SURPLUS CONSUMER (CS)
An important concept describing consumer choice, reflecting the difference
between the MAX Price a consumer is willing to pay and the actual price - the
Market Price.
Consumer Surplus = MAX PRICE YOU WOULD PAY - MARKET PRICE
Example: You find an item at a garage sale that you would secretly be willing to
pay $3 for, and it is marked $1. Your consumer surplus is $3 - 1 = $2. It is an
estimate of your gain from voluntary exchange, which is always WIN-WIN.
Or you buy a $100 sweater on sale at Marshall Fields for $20, you may have
actually been willing to pay $25, you get a $5 consumer bonus, or Consumer
Surplus.
The total value of Consumer Surplus (CS) to ALL consumers can be reflected
using the Demand Curve, as on page 60. It is the area underneath the Demand
Curve, above the Market Price of P1, and represents the Net Gain to all
consumers from market exchange at a price of P1. If the price falls, CS
increases, and if the price rises, CS falls.
SHIFTS (CHANGES) IN DEMAND VS. CHANGES IN QUANTITY
DEMANDED
The Demand curve isolates the effect that price has on Qd (Law of Demand),
holding everything else constant, ceteris paribus. With a Demand Curve, you
give me a Price and I can tell you how much will be purchased at that Price.
Qd = f (P) ONLY!!!
D (f) = (Price of subs, Price of complements, Income, Tastes, Demographics,
expected P, etc.)
A change in quantity demanded is a movement along the curve, shows
(isolates) the response of Qd to a change in Price. Due to graphical constraints
(two dimensions, we are restricted to showing the relation of two variables
along the curve). All other changes we show with a shift in the ENTIRE
demand curve.
Example of common mistake: "As a result of higher gas prices, the demand for
gas fell." This is technically incorrect. A change in prices caused the Quantity
Demanded to change!! It should read: "As a result of higher gas prices,
the quantity demanded fell."
RULE: A change in PRICE leads to a CHANGE IN QUANTITY
DEMANDED (movement along the demand curve), a change in any other
variable leads to a CHANGE IN DEMAND (shift in the entire demand curve.
See graph page 62: Movement A (change or reduction in Q d) versus Movement
B (Increase in Demand).
INCREASE in Demand: Demand curve shifts to the RIGHT.
DECREASE in Demand: Demand curve shifts to the LEFT.
Notice visually that Movement A is MUCH different than Movement B. To be
economically precise, we need a different term for each separate, distinct
movement or change. We are trying to understand, model and analyze dynamic
change in the economy, and need to be able to distinguish between two VERY
different changes.
WHAT CAUSES DEMAND for X TO SHIFT (CHANGE)?
Changes in other variables BESIDES THE PRICE of X, that also affect
consumer choice, affect DEMAND: Changes in income, changes in the size of
the market (# of consumers), changes in the Prices of Related Goods (Y) goods that are either Substitutes or Complements, changes in the expected price
of X in the future, demographic changes, and changes in tastes and preferences
(fads, fashion, trends in lifestyles, music, food, clothing, etc.). See page 64 for
a summary:
1. A rise (fall) in consumer income will increase (decrease) demand.
(Economic conditions, recession or expansion, affect demand)
2. An increase (decrease) in the number of consumers in the market would
increase (decrease) demand. (Is the market expanding or contracting?) See
page 63 - when student population falls in summer, the Demand for pizza falls.
3a. If the Price of Substitute product (Y) goes up (down), D for X increases
(decreases). Example: Price of Pepsi goes up, Quantity demanded for Pepsi
goes down, Demand for Coke INCREASES.
3b. If the Price of a product (Y) that is a complement for X goes down (up),
Demand for X INCREASES .Complements: products used together, like CDs
and CD players, VCRs and videotapes, cars and gas, etc. If the price of CD
Players goes down, demand for CDs will INCREASE. If the price of gas falls,
the demand for cars would go up.
Price of listening to music = price of CDs + price for CD player
Price of driving = price of car + price of gas
4. Expectations about future price influence our decision to buy NOW or
LATER. The Demand Curve reflects our willingness to BUY NOW (vs. later).
If we expect price of cars to go up in the future, we INCREASE our demand
now. Example: Russia announced that vodka prices would rise in one month.
What happened? If we expect prices to fall (go on sale) in the future, we will
DECREASE demand now. What happens when computer prices are expected
to fall?
5. Demographic changes that are either favorable to a market will INCREASE
demand. Example: People are living longer, so the number of retired people (as
a percent of the population) has increased. Demand has increased for
retirement homes in Florida, RVs, cruise vacations, etc.
6. Changes in Consumer Tastes/Preferences in food, fashion, music,
etc. Example: People are more health conscious now, Demand has
INCREASED for what? Demand has DECREASED for what?
PRODUCER CHOICE AND THE LAW OF SUPPLY
Producers/suppliers/firms transform raw materials into goods desired by
households and sell final products to consumers. GM transforms raw materials
like steel and plastic and glass and fabric into automobiles. All those materials
could be used for other purposes/production, so that those materials have to be
"bid away" from other potential uses. The cost of production and the final retail
price must represent the OPPORTUNITY COST of those materials if they had
been used elsewhere.
Example: if gold is made into jewelry, it has to be bid away from alternative
uses in dentistry. To use gold in dentistry, it has to be bid away from jewelry
production. If redwood used is to build houses, it has to be bid away from the
production of picnic tables. If universities hire accounting professors, they
have to be bid away from accounting practice.
Example: If a firm leases a building, it pays rent. If it buys a building by
financing it with a mortgage, it pays interest. Rent and interest are accounting
business expenses. However, if a firm owns its own building outright (no
debt), there is still an economic cost for the building in the form of OPP COST.
What is the OPP COST of using the building? Illustrates the difference
between ECON COST and ACCTG COST.
Firms in a market economy operate under a Profit and Loss system. Profits
occur when a firm has sales revenue that exceeds all costs of production (TR >
TC). Losses occur when a firm's revenue is less than its cost of production (TR
< TC).
Profits and losses provide discipline by rewarding successful firms with profits
and products and penalizing unsuccessful firms and products. Firms that are
successful at pleasing consumers expand and those that don't please consumers
will contract or go out of business. Resources are allocated away from
unsuccessful firms toward successful firms and products.
"Consumer sovereignty" Consumers are kings and queens in the market.
Examples: Two unsuccessful products - New Coke in 1985 and Cadillac
Allante in 1987. In both cases, consumers rejected these products and they were
taken off the market. Coke and GM were disciplined by the market in the form
of losses on these products.
Examples: one restaurant is very successful, makes profits and one is very
unsuccessful, loses money. Profits of the successful restaurant allow it to
expand, get bigger, open up a new branch, start franchising, etc. Profits are a
signal that the owners are pleasing consumers. Profits provide resources to
successful firms to expand. Many national chains and franchises started
originally with ONE STORE - Wal-Mart, McDonalds, Dominos Pizza, etc.
The restaurant that loses money is disciplined. Either they figure out how to
make money/please consumers or they go out of business. If they go out of
business, resources are freed up to go to successful firms/restaurants - workers,
land, building, equipment, capital (business loans), etc.
Profit/loss system guides and directs market activity without any central
control. Decentralized organization.
Law of Supply - there is a direct/positive relation between Price and the
Quantity Supplied by firms. At a higher price, the producer has a greater
incentive to supply goods and services.
Examples: If milk (corn, soybeans, etc.) prices are high, farmers will try to
produce more. If oil prices are higher, oil producers will try to supply more. If
overtime wages are high, workers will supply more labor. 45 hours vs. 40
hours.
Supply curve, page 67. Represents two things:
1. the minimum price necessary to induce producers to supply a specific Q.
2. the valuation (OPP COST) of the resources used in production.
Example: Supply of labor. The wage (price) paid is the value of your talents in
terms of opportunity cost, your next highest valued opportunity. UM-F has to
pay professors a salary that reflects their OPP COST.
PRODUCER SURPLUS - A concept similar to Consumer Surplus, applied to
the Supply (Sellers) side of the market. Producer Surplus = Market Price MIN Price a Seller/Supplier is willing to accept. Example: A musician would
be willing to play for $50 and actually gets offered $200, creating $150
surplus. See page 68. PS represents the net gains to producers from production
and exchange, and includes the net gains to all resource owners. Example: PS
for GM represents the gains to the workers, owners (shareholders), and owners
of all inputs and resources used to build cars.
ELASTIC AND INELASTIC SUPPLY CURVES
From the Law of Supply, we know that an increase in Price will lead to an
increase in the Quantity Supplied. The degree of elasticity tells us how much
Quantity Supplied will increase, measure the responsiveness of suppliers to
price changes. See page 69, illustrates the difference between Elastic Supply
(very responsive to price changes) in Panel a, and Inelastic Supply (very
unresponsive to price changes) in Panel b.
Panel a: Price goes from $1 to $1.50, Elastic Supply goes for soft drinks goes
from 100 to 200 (2x increase) for soft drinks.
Panel b: Price goes from $100 to $150 (same percentage increase as for soft
drinks, 50%), and inelastic supply of physician services only goes from 10 to
12 (1.2x increase).
Example: Wages for unskilled labor goes from $5 to $10/hour because of a new
mall or factory or a special event (Buick Open) vs. Wages for skilled computer
programmers goes from $50,000 to $100,000 because of Y2K. Illustrates the
important concept of SHORT RUN vs. LONG RUN.
Long run (LR) - time period long enough to make changes in property, plant,
equipment, education, training, etc.. Example: build a new factory addition,
close a factory/plant, get training as a computer programmer, engineer, etc.
Time period that allows major expansion or contraction of operation.
Short run (SR) - time period short enough that major changes cannot be made
in property, plant or equipment. Can make changes in labor and/or raw
materials. Capacity constraint of some sort. One year or less, arbitrary period.
In the above example, the supply of unskilled workers should be fairly elastic
(responsive) in the SR since no training is required for these jobs. Many
currently unemployed people would be willing to work part-time if the wages
were high enough, like whom?????? Skilled work many times requires years
of training (engineering, software design, physicians, etc.), so it would time to
get trained or retrained to take advantage of the higher wages.