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Ec1661/API135 Jan 28, 2011

Ec1661/API135 Jan 28, 2011. Avinash Kishore. Outline. Rationality Opportunity Cost Marginal Principle Demand, Supply and the Competitive Equilib . Consumer and Producer Surplus, Deadweight loss Externality Coase Theorem. Basic Principles. Economic actors are rational.

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Ec1661/API135 Jan 28, 2011

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  1. Ec1661/API135Jan 28, 2011 AvinashKishore

  2. Outline • Rationality • Opportunity Cost • Marginal Principle • Demand, Supply and the Competitive Equilib. • Consumer and Producer Surplus, Deadweight loss • Externality • Coase Theorem

  3. Basic Principles • Economic actors are rational. • Being rational = Optimizing = Doing the very best they can with available resources • Rational people think in terms of opportunity cost: the value of the best foregone alternative • Not just the financial outlay • Cost of your college education is not just the tuition fee you pay (Total Cost = Money Cost + Opportunity Cost)

  4. Basic Principles • Rational people think at themargin • Not averages AC = C(Q)/Q MC = ΔC(Q)/ ΔQ • Marginal Cost (MC) is the cost of producing the last unit, or Change in total cost from increasing output by one unit • Similarly for marginal benefit (MB)

  5. Optimal Rule: Produce till MC = Price

  6. Demand: The Steel Mill Example Q = 300 – P • Height of demand curve: marginalwillingness to pay (WTP) • Total WTP= •  marginal WTP = Area under the Demand Curve MB

  7. Supply MC = Q • Supply Curve = MC Curve = Additional Cost of producing one more unit • Total Cost of Production/ Supply = Area under the Supply Curve

  8. Market Equilibrium • Algebraically, • We have Q = 300 – P and MC = Q • Optimization Rule: P = MC • So, Q = 300 – Q or, 2Q = 300 • Q = 150; P = 150

  9. Consumer Surplus CS = Area of the blue triangle = ½ Q*(300-150) = $11250

  10. Producer Surplus

  11. CS +PS = Social Welfare = $22500 • Welfare is maximum when MB = MC. • MB = MC in competitive markets.

  12. Let’s try some other point DWL

  13. What if there is an externality? • Externality is the effect of buyers’ or sellers’ actions on bystanders. • Impact on any party not involved in a given economic transaction. • Can be positive (a beautiful garden) or negative externality (pollution) • MB = MC does not maximize total welfare if there is an externality

  14. Assume there is a laundry nearby • s.t. MD = 0.5Q • Remember: MB = 300 –Q and MPC = Q • New term: MSC = MPC + MD = 1.5Q

  15. Now, Social Welfare is maximized by : • MSC = MB • 300 – Q = 1.5Q or 2.5Q = 300 • Q* = 120; P* = 300 – 120 = $ 180

  16. What if the Mill Still Chooses MB = MPC? ½ (Q-Q*)X (MSC – MB)Q • Loss to steel firm of moving to Q* is the shaded red triangle • This is the area between the MB and MPC curve going from Q to Q*. ½ (Q-Q*)X (MB – MPC)Q* ½ (Q-Q*)X (MDq – MDq*) • Laundry gains the trapezoid area under the MD curve going from Q to Q* = = shaded (blue + red) triangle area • . • DWL from producing Q1 instead of Q* = Area (blue triangle)

  17. Numerical Example • Steel mill’s loss if Q* instead of Q = ½ (Q-Q*)X (MB – MPC)Q* = ½ (30)*(180-120) = $ 900 • Laundry’s gain if Q* instead of Q = ½ (30)X (60+75) = $2025 • DWL @ Q = ½ (Q-Q*)X(MSC– MB)Q = ½ (30)*(225-150) = $1125

  18. Coase Theorem: Property rights to laundry MB – MPC = MD or, MB = MD + MPC Or MB = MSC

  19. CT: Property right to the Mill Once Again MB – MPC = MD or, MB = MD + MPC Or MB = MSC

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