Finance 30210: Managerial
Economics
Supply, Demand, and Equilibrium
If we can’t have everything we want, so we need to decide what to do with the
limited resources we do have.
Efficiency vs. Equity
An allocation of resources
that maximum total
welfare
Under certain
circumstances, the
competitive market
process guarantees
this
An allocation of resources
provides a “fair”
distribution of welfare
Can we trust markets to
produce a desirable
outcome?
Under what circumstances does the market process result in efficient
outcomes?
#1: Many buyers and sellers
– no individual buyer/firm has
any real market power
#2: Homogeneous products
– no variation in product
across firms
#3: No barriers to entry – it’s
costless for new firms to
enter the marketplace
#4: Perfect information –
prices and quality of products
are assumed to be known to
all producers/consumers
#5: No Externalities –ALL
costs/benefits of the product
are absorbed by the
consumer/producer
#6: Transactions are costless
– buyers and sellers incur no
costs in an exchange (i.e. no
taxes)
Can you think of situations where all these assumptions hold?
Lets try an example…suppose that you are a fisherman.
Top catch larger quantities of fish, you have to go farther
from shore and your catch per hour drops
Zone A
50 Fish/hr
300 Max/Day
Zone B
30 Fish/hr
300 Max/Day
You bought a boat for $1,000
Maintenance on the boat is $50/Day
You pay $16/hour in labor costs
You pay $20/hour for fuel and other expenses
What costs are fixed, sunk, and variable?
Zone C
20 Fish/hr
160 Max/Day
Lets try an example…suppose that you are a fisherman. To
catch larger quantities of fish, you have to go farther from
shore and your catch per hour drops
Zone A
Zone B
50 Fish/hr
300 Max/Day
Boat = $50
Labor = $16/hr
Gas = $20/hr
Zone C
30 Fish/hr
300 Max/Day
20 Fish/hr
160 Max/Day
Lets take this section by section…
Zone A
$36 / hr
 $.72 / Fish
50 Fish / Hr
Quantity
Total Cost
Fixed Cost
Variable
Cost
Average Cost
Marginal
Cost
0
$50
$50
$0
---
---
1
$50.72
$50
$.72
$50.72
$.72
2
$51.44
$50
$1.44
$25.72
$.72
3
$52.16
$50
$2.16
$17.39
$.72
Let’s try and picture this…
Dollars
Dollars
AC
TC
VC = $.72*F
$50
FC
$.72
MC
# of Fish
0
# of Fish
0
Lets try an example…suppose that you are a fisherman.
Top catch larger quantities of fish, you have to go farther
from shore and your catch per hour drops
Zone A
Zone B
50 Fish/hr
300 Max/Day
Boat = $50
Labor = $16/hr
Gas = $20/hr
Zone C
30 Fish/hr
300 Max/Day
20 Fish/hr
160 Max/Day
Lets take this section by section…
Zone B
$36 / hr
 $1.20 / Fish
30 Fish / Hr
Quantity
TC
FC
VC
AC
MC
300
$266
$50
$216
$0.88
$.72
301
$267.20
$50
$217.20
$0.88
$1.20
302
$268.40
$50
$218.40
$0.88
$1.20
303
$269.60
$50
$219.60
$0.88
$1.20
Let’s try and picture this…
TC
Dollars
Dollars
VC =$216 + $1.20*F
$266
$50
FC
$1.20
MC
AC
$.88
# of Fish
300
# of Fish
300
Lets try an example…suppose that you are a fisherman.
Top catch larger quantities of fish, you have to go farther
from shore and your catch per hour drops
Zone A
Zone B
50 Fish/hr
300 Max/Day
Boat = $50
Labor = $16/hr
Gas = $20/hr
Zone C
30 Fish/hr
300 Max/Day
20 Fish/hr
160 Max/Day
Lets take this section by section…
Zone C
$36 / hr
 $1.80 / Fish
20 Fish / Hr
Quantity
TC
FC
VC
AC
MC
600
$626
$50
$576
$1.04
$1.20
601
$627.80
$50
$577.80
$1.04
$1.80
602
$629.60
$50
$579.60
$1.04
$1.80
603
$631.40
$50
$581.40
$1.04
$1.80
Let’s try and picture this…
TC
Dollars
Dollars
VC =$576 + $1.80*F
$626
$50
FC
$1.80
MC
AC
$1.04
# of Fish
600
# of Fish
600
All together…
Dollars
Dollars
TC
Slope = 1.80
Slope = 1.20
MC
$1.80
Slope = .72
AC
$50
FC
$1.20
$.72
0
300
600
# of
Fish
# of Fish
0
300
600
Perfectly competitive firms are “price takers”. They see a market price and can’t
change it. Suppose that the market price is $1.20.
Fish
Price
Total Revenue
Total Cost
Profit
0
$1.20
$0
$50
-$50
1
$1.20
$1.20
$50.72
-$49.52
2
$1.20
$2.40
$51.44
-$49.04
3
$1.20
$3.60
$52.16
-$48.56
300
$1.20
$360
$266
$94
301
$1.20
$361.20
$267.20
$94
302
$1.20
$362.40
$268.40
$94
303
$1.20
$363.60
$269.60
$94
600
$1.20
$720
$626
$94
601
$1.20
$721.20
$627.80
$93.40
602
$1.20
$721.40
$629.60
$91.80
603
$1.20
$721.60
$631.40
$90.20
We are looking to maximize profits where profits are the
difference between total revenues and total costs
Dollars
Dollars
TC
$94
TR
$0
# of Fish
Slope = 1.80
$50
Profit
-$50
Slope = 1.20
Slope = .72
0
Profits are
increasing
300
Profits are
maximized
# of Fish
600
Profits are
decreasing
0
Profits are
increasing
300
Profits are
maximized
600
Profits are
decreasing
We could also go at this by looking at costs and benefits at the margin. For a
perfectly competitive firm the market price equals marginal revenue.
Fish
Total Cost
Total Revenue
Marginal Revenue
Marginal
Cost
0
$50
$0
$1.20
$.72
1
$50.72
$1.20
$1.20
$.72
2
$51.44
$2.40
$1.20
$.72
3
$52.16
$3.60
$1.20
$.72
300
$266
$360
$1.20
$.72
301
$267.20
$361.20
$1.20
$1.20
302
$268.40
$362.40
$1.20
$1.20
303
$269.60
$363.60
$1.20
$1.20
600
$626
$720
$1.20
$1.20
601
$627.80
$721.20
$1.20
$1.80
602
$629.60
$721.40
$1.20
$1.80
603
$631.40
$721.60
$1.20
$1.80
Lets plot out marginal revenues and costs rather than total
costs and revenues…
Dollars
Dollars
$94
MC
$1.80
$0
# of Fish
MR
$1.20
Profit
-$50
$.72
0
Marginal
revenue is
greater than
marginal cost
300
0
600
Marginal
revenue is
equal to
marginal cost
Marginal
revenue is
less than
marginal cost
Profits are
increasing
300
Profits are
maximized
600
Profits are
decreasing
When we talk about a supply curve we are talking about the profit maximizing
decisions of individual firms at prevailing market prices
Dollars
Dollars
MC
$1.80
MR
$1.20
$1.20
$.72
# of Fish
0
300
600
At a market price of
$1.20, MR = MC for
any quantity of fish
between 300 and
600
0
300
600
At a market price of
$1.20, this firm will
be willing to supply
any quantity of fish
between 300 and
600
Now, suppose that the market price is $0.72.
Fish
Price
Total Revenue
Total Cost
Profit
0
$0.72
$0
$50
-$50
1
$0.72
$0.72
$50.72
-$50
2
$0.72
$1.44
$51.44
-$50
3
$0.72
$2.16
$52.16
-$50
300
$0.72
$216
$266
-$50
301
$0.72
$216.72
$267.20
-$50.48
302
$0.72
$217.44
$268.40
-$50.96
303
$0.72
$218.16
$269.60
-$51.44
600
$0.72
$432
$626
-$194
601
$0.72
$432.72
$627.80
-$195.08
602
$0.72
$433.44
$629.60
-$196.16
603
$0.72
$434.16
$631.40
-$197.24
Again, lets plot revenues, costs, and profits…
Dollars
Dollars
$0
# of Fish
TC
Slope = 1.80
-$50
Slope = 1.20
Slope = .72
TR
$50
Profit
# of Fish
0
300
Profits are
maximized
(losses are
minimized)
600
Profits are
decreasing
0
300
Profits are
maximized
(losses are
minimized)
600
Profits are
decreasing
We could also go at this by looking at costs and benefits at the margin. For a
perfectly competitive firm the market price equals marginal revenue.
Fish
Total Cost
Total Revenue
Marginal Revenue
Marginal
Cost
0
$50
$0
$.72
$.72
1
$50.72
$0.72
$.72
$.72
2
$51.44
$1.44
$.72
$.72
3
$52.16
$2.16
$.72
$.72
300
$266
$216
$.72
$.72
301
$267.20
$216.72
$.72
$1.20
302
$268.40
$217.44
$.72
$1.20
303
$269.60
$218.16
$.72
$1.20
600
$626
$432
$.72
$1.20
601
$627.80
$432.72
$.72
$1.80
602
$629.60
$433.44
$.72
$1.80
603
$631.40
$434.16
$.72
$1.80
Again, lets plot marginal revenues, marginal costs, and profits…
Dollars
Dollars
$0
MC
$1.80
-$50
$1.20
$.72
MR
Profit
0
300
Marginal
revenue is
equal to
marginal cost
0
600
Marginal
revenue is
less than
marginal cost
300
Profits are
maximized
600
Profits are
decreasing
When we talk about a supply curve we are talking about the profit maximizing
decisions of individual firms at prevailing market prices
Dollars
Dollars
MC
$1.80
$1.20
$1.20
$.72
MR
$.72
# of Fish
0
300
At a market price of
$.72, MR = MC for
any quantity of fish
between 0 and 300
600
0
300
At a market price of
$.72, this firm will be
willing to supply any
quantity of fish
between 0 and 300
600
When we talk about a supply curve we are talking about the profit maximizing
decisions of individual firms at prevailing market prices
Dollars
Dollars
MC
MR
$1.80
$1.80
$1.20
$1.20
$.72
$.72
# of Fish
0
300
600
At a market price of
$1.80, MR = MC for
any quantity of fish
between 600 and
760
0
300
600
At a market price of
$1.80, this firm will be
willing to supply any
quantity of fish between
600 and 760
What if the prevailing market was $1.35?
Dollars
Dollars
MC
MR
$1.35
$1.35
# of Fish
0
300
600
At a market price of
$1.35, 600 fish are
profitable to supply,
but the 601st is not!
0
300
600
At a market price of
$1.35, this firm will be
willing to supply exactly
600 fish.
So we can get an individual firm’s supply curve by following marginal costs!
Suppose that there are 1000 fishermen in the village – all with the same costs.
Dollars
Dollars
$1.80
$1.80
$1.20
$1.20
$.72
$.72
0
300
600
Individual Supply
# of
Fish
0
300,000
600,000
# of
Fish
Market Supply
Market supply adds up the decisions of each individual firm at each prevailing
market price
So where do prices come from? We need to know how many fish people are
actually willing to buy at any prevailing market price.
Dollars
Price
Fish
$2.00
50,000
$1.80
150,000
$1.50
200,000
$1.20
500,000
$1.00
540,000
$.72
600,000
$.50
700,000
$1.80
$1.20
$.72
0
150,000
500,000
900,000
# of
Fish
A demand curve is just a record of how much the market collectively is willing to
buy at any given market price
In equilibrium, total supply should equal total demand. If not, the price
will adjust.
Dollars
Supply
At a $1.80 price, fishermen will bring at
least 600,000 fish to the market, but
only 150,000 will get sold – the price
needs to drop
$1.80
$1.20
$.72
Demand
0
300,000
600,000
500,000
# of
Fish
At a $.72 price, fishermen will bring at
most 300,000 fish to the market, but
600,000 are demanded– the price
needs to rise
Price
Fish
$2.00
50,000
$1.80
150,000
$1.50
200,000
$1.20
500,000
$1.00
540,000
$.72
600,000
$.50
700,000
In equilibrium, total supply should equal total demand
Individual
Market
Dollars
Dollars
Supply
$1.80
$1.80
$1.20
$1.20
MC
MR
$.72
$.72
Demand
0
300,000
600,000
500,000
The market determines the
equilibrium price of $1.20 and 500,000
fish sold by the 1,000 fishermen
0
300
600
At the prevailing market price of
$1.20, each fisherman supplies
between 300 and 600 fish
Boat = $50
Labor = $16/hr
Gas = $20/hr
Fish
Total Revenue
Total Cost
Profit
300
$360
$266
$94
301
$361.20
$267.20
$94
$36 / hr
 $1.20 / Fish
30 Fish / Hr
302
$362.40
$268.40
$94
303
$363.60
$269.60
$94
A Few Diagnostics…
Dollars
Price= $1.20
- Gas Cost = $0.67
Labor’s Value Added= $0.53
* Labor Productivity = 30 Fish/Hr
$16/hr = hourly wage
MC
$1.80
$1.20
MR
Producer Surplus = $144
- Fixed Cost = $50
$144
Accounting Profit= $94
$.72
0
300
600
$94 *100 = 9.4% Return
$1,000
Is this fisherman earning economic profits?
Suppose that the excess returns causes 800 more fishermen (all with
identical costs) to enter the market.
Dollars
Supply
$1.80
$1.20
$.72
Demand
0
300,000
# of
Fish
600,000
540,000
1,080,000
1,368,000
Price
Fish
$2.00
50,000
$1.80
150,000
$1.50
200,000
$1.20
500,000
$1.00
540,000
$.72
600,000
$.50
700,000
In equilibrium, total supply should equal total demand
Individual
Market
Dollars
Dollars
Supply
$1.80
MC
$1.80
$1.20
$1.00
MR
$1.00
$.72
$.72
Demand
0
300,000
600,000
540,000
The market determines the
equilibrium price of $1.00 and 540,000
fish sold by the 1,800 fishermen
0
300
600
At the prevailing market price of
$1.00, each fisherman supplies 300
fish
Boat = $50
Labor = $16/hr
Gas = $20/hr
$36 / hr
 $.72 / Fish
50 Fish / Hr
Fish
Price
Total Revenue
Total Cost
Profit
0
$1.00
$0
$50
-$50
1
$1.00
$1.00
$50.72
-$49.72
2
$1.00
$2.00
$51.44
-$49.44
3
$1.00
$3.00
$52.16
-$49.16
300
$1.00
$300
$266
$34
A Few Diagnostics…
Dollars
Price= $1.00
- Gas Cost = $0.40
Labor’s Value Added= $0.60
* Labor Productivity = 50 Fish/Hr
MC
$1.80
MR
$1.00
$84
$30/hr > hourly wage
Producer Surplus = $84
- Fixed Cost = $50
$.72
Accounting Profit= $34
0
300
600
$34 *100 = 3.4% Return
$1,000
Let’s see if we can’t generalize this a bit. We want marginal costs to be
increasing – this reflects decreasing productivity at the margin
TC
Dollars
Dollars
MC
$1.80
$50
FC
$1.20
$.72
0
300
600
# of
Fish
0
300
600
We are still looking for where marginal revenue equals marginal costs
(i.e. the slopes are the same)
Dollars
Dollars
TC
$94
TR
Slope = P
$0
# of Fish
F*
Profit
-$50
# of Fish
0
300
F*
600
0
300
600
We are still looking for where marginal revenue equals marginal costs
Dollars
Dollars
MC
$0
F*
P*
MR
Profit
-$50
0
F*
0
300
600
We are still looking for where marginal revenue equals marginal costs
Dollars
Dollars
Supply
MC
P*
P*
MR=P
# of Fish
0
F*
For any market price (which equals marginal
revenue for a perfectly competitive firm, there
is a profit maximizing quantity where MR = MC
0
F*
That optimizing quantity becomes a point on
that firms supply curve
We still aggregate decisions across individual suppliers to get market supply
(again, assume 1,000 fishermen)
Dollars
Dollars
Supply
P*
0
Supply
P*
F
# of
Fish
0
1000*F
Individual Supply
Market Supply
# of
Fish
In equilibrium, total supply should equal total demand
Individual
Market
Dollars
Dollars
Supply
MC
$1.44
MR
$1.44
Demand
0
0
400
400,000*
The market determines the
equilibrium price of $1.44 and 400,000
fish sold by the 1,000 fishermen
At the prevailing market price of
$1.44, each fisherman supplies 400
fish
Boat = $50
Labor = $16/hr
Gas = $20/hr
We can still perform whatever diagnostics
we want…
For this calculation to
work, labor
productivity must be
25 fish per hour
Price= $1.44
- Gas Cost = $.80
Labor’s Value Added= $0.64
* Labor Productivity = 25 Fish/Hr
$16/hr = hourly wage
Dollars
MC
PS = (1/2)(400)(1.44)=288
Producer Surplus = $288
- Fixed Cost = $50
Accounting Profit= $238
MR
$1.44
$288
$238 *100 =23.8% Return
$1,000
0
400
Is this fisherman earning economic profits?
Suppose that the excess returns causes 800 more fishermen (all with
identical costs) to enter the market.
Dollars
Dollars
Supply
$1.44
$1.44
$1.03
Demand
0
400,000
576,000 720,000
# of
Fish
0
320
400
Boat = $50
Labor = $16/hr
Gas = $20/hr
We can still perform whatever diagnostics
we want…
At 320 fish, your productivity is 35
Fish/hour
Price= $1.03
- Gas Cost = $.57
Labor’s Value Added= $0.46
* Labor Productivity = 35 Fish/Hr
Dollars
$16/hr = hourly wage
MC
PS = (1/2)(320)(1.03)=165
Producer Surplus = $165
- Fixed Cost = $50
Accounting Profit= $115
MR
$1.03
$165
$115 *100 =11.5% Return
$1,000
0
320
Suppose that we have three fishermen with different productivities. Each
bought a boat for $1,000 and have the same costs as before.
Boat = $50
Labor = $16/hr
Gas = $20/hr
30 Fish/hr
300 Max/Day
$1.20 per
fish
20 Fish/hr
200 Max/Day
$1.80 per
fish
10 Fish/hr
100 Max/Day
$3.60 per
fish
Each of the above fishermen will provide fish to
the marketplace as long as the market price is
equal to or greater to their marginal cost
All a supply curve really does is
order production from lowest cost
to highest cost
Dollars
$3.60
$1.80
$1.20
Fish
0
300
500
600
For a market price that is at least $3.60, fisherman #1 sells 300
fish, fisherman #2 sells 200 fish and fisherman #3 sells 100 fish
For a market price that is at least $1.80, but below $3.60, fisherman #1 sells
300 fish and fisherman #2 sells up to 200 fish.
For a market price that is at least $1.20, but below $1.80, only fisherman #1 sells
fish. He can supply up to 300
Adding a demand curve will give us the equilibrium price and identify the
fisherman who participate in the market as well as the fisherman’s economic
profits
Boat = $50
Labor = $16/hr
Gas = $20/hr
Fisherman #1
Producer Surplus = $540
- Fixed Cost = $50
Dollars
Accounting Profit= $490
Supply
$490 *100 = 49% Return
$1,000
$3.60
Fisherman #2
$3.00
PS= $240
$1.80
PS= $540
Demand
$1.20
Accounting Profit= $190
Fish
0
Producer Surplus = $240
- Fixed Cost = $50
300
500
600
$190 *100 = 19% Return
$1,000
A Supply Function represents the rational
decisions made by a profit maximizing
firm(s).
“Is a function of”
QS  S P 
Quantity
Supplied
Market
Price (+)
As you move up the supply curve, the
rise in price encourages increased
production of existing producers
(intensive margin) as well as the entry of
new producers (extensive margin)
Price
S
High marginal costs are in this portion – they will make
the lowest profits (if they are sold)
Lower marginal costs are in this portion – they will make
the largest profits
Quantity
Everything we talked about on the supply side is mirrored on the demand side.
Just at producers are maximizing profits, consumers maximize their welfare.
Welfare = Total Utility – Total Cost
Dollars
Welfare
0
F*
P*
MC
MU
0
Q
F*
Most consumers experience diminishing marginal utility – each
successive item consumed is worth less in terms of satisfaction
Q
By the same token, a demand curve naturally ranks potential
consumers from highest valuation to lowest valuation. Suppose that
we have three potential consumers.
Would pay up
to $2/fish. Can
consume 100
fish per week.
Would pay up
to $1/fish. Can
consume 50
fish per week.
Would pay up to
$.50/fish. Can
consume 20 fish
per week.
What would this demand curve look like?
Dollars
If fish cost more than $2,
nobody buys them!
$2
If fish cost between $2 and
$1, only Captain buys them!
$1
If fish cost between $.50 and
$1, Captain AND Andrew
Zimmern buy them!
If fish cost more less than $.50 ,
EVERYBODY buys them!
$.50
Fish
0
100
150
170
Price
Quantity Demanded
Above $2
0
$2
0 – 100
Between $2 and $1
100
$1
100 - 150
Between $1 and $.50
150
$.50
Between 150 and 170
Between $.50 and $0
170
For any market price, we know how many fish are
sold and how much each consumer benefits from
the market (consumer surplus)
At a market price of $1.50
Dollars
Captain buys 100 fish for $1.50 apiece.
He saves $.50 per fish for a total of $50 in
savings (surplus)
Neither the baby of Andrew Zimmern are
willing to buy fish for $1.50.
$2
CS = $50
$1.50
$1
$.50
Fish
0
100
150
170
For any market price, we know how many fish are
sold and how much each consumer benefits from
the market (consumer surplus)
At a market price of $.75
Dollars
Captain buys 100 fish for $.75 apiece.
He saves $1.25 per fish for a total of $125
in savings (surplus)
Andrew Zimmern buys 50 fish for $.75.
He saves $.25 per fish for a total of $12.50
in surplus
The baby still is unwilling to buy fish!
$2
CS = $125
$1
CS = $12.50
$.75
$.50
Fish
0
100
150
170
A Demand Function represents the
rational decisions made by a
representative consumer(s)
“Is a function of”
Quantity
Demanded
QD  DP
Market
Price (-)
Price
high marginal valuations are located here
low marginal valuations are located here
D
Quantity
As you move down the demand curve, the
lower price encourages increased
consumption by existing customers
(intensive margin) as well as attracting new
consumers (extensive margin)
Key Point: Demand curves represent marginal utility (what we are willing to pay
for one additional item). Consumer surplus measures total value.
Example: The Diamond/Water Paradox
Water
Diamonds
Price
Price
P*
P*
D
Quantity
D
Quantity
Market Equilibrium: There exists a price where supply equals demand – the
market will find this price automatically.
Price
S
At a price above the equilibrium price, supply
is greater than demand. A surplus drives the
price down
P*
At a price below the equilibrium price, demand
is greater than supply. A shortage drives the
price up
D
Quantity
Q*
Recall an earlier discussion about allocations of resources.
Efficiency vs. Equity
An allocation of resources
that maximum total
welfare
Under certain
circumstances, the
market process
guarantees this
An allocation of resources
provides a “fair”
distribution of welfare
Can we trust markets to
produce a desirable
outcome?
Let’s suppose that we are talking about the market for bananas.
There was a pound of bananas
sold that cost $3 to supply and was
valued by someone at $7. This
transaction created $4 of wealth $2 went to a seller (producer
surplus) and $2 went to a buyer
(consumer surplus)
Would this transaction be wealth
creating? NO!
Price
S
$12
$8
$7
$5
$3
$2
D
$0
Quantity
1,000
There was a pound of bananas sold that cost $2 to supply and was
valued by someone at $8. This transaction created $6 of wealth - $3
went to a seller (producer surplus) and $3 went to a buyer (consumer
surplus)
Competitive markets provide efficient outcomes in that every wealth creating
transaction was undertaken. In other words, consumer surplus and producer
surplus are maximized.
Price
$12
S
Consumer Surplus = (1/2)*($12- $5)*1,000
$3,500
$5
$2,500
Producer Surplus = (1/2)*($5- $0)*1,000
D
$0
Quantity
1,000
Note that $6,000 of wealth was created by this market!
Example: Suppose we have the following petroleum firms. Further suppose that
there is pressure from the public to reduce pollution levels.
Firm
Historical
Emissions
(Tons/yr)
Marginal
Abatement Cost
($/Ton)
Apache
50
12
BP
50
18
Chevron
50
24
Devon
50
30
Exxon
50
36
First Texas
50
42
Gulf
50
48
Hess
50
54
Industry Total
400
How would you
go about
reducing
emissions by
50%
The cheapest way to reduce pollution by 50% would be to require the cheapest 4 firms
to reduce their emissions completely and let the other four firms continue as in the past
$ Per Unit
Pollution
Reduction
Hess
$54
Gulf
$48
First
$42
Exxon
$36
Devon
$30
Chevron
$24
BP
$18
$12
Problems:
•Unfair
•Requires information on
abatement costs
Apache
Quantity of
Emissions
Reduction
We could follow an “across the board” emission reduction program (note:
pollution taxes would have the same basic effect)
Firm
Historical
Emissions
(Tons/yr)
Marginal
Abatement Cost
($/Ton)
Tons of emission
to be reduced
Total abatement
cost
Apache
50
12
25
300
BP
50
18
25
450
Chevron
50
24
25
600
Devon
50
30
25
750
Exxon
50
36
25
900
First Texas
50
42
25
1,050
Gulf
50
48
25
1,200
Hess
50
54
25
1,350
Industry Total
400
200
6,600
Let markets work for you!!!
Example: Cap and Trade as a solution to pollution reduction.
Firm
Historical
Emissions
(Tons/yr)
Marginal
Abatement Cost
($/Ton)
Apache
50
12
BP
50
18
Chevron
50
24
Devon
50
30
Exxon
50
36
First Texas
50
42
Gulf
50
48
Hess
50
54
Industry Total
400
Could BP profit from
selling a pollution
permit to Gulf? What
should the selling price
be?
The Market for pollution permits
$ Per Unit
Pollution
Reduction
$54
Hess
Gulf
$48
Equilibrium price range
Hess
Gulf
First
$42
S
$36
First
Exxon
Exxon
Devon
Devon
$33
$30
Chevron
$24
BP
$18
$12
Apache
Chevron
BP
Apache
D
Quantity of
Emissions
Reduction
The cap and trade program lowered the cost of pollution reduction by $2,400
(from $6,600 to $4,200).
Firm
Historical
Emissions
(Tons/yr)
Marginal
Abatement
Cost ($/Ton)
Initial
Permit
Holdings
Permits
Sold
Permits
Bought
Final Permit
Holdings
Required
Emission
Reduction
Emission
Abatement Cost
Apache
50
12
25
25
0
0
50
$600
BP
50
18
25
25
0
0
50
$900
Chevron
50
24
25
25
0
0
50
$1200
Devon
50
30
25
25
0
0
50
$1500
Exxon
50
36
25
0
25
50
0
$0
First
Texas
50
42
25
0
25
50
0
$0
Gulf
50
48
25
0
25
50
0
$0
Hess
50
54
25
0
25
50
0
$0
Industry
Total
400
200
100
100
400
200
$4,200
Note that cost of purchasing permits equals revenues from selling permits and so
add no additional costs. Lets set the equilibrium permit price at $33.
Firm
Initial
Pollution
Reduction
Final
Pollution
Requirement
Marginal
Abatement
Cost ($/Ton)
Abatement
Cost
Additions/
Savings
Permits
Bought
Permits
Sold
Permit
Cost/Permit
Revenue
Net Gain
Apache
25
50 (+25)
12
$300
0
25
-$825
-$525
BP
25
50 (+25)
18
$450
0
25
-$825
-$375
Chevron
25
50 (+25)
24
$600
0
25
-$825
-$225
Devon
25
50 (+25)
30
$750
0
25
-$825
-$75
Exxon
25
0 (-25)
36
-$900
25
0
$825
-$75
First Texas
25
0 (-25)
42
-$1050
25
0
$825
-$225
Gulf
25
0 (-25)
48
-$1200
25
0
$825
-$375
Hess
25
0 (-25)
54
-$1350
25
0
$825
-$525
Industry
Total
200
200
-$2,400
200
200
$0
-$2,400
The consumer/producer surplus
represents the gains by all firms
$ Per Unit
Pollution
Reduction
$54
Hess
Hess
Gulf
$48
S
Gulf
$525
First
$42
First
$375
$225
Exxon
$36
Exxon
$75
$33
$30
$225
Devon
Devon
$375
$24
Chevron
$525
Chevron
$75
BP
$18
$12
Apache
BP
Apache
D
Quantity of
Emissions
Reduction
We could do this numerically as well…
QS  3P
QD  100  2P
Every $1 increase in
price lowers demand by
2 units
QD  QS
100  2P  3P
100  5P
P  $20
In Equilibrium
Price
S
Every $1 increase in
price raises supply by 3
units
QD  100  220  60
QS  320  60
$20
D
Quantity
60
Consumer and producer surplus give us a numerical value of a
marketplace…
QS  3P
QD  100  2P
Note: a $50 price will
set quantity demanded
equal to zero.
Price
S
Consumer Surplus
1
CS   60 $50  $20   $900
2
$50
$900
$20
$600
Producer Surplus
1
PS   60$20  $0  $600
2
D
$0
Quantity
60
Demand is not simply a function of price, but is, instead, a function of many
variables
“Is a function of”
QD  DP,...
•Income
•Prices of other goods
(Substitutes vs.
Compliments)
•Tastes
•Future Expectations
•Number of Buyers
Price
Demand Shifters
Example: Increase in
Demand
At the initial price of
$10, but with a new
value for one of the
demand shifters,
quantity demanded
has risen to 120 (An
increase in demand)
Price
Holding all the demand
shifters constant at
some level, quantity
demanded at a price of
$10 is 100
$10
D(.’.)
D(…)
Quantity
100
120
Example: How would the loss in income
during the last recession impact the hotel
industry?
S ...
Rate
per
night
At the current $150 market price,
supply is still 50,000, but with a
lower level of income, demand has
fallen to 40,000
$150
DI  $50,000
40,000
50,000
DI  $75,000
# of
Rooms
At the new income level of $50,000, $150 can no longer be
the equilibrium price
Example: How would the loss in income
during the last recession impact the hotel
industry?
S ...
Rate
per
night
$150
$125
DI  $50,000
45,000 50,000
DI  $75,000
# of
Rooms
The decrease in income (which causes a decrease in demand) causes a drop
in sales and a drop in market price
QS  4 P
QD  80  2P  7 I
Every $1 increase
in income
increases demand
by 7 units
With I = $20
With I = $10
80  2P  720  4P
80  2P  710  4P
220  6P
150  6P
P  $25
Q  80
P  $36.67
Q  147
Price
Price
S
S
$36.67
The $10 increase
in income raises
demand by 70
$25
$25
D
D
Quantity
80
Quantity
80
147
Supply is not simply a function of price, but is, instead, a function of many
variables
“Is a function of”
QS  DP,...
Price
Supply Shifters
Example: Decrease in Supply
•Technology
Marginal costs
•Input prices
•Number of sellers
Holding all the supply
shifters constant at
some level, quantity
supplied at a price of
$10 is 100
At the initial price of $10,
but with a new value for
one of the supply shifters,
quantity demanded has
fallen to 80
Price
S(.’.)
S(…)
$10
Quantity
80
100
Example: How would a drop in the wage
rate in Columbia influence the price of
coffee?
Price
per
pound
S w  $8
S w  $6
$5
D...
Pounds
10,000
At the current $5
market price, supply
has risen to 18,000,
but demand is still at
10,000
18,000
At the wage level of $6, $5 can no longer be the equilibrium
price
Example: How would a drop in the wage
rate in Columbia influence the price of
coffee?
Price
per
pound
S w  $8
S w  $6
$5
$4
D...
Pounds
10,000
16,000
The lower wage (which causes an increase in supply) , results
in a lower price and higher sales
QS  4P  .5w
QD  80  2P
Every $1 increase
in wages
decreases supply
by .5 units
With w = $20
With w = $10
80  2P  4P  .520
80  2P  4P  .510
90  6P
85  6P
P  $14.16
Q  52
P  $15
Q  50
Price
Price
S
S
$15
$14.16
The $10 increase
in wages lowers
supply by 5
$14.16
D
D
Quantity
52
Quantity
50
52
Demand curves slope downwards – this reflects the negative relationship between price
and quantity. Elasticity of Demand measures this effect quantitatively
%QD  20
D 

 2
% P
10
Price
 2.75  2.50 

 *100  10%
2.50 

$2.75
$2.50
DI  $50,000
Quantity
4
5
 45

 *100  20%
5


Note that elasticities vary along a linear demand curve
Price
Q  100  2 P
P
Q
$35
30
$34
32
$20
60
$19
62
$10
80
$9
82
 D  2.3
 D  .61
% Change in
Q
% Change
in P
Elasticity
6.7
-2.9
-2.3
$35
$20
3.3
-5
-.61
2.5
-10
-.255
D
30
0
-1
%QD  QD  P 

D 


%P  P  QD 
-2
-3
-4
-5
-6
Slope
-7
-8
-9
-10
12
20
28
80
60
36
44
52
60
68
76
84
Quantity
92
100
Supply curves slope upwards – this reflects the positive relationship between price and
quantity. Elasticity of Supply measures this effect quantitatively
Price
 3.00  2.00 

 *100  50%
2
.
00


S
$3.00
$2.00
Quantity
200
%QS 25
s 

 .5
%P 50
250
 250  200 

 *100  25%
200


Example: What effect would a shutdown of oil production in Iran have on oil
prices?
Yom Kippur war
oil embargo
Iranian
Revolution/
Iran Iraq War
OPEC Cuts
Gulf War
911
PDVSA Strike
Iraq War
Asian
Expansion
Price in 2010 = $67
Iran produces around 4M Barrels per day. This represents around 4% of the
total world supply.
We also know that the elasticity of
demand for oil is around -.05
% QD
D 
% P
With a little rearranging…
%P 
%QD
D
4
% P 
 80
 .05
$67(1.80) = $120
It would be foolish to consider the entire oil market as perfectly competitive, but
perhaps considering the non-OPEC market as perfectly competitive market is not
entirely crazy
Country
Joined
OPEC
Production (Bar/D)
Algeria
1969
2,180,000
Angola
2007
2,015,000
Ecuador
2007
486,100
Iran
1960
3,707,000
Iraq
1960
There are around 100
Non-OPEC countries
producing collectively
55 Million Bar/D.
Country
Production (BBD)
Russia
9,810,000
United States
8,514,000
China
3,795,000
India
3,720,000
Canada
3,350,000
2,420,000
Kuwait
1960
2,274,000
Libya
1962
1,875,000
Nigeria
1971
2,169,000
Qatar
1961
797,000
Saudi Arabia
1960
10,870,000
United Arab
Emirates
1967
3,046,000
Venezuela
1960
2,643,000
Suppose that we consider the following supply demand model:
Demand
Competitive Supply
Qd  a  bP
Qs  c  dP
Parameters to be
estimated
OPEC Supply
Qs  35
Parameters to be
estimated
To estimate four parameters, we need four pieces of information
Variable
2010 Value
Market Price
$67
Market Quantity (Bar/D)
90M
OPEC Supply
35M
Non-OPEC Supply (Bar/D)
55M
Elasticity of Supply (Bar/D)
.10
Elasticity of Demand
-.05
Let’s start with the demand side first. We can relate the equilibrium elasticity
to the parameter ‘b’
%Qd Qd P
d 

%P
P Qd
Qd  a  bP
The parameter ‘b’
represents the
change in quantity
demanded per dollar
change in price
P
 d  b
Qd
A little rearranging…
Variable
2010 Value
Market Price
$67
Market Quantity (Bar/D)
90M
OPEC Supply
35M
Non-OPEC Supply (Bar/D)
55M
Elasticity of Supply (Bar/D)
.10
Elasticity of Demand
-.05
Qd
b   d
P
 90 
b  .05   .067
 67 
Now that we know ‘b’, we can find ‘a’
Qd  a  .067 P
Again, a little
rearranging…
a  Qd  .067 P
a  90  .06767  94.5
Variable
2010 Value
Market Price
$67
Market Quantity (Bar/D)
90M
OPEC Supply
35M
Non-OPEC Supply (Bar/D)
55M
Elasticity of Supply (Bar/D)
.10
Elasticity of Demand
-.05
Qd  94.5  .067 P
We are halfway home!
Repeat the process with the supply side. We can relate the equilibrium
elasticity to the parameter ‘d’
%Qs Qs P
s 

%P
P Qs
Qs  c  dP
The parameter ‘c’
represents the
change in quantity
supplied per dollar
change in price
P
s  d
Qs
A little rearranging…
Variable
2010 Value
Market Price
$67
Market Quantity (Bar/D)
90M
OPEC Supply
35M
Non-OPEC Supply (Bar/D)
55M
Elasticity of Supply (Bar/D)
.10
Elasticity of Demand
-.05
Qs
d  s
P
 55 
d  .10   .082
 67 
We’re estimating the non-OPEC supply, so be
sure to use only the non-OPEC quantity!
Now that we know ‘d’, we can find ‘c’
Qs  c  .082P
Again, a little
rearranging…
c  Qs  .082P
c  55  .08267  49.5
Variable
2010 Value
Market Price
$67
Market Quantity (Bar/D)
90M
OPEC Supply
35M
Non-OPEC Supply (Bar/D)
55M
Elasticity of Supply (Bar/D)
.10
Elasticity of Demand
-.05
Qs  49.5  .082P
That’s it!
Suppose that we consider the following supply demand model:
Demand
Competitive Supply
Qd  94.5  .067 P
Qs  49.5  .082P
OPEC Supply
Qs  35
Let’s double check our results
Qd  Qs
94.5  .067 P  35  49.5  .082 P
10  .149 P
P  $67
Variable
2010 Value
Market Price
$67
Market Quantity
(MBar/D)
90
Qd  94.5  .06767  90
Now, back to the original question. Suppose that Iran’s oil supply is shut down.
OPEC supply drops by 4 BBD
Demand
Competitive Supply
Qd  94.5  .067 P
Qs  49.5  .082P
OPEC Supply
Qs  31
Now factor that into the Supply/Demand Model
Qd  Qs
94.5  .067 P  31  49.5  .082 P
14  .149 P
P  $94
Qd  94.5  .06794  88
Variable
Market Price
$94
Market Quantity
(Bar/D)
88
Now, back to the original question. Suppose that Iran’s oil supply is shut down.
OPEC supply drops by 4 BBD
Price
S
Variable
P' $120
P' $94
P*  $67
D'
86
88
90
Market Price
$94
Market Quantity
(BBD)
88
OPEC Quantity
31
Non-OPEC Quantity
57
D
Quantity
The drop in OPEC supply pushes price up which gives non-OPEC countries the
incentive to increase supply
Partial Equilibrium vs. General Equilibrium
Price
Suppose that effective
advertising increased
the demand for
lemonade. What would
happen.
S
P*
D'
D
Q
*
Quantity
A rise in demand should increase sales and increase
the price right? Is that all?
Partial equilibrium deals with a disturbance in one market. General
Equilibrium recognizes that markets interact with one another and looks at
the interrelations between markets
Price
S
A rise in demand for lemonade
should increase sales and
increase the price.
P*
D'
Sugar
Price
Lemons
S
Price
S
D
Q
*
Quantity
D
Quantity
This increase in
marginal costs
should lower
supply, right!
The rise in lemonade sales
should raise demand for
lemons and sugar which
increases their prices
D
Quantity
Where would you rather live? South Bend or Chicago?
Why?
What’s better in Chicago?
What’s better in South Bend?
Pretty much everything is
better in Chicago!
It’s cheaper in South Bend!
The indifference principle states that once everything is accounted for, every
city must be equally desirable. Otherwise, who would choose to live in an
inferior city.
Lets say that the key advantage to South Bend is its low housing costs. If
Chicago was still preferred, South Bend residents would start moving to
Chicago – this will magnify the benefits of South Bend (cheaper housing)
Median
Home
Price
Chicago Housing Market
Median
Home
Price
South Bend Housing market
S
S
$238,000
$86,000
D
D
Houses
The difference between housing costs should just offset any
advantages Chicago has!
Houses
Renting vs. Buying a House….what’s the better move?
Median
Home
Price
South Bend Rental Market
Median
Rent
South Bend Housing market
S
S
$600
$120,000
D
D
Houses
Suppose that the median rental
rate is $600 per month ($7200 per
year) and the current mortgage
rate is 6%
Rentals
P
$7200
 $120,000
.06
Can you spot the housing bubble?
Easy financing, low interest rates, and expectations of housing price increases
created an artificial spike in housing demand…
Housing prices appreciation (2003-2007): 9%/yr
Median
Home
Price
US Housing market
Housing price appreciation (2003-2010): 2%/yr
S 2003
$262,000
$210,000
$185,000
D2007
D2010
D2003
Expectations of future price increases drives housing
demand up…
Expectations of price decreases drives
demand back down
Houses
….but that demand spike didn’t last.
Question: Are we in an ‘Education Bubble”?
Can we really justify the rapidly rising costs of college tuition or are
students getting in over their heads taking out loans that they will never
be able to afford?
High School Labor Force
College Educated Labor Force
Salary
S
Salary
S
$38,000
$26,000
D
D
Employees
Employees
Universities
Tuition
S
Can these markets be in
equilibrium?
$15,000
D
Enrollment
Consider the earnings across different ages and different education levels.
Age Group
Attainment
25-29
30-34
35-39
40-44
45-49
50-54
55-59
College
$43,121
$55,440
$62,244
$65,973
$66,280
$64,254
$65,240
High School
$28,097
$31,366
$33,443
$35,283
$36,316
$35,270
$37,573
Differential
$15,024
$24,074
$28,801
$30,690
$29,964
$28,984
$27,667
x5
= $75,120
x5
= $120,370
x5
x5
x5
x5
x5
=$926,020
= $144,005 = $153,450 = $149,820 = $144,920 = $138,335
PV 
$15,024 $15,024
$27,667


...

 $350,386
4
5
39
1.05 1.05
1.05
Lets assume
that you could
earn 5%
elsewhere
You receive the first payment 4 years from
now
This isn’t really
right because
you don’t get all
this money up
front
What are the costs of going to college?
Cost
Annual
Expense
Tuition
$15,000
Lost Wages
$26,000
Books, Fees, etc
$1,000
Room & Board
$5,000
$36,000 x 4 = $164,000
Note: we really should
discount these costs as well!
This is not a relevant cost…you
would have paid this anyways!!!
So, a college education costs $164,000 and yields $350,386 in
(discounted) lifetime benefits! Seems worth it!
PV 
$15,024 $15,024
$27,667


...

 $350,386
4
5
39
1.05 1.05
1.05
Alternatively, we can think about the annual salary differential for a college graduate like
the annual payout on a bond. The annual return to a college education would be like
calculating the return necessary so that the PV of the wage differential equals the cost
Cost
Annual
Expense
Tuition
$15,000
Lost Wages
$20,000
Books, Fees, etc
$1,000
PV 
$15, 024
1  i 
4

$36,000 x 4 = $164,000
Note: we really should
discount these costs as well!
$15, 024
1  i 
5
 ... 
Annual return
$27, 667
1  i 
39
 $164, 000
i  11%
Thought of as an investment, a college education pays
11% per year!!
High School Labor Force
College Education Labor Force
Salary
S
Salary
S
$38,000
$26,000
D
D
Employees
Employees
Universities
Tuition
If the costs of
college were truly
less than the
benefits, we would
see more people go
to school
S
Wage differentials
would fall and
college tuitions
would increase
$15,000
D
Enrollment
High School Labor Force
College Education Labor Force
Salary
S
Salary
S
$38,000
$26,000
D
D
Employees
Employees
Universities
Tuition
What we are seeing
is a steady increase
in demand for
skilled labor as
demand for
unskilled labor falls
S
Wage differentials
continue to increase
as college tuitions
increase
$15,000
D
Enrollment
In the years following a divorce, statistics show that
the woman’s living standard falls 27% while the
man’s living standard rises by 10%
Feminists such as Patricia Ireland (NOW)
would argue that this proves divorce is unfair to
women
Couldn’t you just as easily argue that marriage is
unfair to men?
On December 22, 2001, Richard Reid was arrested
trying to blow up an American Airlines flight from Paris
to Miami with a bomb hidden in his shoes.
Many human rights groups have fought
heavily against the practice of racial
profiling by airline security
Isn’t there a better way to secure the safety of our airplanes?
(Hint: could we create a marketplace?)
Paul “Freck” Morgan started a website in 2001 offering a
$20 Pay Per View event…..to watch him cut off his feet with
a homemade guillotine.
Note: The site turned out to be a
hoax…Paul never actually went
through with it!
How should we feel about this entrepreneurial effort? (i.e.
could we/should we repress this market?)