Economics of the Firm The Basics Supply Demand

Economics of the Firm The Basics: Supply & Demand

Introducing homo economicus…. also known as “Economic Man” Economic man is a RATIONAL being

The Fundamental Rule of Economics: Individuals are rational beings and therefore respond to incentives – i. e. they respond to opportunities with Economic Profit = (Expected) Benefit – Opportunity Cost Opportunity cost = Direct (Money) Costs + Implicit Costs In other words, think about opportunity cost as the value of ALL the resources that have been consumed

Example: What would be the opportunity cost of attending Notre Dame as an undergraduate? Do students have an incentive to go to Notre Dame? Item Average 2011/2012 Expense Tuition and Fees $41, 420 Room & Board $11, 390 Books & Supplies $950 Personal Expenses $1, 000 Transportation $500 Total $55, 260 x 4 = $221, 040 So if you wanted a 10% return on your college education, you would need to earn $22, 000 a year more per year after college Is this right?

Example: What is IBM’s opportunity cost? Is IBM earning economic profit? Item 2010* Net Sales 99, 870 Cost of Goods Sold (49, 358) Depreciation (4, 831) Gross Income 45, 681 Selling, General, and Adm. Expense (27, 025) Operating Income 18, 656 Interest Income/Expense 1, 067 Pretax Income 19, 723 Income Taxes (4, 890) Net Income 14, 833 * In Millions Current Stock Price: $166 Shares Outstanding: 1, 287 M

“Economics deals with the Allocation of scarce resources to satisfy unlimited wants”

“You can’t always get what you want…” - Mick Jagger Consumers have limited incomes to spend on a wide variety of goods and services (both now and in the future) Workers have a finite number of hours in the day to work, relax, go to school, etc Firms have finite capacity and limited financial resources, to produce goods and services The economy as a whole has a finite number of resources trying to satisfy a population with unlimited wants!

If we can’t have everything we want, so we need to decide what to do with the limited resources we do have. Efficiency vs. Equity An allocation of resources that maximum total welfare Under certain circumstances, the free market process guarantees this An allocation of resources provides a “fair” distribution of welfare Can we trust markets to produce a desirable outcome?

What does this mean from a business perspective? That is, why should we care? Efficiency vs. Equity An allocation of resources that maximum total welfare If we have an efficient outcome, there are no opportunities to create wealth. An allocation of resources provides a “fair” distribution of welfare With inefficient outcomes, there are wealth creating opportunities.

From a business standpoint, an inefficiency offers an opportunity to create wealth by moving resources to higher value uses! This is done through voluntary transactions. My Value - $80, 000 Consumer Surplus = $5, 000 Suppose that you own a Porsche that you value at $65, 000, but I value at $80, 000 Sale Price = $75, 000 Producer Surplus = $10, 000 Your Value - $65, 000 The sale of your car creates $15, 000 of new wealth. The sale price determines how that wealth is allocated between us

Again, think about efficiency as allocating resources to their highest value VS. Suppose that Exxon acquires drilling rights within a remote area where there will be negligible environmental damage in the traditional sense The Sierra club files a lawsuit to block the drilling (Their personal serenity has been threatened by the knowledge that the oil is being removed from it’s natural habitat) If you are the judge, who should prevail?

VS. If Exxon Wins: • Exxon stockholders gain • Workers gain from added jobs • Motorists see falling gasoline prices If Exxon Wins: • Sierra club members lay awake at night screaming $5 M $10 M A ruling against Exxon in this example would be inefficient – a missed opportunity to make everyone better off.

“A subtle but damaging factor in this is the dominance of economists at business schools. Although there is no evidence that economists are less ethical than members of other discipline, approaching the world through the dollar sign does make people more cynical”* Amitai Etzioni, “When it comes to Ethics, B-Schools Get an F”, Washington Post, August 4, 2002

“In 2006, when Notre Dame played Michigan, the south bend Marriott charged $649 per night - $500 above its usual rate of $149”* Ethicist Joe Holt responds… “It is an act of moral abdication for businesses to pretend that they have no choice but to charge as much as they can based on supply and demand” * Ilan Brat, “Notre Dame Football introduces its Fans to Inflationary Spiral”, Wall Street Journal, September 6, 2006

ALL voluntary transactions create wealth!! Value = $700/Night Consumer Surplus = $550 Consumer Surplus = $50 Price = $650 Price = $150 Producer Surplus = $50 Cost = $100/Night Producer Surplus = $550 Either way, $600 of wealth is created!

Cost = $100/Night Value = $1000/Night You have three rooms to rent. How do you set the price to create the most wealth? Value = $200/Night Value = $600/Night Cost = $100/Night Value = $800/Night Value = $400/Night

Value = $1000/Night CS = $400 PS = $500 At a $600 per night price we create $2100 of wealth Cost = $100/Night CS = $200 Value = $800/Night PS = $500 Cost = $100/Night Value = $600/Night Cost = $100/Night CS = $500 CS = $600 PS = $1500

Value = $1000/Night CS = $850 PS = $50 At a $150 per night price we could create $2100 of wealth Cost = $100/Night CS = $650 Value = $800/Night PS = $50 Cost = $100/Night CS = $450 Value = $600/Night PS = $50 Cost = $100/Night CS = $1950 PS = $150

Value = $200/Night CS = $50 PS = $50 At a $150 per night price we could create $900 of wealth Cost = $100/Night CS = $250 Value = $400/Night PS = $50 Cost = $100/Night CS = $450 Value = $600/Night PS = $50 Cost = $100/Night CS = $750 PS = $150

Charles Darwin vs. Adam Smith: Efficiency and the Competitive Marketplace "Greed captures the essence of the evolutionary spirit. " -Gordon Gekko

What do we mean by a competitive market? #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 – it’s 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 #6: Transactions are costless – buyers and sellers incur no costs in an exchange Can you think of situations where all these assumptions hold?

Lets try an example…suppose that you are a fisherman. Top catch larger quantities of fish, you have to go farther from shore and your catch per hour drops Zone A 50 Fish/hr 300 Max/Day Zone B 30 Fish/hr 300 Max/Day ØYou bought a boat for $1, 000 ØMaintenance on the boat is $50/Day ØYou pay $16/hour in labor costs ØYou pay $20/hour for fuel and other expenses What costs are fixed, sunk, and variable? Zone C 20 Fish/hr 160 Max/Day

Lets try an example…suppose that you are a fisherman. To catch larger quantities of fish, you have to go farther from shore and your catch per hour drops Zone A Zone B 50 Fish/hr 300 Max/Day Boat = $50 Labor = $16/hr Gas = $20/hr Zone C 30 Fish/hr 300 Max/Day 20 Fish/hr 160 Max/Day Lets take this section by section… Zone A Quantity Total Cost Fixed Cost Variable Cost Average Cost Marginal Cost 0 $50 $0 --- 1 $50. 72 $50 $. 72 $50. 72 $. 72 2 $51. 44 $50 $1. 44 $25. 72 $. 72 3 $52. 16 $50 $2. 16 $17. 39 $. 72

Let’s try and picture this… Dollars AC TC VC = $. 72*F $50 0 FC # of Fish $. 72 MC 0 # of Fish

Lets try an example…suppose that you are a fisherman. Top catch larger quantities of fish, you have to go farther from shore and your catch per hour drops Zone A Zone B 50 Fish/hr 300 Max/Day Boat = $50 Labor = $16/hr Gas = $20/hr Zone C 30 Fish/hr 300 Max/Day 20 Fish/hr 160 Max/Day Lets take this section by section… Zone B Quantity TC FC VC AC MC 300 $266 $50 $216 $0. 88 $. 72 301 $267. 20 $50 $217. 20 $0. 88 $1. 20 302 $268. 40 $50 $218. 40 $0. 88 $1. 20 303 $269. 60 $50 $219. 60 $0. 88 $1. 20

Let’s try and picture this… Dollars TC Dollars VC =$266 + $1. 20*F $266 $50 FC $1. 20 MC AC $. 88 300 # of Fish

Lets try an example…suppose that you are a fisherman. Top catch larger quantities of fish, you have to go farther from shore and your catch per hour drops Zone A Zone B 50 Fish/hr 300 Max/Day Boat = $50 Labor = $16/hr Gas = $20/hr Zone C 30 Fish/hr 300 Max/Day 20 Fish/hr 160 Max/Day Lets take this section by section… Zone C Quantity TC FC VC AC MC 600 $626 $50 $576 $1. 04 $1. 20 601 $627. 80 $577. 80 $1. 04 $1. 80 602 $629. 60 $579. 60 $1. 04 $1. 80 603 $631. 40 $581. 40 $1. 04 $1. 80

Let’s try and picture this… TC Dollars VC =$576 + $1. 80*F $576 $50 FC $1. 80 MC AC $1. 04 600 # of Fish

All together… Dollars TC Dollars Slope = 1. 80 Slope = 1. 20 MC $1. 80 Slope =. 72 $50 FC ATC $1. 20 $. 72 0 300 600 # of Fish

Perfectly competitive firms are “price takers”. They see a market price and can’t change it. Suppose that the market price is $1. 20. Fish Price Total Revenue Total Cost Profit 0 $1. 20 $0 $50 -$50 1 $1. 20 $50. 72 -$49. 52 2 $1. 20 $2. 40 $51. 44 -$49. 04 3 $1. 20 $3. 60 $52. 16 -$48. 56 300 $1. 20 $360 $266 $94 301 $1. 20 $361. 20 $267. 20 $94 302 $1. 20 $362. 40 $268. 40 $94 303 $1. 20 $363. 60 $269. 60 $94 600 $1. 20 $720 $626 $94 601 $1. 20 $721. 20 $627. 80 $93. 40 602 $1. 20 $721. 40 $629. 60 $91. 80 603 $1. 20 $721. 60 $631. 40 $90. 20

We are looking to maximize profits where profits are the difference between total revenues and total costs Dollars TC TR $94 $0 # of Fish Slope = 1. 80 $50 Profit -$50 Slope = 1. 20 Slope =. 72 0 Marginal revenue is greater than marginal cost 300 600 Marginal revenue is equal to marginal cost # of Fish Marginal revenue is less than marginal cost 0 Profits are increasing 300 Profits are maximized 600 Profits are decreasing

We 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. Fish Total Cost Total Revenue Marginal Cost 0 $50 $0 $1. 20 $. 72 1 $50. 72 $1. 20 $. 72 2 $51. 44 $2. 40 $1. 20 $. 72 3 $52. 16 $3. 60 $1. 20 $. 72 300 $266 $360 $1. 20 $. 72 301 $267. 20 $361. 20 $1. 20 302 $268. 40 $362. 40 $1. 20 303 $269. 60 $363. 60 $1. 20 600 $626 $720 $1. 20 601 $627. 80 $721. 20 $1. 80 602 $629. 60 $721. 40 $1. 20 $1. 80 603 $631. 40 $721. 60 $1. 20 $1. 80

Lets plot out marginal revenues and costs rather than total costs and revenues… Dollars $94 MC $1. 80 MR $1. 20 $0 # of Fish Profit -$50 $. 72 0 Marginal revenue is greater than marginal cost 300 0 600 Marginal revenue is equal to marginal cost Marginal revenue is less than marginal cost Profits are increasing 300 Profits are maximized 600 Profits are decreasing

When we talk about a supply curve we are talking about the profit maximizing decisions of individual firms at prevailing market prices Dollars MC $1. 80 MR $1. 20 $. 72 # of Fish 0 300 600 At a market price of $1. 20, MR = MC for any quantity of fish between 300 and 600 0 300 600 At a market price of $1. 20, this firm will be willing to supply any quantity of fish between 300 and 600

Perfectly competitive firms are “price takers”. They see a market price and can’t change it. Suppose that the market price is $0. 72. Fish Price Total Revenue Total Cost Profit 0 $0. 72 $0 $50 -$50 1 $0. 72 $50. 72 -$50 2 $0. 72 $1. 44 $51. 44 -$50 3 $0. 72 $2. 16 $52. 16 -$50 300 $0. 72 $216 $266 -$50 301 $0. 72 $216. 72 $267. 20 -$50. 48 302 $0. 72 $217. 44 $268. 40 -$50. 96 303 $0. 72 $218. 16 $269. 60 -$51. 44 600 $0. 72 $432 $626 -$194 601 $0. 72 $432. 72 $627. 80 -$195. 08 602 $0. 72 $433. 44 $629. 60 -$196. 16 603 $0. 72 $434. 16 $631. 40 -$197. 24

All together… Dollars $0 # of Fish TC Slope = 1. 80 -$50 Slope = 1. 20 Slope =. 72 TR $50 0 Profit 300 Marginal revenue is equal to marginal cost 600 Marginal revenue is less than marginal cost # of Fish 0 300 Profits are maximized 600 Profits are decreasing

Perfectly competitive firms are “price takers”. They see a market price and can’t change it. Suppose that the market price is $. 72. Fish Total Cost Total Revenue Marginal Cost 0 $50 $0 $. 72 1 $50. 72 $. 72 2 $51. 44 $. 72 3 $52. 16 $. 72 300 $266 $216 $. 72 301 $267. 20 $216. 72 $1. 20 302 $268. 40 $217. 44 $. 72 $1. 20 303 $269. 60 $218. 16 $. 72 $1. 20 600 $626 $432 $. 72 $1. 20 601 $627. 80 $432. 72 $1. 80 602 $629. 60 $433. 44 $. 72 $1. 80 603 $631. 40 $434. 16 $. 72 $1. 80

All together… Dollars $0 MC $1. 80 -$50 $1. 20 $. 72 MR Profit 0 300 Marginal revenue is equal to marginal cost 0 600 Marginal revenue is less than marginal cost 300 Profits are maximized 600 Profits are decreasing

When we talk about a supply curve we are talking about the profit maximizing decisions of individual firms at prevailing market prices Dollars MC $1. 80 $1. 20 $. 72 MR $. 72 # of Fish 0 300 600 At a market price of $. 72, MR = MC for any quantity of fish between 0 and 300 0 300 600 At a market price of $. 72, this firm will be willing to supply any quantity of fish between 0 and 300

When we talk about a supply curve we are talking about the profit maximizing decisions of individual firms at prevailing market prices Dollars MC MR $1. 80 $1. 20 $. 72 # of Fish 0 300 600 At a market price of $1. 80, MR = MC for any quantity of fish between 600 and 760 0 300 600 At a market price of $1. 80, this firm will be willing to supply any quantity of fish between 600 and 760

What if the prevailing market was $1. 35? Dollars MC MR $1. 35 # of Fish 0 300 600 At a market price of $1. 35, 600 fish are profitable to supply, but the 601 st is not! 0 300 600 At a market price of $1. 35, this firm will be willing to supply exactly 600 fish.

So we can get an individual firm’s supply curve by following marginal costs! Suppose that there are 1000 fishermen in the village – all with the same costs. Dollars $1. 80 $1. 20 $. 72 0 300 600 Individual Supply # of Fish 0 300, 000 600, 000 # of Fish Market Supply Market supply adds up the decisions of each individual firm at each prevailing market price

So where do prices come from? We need to know how many fish people are actually willing to buy at any prevailing market price. Dollars Price Fish $2. 00 50, 000 $1. 80 150, 000 $1. 50 200, 000 $1. 20 500, 000 $1. 00 540, 000 $. 72 600, 000 $. 50 700, 000 $1. 80 $1. 20 $. 72 0 150, 000 500, 000 900, 000 # of Fish A demand curve is just a record of how much the market collectively is willing to buy at any given market price

In equilibrium, total supply should equal total demand. If not, the price will adjust. Dollars Supply At 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 $1. 80 $1. 20 $. 72 Demand 0 300, 000 600, 000 At a $. 72 price, fishermen will bring at most 300, 000 fish to the market, but 600, 000 are demanded– the price needs to rise # of Fish Price Fish $2. 00 50, 000 $1. 80 150, 000 $1. 50 200, 000 $1. 20 500, 000 $1. 00 540, 000 $. 72 600, 000 $. 50 700, 000

In equilibrium, total supply should equal total demand Individual Market Dollars Supply $1. 80 $1. 20 MC MR $. 72 Demand 0 300, 000 600, 000 500, 000 The market determines the equilibrium price of $1. 20 and 500, 000 fish sold by the 1, 000 fishermen 0 300 600 At the prevailing market price of $1. 20, each fisherman supplies between 300 and 600 fish

Boat = $50 Labor = $16/hr Gas = $20/hr Fish Total Revenue Total Cost Profit 300 $360 $266 $94 301 $361. 20 $267. 20 $94 302 $362. 40 $268. 40 $94 303 $363. 60 $269. 60 $94 A Few Diagnostics… Dollars Price= $1. 20 - Gas Cost = $0. 67 Labor’s Value Added= $0. 53 * Labor Productivity = 30 Fish/Hr $16/hr = hourly wage MC $1. 80 $1. 20 MR $144 Accounting Profit= $94 $. 72 0 Producer Surplus = $144 - Fixed Cost = $50 300 600 $94 *100 = 9. 4% Return $1, 000 Is this fisherman earning economic profits?

Suppose that the excess returns causes 800 more fishermen (all with identical costs) to enter the market. Dollars Supply $1. 80 $1. 20 $. 72 Demand 0 300, 000 # of Fish 600, 000 540, 000 1, 080, 000 1, 368, 000 Price Fish $2. 00 50, 000 $1. 80 150, 000 $1. 50 200, 000 $1. 20 500, 000 $1. 00 540, 000 $. 72 600, 000 $. 50 700, 000

In equilibrium, total supply should equal total demand Individual Market Dollars Supply $1. 80 MC $1. 80 $1. 20 $1. 00 MR $1. 00 $. 72 Demand 0 300, 000 600, 000 540, 000 The market determines the equilibrium price of $1. 00 and 540, 000 fish sold by the 1, 800 fishermen 0 300 600 At the prevailing market price of $1. 00, each fisherman supplies 300 fish

Boat = $50 Labor = $16/hr Gas = $20/hr Fish Price Total Revenue Total Cost Profit 0 $1. 00 $0 $50 -$50 1 $1. 00 $50. 72 -$49. 72 2 $1. 00 $2. 00 $51. 44 -$49. 44 3 $1. 00 $3. 00 $52. 16 -$49. 16 300 $1. 00 $300 $266 $34 A Few Diagnostics… Dollars Price= $1. 00 - Gas Cost = $0. 40 Labor’s Value Added= $0. 60 * Labor Productivity = 50 Fish/Hr MC $1. 80 $1. 00 $. 72 MR $84 $30/hr > hourly wage Producer Surplus = $84 - Fixed Cost = $50 Accounting Profit= $34 0 300 600 $34 *100 = 3. 4% Return $1, 000

Let’s see if we can’t generalize this a bit. We want marginal costs to be increasing – this reflects decreasing labor productivity at the margin Dollars TC Dollars MC $1. 80 $50 $1. 20 FC $. 72 0 300 600 # of Fish

All together… Dollars TC TR Slope = 1. 20 $94 $0 # of Fish F* Profit -$50 0 300 F* 600 # of Fish 0 300 600 We are still looking for where marginal revenue equals marginal costs (i. e. the slopes are the same)

All together… Dollars MC $0 P* F* MR Profit -$50 0 F* 0 300 600 We are still looking for where marginal revenue equals marginal costs

Dollars Supply MC P* MR P* # of Fish 0 F* For any market price (which is marginal revenue for a perfectly competitive firm, there is a profit maximizing quantity where MR = MC 0 F* That optimizing quantity becomes a point on that firms supply curve

We still aggregate decisions across individual suppliers to get market supply (again, assume 1, 000 fishermen) Dollars Supply P* 0 Supply P* F # of Fish 0 1000*F Individual Supply Market Supply # of Fish

In equilibrium, total supply should equal total demand Individual Market Dollars Supply MC $1. 44* MR 1. 44* Demand 0 0 400, 000* The market determines the equilibrium price of $1. 44 and 400, 000 fish sold by the 1, 000 fishermen At the prevailing market price of $1. 44, each fisherman supplies 400 fish

Boat = $50 Labor = $16/hr Gas = $20/hr We can still perform whatever diagnostics we want… At 400 fish, your productivity is 25 Fish/hour Price= $1. 44 - Gas Cost = $. 80 Labor’s Value Added= $0. 64 * Labor Productivity = 25 Fish/Hr Dollars $16/hr = hourly wage MC PS = (1/2)(400)(1. 44)=288 Producer Surplus = $288 - Fixed Cost = $50 Accounting Profit= $238 MR $1. 44 $288 $238 *100 =23. 8% Return $1, 000 0 400 Is this fisherman earning economic profits?

Suppose that the excess returns causes 800 more fishermen (all with identical costs) to enter the market. Dollars Supply $1. 44 $1. 03 Demand 0 400, 000 576, 000 720, 000 # of Fish 0 320 400

Boat = $50 Labor = $16/hr Gas = $20/hr We can still perform whatever diagnostics we want… At 320 fish, your productivity is 35 Fish/hour Price= $1. 03 - Gas Cost = $. 57 Labor’s Value Added= $0. 46 * Labor Productivity = 35 Fish/Hr Dollars $16/hr = hourly wage MC PS = (1/2)(320)(1. 03)=165 Producer Surplus = $165 - Fixed Cost = $50 Accounting Profit= $115 MR $1. 03 $165 $115 *100 =11. 5% Return $1, 000 0 320

Suppose that we have three fishermen with different productivities. Each bought a boat for $1, 000 and have the same costs as before. Boat = $50 Labor = $16/hr Gas = $20/hr 30 Fish/hr 300 Max/Day $1. 20 per fish 20 Fish/hr 200 Max/Day $1. 80 per fish 10 Fish/hr 100 Max/Day $3. 60 per fish Each of the above fishermen will provide fish to the marketplace as long as the market price is equal to or greater to their marginal cost

All a supply curve really does is order production from lowest cost to highest cost Dollars $3. 60 $1. 80 $1. 20 Fish 0 300 500 600 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 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 $1. 20, but below $1. 80, only fisherman #1 sells fish. He can supply up to 300

Adding a demand curve will give us the equilibrium price and identify the fisherman who participate in the market as well as the fisherman’s economic profits Boat = $50 Labor = $16/hr Gas = $20/hr Fisherman #1 Producer Surplus = $540 - Fixed Cost = $50 Dollars Accounting Profit= $490 Supply $490 *100 = 49% Return $1, 000 $3. 60 Fisherman #2 $3. 00 PS= $240 $1. 80 PS= $540 Demand $1. 20 Accounting Profit= $190 Fish 0 Producer Surplus = $240 - Fixed Cost = $50 300 500 600 $190 *100 = 19% Return $1, 000

A Supply Function represents the rational decisions made by a profit maximizing firm(s). “Is a function of” Quantity Supplied Price S Market Price (+) Higher cost producers are in this portion – they will make the lowest profits (if they participate in the marketplace) Lower cost producers are in this portion – they will make the largest profits Quantity A supply curve naturally ranks potential suppliers from lowest marginal costs to higher marginal costs

Example: Cell Phones Company Price EPS/P (%) ROE ROA Sprint $3. 11 (1. 05) 33% 21% . 06% Verizon $34. 62 $2. 23 6. 4% 16% 5% AT&T $28. 44 $3. 44 12% 18% 4. 5% Price S Quantity A supply curve naturally ranks potential suppliers from lowest marginal costs to higher marginal costs

By the same token, a demand curve naturally ranks potential consumers from highest valuation to lowest valuation. Suppose that we have three potential consumers of rats. Would pay up to $25/rat. Can consume 100 rats per week. Would pay up to $10/rat. Can consume 50 rats per week. Would pay up to $1/rat. Can consume 20 rats per week. What would this demand curve look like?

Dollars If rats cost more than $25/rat, nobody buys them! $25 If rats cost more between $25/rat and $15/rat, only Shrek buys them! $10 If rats cost more between $10/rat and $1/rat, Shrek AND Anthony Zimmern buy them! If rats cost more less than $1/rat, EVERYBODY buys them! $1 Fish 0 100 150 170 Price Quantity Demanded Above $25 0 – 100 Between $25 and $10 100 - 150 Between $10 and $1 150 $1 Between 150 and 170 Between $1 and $0 170

For any market price, we know how many rats are sold and how much each consumer benefits from the market (consumer surplus) At a market price of $15 Dollars ØShrek buys 100 rats for $15 apiece. He saves $10 per rat for a total of $1000 in savings (surplus) ØNeither the baby of Anthony Zimmern are willing to buy rats for $15. $25 CS = $1000 $15 $10 $1 Fish 0 100 150 170

For any market price, we know how many rats are sold and how much each consumer benefits from the market (consumer surplus) At a market price of $5 Dollars ØShrek buys 100 rats for $5 apiece. He saves $20 per rat for a total of $2000 in savings (surplus) ØAnthony Zimmern buys 50 rats for $5. He saves $5 per rat for a total of $250 in surplus ØThe baby still is unwilling to buy rats! $25 CS = $2000 $10 CS = $250 $5 $1 Fish 0 100 150 170

A Demand Function represents the rational decisions made by a representative consumer(s) “Is a function of” Quantity Demanded Price Consumers with high valuations are located here Consumers with low valuations are located here D Quantity Market Price (-)

Key Point: Demand curves represent marginal utility (what we are willing to pay for one additional unit). Consumer surplus measures total value. Example: The Diamond/Water Paradox Water Diamonds Price S P* D Quantity

Market Equilibrium: There exists a price where supply equals demand – the market will find this price automatically. Price S At a price above the equilibrium price, supply is greater than demand. A surplus drives the price down P* D Q* At a price above the equilibrium price, demand is greater than supply. A surplus drives the price up Quantity

Let’s suppose that we are talking about the market for bananas. There 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) Would this transaction be wealth creating? Price S $8 $7 $5 $3 $2 D 1, 000 Quantity 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)

Recall an earlier discussion about allocations of resources. Efficiency vs. Equity An allocation of resources that maximum total welfare Under certain circumstances, the market process guarantees this An allocation of resources provides a “fair” distribution of welfare Can we trust markets to produce a desirable outcome?

Competitive markets provide efficient outcomes in that every wealth creating transaction was undertaken. In other words, consumer surplus and producer surplus are maximized. Price $12 S Consumer Surplus = (1/2)*($12 - $5)*1, 000 $3, 500 $5 $2, 500 Producer Surplus = (1/2)*($5 - $0)*1, 000 D $0 1, 000 Note that $6, 000 of wealth was created by this market! Quantity

Example: Suppose we have the following petroleum firms. Further suppose that there is pressure from the public to reduce pollution levels. 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 How would you go about reducing emissions by 50%

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 $ Per Unit Pollution Reduction Hess $54 Gulf $48 First $42 Exxon $36 Devon $30 Chevron $24 BP $18 $12 Problems: • Unfair • Requires information on abatement costs Apache Quantity of Emissions Reduction

We could follow an “across the board” emission reduction program (note: pollution taxes would have the same basic effect) Firm Historical Emissions (Tons/yr) Marginal Abatement Cost ($/Ton) 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

Let markets work for you!!! Example: Cap and Trade as a solution to pollution reduction. 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 Could BP profit from selling a pollution permit to Gulf? What should the selling price be?

The Market for pollution permits $ Per Unit Pollution Reduction $54 Hess Gulf $48 Equilibrium price range Hess Gulf First $42 $36 $30 Chevron $24 BP $18 $12 Apache S First Exxon Devon $33 Chevron BP Apache D Quantity of Emissions Reduction

The cap and trade program lowered the cost of pollution reduction by $2, 400 (from $6, 600 to $4, 200). Firm Historical Emissions (Tons/yr) Marginal Abatement Cost ($/Ton) 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 400 200 100 400 200 $4, 200

Note that cost of purchasing permits equals revenues from selling permits and so additional costs. Lets set the equilibrium permit price at $33. Firm Initial Pollution Reduction Final Pollution Requirement Marginal Abatement Cost ($/Ton) 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 -$2, 400 200 $0 -$2, 400

The consumer/producer surplus represents the gains by all firms $ Per Unit Pollution Reduction $54 Hess Gulf $48 $525 $42 Gulf First $375 S $225 $36 First Exxon $75 $30 $225 Devon $33 Devon $375 $24 Chevron $75 BP $18 $12 Chevron $525 Apache BP Apache D Quantity of Emissions Reduction

Demand is not simply a function of price, but is, instead, a function of many variables “Is a function of” • Income • Prices of other goods (Substitutes vs. Compliments) • Tastes • Future Expectations • Number of Buyers Holding all the demand shifters constant at some level, quantity demanded at a price of $10 is 100 Price Demand Shifters Example: Increase in Demand 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) Price $10 D(. ’. ) D(…) 100 120 Quantity

Supply is not simply a function of price, but is, instead, a function of many variables “Is a function of” Price • Technology Marginal costs • Input prices • Number of sellers Holding all the supply shifters constant at some level, quantity supplied at a price of $10 is 100 Supply Shifters Example: Decrease in Supply At the initial price of $10, but with a new value for one of the supply shifters, quantity demanded has fallen to 80 Price S(. ’. ) S(…) $10 80 100 Quantity

Example: How would the loss in income during the last recession impact the hotel industry? Rate per night At the current $150 market price, supply is still 50, 000, but with a lower level of income, demand has fallen to 40, 000 $150 40, 000 50, 000 # of Rooms At the new income level of $50, 000, $150 can no longer be the equilibrium price

Example: How would the loss in income during the last recession impact the hotel industry? Rate per night $150 $125 45, 000 50, 000 # of Rooms The decrease in income (which causes a decrease in demand) causes a drop in sales and a drop in market price

Example: How would a drop in the wage rate in Columbia influence the price of coffee? Price per pound $5 10, 000 18, 000 Pounds 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

Example: How would a drop in the wage rate in Columbia influence the price of coffee? Price per pound $5 $4 10, 000 16, 000 Pounds The lower wage (which causes an increase in supply) , results in a lower price and higher sales

Partial Equilibrium vs. General Equilibrium Price Suppose that effective advertising increased the demand for lemonade. What would happen. Quantity 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 Price A rise in demand for lemonade should increase sales and increase the price. Sugar Price Lemons S Price S Quantity D Quantity This increase in marginal costs should lower supply, right! The rise in lemonade sales should raise demand for lemons and sugar which increases their prices D Quantity

Where would you rather live? South Bend or Chicago? Why? What’s better in Chicago? What’s better in South Bend? Pretty much everything is better in Chicago! 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.

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 South Bend Housing market Chicago Housing Market Houses The difference between housing costs should just offset any advantages Chicago has! Houses

Renting vs. Buying a House…. what’s the better move? Median Home Price Median Rent South Bend Housing market Houses Suppose that the median rental rate is $600 per month ($7200 per year) and the current mortgage rate is 6% South Bend Rental Market Rentals

Can you spot the housing bubble?

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?

High School Labor Force College Educated Labor Force Salary Employees Tuition Employees Universities Can these markets be in equilibrium? $15, 000 Enrollment

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 = $120, 370 x 5 x 5 x 5 =$926, 020 = $144, 005 = $153, 450 = $149, 820 = $144, 920 = $138, 335 This isn’t really right because you don’t get all this money up front Lets assume that you could earn 5% elsewhere You receive the first payment 4 years from now

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 $36, 000 x 4 = $144, 000 Note: we really should discount these costs as well! This is not a relevant cost…you would have paid this anyways!!! 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, 000 Note: we really should discount these costs as well! Annual return Thought of as an investment, a college education pays 11% per year!!

High School Labor Force College Education Labor Force Salary Employees Tuition If the costs of college were truly less than the benefits, we would see more people go to school $15, 000 Employees Universities Wage differentials would fall and college tuitions would increase Enrollment

High School Labor Force College Education Labor Force Salary Employees Tuition What we are seeing is a steady increase in demand for skilled labor as demand for unskilled labor falls $15, 000 Employees Universities Wage differentials continue to increase as college tuitions increase Enrollment

The Average Shopping cart in the US today is approximately three times as big as its 1975 counterpart Ralph Nader has argued that this is a prime example of consumers being manipulated by unscrupulous capitalists – bigger carts shame consumers into bigger purchases. What’s wrong with this argument?

Microsoft’s new Xbox 360 gaming console was released in North America on November 22 at a retail price of $299. Available supply sold out almost immediately as Christmas shoppers stood in line for this year’s hot item. (Microsoft has increased its sales target from 3 M units to 6 M units). What’s odd about this? ?

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 security Isn’t 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 hoax…Paul never actually went through with it! How should we feel about this entrepreneurial effort? (i. e. could we/should we repress this market? )