EC 100 Class 3

1. EC 100 Class 3

2. Question 1 • A consumer values the first unit of a good they consume at £10, the second at £8, the third at £6 and the fourth at £5. If the price of the good is £7 how many units of the good do they buy?

3. Question 1 and 2 • A consumer values the first unit of a good they consume at £10, the second at £8, the third at £6 and the fourth at £5. If the price of the good is £7 how many units of the good do they buy? • Gains from first unit: 10-7 =3 > 0 • Gains from second unit: 8-7 = 1 >0 • Gains from third unit: 6 – 7<0 – so better off not purchasing third unit • So total surplus to consumer = 3 + 1 = 4

4. Question 3 • Supply curve reflects the sellers marginal cost – each unit sold at marginal cost covers only cost of producing this unit. • Hence producers do not earn anything on the “marginal unit” sold. • If the supply curve is horizontal, all “inframarginal” units are sold at marginal cost as well.

5. Question 3 Price, P • Extreme Cases of Horizontal Supply – Producer surplus = 0. Equilibrium price Supply Curve Demand = Willingness to pay Q1* Quantity, Q

6. Question 4 Price, P • Downward shift in supply curve: price sold is still = MC for all inframarginal units. So producer surplus = 0, only consumers benefit. Supply Curve Equilibrium price Demand Q1* Quantity, Q

7. Question 5 • Absolute advantage: country is the lowest cost producer of that good. • Comparative advantage: country makes the good relatively cheaper than other goods. • Country has a lower opportunity cost for producing the good

8. Law of comparative advantage: countries should specialize in production of the good(s) for which they have a comparative advantage. • This produces higher overall output (to be shared between countries) • Country always has a comparative advantage in something • (Free market provides right incentives for this to happen – no government involvement necessary)

9. Question 5

10. Question 6 • Suppose a country is in the unfortunate position of not having an absolute advantage in the production of any good. Tick all of the following statements that must then be true

11. Question 7 • Another example… • A person in China can produce 100kg of rice in a year or 10 litres of olive oil (or a combination of the two). A person in Italy can produce 25kg of rice in a year or 50 litres of olive oil (or a combination of the two). Which of the following statements are true

12. Question 7 • Absolute advantages: Italy has absolute advantage to produce Oil, while China has absolute advantage to produce rice. • Comparative advantage: Italy has comparative advantage in olive oil, China has comparative advantage in rice. • So: • Italy should specialize in olive oil (and export to China for rice…) • China should specialize in rice (and export to Italy for olive oil…)

13. Studying Policy intervention • A key part of this course is for you to be able to understand the impacts of different policy interventions • Or to have the tools to analyze the effects of policy interventions in a simple framework of supply and demand. • Very common interventions: taxes, subsidies, price regulation…

14. Question 9 • The house rental market is perfectly competitive but renting a house is expensive so the government decides to impose a ceiling on rents that is below the market-clearing price. What will happen to the amount of housing in the market?

15. Question 9 • Now there is excess demand Price Ceiling New Q

16. Question 10 • Some PS becomes CS – overall surplus falls (brown area is DWL) Price Ceiling New Q

17. Question 11 • What about consumer surplus? … it depends Loose this Gain this Price Ceiling New Q

18. Question 11 • What about consumer surplus? … it depends • The crucial factor is the steepness of the supply curve… • If supply very elastic – flat supply curve – quantity falls sharply after price ceiling • DWL very high

19. Question 12 • What about producer surplus? … it goes down • Intuition: • Profits = (P-AC)*Q • Prices and quantity both fall so firms are losing out

20. Question 12 • What about producer surplus? … it goes down Price Ceiling New Q

21. Discussion Question – Payday Lending • To repay a £400 loan for 45 days costs £588 which works out as an annualized rate of interest of 5000 per cent per year. • People can take out mortgages right now (if eligible) at an interest rate of less than 4 per cent per year.

22. The interest rates charged are exploitative and Wonga should be banned? • Key point: probably not the same people… • People choose to use Wonga, so they must be better off • Good argument against banning Wonga • Assuming people know what is best for them… • Government bans drugs, smoking (<18) etc so why not Wonga?

23. The interest rates charged are exploitative and so rates should be capped. • See question 12 – effect on consumer surplus is ambiguous • Some people lose out – can no longer get a loan. • Is market for loans perfectly competitive? • If so, interest rates represent cost of providing loans • If barriers to entry, scope for government involvement (see monopoly topics…)

24. Wonga should be allowed but the interest rates it charges should be capped. • Interest rate caps may not solve the problem,as it means that some loans are not granted that would have been granted otherwise. • The people who do not get the loans are worse off. • Who are the people using this service? Why are they using this? Is there some other inherent market failure that may drive this?