Supply and demand
Part 3
Underlying assumptions in
economic theory
The underlying value judgement
Individual (Homo oeconomicus hypothesis) sovereignty:
Resources should be allocated according to what people want.
(Pareto-efficiency)
The underlying concept
Opportunity costs:
In order to consume more of good 1 (e.g., boats) you have to give
up some consumption of good 2 (e.g., environmental quality or
leisure).
Let’s go deeper into demand
Individuals have preferences over goods & services including the
environment. It’s all based on UTILITY
The individual preferences can be translated into an willingness to
pay (WTP), reflecting the individual benefits from consumption.
Generally, the marginal willingness to pay declines with the amount
consumed.
Let us ignore the environment for the time being.
From individual needs to an aggregated demand curve !
law of diminishing returns
Gossen's First Law is the “law” of diminishing marginal utility: that
marginal utilities are diminishing across the ranges relevant to
decision-making.
Gossen's Second Law, which presumes that utility is at least
weakly quantified, is that in equilibrium an agent will allocate
expenditures so that the ratio of marginal utility to price (marginal
cost of acquisition) is equal across all goods and services.
example
Benefits and Costs
Marginal WTP
50
1
Aggregated demand curve
Quantity
Benefits and Costs
Marginal WTP
50
Aggregated demand curve
42
12
Quantity
Benefits and Costs
Marginal WTP
50
Aggregated demand curve
42
35
WTP
10
Quantity
Benefits and Costs
Marginal WTP
50
Aggregated demand curve
42
35
WTP
10
Quantity
Benefits and Costs
Marginal WTP
50
Aggregated demand curve
42
35
WTP
10
Quantity
Benefits and Costs
Marginal WTP
50
Aggregated demand curve
42
35
WTP
10
Quantity
Question: How do we get to know the marginal
willingness to pay of somebody?
Benefits and Costs
Marginal WTP
Aggregated demand curve
Linear relationship
 This makes it easier for
us to handle!
WTP
Quantity
10
Benefits and Costs
Summing up individual WTP yields total WTP.
Total willingness to pay is equal to total benefits from consumption.
Total (marginal) WTP provides a measure of a society’s benefits
from consumption.
Benefits and Costs
The production side:
The available technologies determine the production possibilities.
Producing goods/services implies (opportunity) costs
Marginal cost curve shows the costs of producing one additional
unit.
Marginal costs are non-decreasing with output.
Total costs are the sum of marginal costs.
Benefits and Costs
Relationship of marginal to total costs
Marginal Costs
Marginal Costs
Total Costs
Quantity
20
Socially Optimal Outcome
Calculation of net benefits:
total (aggregate) net benefits = total (aggr.) benefits – total costs
Efficiency:
An allocation is efficient if this allocation maximises net benefits.
Optimality condition:
Net benefits are maximised if marginal benefits equal marginal
costs.
Socially Optimal Outcome
Derivation of net benefits
Marginal WTP/Costs
Net
Benefit
Maximum price
Total Costs
Quantity
Q*
Additional reading
for those interested:
• Duncan Kennedy, Cost-Benefit Analysis of Entitlement
Problems: A critique; Stanford Law Review, Vol. 33, No. 3 (Feb.,
1981), pp. 387-445
Stable URL: http://www.jstor.org/stable/1228354
Why is the market economy
best in theory?
Both consumers and producers are better off because there is a market
in this good, i.e. there are gains from trade.
The maximum possible total surplus (highest possible gain to society) is
achieved at market equilibrium.
In the market equilibrium there is no way to make some people better off
without making others worse off  markets are efficient. (no pareto
optimum possible)
The benifits of the market
system
Example: Market for books
Two cases
It’s all about books
Situation No. 1 “Demand”:
We have a market for books. Imagine we would take an
economics book from Mia (who bought it) and give it to Bob,
who thought it is too expensive. What are the effects?
Reallocating consumption
lowers consumer surplus
Case No. 2
Situation No. 2 “Supply”:
Two booksellers (Yvonne & Xavier) are competing on the
market. Imagine Yvonne would be forced to sell her book
instead of Xavier. What would be the effect?
Reallocating Sales Lowers
Producer Surplus
The market performs
4 important functions
It allocates consumption of the good to the potential buyers who
value it the most.
It allocates sales to the potential sellers who most value the right to
sell the good.
It ensures that every consumer who makes a purchase values the
good more than every seller who makes a sale.
It ensures that every potential buyer who doesn’t make a purchase
values the good less than every potential seller who doesn’t make
a sale.
Freakonomics blog
What problems to exist if we deal with supply
and demand ?
Refer to problems mentioned in the articles
Links to articles
• http://www.freakonomics.com/2012/02/01/are-superbowl-ads-too-cheap/
• http://www.freakonomics.com/2012/01/12/theeconomics-of-prostitution-belle-epoque-edition/
• http://www.freakonomics.com/2011/12/02/why-doesa-caucasian-dollhouse-cost-nearly-70-more-than-anafrican-american-dollhouse/
Defining and Measuring
Elasticity
The price elasticity of demand is the ratio of the percent change in
the quantity demanded to the percent change in the price as we move
along the demand curve.
Different
Different
values
values
for
for
elasticity
elasticity
Different
Different
values
values
for
for
elasticity
elasticity
Different values for elasticity
Interpreting the Price Elasticity of
Demand: How Elastic Is Elastic?
Demand is:
elastic if the price elasticity of demand is greater than 1,
inelastic if the price elasticity of demand is less than 1, and
unit-elastic (or iso-elastic) if the price elasticity of demand
is exactly 1.
Price Elasticity of Supply
…and nearly the same, just the other way around…
The price elasticity of supply is a measure of the responsiveness of the
quantity of a good supplied to the price of that good.
Quick review of demand
Review:
Demand curve illustrates relationship between price & quantity
demanded
The „law of demand“ asserts that demand curves normally slope
downward  higher price, fewer quantity
Increase in demand  right-shift of the curve
Decrease in demand  left-shift of the curve
4 main factors that can shift the curve:
(1) price of a related good: substitute or complement (2) income
(3) tastes and (4) expectations
Quick review of supply
Review:
supply curve illustrates relationship between price and quantity
supplied
The supply curves are normally sloping upwards  higher price,
more quantity offered
Increase in supply  right-shift of the curve
Decrease in supply  left-shift of the curve
3 main factors that can shift the curve:
(1) input prices (2) technology and (3) expectations
A different view on
supply & demand
Any questions left ?
1. Introduction
2. Markets,
Firms &the
Role of
Government
3. Global
Economy I
4. Global
Economy II
5. Global
Economy III