EC 100 Class 3
Question 1
• A consumer values the first unit of a good they consume at £10, the
second at £8, the third at £6 and the fourth at £5. If the price of the good
is £7 how many units of the good do they buy?
Question 1 and 2
• A consumer values the first unit of a good they consume at £10, the
second at £8, the third at £6 and the fourth at £5. If the price of the good
is £7 how many units of the good do they buy?
• Gains from first unit: 10-7 =3 > 0
• Gains from second unit: 8-7 = 1 >0
• Gains from third unit: 6 – 7<0 – so better off not purchasing third unit
• So total surplus to consumer = 3 + 1 = 4
Question 3
• Supply curve reflects the sellers marginal cost – each unit
sold at marginal cost covers only cost of producing this unit.
• Hence producers do not earn anything on the “marginal
unit” sold.
• If the supply curve is horizontal, all “inframarginal” units
are sold at marginal cost as well.
Question 3
• Extreme Cases of Horizontal Supply –
Producer surplus = 0.
Price
,P
Equilibrium
price
Supply
Curve
Demand =
Willingness
to pay
Q
*
1
Quantity,
Question 4
• Downward shift in supply curve: price sold is
still = MC for all inframarginal units. So
producer surplus = 0, only consumers benefit.
Price
,P
Supply
Curve
Equilibrium
price
Demand
Q
*
1
Quantity,
Question 5
• Absolute advantage: country is the lowest cost
producer of that good.
• Comparative advantage: country makes the
good relatively cheaper than other goods.
– Country has a lower opportunity cost for
producing the good
• Law of comparative advantage: countries
should specialize in production of the good(s)
for which they have a comparative advantage.
– This produces higher overall output (to be shared
between countries)
– Country always has a comparative advantage in
something
– (Free market provides right incentives for this to
happen – no government involvement necessary)
Question 5
Question 6
• Suppose a country is in the unfortunate
position of not having an absolute advantage
in the production of any good. Tick all of the
following statements that must then be true
Question 7
• Another example…
• A person in China can produce 100kg of rice in a year or 10 litres of olive
oil (or a combination of the two). A person in Italy can produce 25kg of
rice in a year or 50 litres of olive oil (or a combination of the two). Which
of the following statements are true
Question 7
• Absolute advantages: Italy has absolute advantage to produce
Oil, while China has absolute advantage to produce rice.
• Comparative advantage: Italy has comparative advantage in
olive oil, China has comparative advantage in rice.
• So:
– Italy should specialize in olive oil (and export to
China for rice…)
– China should specialize in rice (and export to Italy
for olive oil…)
Studying Policy intervention
• A key part of this course is for you to be able
to understand the impacts of different policy
interventions
• Or to have the tools to analyze the effects of
policy interventions in a simple framework of
supply and demand.
• Very common interventions: taxes, subsidies,
price regulation…
Question 9
• The house rental market is perfectly
competitive but renting a house is expensive
so the government decides to impose a ceiling
on rents that is below the market-clearing
price. What will happen to the amount of
housing in the market?
Question 9
• Now there is excess demand
Price Ceiling
New Q
Question 10
• Some PS becomes CS – overall surplus falls (brown area is
DWL)
Price Ceiling
New Q
Question 11
• What about consumer surplus? … it depends
Loose this
Gain this
Price Ceiling
New Q
Question 11
• What about consumer surplus? … it depends
• The crucial factor is the steepness of the
supply curve…
• If supply very elastic – flat supply curve –
quantity falls sharply after price ceiling
• DWL very high
Question 12
• What about producer surplus? … it goes down
• Intuition:
• Profits = (P-AC)*Q
– Prices and quantity both fall so firms are losing
out
Question 12
• What about producer surplus? … it goes down
Price Ceiling
New Q
Discussion Question – Payday Lending
• To repay a £400 loan for 45 days costs £588
which works out as an annualized rate of
interest of 5000 per cent per year.
• People can take out mortgages right now (if
eligible) at an interest rate of less than 4 per
cent per year.
The interest rates charged are exploitative and
Wonga should be banned?
• Key point: probably not the same people…
• People choose to use Wonga, so they must be
better off
– Good argument against banning Wonga
– Assuming people know what is best for them…
– Government bans drugs, smoking (<18) etc so why
not Wonga?
The interest rates charged are exploitative and
so rates should be capped.
• See question 12 – effect on consumer surplus
is ambiguous
• Some people lose out – can no longer get a
loan.
• Is market for loans perfectly competitive?
– If so, interest rates represent cost of providing
loans
– If barriers to entry, scope for government
involvement (see monopoly topics…)
Wonga should be allowed but the interest rates
it charges should be capped.
• Interest rate caps may not solve the problem,
as it means that some loans are not granted
that would have been granted otherwise.
• The people who do not get the loans are
worse off.
• Who are the people using this service? Why
are they using this? Is there some other
inherent market failure that may drive this?