of Principles Economics I
Economics 101 Section 400 Class 7
Announcements
Reading: Chapter 4 Assignment 4
Quiz 2 in discussion section Thursday/Friday
Based on material from Assignment 4
Available online
Reminder: Exam - February 11 8:00pm 10:00pm
Practice exam available Monday of next week
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2
Auction Aftermath
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3
Industrial growth in China/India raises oil demand on world market
Price
Supply
P1 P0
Demand1 Demand0
Q0
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Q1
Qd
Quantity
4
Excess demand
The market for cars in the US: Supply effects from oil price Supply increase Price
1
Supply0
P1 P0
Oil price increase (increasing transport costs)
Demand0
Qs
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Q1
Q0
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Quantity
5
Excess Demand
The market for cars in the US: Demand side effects of oil price increase Price
Supply
P0
Oil price increase (oil and cars are complements)
P1
Demand1
Demand0
Qd
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Q1
Q0
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Quantity
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Excess Supply
The market for small/efficient cars in the US
Price Supply
P1 P0
Increase in price of gas (a substitute)
Demand1
Demand0
Q0
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Q1
Qd
Quantity
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Excess Demand
The market for cars in the US: effects of oil price increases
Price Supply1 Supply0
P0
Demand1
Demand0
Q1
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Q0
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Quantity
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The market for cars in the US: effects of oil price increases
Price Supply1 XXS Supply0
P0 P1
Demand1
Demand0
Q1
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Q0
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Quantity
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The car market and gas prices
Demand side effects:
Supply side effects:
High gas prices should depress car prices Reduce sales quantity
High gas prices will increase car prices Reduce sales quantity
Net effects:
Sales will certainly fall Ambiguous effect on prices:
If XSS at initial then prices will If XXS at initial then prices will
See: "Auto sales show 2007 was a clunker of a year" and "Auto Sales in Japan Fall to 35-Year Low"
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prices (i.e. relatively large fall in demand) fall prices (i.e. relatively large fall in supply) rise
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Recent Auto Industry Experiences
Reduced sales Reduction in sales most significant in relatively inefficient vehicles
E.g SUV sales
Relatively efficient vehicle sales have been high
E.g. Electric hybrids
See: "US Goes Hybrid"
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The market for cars in high growth economies (e.g China, India): effects of oil price increases Price
Supply1
P1 P0
Supply0
High gas prices increase production costs
Rising Incomes
XSD
Demand0
Demand1
QS
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Q0
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QD
Quantity
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High Growth Economy Experience
Supply Effect: Higher gas prices
Demand Effect: Higher incomes
Increased price and reduced sales Increased price and increased sales
Predicted Net Effect:
Increased price Ambiguous effect on sales
Observed Effect
Increased price Increase in volumes
See: "Chrysler Aims to Double Overseas Sales", "China's New Auto Sales Likely to Top 10 M. in 2008" and "Driving India"
Demand effect from increased incomes is large Production costs probably also falling (associated with growth)
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Predicting Market Changes Using Supply and Demand
Demand shifts to the right
Increase in market price Increase in sales Motivated by
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Increasing incomes (normal goods) Reducing incomes (inferior goods) Increased price of substitute good Reduced price of complementary good Favorable market information (e.g. advertising, news, etc) Increase in number of consumers
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Predicting Market Changes Using and Supply Demand
Last two examples involved simultaneous shifts in S and D
Oil price increases in the US:
Oil price increase in India and income growth
Reduced sales, ambiguous effect on price
Increased price, ambiguous effect on sales
Will always be the case that:
Changes is either Q or P can be predicted Changes in the other variable will be ambiguous If S & D both increase or both decrease, can predict change in Q If S & D change in opposite direction, predict change in P on the basis of the excess demand/supply created at initial price
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Market Outcomes
Supply and Demand model lets us predict changes in Q and P from changes in market conditions
Answer normative questions: what will happen?
Raises fundamental normative questions
If we can predict what will happen, can we determine whether the outcome is desirable?
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Market Outcomes and Efficiency
To answer normative questions, we need to apply some criterion
We use the notion of Pareto Efficiency
Suppose the market allocates resources as described by the Supply and Demand model Is it possible to reallocate resources in such a way that we make some people better off without harming others?
Produce more or less? Distribute available goods differently?
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Social Surplus
Measure of the net benefits from allocating resources in any given way The difference between:
1. The value of other goods consumers were prepared to give up in order to obtain the goods produced; and 2. The value of other goods the economy had to give up in order to produce those goods
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Consumers' valuation of goods produced
$/unit
Gross consumer valuation of Q* units
Demand Valuation Marginal Q*
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Units of output
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Opportunity cost of goods produced
$/unit
Supply
Marginal Opportunity Cost
Gross opportunity cost of Q* units
Q*
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Units of output
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Social Surplus
$/unit Gross consumer valuation of Q* units
Marginal Opportunity Cost
Social Surplus
Additional social Consumer valuation of the surplus from marginal unit the marginal unit Marginal Valuation Opportunity cost of the marginal unit Gross opportunity cost of Q* units Q* Units of output
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Social Surplus and Pareto Efficiency
In the previous example, we had Q* units produced Showed that producing a marginal unit could increase social surplus Explicitly, the marginal unit provides benefits to somebody that exceed the opportunity cost of producing the good
Suggests that this allocation is not efficient Efficiency demands that social surplus be maximized
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Maximizing Social Surplus
Possible to increase social surplus if the value of the marginal unit exceeds the cost of that unit
i.e. MV > MC
Conclude that we should increase output of this good until MV = MC
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Social Surplus
$/unit Gross consumer valuation of Q units
MC
Social surplus
Consumer valuation of the marginal unit Lost social surplus
MV
Q Q*
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Opportunity cost of the marginal unit Gross opportunity cost of Q units Units of output
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Efficient Output Level
Efficient allocation of resources demands
Social Surplus is maximized MV = MC
If producers and consumer face the same price, and
Consumers purchase Q such that P = MV Producers produce Q such that P = MC Then market clears and output level is efficient
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The Efficiency of the Market
$/unit
Consumer surplus
MC
Supply
Social surplus
P*
Producer surplus
MV
Demand
Q*
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Units of output
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