output

Q

MC curve passes through lowest point of AVC curve. Output units are small, so curves look smooth.


Consumer surplus2

Consumer Surplus

price or cost per unit of output

Height of demand curve is marginal benefit (willingness to pay for last unit). Net benefit of each unit is difference between demand curve height and price.Sum of these differences is consumer surplus = area to left of demand curve above P.

AVC(Q) average variable cost

P

P'

output

Q

MC curve passes through lowest point of AVC curve. Output units are small, so curves look smooth.


Consumer surplus3

Consumer Surplus

price or cost per unit of output

Height of demand curve is marginal benefit (willingness to pay for last unit). Net benefit of each unit is difference between demand curve height and price. Sum of these differences is consumer surplus = area to left of demand curve above P.

AVC(Q) average variable cost

P

P'

output

Q

MC curve passes through lowest point of AVC curve. Output units are small, so curves look smooth.


Competitive equilibrium and total surplus

Competitive Equilibrium and Total Surplus

price or cost per unit of output

For private goods without externalitites, total surplus is maximized at competitive equilibrium.

AVC(Q) average variable cost

P

P'

output

Q

MC curve passes through lowest point of AVC curve. Output units are small, so curves look smooth.


Second welfare theorem

Second Welfare Theorem

In an economy with no fundamental externalities

and no significant increasing returns,

every efficient allocation is a competitive

equilibrium allocationafter redistribution of initial ownership or lump sum transfers.

LUMP SUM TRANSFER to an agent:

Agent cannot affect the amount transferred.

Positive transfer: goods or money given to agent;

Negative transfer: goods or money taken away

Negative lump sum transfer = lump sum tax

In Theorem: No bias. Efficient is eq with transfers.


Second welfare theorem1

Second Welfare Theorem

In an economy with no fundamental externalities

and no significant increasing returns,

every efficient allocation is a competitive

equilibrium allocationafter redistribution of initial ownership or lump sum transfers.

LUMP SUM TRANSFER or TAX leaves prices same for all agents, so MRS can be equal for all.

Other transfers or taxes are distortionary: depend on how much is traded, make buyers and sellers face different prices (example: payroll tax used to pay social security benefits).


Second welfare theorem2

Second Welfare Theorem

In an economy with no fundamental externalities

and no significant increasing returns,

every efficient allocation is a competitive

equilibrium allocationafter redistribution of initial ownership or lump sum transfers.

LUMP SUM TRANSFER (positive or negative):

Agent cannot affect the amount.

In Theorem: No bias. Under assumptions, every efficient allocation is equilibrium with transfers.


Consumer theory markets and economic welfare

With significant increasing returns, and

decentralized information

(only consumers know their preferences;

only firms know their production possibilities)

NO ALLOCATION MECHANISM ASSURES

PARETO EFFICIENT ALLOCATION.

Calsamiglia, Hurwicz (1975)


Summary free markets and efficiency

Summary: Free Markets and Efficiency

Pareto efficiency; Fundamental externality.

Without fundamental externalities, efficiency requires traders to have equal rates of substitution for each pair of divisible goods.

In CE, these rates of substitution are equated.

Conclusion: With small fundamental externalities, competition reaching eq yields nearly efficient allocation.Problems: missing or limited markets; competitive behavior impossible with significant increasing returns; eq may never be reached.


Summary free markets and efficiency1

Summary: Free Markets and Efficiency

Pareto efficiency; Fundamental externality.

Without fundamental externalities, efficiency requires traders to have equal rates of substitution for each pair of divisible goods.

In CE, these rates of substitution are equated.

Conclusion: With small fundamental externalities, competition reaching eq yields nearly efficient allocation.Problems:With big fundamental externalities, equal private rates of substitution are inefficient.


Summary free markets and efficiency2

Summary: Free Markets and Efficiency

Pareto efficiency; Fundamental externality.

Without fundamental externalities, efficiency requires traders to have equal rates of substitution for each pair of divisible goods.

In CE, these rates of substitution are equated.

Potential gov roles: promoting markets, making up for missing or limited ones, regulating externalities, promoting competition where inefficient externalities are small.


Summary free markets and efficiency3

Summary: Free Markets and Efficiency

Pareto efficiency; Fundamental externality.

Without fundamental externalities, efficiency requires traders to have equal rates of substitution for each pair of divisible goods.

In CE, these rates of substitution are equated.

Markets sometimes contribute to efficiency where fundamental welfare theorems do not apply: allow taking advantage of increasing returns.


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