Economics of the Firm

Finance 30210: Managerial EconomicsSupply, Demand, and EquilibriumEfficiency vs. EquityAn allocation of resources that maximum total welfareAn allocation of resources provides a fair distribution of welfareUnder certain circumstances, the competitive market process guarantees thisCan we trust markets to produce a desirable outcome?If we cant have everything we want, so we need to decide what to do with the limited resources we do have.Under what circumstances does the market process result in efficient outcomes?#1: Many buyers and sellers no individual buyer/firm has any real market power#2: Homogeneous products no variation in product across firms#3: No barriers to entry its costless for new firms to enter the marketplace#4: Perfect information prices and quality of products are assumed to be known to all producers/consumers#5: No Externalities ALL costs/benefits of the product are absorbed by the consumer/producer#6: Transactions are costless buyers and sellers incur no costs in an exchange (i.e. no taxes)Can you think of situations where all these assumptions hold?3

50 Fish/hr300 Max/Day30 Fish/hr300 Max/Day20 Fish/hr160 Max/DayLets try an examplesuppose that you are a fisherman. Top catch larger quantities of fish, you have to go farther from shore and your catch per hour dropsZone AZone BZone CYou bought a boat for $1,000Maintenance on the boat is $50/DayYou pay $16/hour in labor costsYou pay $20/hour for fuel and other expensesWhat costs are fixed, sunk, and variable?

50 Fish/hr300 Max/Day30 Fish/hr300 Max/Day20 Fish/hr160 Max/DayLets try an examplesuppose that you are a fisherman. To catch larger quantities of fish, you have to go farther from shore and your catch per hour dropsBoat = $50Labor = $16/hrGas = $20/hrLets take this section by sectionZone AZone BZone CQuantityTotal CostFixed CostVariable CostAverage CostMarginal Cost0$50$50$0------1$50.72$50$.72$50.72$.722$51.44$50$1.44$25.72$.723$52.16$50$2.16$17.39$.72Zone A

# of FishDollarsFC$50TCVC = $.72*F# of FishDollarsMC$.72ACLets try and picture this00

50 Fish/hr300 Max/Day30 Fish/hr300 Max/Day20 Fish/hr160 Max/DayLets try an examplesuppose that you are a fisherman. Top catch larger quantities of fish, you have to go farther from shore and your catch per hour dropsBoat = $50Labor = $16/hrGas = $20/hrLets take this section by sectionZone AZone BZone CQuantityTCFCVCACMC300$266$50$216$0.88$.72301$267.20$50$217.20$0.88$1.20302$268.40$50$218.40$0.88$1.20303$269.60$50$219.60$0.88$1.20Zone B

# of FishDollarsFC$50TCVC =$216 + $1.20*F# of FishDollarsMC$1.20ACLets try and picture this300300$266$.88

50 Fish/hr300 Max/Day30 Fish/hr300 Max/Day20 Fish/hr160 Max/DayLets try an examplesuppose that you are a fisherman. Top catch larger quantities of fish, you have to go farther from shore and your catch per hour dropsBoat = $50Labor = $16/hrGas = $20/hrLets take this section by sectionZone AZone BZone CQuantityTCFCVCACMC600$626$50$576$1.04$1.20601$627.80$50$577.80$1.04$1.80602$629.60$50$579.60$1.04$1.80603$631.40$50$581.40$1.04$1.80Zone C

# of FishDollarsFC$50TCVC =$576 + $1.80*F# of FishDollarsMC$1.80ACLets try and picture this600600$626$1.04# of FishDollarsFC$50TC# of FishDollarsMC$.72All together00$1.20Slope = 1.80Slope = 1.20Slope = .72300600$1.80AC300600Perfectly competitive firms are price takers. They see a market price and cant change it. Suppose that the market price is $1.20.FishPriceTotal RevenueTotal CostProfit0$1.20$0$50-$501$1.20$1.20$50.72-$49.522$1.20$2.40$51.44-$49.043$1.20$3.60$52.16-$48.56300$1.20$360$266$94301$1.20$361.20$267.20$94302$1.20$362.40$268.40$94303$1.20$363.60$269.60$94600$1.20$720$626$94601$1.20$721.20$627.80$93.40602$1.20$721.40$629.60$91.80603$1.20$721.60$631.40$90.20# of FishDollars$50TC# of FishDollars-$50We are looking to maximize profits where profits are the difference between total revenues and total costs00$0Slope = 1.80Slope = 1.20Slope = .72300600$94300600TRProfitProfits are increasingProfits are maximizedProfits are decreasingProfits are increasingProfits are maximizedProfits are decreasingWe could also go at this by looking at costs and benefits at the margin. For a perfectly competitive firm the market price equals marginal revenue.FishTotal CostTotal RevenueMarginal RevenueMarginal Cost0$50$0$1.20$.721$50.72$1.20$1.20$.722$51.44$2.40$1.20$.723$52.16$3.60$1.20$.72300$266$360$1.20$.72301$267.20$361.20$1.20$1.20302$268.40$362.40$1.20$1.20303$269.60$363.60$1.20$1.20600$626$720$1.20$1.20601$627.80$721.20$1.20$1.80602$629.60$721.40$1.20$1.80603$631.40$721.60$1.20$1.80# of FishDollars-$50Lets plot out marginal revenues and costs rather than total costs and revenues0$0$94300600DollarsMC$.720$1.20$1.80300600MRProfitMarginal revenue is greater than marginal costProfits are increasingMarginal revenue is equal to marginal costProfits are maximizedMarginal revenue is less than marginal costProfits are decreasing# of FishDollarsWhen we talk about a supply curve we are talking about the profit maximizing decisions of individual firms at prevailing market prices0$1.20300600DollarsMC$.720$1.20$1.80300600MRAt a market price of $1.20, MR = MC for any quantity of fish between 300 and 600At a market price of $1.20, this firm will be willing to supply any quantity of fish between 300 and 600Now, suppose that the market price is $0.72.FishPriceTotal RevenueTotal CostProfit0$0.72$0$50-$501$0.72$0.72$50.72-$502$0.72$1.44$51.44-$503$0.72$2.16$52.16-$50300$0.72$216$266-$50301$0.72$216.72$267.20-$50.48302$0.72$217.44$268.40-$50.96303$0.72$218.16$269.60-$51.44600$0.72$432$626-$194601$0.72$432.72$627.80-$195.08602$0.72$433.44$629.60-$196.16603$0.72$434.16$631.40-$197.24# of FishDollars$50TC# of FishDollars-$50Again, lets plot revenues, costs, and profits00$0Slope = 1.80Slope = 1.20Slope = .72300600300600TRProfitProfits are maximized (losses are minimized)Profits are decreasingProfits are maximized (losses are minimized)Profits are decreasingFishTotal CostTotal RevenueMarginal RevenueMarginal Cost0$50$0$.72$.721$50.72$0.72$.72$.722$51.44$1.44$.72$.723$52.16$2.16$.72$.72300$266$216$.72$.72301$267.20$216.72$.72$1.20302$268.40$217.44$.72$1.20303$269.60$218.16$.72$1.20600$626$432$.72$1.20601$627.80$432.72$.72$1.80602$629.60$433.44$.72$1.80603$631.40$434.16$.72$1.80We could also go at this by looking at costs and benefits at the margin. For a perfectly competitive firm the market price equals marginal revenue.DollarsMC$.720$1.20$1.80300600MRDollars-$500$0300600ProfitMarginal revenue is equal to marginal costMarginal revenue is less than marginal costProfits are maximizedProfits are decreasingAgain, lets plot marginal revenues, marginal costs, and profits# of FishDollarsWhen we talk about a supply curve we are talking about the profit maximizing decisions of individual firms at prevailing market prices0$1.20300600DollarsMC$.720$1.20$1.80300600MRAt a market price of $.72, MR = MC for any quantity of fish between 0 and 300At a market price of $.72, this firm will be willing to supply any quantity of fish between 0 and 300$.72# of FishDollarsWhen we talk about a supply curve we are talking about the profit maximizing decisions of individual firms at prevailing market prices0$1.20300600DollarsMC$.720$1.20$1.80300600MRAt a market price of $1.80, MR = MC for any quantity of fish between 600 and 760At a market price of $1.80, this firm will be willing to supply any quantity of fish between 600 and 760$.72$1.80# of FishDollarsWhat if the prevailing market was $1.35?0$1.35300600DollarsMC0$1.35300600MRAt a market price of $1.35, 600 fish are profitable to supply, but the 601st is not!At a market price of $1.35, this firm will be willing to supply exactly 600 fish.# of FishDollarsSo we can get an individual firms supply curve by following marginal costs! Suppose that there are 1000 fishermen in the village all with the same costs.0$1.80300600Individual Supply$1.20$.72# of FishDollars0$1.80300,000600,000Market Supply$1.20$.72Market supply adds up the decisions of each individual firm at each prevailing market priceSo where do prices come from? We need to know how many fish people are actually willing to buy at any prevailing market price.# of FishDollars0$1.80500,000900,000$1.20$.72150,000A demand curve is just a record of how much the market collectively is willing to buy at any given market pricePriceFish$2.0050,000$1.80150,000$1.50200,000$1.20500,000$1.00540,000$.72600,000$.50700,000# of FishDollars0$1.80300,000600,000$1.20$.72In equilibrium, total supply should equal total demand. If not, the price will adjust. SupplyDemandPriceFish$2.0050,000$1.80150,000$1.50200,000$1.20500,000$1.00540,000$.72600,000$.50700,000At a $1.80 price, fishermen will bring at least 600,000 fish to the market, but only 150,000 will get sold the price needs to drop At a $.72 price, fishermen will bring at most 300,000 fish to the market, but 600,000 are demanded the price needs to rise500,000In equilibrium, total supply should equal total demandThe market determines the equilibrium price of $1.20 and 500,000 fish sold by the 1,000 fishermenMarketDollars0$1.80300,000600,000$1.20$.72DemandSupply500,000Dollars$.720$1.20$1.80300600IndividualAt the prevailing market price of $1.20, each fisherman supplies between 300 and 600 fishMCMRDollars$.720$1.20$1.80300600MCMRFishTotal RevenueTotal CostProfit300$360$266$94301$361.20$267.20$94302$362.40$268.40$94303$363.60$269.60$94$144Boat = $50Labor = $16/hrGas = $20/hr

* Labor Productivity = 30 Fish/HrPrice= $1.20- Gas Cost = $0.67Labors Value Added= $0.53$16/hr = hourly wageProducer Surplus = $144- Fixed Cost = $50Accounting Profit= $94$94$1,000*100 = 9.4% ReturnA Few DiagnosticsIs this fisherman earning economic profits?# of FishDollars0$1.80300,000600,000$1.20$.72Suppose that the excess returns causes 800 more fishermen (all with identical costs) to enter the market. SupplyDemandPriceFish$2.0050,000$1.80150,000$1.50200,000$1.20500,000$1.00540,000$.72600,000$.50700,000540,0001,080,0001,368,000In equilibrium, total supply should equal total demandThe market determines the equilibrium price of $1.00 and 540,000 fish sold by the 1,800 fishermenMarketDollars0$1.80300,000600,000$1.00$.72DemandSupply540,000Dollars$.720$1.00$1.80300600IndividualAt the prevailing market price of $1.00, each fisherman supplies 300 fishMCMR$1.20Dollars$.720$1.00$1.80300600MCMR$84Boat = $50Labor = $16/hrGas = $20/hr

FishPriceTotal RevenueTotal CostProfit0$1.00$0$50-$501$1.00$1.00$50.72-$49.722$1.00$2.00$51.44-$49.443$1.00$3.00$52.16-$49.16300$1.00$300$266$34 * Labor Productivity = 50 Fish/HrPrice= $1.00- Gas Cost = $0.40Labors Value Added= $0.60$30/hr > hourly wageProducer Surplus = $84- Fixed Cost = $50Accounting Profit= $34$34$1,000*100 = 3.4% ReturnA Few DiagnosticsDollarsMC$.720$1.20$1.80300600Lets see if we cant generalize this a bit. We want marginal costs to be increasing this reflects decreasing productivity at the margin # of FishDollarsFC$50TC0300600# of FishDollarsTC# of FishDollars-$5000$0Slope = P300600$94300600TRProfitF*F*We are still looking for where marginal revenue equals marginal costs (i.e. the slopes are the same)Dollars-$500$0300600ProfitDollarsMC0F*MRP*F*We are still looking for where marginal revenue equals marginal costs34# of FishDollars0P*DollarsMC0P*MR=PF*F*SupplyFor any market price (which equals marginal revenue for a perfectly competitive firm, there is a profit maximizing quantity where MR = MCThat optimizing quantity becomes a point on that firms supply curveWe are still looking for where marginal revenue equals marginal costs# of FishDollars0Individual SupplyP*# of FishDollars0Market SupplyP*We still aggregate decisions across individual suppliers to get market supply (again, assume 1,000 fishermen)F1000*FSupplySupplyIn equilibrium, total supply should equal total demandThe market determines the equilibrium price of $1.44 and 400,000 fish sold by the 1,000 fishermenMarketDollars0$1.44DemandSupply400,000*Dollars0$1.44IndividualAt the prevailing market price of $1.44, each fisherman supplies 400 fishMCMR400Dollars0$1.44400MCMRBoat = $50Labor = $16/hrGas = $20/hr * Labor Productivity = 25 Fish/HrPrice= $1.44- Gas Cost = $.80Labors Value Added= $0.64$16/hr = hourly wageProducer Surplus = $288- Fixed Cost = $50Accounting Profit= $238$238$1,000*100 =23.8% ReturnWe can still perform whatever diagnostics we wantIs this fisherman earning economic profits?PS = (1/2)(400)(1.44)=288$288For this calculation to work, labor productivity must be 25 fish per hour# of FishDollars0$1.44Suppose that the excess returns causes 800 more fishermen (all with identical costs) to enter the market. SupplyDemand400,000$1.03576,000Dollars0$1.44400320720,000Dollars0$1.03320MCMRBoat = $50Labor = $16/hrGas = $20/hr * Labor Productivity = 35 Fish/HrPrice= $1.03- Gas Cost = $.57Labors Value Added= $0.46$16/hr = hourly wageProducer Surplus = $165- Fixed Cost = $50Accounting Profit= $115$115$1,000*100 =11.5% ReturnWe can still perform whatever diagnostics we wantAt 320 fish, your productivity is 35 Fish/hourPS = (1/2)(320)(1.03)=165$165Suppose that we have three fishermen with different productivities. Each bought a boat for $1,000 and have the same costs as before.

30 Fish/hr300 Max/Day20 Fish/hr200 Max/Day10 Fish/hr100 Max/DayBoat = $50Labor = $16/hrGas = $20/hr$1.20 per fish$1.80 per fish$3.60 per fishEach of the above fishermen will provide fish to the marketplace as long as the market price is equal to or greater to their marginal costDollars0$3.60$1.80$1.20Fish300500600

For a market price that is at least $1.20, but below $1.80, only fisherman #1 sells fish. He can supply up to 300 For a market price that is at least $1.80, but below $3.60, fisherman #1 sells 300 fish and fisherman #2 sells up to 200 fish. For a market price that is at least $3.60, fisherman #1 sells 300 fish, fisherman #2 sells 200 fish and fisherman #3 sells 100 fish All a supply curve really does is order production from lowest cost to highest costDollars0$3.60$1.80$1.20Fish300500600

Adding a demand curve will give us the equilibrium price and identify the fisherman who participate in the market as well as the fishermans economic profitsDemandSupply$3.00Boat = $50Labor = $16/hrGas = $20/hrProducer Surplus = $540- Fixed Cost = $50Accounting Profit= $490$490$1,000*100 = 49% ReturnFisherman #1PS= $540- Fixed Cost = $50Accounting Profit= $190$190$1,000*100 = 19% ReturnFisherman #2Producer Surplus = $240PS= $240

Quantity SuppliedIs a function ofMarket Price (+)A Supply Function represents the rational decisions made by a profit maximizing firm(s).QuantityPriceSLower marginal costs are in this portion they will make the largest profitsHigh marginal costs are in this portion they will make the lowest profits (if they are sold)As you move up the supply curve, the rise in price encourages increased production of existing producers (intensive margin) as well as the entry of new producers (extensive margin) Everything we talked about on the supply side is mirrored on the demand side. Just at producers are maximizing profits, consumers maximize their welfare.Welfare0QDollarsMU0F*MC P*F*QWelfare = Total Utility Total Cost Most consumers experience diminishing marginal utility each successive item consumed is worth less in terms of satisfactionBy the same token, a demand curve naturally ranks potential consumers from highest valuation to lowest valuation. Suppose that we have three potential consumers.Would pay up to $2/fish. Can consume 100 fish per week.Would pay up to $1/fish. Can consume 50 fish per week.Would pay up to $.50/fish. Can consume 20 fish per week.What would this demand curve look like?

Dollars0$2$.50Fish100150170$1If fish cost more than $2, nobody buys them!If fish cost between $2 and $1, only Captain buys them!If fish cost between $.50 and $1, Captain AND Andrew Zimmern buy them!If fish cost more less than $.50 , EVERYBODY buys them!PriceQuantity DemandedAbove $20$20 100Between $2 and $1100$1100 - 150Between $1 and $.50150$.50Between 150 and 170Between $.50 and $0170

Dollars0$2$.50Fish100150170$1For any market price, we know how many fish are sold and how much each consumer benefits from the market (consumer surplus)$1.50At a market price of $1.50

Captain buys 100 fish for $1.50 apiece. He saves $.50 per fish for a total of $50 in savings (surplus)Neither the baby of Andrew Zimmern are willing to buy fish for $1.50. CS = $50

Dollars0$2$.50Fish100150170$1For any market price, we know how many fish are sold and how much each consumer benefits from the market (consumer surplus)$.75At a market price of $.75

Captain buys 100 fish for $.75 apiece. He saves $1.25 per fish for a total of $125 in savings (surplus)Andrew Zimmern buys 50 fish for $.75. He saves $.25 per fish for a total of $12.50 in surplusThe baby still is unwilling to buy fish!CS = $125CS = $12.50

QuantityPrice

Quantity DemandedIs a function ofMarket Price (-)A Demand Function represents the rational decisions made by a representative consumer(s)Dhigh marginal valuations are located herelow marginal valuations are located hereAs you move down the demand curve, the lower price encourages increased consumption by existing customers (intensive margin) as well as attracting new consumers (extensive margin)Key Point: Demand curves represent marginal utility (what we are willing to pay for one additional item). Consumer surplus measures total value.QuantityPriceDQuantityPriceD

Water

DiamondsP*P*Example: The Diamond/Water ParadoxMarket Equilibrium: There exists a price where supply equals demand the market will find this price automatically.QuantityPriceDSP*Q*At a price above the equilibrium price, supply is greater than demand. A surplus drives the price down At a price below the equilibrium price, demand is greater than supply. A shortage drives the price up Efficiency vs. EquityAn allocation of resources that maximum total welfareAn allocation of resources provides a fair distribution of welfareUnder certain circumstances, the market process guarantees thisCan we trust markets to produce a desirable outcome?Recall an earlier discussion about allocations of resources.Lets suppose that we are talking about the market for bananas.QuantityPriceDS$51,000$8$2There was a pound of bananas sold that cost $3 to supply and was valued by someone at $7. This transaction created $4 of wealth - $2 went to a seller (producer surplus) and $2 went to a buyer (consumer surplus)There was a pound of bananas sold that cost $2 to supply and was valued by someone at $8. This transaction created $6 of wealth - $3 went to a seller (producer surplus) and $3 went to a buyer (consumer surplus)$3$7Would this transaction be wealth creating? NO!$12$0Competitive markets provide efficient outcomes in that every wealth creating transaction was undertaken. In other words, consumer surplus and producer surplus are maximized.QuantityPriceDS$51,000$0$12Consumer Surplus = (1/2)*($12- $5)*1,000$3,500Producer Surplus = (1/2)*($5- $0)*1,000$2,500Note that $6,000 of wealth was created by this market!FirmHistorical Emissions (Tons/yr)Marginal Abatement Cost ($/Ton)Apache5012BP5018Chevron5024Devon5030Exxon5036First Texas 5042Gulf 5048Hess5054Industry Total400Example: 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%ApacheBPChevronDevonExxonFirstGulfHess$ Per Unit Pollution ReductionQuantity of Emissions Reduction$12$18$24$30$36$42$48$54The cheapest way to reduce pollution by 50% would be to require the cheapest 4 firms to reduce their emissions completely and let the other four firms continue as in the pastProblems: UnfairRequires information on abatement costsFirmHistorical Emissions (Tons/yr)Marginal Abatement Cost ($/Ton)Tons of emission to be reducedTotal abatement costApache501225300BP501825450Chevron502425600Devon503025750Exxon503625900First Texas 5042251,050Gulf 5048251,200Hess5054251,350Industry Total4002006,600We 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.FirmHistorical Emissions (Tons/yr)Marginal Abatement Cost ($/Ton)Apache5012BP5018Chevron5024Devon5030Exxon5036First Texas 5042Gulf 5048Hess5054Industry Total400Could BP profit from selling a pollution permit to Gulf? What should the selling price be?Let markets work for you!!!ApacheBPChevronDevonExxonFirstGulfHess$ Per Unit Pollution ReductionQuantity of Emissions ReductionHessGulfFirstExxonDevonChevronBPApacheDSThe Market for pollution permits$12$18$24$30$36$42$48$54Equilibrium price range$33FirmHistorical Emissions (Tons/yr)Marginal Abatement Cost ($/Ton)Initial Permit HoldingsPermits SoldPermits BoughtFinal Permit HoldingsRequired Emission ReductionEmission Abatement CostApache501225250050$600BP501825250050$900Chevron502425250050$1200Devon503025250050$1500Exxon503625025500$0First Texas 504225025500$0Gulf 504825025500$0Hess505425025500$0Industry Total400200100100400200$4,200The cap and trade program lowered the cost of pollution reduction by $2,400 (from $6,600 to $4,200). FirmInitial Pollution ReductionFinal Pollution RequirementMarginal Abatement Cost ($/Ton)Abatement Cost Additions/SavingsPermits BoughtPermits SoldPermit Cost/Permit RevenueNet GainApache2550 (+25)12$300025-$825-$525BP2550 (+25)18$450025-$825-$375Chevron2550 (+25)24$600025-$825-$225Devon2550 (+25)30$750025-$825-$75Exxon250 (-25)36-$900250$825-$75First Texas 250 (-25)42-$1050250$825-$225Gulf 250 (-25)48-$1200250$825-$375Hess250 (-25)54-$1350250$825-$525Industry Total200200-$2,400200200$0-$2,400Note that cost of purchasing permits equals revenues from selling permits and so add no additional costs. Lets set the equilibrium permit price at $33.ApacheBPChevronDevonExxonFirstGulfHess$ Per Unit Pollution ReductionQuantity of Emissions ReductionHessGulfFirstExxonDevonChevronBPApacheDSThe 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$75We could do this numerically as well

Every $1 increase in price lowers demand by 2 units

Every $1 increase in price raises supply by 3 unitsIn Equilibrium

PriceQuantitySD$2060

Consumer and producer surplus give us a numerical value of a marketplacePriceQuantitySD$2060$50$0Note: a $50 price will set quantity demanded equal to zero.Consumer Surplus

Producer Surplus

$900$600Demand is not simply a function of price, but is, instead, a function of many variablesIncomePrices of other goods (Substitutes vs. Compliments)Tastes Future ExpectationsNumber of Buyers

Is a function ofPriceDemand ShiftersQuantityPrice$10100D()Holding all the demand shifters constant at some level, quantity demanded at a price of $10 is 100120At 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: Increase in Demand# of RoomsRate per night

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

$15050,000

40,000At the current $150 market price, supply is still 50,000, but with a lower level of income, demand has fallen to 40,000At the new income level of $50,000, $150 can no longer be the equilibrium priceThe decrease in income (which causes a decrease in demand) causes a drop in sales and a drop in market price# of RoomsRate per night

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

$15050,000

45,000$125

With I = $10

PriceQuantitySD$2580Every $1 increase in income increases demand by 7 unitsPriceQuantitySD$2580With I = $20

The $10 increase in income raises demand by 70147$36.67Supply is not simply a function of price, but is, instead, a function of many variablesTechnologyInput pricesNumber of sellers

Is a function ofPriceSupply ShiftersQuantityPrice$10100S()Holding all the supply shifters constant at some level, quantity supplied at a price of $10 is 10080At the initial price of $10, but with a new value for one of the supply shifters, quantity demanded has fallen to 80S(..)Marginal costsExample: Decrease in SupplyPoundsPrice per pound

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

$510,00018,000At the current $5 market price, supply has risen to 18,000, but demand is still at 10,000At the wage level of $6, $5 can no longer be the equilibrium price

PoundsPrice per pound

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

$510,00016,000The lower wage (which causes an increase in supply) , results in a lower price and higher sales

$4

With w = $10

PriceQuantitySD$14.1652PriceQuantitySD$1552With w = $20

The $10 increase in wages lowers supply by 5Every $1 increase in wages decreases supply by .5 units50$14.16Demand curves slope downwards this reflects the negative relationship between price and quantity. Elasticity of Demand measures this effect quantitatively QuantityPrice$2.505

$2.754

Note that elasticities vary along a linear demand curveQuantityPrice$3530

6080$20

PQ% Change in Q% Change in PElasticity$3530$34326.7-2.9-2.3$2060$19623.3-5-.61$1080$9822.5-10-.255

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

QuantityPrice$2.00200

$3.00250

Yom Kippur war oil embargoIranian Revolution/ Iran Iraq WarGulf WarOPEC Cuts911PDVSA StrikeIraq WarAsian ExpansionExample: What effect would a shutdown of oil production in Iran have on oil prices?Price in 2010 = $67Iran produces around 4M Barrels per day. This represents around 4% of the total world supply.

We also know that the elasticity of demand for oil is around -.05

With a little rearranging

$67(1.80) = $120It 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 crazyCountryJoined OPECProduction (Bar/D)Algeria19692,180,000Angola20072,015,000Ecuador2007486,100Iran19603,707,000Iraq19602,420,000Kuwait19602,274,000Libya19621,875,000Nigeria19712,169,000Qatar1961797,000Saudi Arabia196010,870,000United Arab Emirates19673,046,000Venezuela19602,643,000There are around 100 Non-OPEC countries producing collectively 55 Million Bar/D. CountryProduction (BBD)Russia9,810,000United States8,514,000China3,795,000India3,720,000Canada3,350,000Suppose that we consider the following supply demand model:

Parameters to be estimated

Parameters to be estimatedTo estimate four parameters, we need four pieces of informationVariable 2010 ValueMarket Price$67Market Quantity (Bar/D)90MOPEC Supply35MNon-OPEC Supply (Bar/D)55MElasticity of Supply (Bar/D).10Elasticity of Demand-.05Competitive SupplyDemandOPEC Supply

Lets start with the demand side first. We can relate the equilibrium elasticity to the parameter b

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

A little rearranging

Variable 2010 ValueMarket Price$67Market Quantity (Bar/D)90MOPEC Supply35MNon-OPEC Supply (Bar/D)55MElasticity of Supply (Bar/D).10Elasticity of Demand-.05

Now that we know b, we can find aAgain, a little rearranging

We are halfway home!Variable 2010 ValueMarket Price$67Market Quantity (Bar/D)90MOPEC Supply35MNon-OPEC Supply (Bar/D)55MElasticity of Supply (Bar/D).10Elasticity of Demand-.05

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

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

A little rearranging

Were estimating the non-OPEC supply, so be sure to use only the non-OPEC quantity!Variable 2010 ValueMarket Price$67Market Quantity (Bar/D)90MOPEC Supply35MNon-OPEC Supply (Bar/D)55MElasticity of Supply (Bar/D).10Elasticity of Demand-.05

Now that we know d, we can find cAgain, a little rearranging

Thats it!Variable 2010 ValueMarket Price$67Market Quantity (Bar/D)90MOPEC Supply35MNon-OPEC Supply (Bar/D)55MElasticity of Supply (Bar/D).10Elasticity of Demand-.05Suppose that we consider the following supply demand model:

Lets double check our resultsVariable 2010 ValueMarket Price$67Market Quantity (MBar/D)90Competitive SupplyDemandOPEC Supply

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

Now factor that into the Supply/Demand Model Variable Market Price$94Market Quantity (Bar/D)88Competitive SupplyDemandOPEC Supply

QuantityPrice

Now, back to the original question. Suppose that Irans oil supply is shut down. OPEC supply drops by 4 BBDVariable Market Price$94Market Quantity (BBD)88OPEC Quantity31Non-OPEC Quantity57The drop in OPEC supply pushes price up which gives non-OPEC countries the incentive to increase supply

Partial Equilibrium vs. General EquilibriumQuantityPrice

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 marketsQuantityPrice

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

PriceQuantityDSPriceQuantityDSSugarLemonsThe rise in lemonade sales should raise demand for lemons and sugar which increases their pricesThis increase in marginal costs should lower supply, right!Where would you rather live? South Bend or Chicago?

Why?Whats better in Chicago?

Pretty much everything is better in Chicago! Whats better in South Bend?

Its 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

HousesMedian Home Price

South Bend Housing marketChicago Housing MarketLets 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 PriceThe difference between housing costs should just offset any advantages Chicago has!Renting vs. Buying a House.whats the better move?Houses

RentalsMedian Rent

South Bend Housing marketSouth Bend Rental MarketMedian Home PriceSuppose that the median rental rate is $600 per month ($7200 per year) and the current mortgage rate is 6%

Can you spot the housing bubble?Houses

US Housing marketMedian Home Price

Easy financing, low interest rates, and expectations of housing price increases created an artificial spike in housing demand

Expectations of future price increases drives housing demand upExpectations of price decreases drives demand back down.but that demand spike didnt last.Housing prices appreciation (2003-2007): 9%/yrHousing price appreciation (2003-2010): 2%/yr

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?EmployeesSalary

EmployeesSalary

EnrollmentTuition

$15,000High School Labor ForceCollege Educated Labor ForceUniversitiesCan these markets be in equilibrium?

Consider the earnings across different ages and different education levels.Age GroupAttainment25-2930-3435-3940-4445-4950-5455-59College$43,121$55,440$62,244$65,973$66,280$64,254$65,240High School$28,097$31,366$33,443$35,283$36,316$35,270$37,573Differential$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=$926,020This isnt really right because you dont get all this money up front

You receive the first payment 4 years from nowLets assume that you could earn 5% elsewhereWhat are the costs of going to college?CostAnnual ExpenseTuition$15,000Lost Wages$26,000Books, Fees, etc$1,000Room & Board$5,000This is not a relevant costyou would have paid this anyways!!!$36,000 x 4 = $164,000Note: we really should discount these costs as well!

So, a college education costs $164,000 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 costCostAnnual ExpenseTuition$15,000Lost Wages$20,000Books, Fees, etc$1,000$36,000 x 4 = $164,000Note: we really should discount these costs as well!

Annual return

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

EmployeesSalary

EnrollmentTuition

$15,000High School Labor ForceCollege Education Labor ForceUniversitiesIf the costs of college were truly less than the benefits, we would see more people go to schoolWage differentials would fall and college tuitions would increaseEmployeesSalary

EmployeesSalary

EnrollmentTuition

$15,000High School Labor ForceCollege Education Labor ForceUniversitiesWhat we are seeing is a steady increase in demand for skilled labor as demand for unskilled labor fallsWage differentials continue to increase as college tuitions increase

In the years following a divorce, statistics show that the womans living standard falls 27% while the mans living standard rises by 10%

Feminists such as Patricia Ireland (NOW) would argue that this proves divorce is unfair to womenCouldnt you just as easily argue that marriage is unfair to men?

On December 22, 2001, Richard Reid was arrested trying to blow up an American Airlines flight from Paris to Miami with a bomb hidden in his shoes.

Many human rights groups have fought heavily against the practice of racial profiling by airline securityIsnt there a better way to secure the safety of our airplanes? (Hint: could we create a marketplace?)Paul Freck Morgan started a website in 2001 offering a $20 Pay Per View event..to watch him cut off his feet with a homemade guillotine. Note: The site turned out to be a hoaxPaul never actually went through with it!How should we feel about this entrepreneurial effort? (i.e. could we/should we repress this market?)

Chart13.3918.933.619.273.620.664.7522.999.3541.0312.2149.1313.149.8914.451.4614.9549.6925.174.2337.4298.5235.7585.3231.8371.5229.0863.2928.7559.9826.9254.2314.4428.5417.7533.8514.8727.2818.3332.0323.1938.3520.232.1419.2529.7316.7525.1315.6622.8916.7523.8220.4628.2518.6425.1711.9115.8416.5621.4927.3934.452328.1622.8127.4627.6932.6237.6643.1750.0455.4758.362.6564.266.9791.4891.7753.4853.9269.8569.85

NominalInflation Adjusted

Sheet1YearNominalInflation Adjusted1970$3.39$18.931971$3.60$19.271972$3.60$20.661973$4.75$22.991974$9.35$41.031975$12.21$49.131976$13.10$49.891977$14.40$51.461978$14.95$49.691979$25.10$74.231980$37.42$98.521981$35.75$85.321982$31.83$71.521983$29.08$63.291984$28.75$59.981985$26.92$54.231986$14.44$28.541987$17.75$33.851988$14.87$27.281989$18.33$32.031990$23.19$38.351991$20.20$32.141992$19.25$29.731993$16.75$25.131994$15.66$22.891995$16.75$23.821996$20.46$28.251997$18.64$25.171998$11.91$15.841999$16.56$21.492000$27.39$34.452001$23.00$28.162002$22.81$27.462003$27.69$32.622004$37.66$43.172005$50.04$55.472006$58.30$62.652007$64.20$66.972008$91.48$91.772009$53.48$53.922010 Partial$69.85$69.85To resize chart data range, drag lower right corner of range.

Chart1100.590101.690102.7801040105.250106.40107.140107.860108.610109.490110.570111.80113.050114.120115.080115.840116.30116.90117.50118.250119.030119.690120.280120.670121.360122.190123.320124.50125.930127.40128.880130.310131.530132.850134.10135.410136.470137.450138.370139.240140.150140.930142.120143.550145.260146.990148.820150.760152.630154.540156.90159.340161.760164.320166.390168.080169.660171.30173.090175.080177.540180.240183.160185.480187.550189.560191.410193.40195.640197.890200.140202.150203.740205.320206.090206.60206.520205.850205.060204.210203.640203.560203.610203.40203.630203.940203.870202.820201.060198.930197.150195.090193.220190.990187.810184.920181.90178.30175.010172.380169.620167.330164.910162.420159.260156.280153.480150.420147.340145.230142.610141.530140.970141.560142.960143.90144.250144.730145.150145.740146.330146.340146.110147.140147.580147.520147.410146.120144.760143.450142.720142.160141.690141.270140.40141.020140.950

S&P Case/Schiller IndexCPI Rental Index

Sheet1DATES&P Case/Schiller IndexRent Index2000-01-01100.59180.9002000-02-01101.69181.3002000-03-01102.78181.9002000-04-01104.00182.3002000-05-01105.25182.8002000-06-01106.40183.4002000-07-01107.14184.1002000-08-01107.86184.8002000-09-01108.61185.4002000-10-01109.49186.1002000-11-01110.57186.7002000-12-01111.80187.4002001-01-01113.05188.0002001-02-01114.12188.7002001-03-01115.08189.5002001-04-01115.84190.2002001-05-01116.30191.1002001-06-01116.90191.8002001-07-01117.50192.5002001-08-01118.25193.2002001-09-01119.03194.0002001-10-01119.69194.7002001-11-01120.28195.4002001-12-01120.67196.2002002-01-01121.36196.8002002-02-01122.19197.5002002-03-01123.32198.1002002-04-01124.50198.5002002-05-01125.93198.9002002-06-01127.40199.5002002-07-01128.88200.0002002-08-01130.31200.3002002-09-01131.53200.8002002-10-01132.85201.3002002-11-01134.10201.9002002-12-01135.41202.4002003-01-01136.47203.2002003-02-01137.45203.5002003-03-01138.37204.0002003-04-01139.24204.5002003-05-01140.15205.0002003-06-01140.93205.3002003-07-01142.12205.8002003-08-01143.55206.2002003-09-01145.26206.7002003-10-01146.99206.9002003-11-01148.82207.4002003-12-01150.76207.7002004-01-01152.63208.1002004-02-01154.54208.6002004-03-01156.90209.1002004-04-01159.34209.7002004-05-01161.76210.3002004-06-01164.32210.9002004-07-01166.39211.4002004-08-01168.08212.0002004-09-01169.66212.5002004-10-01171.30212.8002004-11-01173.09213.1002004-12-01175.08213.7002005-01-01177.54214.3002005-02-01180.24214.9002005-03-01183.16215.4002005-04-01185.48216.0002005-05-01187.55216.5002005-06-01189.56217.0002005-07-01191.41217.7002005-08-01193.40218.1002005-09-01195.64218.7002005-10-01197.89219.3002005-11-01200.14219.9002005-12-01202.15220.3002006-01-01203.74220.8002006-02-01205.32221.5002006-03-01206.09222.2002006-04-01206.60222.9002006-05-01206.52223.7002006-06-01205.85224.6002006-07-01205.06225.4002006-08-01204.21226.3002006-09-01203.64227.2002006-10-01203.56228.0002006-11-01203.61228.8002006-12-01203.40229.8002007-01-01203.63230.6292007-02-01203.94231.5532007-03-01203.87232.3472007-04-01202.82232.9562007-05-01201.06233.6362007-06-01198.93234.2772007-07-02197.15234.9692007-08-01195.09235.4942007-09-01193.22236.2262007-10-01190.99237.1872007-11-01187.81238.0562007-12-01184.92238.9092008-01-01181.90239.6072008-02-01178.30240.1112008-03-01175.01240.7072008-04-01172.38241.4222008-05-01169.62241.8642008-06-01167.33242.8182008-07-01164.91243.6292008-08-01162.42244.4002008-09-01159.26245.1312008-10-01156.28245.9542008-11-01153.48246.6112008-12-01150.42247.1062009-01-01147.34247.6822009-02-01145.23248.0812009-03-01142.61248.4512009-04-01141.53248.8092009-05-01140.97249.0952009-06-01141.56249.2262009-07-01142.96249.2452009-08-01143.90249.2732009-09-01144.25249.1882009-10-01144.73249.0432009-11-01145.15248.8712009-12-01145.74248.8492010-01-01146.33248.8412010-02-01146.34248.7982010-03-01146.11248.8782010-04-01147.14248.8942010-05-01147.58248.9342010-06-01147.52249.0882010-07-01147.41249.3522010-08-01146.12249.2802010-09-01144.76249.5932010-10-01143.45249.8162010-11-01142.72250.3472010-12-01142.16250.8442011-01-01141.69251.2492011-02-01141.27251.6072011-03-01140.40251.9302011-04-01141.02252.1022011-05-01140.95252.403