Finance 30210: Managerial Economics

Finance 30210: Managerial Economics

Supply, Demand, and Equilibrium

Bushels of Wheat

Total Cost

1 $2

2 $5

3 $9

4 $14

5 $20

6 $27

7 $35

Bushels of Wheat

Total Cost

1 $3

2 $7

3 $12

4 $18

5 $25

6 $33

7 $42

Bushels of Wheat

Total Cost

1 $1

2 $3

3 $6

4 $10

5 $15

6 $21

7 $28

Suppose that you are the “Wheat Czar”. You are asked to use the three farmers to produce 15 bushels of wheat as cheaply as possible.

Farmer #1 Farmer #2 Farmer #3

You decide that farmers 1 and 3 are the cheapest so you have them produce as much as possible and then have farmer 2 make up the rest. Could you do better?

66$3$35$28$ TC

Bushels of Wheat

Total Cost

1 $2

2 $5

3 $9

4 $14

5 $20

6 $27

7 $35

Bushels of Wheat

Total Cost

1 $3

2 $7

3 $12

4 $18

5 $25

6 $33

7 $42

Bushels of Wheat

Total Cost

1 $1

2 $3

3 $6

4 $10

5 $15

6 $21

7 $28

Suppose that you are the “Wheat Czar”. You are asked to use the three farmers to produce 15 bushels of wheat as cheaply as possible.


By having farmer #3 scale back by one bushel, you save $7

By having farmer #2 scale up by one bushel, you spend $4

63$7$35$21$ TC

The same 15 bushels are produced at a net $3 savings!

Bushels of Wheat

Total Cost

1 $2

2 $5

3 $9

4 $14

5 $20

6 $27

7 $35

Consider the following farmer:

Average Cost vs. Marginal Cost

50.3$414$

QTCAC

5$349$14$

QTCMC

Bushels of Wheat

Total Cost

Average Cost

Marginal Cost

1 $2 $2 $2

2 $5 $2.50 $3

3 $9 $3 $4

4 $14 $3.50 $5

5 $20 $4 $6

6 $27 $4.50 $7

7 $35 $5 $8

Average Cost is simply the total cost divided by quantity produced

Marginal Cost refers to the additional costs incurred by producing on more unit

Bushels of Wheat

Marginal Cost

1 $2

2 $3

3 $4

4 $5

5 $6

6 $7

7 $8

Bushels of Wheat

Marginal Cost

1 $3

2 $4

3 $5

4 $6

5 $7

6 $8

7 $9

Bushels of Wheat

Marginal Cost

1 $1

2 $2

3 $3

4 $4

5 $5

6 $6

7 $7

Suppose that you are the ‘Wheat Czar”. You are asked to use the three farmers to produce 15 bushels of wheat as cheaply as possible.

The efficient (lowest cost solution) is where marginal costs are equal across all producers.

59$21$18$20$ TC


Suppose that rather than choosing what each farmer grows you make the offer ‘I will buy any wheat produced for $6”.

Farmer #1

Bushels of Wheat

Total Revenue (P*Q)

Total Cost

Profit

1 $6 $2 $4

2 $12 $5 $7

3 $18 $9 $9

4 $24 $14 $10

5 $30 $20 $10

6 $36 $27 $9

7 $42 $35 $7

At a $6 price, Farmer #1 would choose to produce 5 bushels as a profit maximizing decision. (P=MC)

Farmer #1’s decision is not only individually optimal, but socially optimal (efficient) as well!! Further, this solution requires no information on individual farmers’

Bushels of Wheat

Marginal Cost

1 $2

2 $3

3 $4

4 $5

5 $6

6 $7

7 $8

Bushels of Wheat

Marginal Cost

1 $3

2 $4

3 $5

4 $6

5 $7

6 $8

7 $9

Bushels of Wheat

Marginal Cost

1 $1

2 $2

3 $3

4 $4

5 $5

6 $6

7 $7

At a stated market price of $4, each farmer chooses to produce up to the point where P=MC

Farmer #1 Farmer #2 Farmer #3Market Price

Total Supply

$1 1

$2 3

$3 6

$4 9

$5 12

$6 15

$7 18

Market Supply

The market supply function simply adds up the decisions of each farmer at each potential market price

Market Price

Total Supply

$1 1

$2 3

$3 6

$4 9

$5 12

$6 15

$7 18

Market Supply

PSQS Quantity Supplied

“Is a function of”

Market Price (+)

A Supply Function represents the rational decisions made by a representative firm(s)

Bushels of Wheat

Price

$4.00

9

S

$6.00

15

Now, as “Wheat Czar” you have 15 bushels of wheat to distribute amongst your citizens. To whom do you give the wheat?

Bushels of Wheat

Marginal Value

1 $18

2 $16

3 $14

4 $12

5 $10

6 $8

7 $6

Bushels of Wheat

Marginal Value

1 $10

2 $8

3 $6

4 $4

5 $2

6 $1

7 $0

Bushels of Wheat

Marginal Value

1 $14

2 $12

3 $10

4 $8

5 $6

6 $4

7 $2

Citizen #1 Citizen #2 Citizen #3

Note: Marginal value is the dollar amount each citizen is willing to pay for each additional bushel of wheat

Suppose we started out with citizens 1 and 3 getting 7 bushels each and citizen 2 getting one. We could do better, right?

Total Value = $84 Total Value = $10 Total Value = $56 Total = $150


Bushels of Wheat

Marginal Value

1 $18

2 $16

3 $14

4 $12

5 $10

6 $8

7 $6

Bushels of Wheat

Marginal Value

1 $10

2 $8

3 $6

4 $4

5 $2

6 $1

7 $0

Bushels of Wheat

Marginal Value

1 $14

2 $12

3 $10

4 $8

5 $6

6 $4

7 $2


Note: Marginal value is the dollar amount each citizen is willing to pay for each additional bushel of wheat

By taking a bushel from #3 and giving it to #2, we get a net gain of $6 (A loss of $2 by #3 and a gain of $8 by #2)



Bushels of Wheat

Marginal Value

1 $18

2 $16

3 $14

4 $12

5 $10

6 $8

7 $6

Bushels of Wheat

Marginal Value

1 $10

2 $8

3 $6

4 $4

5 $2

6 $1

7 $0

Bushels of Wheat

Marginal Value

1 $14

2 $12

3 $10

4 $8

5 $6

6 $4

7 $2


As with the farmers, the best allocation is where values by all citizens (at the margin) are equal.

By taking a bushel from #3 and giving it to #2, we get a net gain of $6 (A loss of $2 by #3 and a gain of $8 by #2) – As with the producers, announcing “I will sell wheat at $6/ bushel” would accomplish the same thing!


Bushels of Wheat

Marginal Value

1 $18

2 $16

3 $14

4 $12

5 $10

6 $87 $6

Bushels of Wheat

Marginal Value

1 $10

2 $8

3 $6

4 $4

5 $2

6 $1

7 $0

Bushels of Wheat

Marginal Value

1 $14

2 $12

3 $10

4 $8

5 $6

6 $4

7 $2


At a market price of, say $6, each buyer decides how much to purchase

The market demand function simply adds up the decisions of each citizen at each potential market price

Market Price Bushels of Wheat

$2 19

$4 17

$6 15

$8 12

$10 9

$12 6

$14 4

Quantity

Price

$6

15

PDQD Quantity Demanded


Market Price (-)

A Demand Function represents the rational decisions made by a representative consumer(s)

Market Price Bushels of Wheat

$2 19

$4 17

$6 15

$8 12

$10 9

$12 6

$14 4D

$10

9

Bushels of Wheat

Marginal Value

1 $18

2 $16

3 $14

4 $12

5 $10

6 $8

7 $6

Bushels of Wheat

Marginal Value

1 $10

2 $8

3 $6

4 $4

5 $2

6 $1

7 $0

Bushels of Wheat

Marginal Value

1 $14

2 $12

3 $10

4 $8

5 $6

6 $4

7 $2

Bushels of Wheat

Marginal Cost

1 $2

2 $3

3 $4

4 $5

5 $6

6 $7

7 $8

Bushels of Wheat

Marginal Cost

1 $3

2 $4

3 $5

4 $6

5 $7

6 $8

7 $9

Bushels of Wheat

Marginal Cost

1 $1

2 $2

3 $3

4 $4

5 $5

6 $6

7 $7

Market Price

Bushels of Wheat

$2 19

$4 17

$6 15

$8 12

$10 9

$12 6

$14 4

Market Price

Bushels of Wheat

$1 1

$2 3

$3 6

$4 9

$5 12

$6 15

$7 18

Farmer #1 Farmer #2 Farmer #3 Market Supply

Citizen #1 Citizen #2 Citizen #3 Market Demand

An announcement of “ I will buy and sell at $6” Gets the job done!

Quantity

Price

D

There is no need to even set the price. The market will find the $6 price on its own!

S

$6

15

We would call the $6 price the equilibrium price

Market Price

Bushels of Wheat

$2 19

$4 17

$6 15

$8 12

$10 9

$12 6

$14 4

Market Price

Bushels of Wheat

$1 1

$2 3

$3 6

$4 9

$5 12

$6 15

$7 18

Market SupplyMarket Demand

Quantity

Price

D

A market price below the equilibrium price would create a shortage!

S

$2.00

3 19At a price of $2.00, total supply is 3, but demand is at least 19

Market Price

Bushels of Wheat

$2 19

$4 17

$6 15

$8 12

$10 9

$12 6

$14 4

Market Price

Bushels of Wheat

$1 1

$2 3

$3 6

$4 9

$5 12

$6 15

$7 18

Market Supply Market Demand

Quantity

Price

D

S

$8.00

12 20

At a price of $8.00, total supply is 20, but demand is less than 12

A market price above the equilibrium price would create a surplus!

Market Price

Bushels of Wheat

$2 19

$4 17

$6 15

$8 12

$10 9

$12 6

$14 4

Market Price

Bushels of Wheat

$1 1

$2 3

$3 6

$4 9

$5 12

$6 15

$7 18

$8 20

Market Supply Market Demand

Quantity

Price

D

Note that citizen #1 would’ve paid up to $14 for the third bushel of wheat, but was only charged $6 in the marketplace. The $8 difference is referred to as consumer surplus

S

$6

15

Bushels of Wheat

Marginal Value

Consumer Surplus

1 $18 $12

2 $16 10

3 $14 $8

4 $12 $6

5 $10 $4

6 $8 $2

7 $6 $0

Citizen #1

$14

3

$8

Total = $42

Quantity

Price

D

Also, note that Farmer #1 would’ve sold that 3rd bushel of wheat for as low as $4. The difference a producers marginal cost and the market price is referred to as producer surplus.

S

$6

15

$4

3

$2

Total = $10

Bushels of Wheat

Marginal Cost

Producer Surplus

1 $2 $4

2 $3 $3

3 $4 $2

4 $5 $1

5 $6 $0

6 $7 ---

7 $8 ---

Farmer #1

Farmer #1

Bushels of Wheat

Marginal Cost

Producer Surplus

1 $2 $4

2 $3 $3

3 $4 $2

4 $5 $1

5 $6 $0

6 $7 $---

7 $8 $---

Bushels of Wheat

Marginal Cost

Producer Surplus

1 $3 $3

2 $4 $2

3 $5 $1

4 $6 $0

5 $7 $---

6 $8 $---

7 $9 $---

Bushels of Wheat

Marginal Cost

Producer Surplus

1 $1 $5

2 $2 $4

3 $3 $3

4 $4 $2

5 $5 $1

6 $6 $0

7 $7 $---

Farmer #2 Farmer #3

Bushels of Wheat

Marginal Value

Consumer Surplus

1 $18 $12

2 $16 10

3 $14 $8

4 $12 $6

5 $10 $4

6 $8 $2

7 $6 $0

Citizen #1Bushels of Wheat

Marginal Value

Consumer Surplus

1 $10 $4

2 $8 $2

3 $6 $0

4 $4 $---

5 $2 $---

6 $1 $---

7 $0 $---

Citizen #2Bushels of Wheat

Marginal Value

Consumer Surplus

1 $14 $8

2 $12 $6

3 $10 $4

4 $8 $2

5 $6 $0

6 $4 $---

7 $2 $---

Citizen #3

Total = $10 Total = $6 Total = $15

Total = $42 Total = $6 Total = $20

Quantity

Price

D

A competitive marketplace maximizes the total consumer plus producer surplus. An efficient outcome!

S

15

Total = $68

Consumer Surplus

Producer Surplus

$42 $10

$6 $6

$20 $15

Total = $31

Total = $99$68

$31

Firm Historical Emissions (Tons/yr)

Marginal Abatement Cost ($/Ton)

Apache 50 12

BP 50 18

Chevron 50 24

Devon 50 30

Exxon 50 36

First Texas 50 42

Gulf 50 48

Hess 50 54

Industry Total 400

Example: Suppose we have the following petroleum firms. Further suppose that there is pressure from the public to reduce pollution levels.

How would you go about reducing emissions by 50%

Apache

BP

Chevron

Devon

Exxon

First

Gulf

Hess

$ Per Unit Pollution Reduction

Quantity of Emissions Reduction

$12

$18

$24

$30

$36

$42

$48

$54

The cheapest way to reduce pollution by 50% would be to require the cheapest 4 firms to reduce their emissions completely and let the other four firms continue as in the past

Problems: • Unfair• Requires information on

abatement costs



Tons of emission to be reduced

Total abatement cost

Apache 50 12 25 300

BP 50 18 25 450

Chevron 50 24 25 600

Devon 50 30 25 750

Exxon 50 36 25 900

First Texas 50 42 25 1,050

Gulf 50 48 25 1,200

Hess 50 54 25 1,350

Industry Total 400 200 6,600

We could follow an “across the board” emission reduction program (note: pollution taxes would have the same basic effect)

Example: Cap and Trade as a solution to pollution reduction.Firm Historical

Emissions (Tons/yr)


Apache 50 12

BP 50 18

Chevron 50 24

Devon 50 30

Exxon 50 36

First Texas 50 42

Gulf 50 48

Hess 50 54

Industry Total 400

Could BP profit from selling a pollution permit to Gulf? What should the selling price be?

Let markets work for you!!!

Apache

BP

Chevron

Devon

Exxon

First

Gulf

Hess



Hess

Gulf

First

Exxon

Devon

Chevron

BP

ApacheD

S

The Market for pollution permits

$12

$18

$24

$30

$36

$42

$48

$54

Equ

ilibr

ium

pric

e ra

nge

$33



Initial Permit Holdings

Permits Sold

Permits Bought

Final Permit Holdings

Required Emission Reduction

Emission Abatement Cost

Apache 50 12 25 25 0 0 50 $600

BP 50 18 25 25 0 0 50 $900

Chevron 50 24 25 25 0 0 50 $1200

Devon 50 30 25 25 0 0 50 $1500

Exxon 50 36 25 0 25 50 0 $0

First Texas

50 42 25 0 25 50 0 $0

Gulf 50 48 25 0 25 50 0 $0

Hess 50 54 25 0 25 50 0 $0

Industry Total

400 200 100 100 400 200 $4,200

The cap and trade program lowered the cost of pollution reduction by $2,400 (from $6,600 to $4,200).

Firm Initial Pollution Reduction

Final Pollution Requirement


Abatement Cost Additions/Savings

Permits Bought

Permits Sold

Permit Cost/Permit Revenue

Net Gain

Apache 25 50 (+25) 12 $300 0 25 -$825 -$525

BP 25 50 (+25) 18 $450 0 25 -$825 -$375

Chevron 25 50 (+25) 24 $600 0 25 -$825 -$225

Devon 25 50 (+25) 30 $750 0 25 -$825 -$75

Exxon 25 0 (-25) 36 -$900 25 0 $825 -$75

First Texas 25 0 (-25) 42 -$1050 25 0 $825 -$225

Gulf 25 0 (-25) 48 -$1200 25 0 $825 -$375

Hess 25 0 (-25) 54 -$1350 25 0 $825 -$525

Industry Total

200 200 -$2,400 200 200 $0 -$2,400

Note that cost of purchasing permits equals revenues from selling permits and so add so additional costs. Lets set the equilibrium permit price at $33.

Apache

BP

Chevron

Devon

Exxon

First

Gulf

Hess



Hess

Gulf

First

Exxon

Devon

Chevron

BP

ApacheD

S

The consumer/producer surplus represents the gains by all firms

$12

$18

$24

$30

$36

$42

$48

$54

$33

$525

$375$225

$75

$225$375

$525$75

So far, we have the following:

PDQD Quantity Demanded


Market Price (-)

PSQS Quantity Supplied


Market Price (+)

Quantity

Price

D

S

Q*

CS

PS

Consumer surplus represents all the gains to buyers in the market

Producer surplus represents all the gains to buyers in the market

P*

We can find an equilibrium price where demand equals supply

We could do this numerically as well…

PQD 2100

Every $1 increase in price lowers demand by 2 units

PQS 410

Every $1 increase in price raises supply by 4 units

In Equilibrium SD QQ PP 4102100

P69015$P 70152100 DQ

7015410 SQ

Price

Quantity

S

D

$15

70

PQD 2100 PQS 410

Consumer and producer surplus give us a numerical value of a marketplace…

Price

Quantity

S

D

$15

70

$50

$0

Note: a $50 price will set quantity demanded equal to zero.

Consumer Surplus

225,1$15$50$7021

CS

Producer Surplus

525$0$15$7021

PS

$1225

$525

Demand is not simply a function of price, but is, instead, a function of many variables

• Income• Prices of other goods

(Substitutes vs. Compliments)

• Tastes • Future Expectations• Number of Buyers

,...PDQD


Price Demand Shifters

Quantity

Price

$10

100

D(…)

Holding all the demand shifters constant at some level, quantity demanded at a price of $10 is 100

120

At the initial price of $10, but with a new value for one of the demand shifters, quantity demanded has risen to 120 (An increase in demand)

D(.’.)

Example

Supply is not simply a function of price, but is, instead, a function of many variables

• Technology• Input prices• Number of sellers

,...PDQS


Price Supply Shifters

Quantity

Price

$10

100

S(…)

Holding all the supply shifters constant at some level, quantity supplied at a price of $10 is 100

80

At the initial price of $10, but with a new value for one of the supply shifters, quantity demanded has fallen to 80 (A decrease in supply) S(.’.)

Marginal costs

Example

# of Rooms

Rate per night

000,50$ID

Example: How would the loss in income during the last recession impact the hotel industry?

...S

$150

50,000

000,75$ID

40,000

At the current $150 market price, supply is still 50,000, but with a lower level of income, demand has fallen to 40,000

At the new income level of $50,000, $150 can no longer be the equilibrium price

The decrease in income (which causes a decrease in demand) causes a drop in sales and a drop in market price

# of Rooms

Rate per night

000,50$ID

Example: How would the loss in income during the last recession impact the hotel industry?

...S

$150

50,000

000,75$ID

45,000

$125

Pounds

Price per pound

...D

Example: How would a drop in the wage rate in Columbia influence the price of coffee?

8$wS

$5

10,000 18,000

At the current $5 market price, supply has risen to 18,000, but demand is still at 10,000

At the wage level of $6, $5 can no longer be the equilibrium price

6$wS

Pounds

Price per pound

...D

Example: How would a drop in the wage rate in Columbia influence the price of coffee?

8$wS

$5

10,000 16,000

The lower wage (which causes an increase in supply) , results in a lower price and higher sales

6$wS

$4

We could do this numerically as well…

IPQD 5.2100 PQS 410

Income in thousands

Suppose that average income is $60,000

PPQD 2130605.2100

PriceS

D( I =$60,000)

$20

90

SD QQ PP 4102130

P612020$P 90202130 DQ

9020410 SQ

Suppose that average income is $72,000

PPQD 2136725.2100

PriceS

D( I =$60,000)

$20

90

SD QQ PP 4102136

P612621$P 94212136 DQ

9421410 SQ

Suppose that income rose to $72,000…

D( I =$72,000)

$21

94

Demand curves slope downwards – this reflects the negative relationship between price and quantity. Elasticity of Demand measures this effect quantitatively

Quantity

Price

$2.50

5

000,50$ID

$2.75

4

%20100*554

%10100*50.250.275.2

21020

%%

PQD

D

Consider the following demand curve

Quantity

Price

$30

50

D

PQD

D

%%PQD 5200

We have the elasticity formulaEvery dollar increase in price lowers quantity demanded by 5 units

A little rearranging gives us:

D

DDD Q

PPQ

PQ

%%

Change in quantity per dollar change in price

350305

D

Note that elasticities vary along a linear demand curve

Quantity

Price

$30

50

D

D

DD Q

PPQ 5

%%

PQD 5200

We have the elasticity formulaEvery dollar increase in price lowers quantity demanded by 5 units

350305

D

100 150

$20

$10

1100205

D

333.150105

D

Total revenue equals price times quantity. If you want to increase revenues, should you raise price or lower price?

Quantity

Price

$30

50

D

350305

D

100 150

$20

$10

1100205

D

333.150105

D

PQTR

QPTR %%%

PD %

PTR D %1%

Revenues = $1500

Revenues = $2000

Revenues = $1500

Supply curves slope upwards – this reflects the positive relationship between price and quantity. Elasticity of Supply measures this effect quantitatively

%25100*200200250

%50100*00.200.200.3

5.5025

%%

PQS

s

Quantity

Price

$2.00

200

S

$3.00

250

Consider the following supply curve

Quantity

Price

$25

170

S

PQs

S

%%PQS 620

We have the elasticity formulaEvery dollar increase in price raises quantity supplied by 6 units

A little rearranging gives us:

S

SSs Q

PPQ

PQ

%%

Change in quantity per dollar change in price

88.170256

s

Yom Kippur war oil embargo

Iranian Revolution/ Iran Iraq War Gulf War

OPEC Cuts

911

PDVSA StrikeIraq WarAsian Expansion

Example: What effect would a shutdown of oil production in Iran have on oil prices?

It would be foolish to consider the entire oil market as perfectly competitive, but perhaps considering the non-OPEC market as perfectly competitive market is not entirely crazy

Country Joined OPEC

Production (Bar/D)

Algeria 1969 2,180,000

Angola 2007 2,015,000

Ecuador 2007 486,100

Iran 1960 3,707,000

Iraq 1960 2,420,000

Kuwait 1960 2,274,000

Libya 1962 1,875,000

Nigeria 1971 2,169,000

Qatar 1961 797,000

Saudi Arabia 1960 10,870,000

United Arab Emirates

1967 3,046,000

Venezuela 1960 2,643,000

There are around 100 Non-OPEC countries producing collectively 55M Bar/D.

Country Production (Bar/D)

Russia 9,810,000

United States 8,514,000

China 3,795,000

India 3,720,000

Canada 3,350,000

Suppose that we consider the following supply demand model:

bPaQd

Parameters to be estimated

dPcQs

Parameters to be estimated

To estimate four parameters, we need four pieces of information

Variable 2010 Value

Market Price $67

Market Quantity (Bar/D) 90M

OPEC Supply 35M

Non-OPEC Supply (Bar/D) 55M

Elasticity of Supply (Bar/D) .10

Elasticity of Demand -.05

Competitive SupplyDemand OPEC Supply

35sQ

bPaQd

Let’s start with the demand side first. We can relate the equilibrium elasticity to the parameter ‘b’

d

ddd Q

PPQ

PQ

%%

The parameter ‘b’ represents the change in quantity demanded per dollar change in price

dd Q

Pb

A little rearranging…

PQb d

d

067.679005.

b

Variable 2010 Value

Market Price $67


OPEC Supply 35M




PaQd 067.

Now that we know ‘b’, we can find ‘a’

Again, a little rearranging…

PQa d 067.

5.9467067.90 a

PQd 067.5.94

We are halfway home!

Variable 2010 Value

Market Price $67


OPEC Supply 35M




dPcQs

Repeat the process with the supply side. We can relate the equilibrium elasticity to the parameter ‘d’

s

sss Q

PPQ

PQ

%%

The parameter ‘c’ represents the change in quantity supplied per dollar change in price

ss Q

Pd

A little rearranging…

PQb s

s

082.675510.

d

We’re estimating the non-OPEC supply, so be sure to use only the non-OPEC quantity!

Variable 2010 Value

Market Price $67


OPEC Supply 35M




PcQs 082.

Now that we know ‘d’, we can find ‘c’

Again, a little rearranging…

PQc s 082.

5.4967082.55 c

PQs 082.5.49

That’s it!

Variable 2010 Value

Market Price $67


OPEC Supply 35M




Suppose that we consider the following supply demand model:

PQd 067.5.94 PQs 082.5.49

Let’s double check our results

Variable 2010 Value

Market Price $67

Market Quantity (Bar/D)

90


35sQ

67$149.10

082.5.4935067.5.94

PP

PPQQ sd

9067067.5.94 dQ

Now, back to the original question. Suppose that Iran’s oil supply is shut down. OPEC supply drops by 4 BBD

PQd 067.5.94 PQs 082.5.49

Now factor that into the Supply/Demand Model

Variable

Market Price $94

Market Quantity (Bar/D)

88


31sQ

94$149.14

082.5.4931067.5.94

PP

PPQQ sd

8894067.5.94 dQ

Quantity

Price S

D

67$*P

90

'D

86 88

94$'P

Now, back to the original question. Suppose that Iran’s oil supply is shut down. OPEC supply drops by 4 BBD

Variable

Market Price $94

Market Quantity (BBD)

88

OPEC Quantity 31

Non-OPEC Quantity 57

The drop in OPEC supply pushes price up which gives non-OPEC countries the incentive to increase supply

Partial Equilibrium vs. General Equilibrium

Quantity

Price S

D

*P

*Q

'D

Suppose that effective advertising increased the demand for lemonade. What would happen.

A rise in demand should increase sales and increase the price right? Is that all?

Partial equilibrium deals with a disturbance in one market. General Equilibrium recognizes that markets interact with one another and looks at the interrelations between markets

Quantity

Price S

D

*P

*Q

'D

A rise in demand for lemonade should increase sales and increase the price.

Price

Quantity

D

S Price

Quantity

D

S

Sugar Lemons

The rise in lemonade sales should raise demand for lemons and sugar which increases their prices

This increase in marginal costs should lower supply, right!

Where would you rather live? South Bend or Chicago?

Why?

What’s better in Chicago?

Pretty much everything is better in Chicago!

What’s better in South Bend?

It’s cheaper in South Bend!

The indifference principle states that once everything is accounted for, every city must be equally desirable. Otherwise, who would choose to live in an inferior city.

Houses

S

D

000,86$

Houses

Median Home Price S

D

000,238$

South Bend Housing marketChicago Housing Market

Lets say that the key advantage to South Bend is its low housing costs. If Chicago was still preferred, South Bend residents would start moving to Chicago – this will magnify the benefits of South Bend (cheaper housing)

Median Home Price

The difference between housing costs should just offset any advantages Chicago has!

Question: Are we in an ‘Education Bubble”?

Can we really justify the rapidly rising costs of college tuition or are students getting in over their heads taking out loans that they will never be able to afford?

Employees

Salary

S

D

000,26$

Employees

Salary S

D

000,38$

Enrollment

Tuition

D

S

$15,000

High School Labor Force College Educated Labor Force

Universities

Can these markets be in equilibrium?

Consider the earnings across different ages and different education levels.

Age Group

Attainment 25-29 30-34 35-39 40-44 45-49 50-54 55-59

College $43,121 $55,440 $62,244 $65,973 $66,280 $64,254 $65,240

High School $28,097 $31,366 $33,443 $35,283 $36,316 $35,270 $37,573

Differential $15,024 $24,074 $28,801 $30,690 $29,964 $28,984 $27,667

x 5 = $75,120

x 5 = $144,005

x 5 = $153,450

x 5 = $149,820

x 5 = $144,920

x 5 = $138,335

x 5 = $120,370 =$926,020

This isn’t really right because you don’t get all this money up front

386,350$

05.1667,27$...

05.1024,15$

05.1024,15$

3954 PV

You receive the first payment 4 years from now

Lets assume that you could earn 5% elsewhere

What are the costs of going to college?

Cost Annual Expense

Tuition $15,000

Lost Wages $20,000

Books, Fees, etc $1,000

Room & Board $5,000

This is not a relevant cost…you would have paid this anyways!!!

$36,000 x 4 = $144,000Note: we really should discount these costs as well!

386,350$

05.1667,27$...

05.1024,15$

05.1024,15$

3954 PV

So, a college education costs $144,000 and yields $350,386 in (discounted) lifetime benefits! Seems worth it!

Alternatively, we can think about the annual salary differential for a college graduate like the annual payout on a bond. The annual return to a college education would be like calculating the return necessary so that the PV of the wage differential equals the cost

Cost Annual Expense

Tuition $15,000

Lost Wages $20,000

Books, Fees, etc $1,000 $36,000 x 4 = $144,000Note: we really should discount these costs as well!

000,144$

1667,27$...

1024,15$

1024,15$

3954

iii

PV

Annual return %11i

Thought of as an investment, a college education pays 11% per year!!

Employees

Salary

S

D

000,26$

Employees

Salary S

D

000,38$

Enrollment

Tuition

D

S

$15,000

High School Labor Force College Education Labor Force

Universities

If the costs of college were truly less than the benefits, we would see more people go to school

Wage differentials would fall and college tuitions would increase

Employees

Salary

S

D

000,26$

Employees

Salary S

D

000,38$

Enrollment

Tuition

D

S

$15,000

High School Labor Force College Education Labor Force

Universities

What we are seeing is a steady increase in demand for skilled labor as demand for unskilled labor falls

Wage differentials continue to increase as college tuitions increase

Finance 30210: Managerial Economics

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