Equilibrium
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 We have now derived both the market demand curve
(Q d (p)) and market supply curve (Q s (p)) from first principles .
 Equilibrium price and quantity is determined by finding price that equates these two curves (picture):
Q d (p*) = Q s (p*)
 Ex: Consider the following demand and supply curves:
 Q d (p) = 55 – 5p


Q s (p) = 0 if p < 5
= p/2
What is equilibrium price and quantity?
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 Often we are interested in analyzing how changes in the market affect equilibrium price and quantity.

Generally called “comparative statics”
 Given we know where our supply and demand functions come from, comparative statics are often straightforward.
 Changes in production technology, price of inputs, affect
MC and therefore cause a shift in supply curve and cause movement along the demand curve.

Changes in preferences, or prices of complements or substitutes, will shift the demand curve and cause movement along supply curve.
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 Equilbrium under perfect competition results in a given allocation of goods to consumers and revenue to firms (which are owned by still other consumers).
 How does this allocation compare to other ways of allocating resources?
 To answer this question, first consider what the area underneath the demand curve but above the equilibrium price tells us.
 How about area underneath the price but above supply curve?
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
So we can think of the change in Consumers’ Surplus associated with an increase in price.
$ p’’
1 2 p’
Q d (p) q” q’ q


(1) Loss in CS due to having to pay more for each unit consumed.
(2) Loss in CS due to fewer overall units consumed.
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
We can also think of the change in Producers’ Surplus associated with an increase in price.
$
Q s (p) p”
1 2 p’ q” q’ q


(1) Gain in PS due to higher profits for each unit sold.
(2) Gain in PS due to more overall units sold.
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

We can think about changes in Consumer/Producer
Surplus to think about who is affected by changes in economic environment.
 Impacts often depend on relative slopes of Supply and
Demand Curves
Examples:
 Price controls (e.g. a price ceiling of $3/gal on gasoline).
 Who benefits from change in technological efficiency?
(e.g. costs of production and ease of entry into computer market over last 20 years).
 How does increase in drug enforcement affect drug market?
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 Example:

Let’s use these tools to analyze article about impact of biofuel demand on Guatemalan economy described in the NYT article.
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 We often interested in Net Surplus in the economy, or simply the sum of consumer surplus plus producer surplus.
 This is some measure of how much value a market is creating
 As we will see, this relates to Pareto Efficiency
 (Pareto) Efficient Outcome: No one can be made better off without making someone else worse off.
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 Example: Consider the allocation of apartments.
 Suppose there are four types of people (20 of each)
 Type 1 – will pay up to $1000 for an apartment
 Type 2 – will pay up to $800 for an apartment


Type 3 – will pay up to $600 for an apartment
Type 4 – will pay up to $400 for an apartment
 Supply of apartments given by supply function
Q s (p) = p/7.5
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 Consider rent control of $300
 Total supply of apartments: Q s (300) = (300)/7.5 = 40
 Demand exceeds supply at $300, so apartments randomly allocated,
10 to each type.

Net Surplus
$1000
$800
$600
$400
$300
Q s (p)
20 40 60 80 apartments
 Is this Pareto Efficient?
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 What if we kept rent control and random initial allocation, but let people trade apartments for cash after initial allocation?

E.g. suppose a side market was enacted where apartments could be traded for $610.
$1000
$800
$600
$400
$300
Q s (p)
20 40 60 80 apartments

Is this Pareto Efficient?
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 What if market dictated apartments?


Consider a price of $450


60 apartments demanded (Type 1s, Type 2s, Type 3s)
Q s (450) = (450)/7.5 = 60 apartments supplied
Net Surplus
$1000
$800
$600
$400
$300
Q s (p)
20 40 60 80 apartments
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 First Welfare Theorem: Under perfect competition, markets lead to Pareto Efficient outcomes.
 Generally it will be true that Pareto Efficient outcomes are outcomes that maximize net surplus (why is this true?)
 Markets achieve Pareto Efficiency by essentially performing two functions:
1.
Rations scarce resources to those who “value” goods the most (however, do note that value depends on income!)
2.
Provide allocative signals, telling those with factors of production how those factors will be valued in alternate uses.
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 Another way of saying this is that perfect markets mean that all mutually beneficial trades have been made.


Not only between producers and consumers, but also between those with factors of production to invest and those who need such factors for production.
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 So our First Welfare Theorem shows that markets lead to efficiency .


No trades between any two people can make one better off without hurting the other.
Production of goods maximized in the sense that cost of producing another unit will exceed the willingness to pay of the marginal consumer of that product.

So can we say that society is “better off” under market allocation than rent control allocation?
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 Other figures of note:
 Since 2000, median income fell by 12.4 percent, but during that time economy grew by 18 percent.

Top 1 percent of households garnered 65 percent of the nation’s income growth from 2002-2007.
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 This reveals a fundamental insight that comes out of studying economics.

How do you weigh one person’s utility against another’s?
 What is the correct social welfare function?
 Therefore, economists tend to focus on evaluating how much efficiency might we have to give up to get more equality and/or achieve other social goals (This leads to Taxation)
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 Consider two ways of collecting taxes:
 From consumers (e.g. pay some amount t for each unit purchased)
 How would this affect equilibrium?
 From firms (e.g. pay some amount t for each unit sold)
 How would this affect equilibrium?
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 Does who nominally pays tax really matter?
 How much of incidence is borne by consumers? How much is borne by producers?
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 How does tax incidence depend on relative responsiveness of supply and demand?
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 Besides tax incidence, what else do we notice happens when we impose a tax?
 Given this, what kind of goods are best to tax?
 How do income taxes fit into this?
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