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Lesson 3

Lesson 3. The Meaning of Price, Value, and Economic Efficiency. Consumer and Producer Surplus. Diamond Water Paradox. Efficiency of Competitive Market equilibrium Efficiency Implications of Price Controls and Taxes. Area under demand = total value of that output. 1. P 1. 2. 3. P e. 5.

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Lesson 3

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  1. Lesson 3 The Meaning of Price, Value, and Economic Efficiency. Consumer and Producer Surplus. Diamond Water Paradox. Efficiency of Competitive Market equilibrium Efficiency Implications of Price Controls and Taxes.

  2. Area under demand = total value of that output 1 P1 2 3 Pe 5 4 D Qe Q1 Total Value of Qe Units= 1+2+3+4+5 Total Value of Q1 Units= 1+2+4

  3. Area under supply = total cost (net of fixed costs) P1 Pe 1 2 Q1 Qe Increase in Total Cost when output increases from Q1 to Qe =1+2

  4. Role of Price • Mechanism for Allocating Goods in Markets: willingness to pay. • What are alternative mechanisms? • First come, first served • Strongest and most Powerful • Random Selection • Friends and relatives

  5. Meaning of Price • What is the meaning of price when it is used to allocate goods? What does a high, or a low, price tell us about the product? • Diamond-Water paradox: why are diamonds expensive when water is so cheap?

  6. Meaning of Price (diamond-water Paradox Average Value Water PA Dwater Swater Pw Qw Total Value of Water is entire area Average value of water is mid value of water used. So what does price measure?

  7. Meaning of Price (continued) Sdiamonds Average Value Diamonds Pd Ddiamonds QDiamonds value of diamonds

  8. Meaning of Price (continued) Sdiamonds Average Value Water Average Value Diamonds Pd Dwater Swater Pw Ddiamonds Qw QDiamonds Total Value of Water is greater than value of diamonds Average value of water is also greater. So what does price measure?

  9. Meaning of Price in Markets • Price Measures the value of the last unit sold, or marginal unit. • Price, therefore, is unrelated to average or total value of a product. • Salary, which is the price of labor, need not be related to the “value” of the worker or the work. • How can one group of workers generate higher wages for themselves?

  10. Consumer and Producer Surplus • Consumer surplus is the difference between the price paid and the higher price that consumers would have been willing to pay for the product. • Producer surplus is the difference between the payment received and the minimum payment that producers would have accepted.

  11. Consumer and Producer Surplus P1 1 3 Pe 4 2 Qe Q1 CS = 1 PS = 2 DWL = 3+4

  12. Price Controls • Artificial Government Restraint of Price • Can be a floor, or a ceiling • Popular during wars, or in non-market economies • Simple view: distortion in output • More complete view: wrong consumers get product.

  13. Price Floor at P1 1 P1 7 2 3 Pe 8 5 4 6 Q1 Qe CS Before Price Control= 1+2+3 Ps Before Price Control = 4+5+6 CS After Price Control = 1 PS After Price Control = 2+4+6

  14. Price Floor at P1 AND wrong producers 1 P1 7 2 8 3 Pe 5 4 6 Q1 Qe Q0 Q2 CS Before Price Control= 1+2+3+8 Ps Before Price Control = 4+5+6 CS After Price Control = 1 PS After Price Control = 2

  15. Rent Control (Price Ceiling) 1 2 3 Pe 5 4 transfer 7 Prc 6 Q1 Qe CS Before Price Control= 1+2+3 Ps Before Price Control = 4+5+6 CS After Price Control = 1+2+4 PS After Price Control = 6

  16. Government guarantees price at P1 and and sells output at market clearing price S 1 P1 7 2 3 Pe 8 5 4 10 6 Pclearing Revenue from Consumers 9 D Q1 Qe Q2 CS After Price Control = 1+2+3+4+5+6+10 PS After Price Control = 2+3+4+5+7+9 CS Before Price Control= 1+2+3 Ps Before Price Control = 4+5+9 Taxpayers = 2+3+4+5+6+7+8+10

  17. Government guarantees price at P1 and burns any output it can not sell at that price 1 P1 7 2 3 Pe 8 5 4 10 6 Pclearing 9 11 12 Q1 Qe Q2 CS After Price Control = 1 PS After Price Control = 2+3+4+5+7+9 Taxpayers = 3+5+6+7+8+10+11+12 CS Before Price Control= 1+2+3 Ps Before Price Control = 4+5+9

  18. Who Pays For A Tax? • Terminology in Book is not exactly correct. • Two forms of analysis: decreasing supply or decreasing demand. • Tax burden is shared depending on slope of both curves.

  19. St Tax from consumer’s vantage S }amount of tax P1 Pe Price Paid by Consumer D Qe Q1

  20. Tax from producer’s vantage S P1 Pe Price received by Producer P0 }amount of tax D Qe Q1 Dt

  21. Distortion from Tax St S }amount of tax P1 Price Paid by Consumer Pe P0 D Qe Q1

  22. Instance of Tax borne by Producer S1 P S P1 Price Paid by Consumer D with infinite elasticity Q1 Q2 Q

  23. Instance of Tax borne by Consumer D with zero elasticity S1 P S P1 Price Paid by Consumer P0 Q0 Q

  24. Instance of Tax borne by Consumer P S with infinite elasticity P0 Price Received by Producer D Dt Q1 Q0 Q

  25. Instances of Tax borne by producer P S with zero elasticity P0 Price Received by Producer P1 D Dt Q0 Q

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