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AGEC/FNR 406 LECTURE 8

AGEC/FNR 406 LECTURE 8. A rural market in the Philippines. Static Efficiency. Lecture Goals:. 1. Bring together supply and demand analysis. 2. Identify equilibrium conditions and the key aspects of static efficiency. Markets.

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AGEC/FNR 406 LECTURE 8

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  1. AGEC/FNR 406 LECTURE 8 A rural market in the Philippines

  2. Static Efficiency Lecture Goals: 1. Bring together supply and demand analysis 2. Identify equilibrium conditions and the key aspects of static efficiency

  3. Markets What is a market? 1. A place where buyers and sellers interact (either physically or virtually) 2. A place where consumers reveal their willingness (and ability) to pay 3. A place where producers (or sellers) reveal the cost of supplying goods 4. A place where private decisions regarding optimality are made.

  4. Part 1: Consumer Demand Consumers make tradeoffs. Why? 1. Different bundles of goods provide different levels of utility 2. Marginal utility is diminishing 3. Prices influence decision making 4. Choices depend on income

  5. Key Point A consumer’s optimal consumption pattern occurs where the marginal utilities of consumption are equal to the ratio of prices, i.e. where the budget constraint is tangent to the indifference curve. The goods that consumers demand reflect the tradeoffs that consumers are willing to accept.

  6. Demand curve Price 25 A demand curve measures the amount of a particular good that a person would be willing to purchase at a range of prices, i.e. the marginal benefit. • 20 D = MB 1 Quantity

  7. Willingness to pay Price 25 willingness to pay = area under demand curve • • Total willingness to pay = sum of willingness to pay for each and every unit of a good D 1 2 Quantity

  8. Willingness to pay Price Total willingness to pay = area under the demand curve, located to the left of the allocation of interest. • Total willingness to pay is a measure of private benefitsassociated with consumption. D Quantity

  9. Importance of demand curves: Price • demand = willingness to paywillingness to pay is an indicator of private value to the individual 20 • 5 Demand for CDs 1 4 Quantity of CDs purchased

  10. Willingness to pay Total willingness to pay is a narrow definition:it measures what someone would be willing to pay. If no one is willing to pay, is the value zero? From an economic perspective, the answer is:YES

  11. willingness to pay  price Price 25 willingness to pay = area under demand curve • 20 For 1 CD, individual pays $20 BUT... willingness to pay > priceWTP = $20 x 1 + ($5 x 1)/2 = $22.5 Demand for CDs 1 Quantity of CDs purchased

  12. willingness to pay  price Price 25 For 4 CDs, individual pays $5 x 4 = $20 BUT... WTP = $5 x 4 + ($20 x 4)/2 = $60 • 5 Demand for CDs 4 Quantity of CDs purchased

  13. Can we be creative in assessing willingness to pay? YES Q: What is the value of an Oak Savannah Remnant? A : The price The Nature Conservancy is willing to pay to purchase and protect it.

  14. Can we be creative in assessing willingness to pay? YES Q: What is the value of having clean drinking water? A : The price of bottled water or the cost of a water filtration system.

  15. Consumer surplus Price 25 The excess of willingness to pay over the amount actually paid (i.e. the triangle in the graph) is called “consumer surplus”. • 5 4

  16. Part 2: Supply S=MC P The supply curve is an incremental measure of the private cost of producing additional units of a good.To get more, a higher price must be paid. Q

  17. Producer surplus Price 25 The excess of price over the cost of production (i.e. the triangle in the graph) is called “producer surplus”. • 5 4

  18. Market Equilibrium P A market will reach an equilibrium where the quantity demanded equals the quantity supplied. S=MC P* D=MB Q* Q

  19. Market Equilibrium P At a given price... If supply exceeds demand: Price will fall and quantity demanded will increase. S=MC D=MB QD QS Q

  20. Market Equilibrium P At a given price... If demand exceeds supply: Price will rise and quantity demanded will fall. S D QS QD Q

  21. Market Equilibrium P When D=S, MB=MCMarket achieves “Static Efficiency” S=MC P* D=MB Q* Q

  22. Calculating Net Benefit P Total Benefit = area under the demand curve S=MC Total Cost = area under the supply curve D=MB Net Benefit = TotalBenefit - Total Cost Q

  23. Static Efficiency P Static Efficiency is obtained when Net Benefit is Maximized, i.e. when MB=MC S=MC D=MB Q

  24. Conditions satisfied by static efficiency 1. Factors paid marginal value product (MVP) 2. Price ratio = MRTS 3. Ratio of MUs = Ratio of prices As a result, opportunity costs in consumption equal opportunity costs in production

  25. Static vs. dynamic efficiency The “model” discussed above is static, meaning it is concerned with maximization of net benefits for a single time period. Many economic decisions that occur over time are a series of static decisions. Example: Shopping for Food Choose groceries each week, consume them, then start over again next week.

  26. Static vs. dynamic efficiency A dynamic decision is one in which today’s decision has some impact on the choices or outcomes available in the future. Many economy-environment decisions are inherently dynamic decisions. Example: Forestry If you choose to harvest trees this year, harvesting next year is no longer an option.

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