Lec07-Applying_Consumer_Theory_Competitive_Markets

Lec07-Applying_Consumer_Theory_Competitive_Markets -...

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Lecture Note 7: Applying Consumer Theory to Competitive Markets — The United States Sugar Program David Autor 14.03 Applied Microeconomics and Public Policy, Fall 2005 1
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1 Applying Consumer Theory to Competitive Markets When exchange takes place voluntarily, we generally assume that it makes all participants better o f . Otherwise, participants would not have voluntarily engaged in the exchange. It’s useful to have a dollar metric of the gains from transacting. As we’ve already found in our use of the expenditure function for the food stamps program, this measure is consumer surplus. The notion of consumer surplus is critical because although we can readily measure the direct costs of a given project or policy (i.e., building a bridge, imposing a tari f ), it’s less obvious how we measure the bene f ts. Demand curves allow us to measure these bene f ts. Think of market demand curve is the set of consumers arrayed in inverse ordering from the person with the highest willingness to pay (WTP) for a good to the person with the lowest WTP. Similarly, think of the market supply curve as the set of producers arrayed in order from f rm willing to produce at lowest price to f rm demanding the highest price to produce a good. What market ideally does is match consumers and producers: If a producer is willing to produce at a price less than or equal what a consumer is willing to pay, that transaction will occur. Most consumers will be buying at a price below than their maximal willingness to pay. Most producers will be selling at a price above their lowest willingness to produce. Marginal producer and consumer will be indi f erent. It is easy to see that when this mechanism works correctly, it maximizes the sum of producer and consumer surplus: All gains from trade are realized. All transactions that bene f t both parties occur. No transactions occur that do not bene f t both parties. 2
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It is noteworthy that this metric does not place any greater weight on consumer or pro- ducer surplus: If supply is perfectly elastic, all of the surplus is captured by consumers. If demand is perfectly elastic, all of the surplus is captured by producers. Why do we want to maximize surplus without any regard for who are the bene f ciaries? Isn’t there a trade-o f between equity and e ciency? Answer: No , not in a competitive market. We’ll study this issue shortly in general equilibrium theory. Butforthemoment ,takeitonfa iththatwejustwanttomax im izethep ie ,andwe don’t need to worry about who gets which slice.
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This note was uploaded on 04/11/2008 for the course ECON 14.03 taught by Professor Autor during the Spring '08 term at MIT.

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Lec07-Applying_Consumer_Theory_Competitive_Markets -...

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