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Lecture 8 Mutual Gains from Trade

Lecture 8 Mutual Gains from Trade. We rely on other people to produce things we want: We are not forced to rely on others. Why do we voluntarily rely on others through the market process? We must answer this question: What are the gains from mutually beneficial exchange?.

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Lecture 8 Mutual Gains from Trade

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  1. Lecture 8Mutual Gains from Trade We rely on other people to produce things we want: • We are not forced to rely on others. • Why do we voluntarily rely on others through the market process? We must answer this question: • What are the gains from mutually beneficial exchange?

  2. Mutual gains—Simple Example • You buy food from a grocer because she is willing to sell to you at a price that is: • 1) less than the value you place on the good, and/or • 2) less than your costs of producing it yourself • Therefore, you gain from shopping at grocer (consumer surplus) • Grocer sells to you. You are willing to pay a price that is: • 1) more than the cost of producing the good, and/or • 2) more than the seller’s next best alternative • Therefore, grocer gains from selling to you (producer surplus) • We are joined together by mutual gains through market exchange

  3. The consumers’ perspective • Look at demand side of market and ask: What is the total value in use to consumers of the quality Q*? It is the total area under demand curve from 0 to Q* (OABQ*) • People usually do not have to give up all of this because suppliers will deliver at a price of P* Price A B P* Demand O Q*Quantity

  4. What Will the Price Be? • Price and value may have little relationship. -- Suppose you have a treasure chest with $10 million in it and you know you must get it open quickly or you lose the money. How much would you be willing to pay for a $5 tool to let you break the chest open? The difference in value to a user and price paid in exchange is consumers’ surplus.

  5. Consumer surplus • The gains from trade going to consumers: Total use value (ABQ*0) minus Total expenditures (P*BQ*0) equals Consumer surplus (ABP*) Price A B P* Demand 0 Q* Quantity

  6. The producers’ perspective Look at supply side of market and ask: What is the total cost to producers of the quantity Q*?” Three equal descriptions are: 1. minimum you would accept to produce Q* rather than Q=0 2. sum of the marginal costs from 0 to Q* 3. area under the supply curve from 0 to Q* • Producers usually do not have to settle for MC, because demanders will pay a price of P* Price Supply = MC P* B 0 Q* Quantity

  7. Producer surplusThe gains from trade going to the producer: • Total revenue (P*BQ*0) Minus • Total costs (0CBQ*) [Costs must be recovered or no production.] Equals • Producer surplus (P*BC) Price S = MC P* B C 0 Q* Quantity

  8. Putting It All Together Market Price Demand Supply Price Price A A S S B B P* P* P* B D D C C 0 0 0 Q* Quantity Q* Quantity Q* Quantity There are gains to suppliers and demanders — room for bargaining. Who gets producer and consumer surplus? Area ABC is up for grabs!

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