1, Econ. Section 5
September 14, 2005
GSI: Rachel Polimeni
Today:
I. Announcements
II. Key points and examples on rationing (Chapter 4)
III. Key points and examples on consumer and producer surplus (Chapter 4)
IV. If time: reminders about PPF
Next Time:
- Elasticity (Chapter 4) and maybe Utility (Chapter 5)
I. Announcements
II. RATIONING
1. Price Rationing: The process by which the market system allocates goods and services to consumers when
quantity demanded exceeds quantity supplied. Price rationing means that prices will rise to clear the market.
Example: Look at the market for apartments, and suppose that currently price is below the equilibrium (market
clearing) price.
If the market is left to its own forces, what happens to the price of apartments traded?
Who gets the apartments?
2. Non-Price Rationing: When prices are not allowed to rise to clear the markets, the shortage will continue. Other
mechanisms will determine how the limited supply is allocated.
Example: Suppose that the government decides that rents are too high and sets a price ceiling on rent that is lower
than the equilibrium price. A price ceiling is a maximum price that sellers may charge for a good.
On your graph, what is the actual amount of apartments being traded?
Since demand exceeds supply, but prices cannot adjust, what will happen? How are the apartments allocated?
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Econ. 1, Section 5
September 14, 2005
GSI: Rachel Polimeni
Note: What happens if the price ceiling is set above the market price?
Example: Hurricane Katrina contaminates all fresh water sources in New Orleans. At the same time, roads are
flooded and companies cannot receive shipments of bottled water. What happens to the equilibrium price and
quantity of bottled water in New Orleans?
Now, redraw the final supply and demand curves on the axes below. Should a price ceiling be put in place for
bottled water? (This is a normative question.) What are the arguments for or against? Show the effects of a price
ceiling on the axes below.
3. Price Floor: A minimum price below which exchange is not permitted.
Example: The government imposes a minimum wage above the market wage. What happens?
Note: What happens if the minimum wage is above the market wage?
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Econ. 1, Section 5
September 14, 2005
GSI: Rachel Polimeni
III. Consumer and Producer Surplus
We want to be able to analyze the effects of a price floor or price ceiling. One way to do this is to look at producer
and consumer surplus.
1. Consumer Surplus: The difference between the maximum amount a person is willing to pay for a good and its
current market price.
Example: Look at Bobs demand schedule for Cal t-shirts. Suppose the market price (determined by market supply
and market demand) is $10.
To buy 1 shirt, Bob is willing to pay $20, but the price he pays is only $10. So consumer surplus is ______.
Consumer surplus can be thought of as the value of Bobs happiness at paying less than he is willing to pay.
Price
$5
$10
$15
$20
Quantity Demanded
4
3
2
1
Consumer Surplus
What does this look like in a graph? Where is Bobs total consumer surplus for buying 3 t-shirts?
Example: Usually well at look consumer surplus for an entire market. Consider the market for Cal T-shirts.
Where is the consumer surplus?
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Econ. 1, Section 5
September 14, 2005
GSI: Rachel Polimeni
2. Producer Surplus: The difference between the current market price and the full cost of production for the firm.
Example: Consider a supplier of cakes, Cakeys Cake shop. Suppose the market price (determined by market supply
and market demand) is $15 for a cake.
Here is Cakeys supply schedule. Note that the price in the supply schedule respresents the producers full cost of
production as mentioned in the definition of producer surplus.
Cakeys was willing to supply one cake at $10. Cakey is able to sell that first cake at $15. Cakeys producer surplus
for that cake is: _________.
Price
$5
$10
$15
$20
Quantity Supplied
0
1
2
3
Producer Surplus
What does this look like in a graph? Where is Cakeys total consumer surplus for selling 2 cakes?
Example: Usually well look at producer surplus for an entire market. Consider the market for Cakes.
Where is the producer surplus?
On the same graph, where is the consumer surplus?
How can we increase the consumer plus producer surplus without shifting the curves?
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Econ. 1, Section 5
September 14, 2005
GSI: Rachel Polimeni
Examples of Consumer and Producer Surplus:
1) Consider the market for apartments. The government imposes a rent ceiling below the market price.
On the graph, what quantity is traded in the market at the rent ceiling price?
Where is the consumer surplus?
Where is the producer surplus?
How could the consumer plus producer surplus be increased without shifting the supply or demand curves?
Deadweight loss: The net loss of producer and consumer surplus from underproduction or overproduction.
On the picture above, where is the deadweight loss?
2) Consider the labor market. The government imposes a minimum wage that is above the market clearing price.
On the graph, what quantity is traded in the market at the rent ceiling price?
Where is the consumer surplus?
Where is the producer surplus?
Where is the deadweight loss?
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Econ. 1, Section 5
September 14, 2005
GSI: Rachel Polimeni
3) Suppose there is a price ceiling on bottled water, as in the hurricane Katrina example.
On the graph, what quantity is traded in the market at the rent ceiling price?
Where is the consumer surplus?
Where is the producer surplus?
Where is the deadweight loss?
Do the answers to these questions change your opinion on whether there should be a price ceiling on water?
IV. Reminders about PPF: Be sure you know how to answer these questions.
1. What does it mean when the PPF curve is straight?
2. Why are PPF curves often depicted as being bowed outward? What does this mean?
3. What are the keys to gains from trade? (In other words, what must be possible for gains from trade to occur?)
4. Midterm question: Spring 2005 number 5b
Pat and Thanh live together. They are equally skilled at housework and earn the same amount of money working.
What, if anything, will Pat and Thanh gain if they specialize and trade? Explain your answer using economic
concepts.
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