Figure 1. Do You Use Facebook? Economics is greatly impacted by how well information travels through society. Today, social media giants like Twitter, Facebook, and Instagram are major forces on the information super highway. (Credit: Johan Larsson/Flickr)

What is economics and why should you spend your time learning it? After all, there are other disciplines you could be studying, and other ways you could be spending your time. As the topic feature just mentioned, making choices is at the heart of what economists study, and your decision to take this course is as much as economic decision as anything else.

It is important to distinguish microeconomics from macroeconomics. Whereas macro studies how the aggregate economy behaves, with reference to inflation, price levels, rate of growth, national income, unemployment and more, micro focuses on individual decisions.

Economics is probably not what you think. It is not primarily about money or finance. It is not primarily about business. It is not mathematics. What is it then? It is both a subject area and a way of viewing the world.

At its core, Economics is the study of how humans make decisions in the face of scarcity. These can be individual decisions, family decisions, business decisions or societal decisions. If you look around carefully, you will see that scarcity is a fact of life. Scarcity means that human wants for goods, services and resources exceed what is available. Resources, such as labor, tools, land, and raw materials are necessary to produce the goods and services we want but they exist in limited supply. Of course, the ultimate scarce resource is time – everyone, rich or poor, has just 24 hours in the day to try to acquire the goods they want. At any point in time, there is only a finite amount of resources available.

Think about it this way: In 2016, the labor force in Canada contained 19.4 million workers, according to Statistics Canada. The total area of the Canada is 9.99 million square kilometres. These are large numbers for such crucial resources, however, they are limited. Because these resources are limited, so are the numbers of goods and services we produce with them. Combine this with the fact that human wants seem to be virtually infinite, and you can see why scarcity is a problem.

Figure 1. Scarcity of Resources. Homeless people are a stark reminder that scarcity of resources is real. (Credit: “daveynin”/Flickr Creative Commons)

If you still do not believe that scarcity is a problem, consider the following: Does everyone need food to eat? Does everyone need a decent place to live? Does everyone have access to healthcare? In every country in the world, there are people who are hungry, homeless, and in need of healthcare, just to focus on a few critical goods and services. Why is this the case? It is because of scarcity. Let’s delve into the concept of scarcity a little deeper, because it is crucial to understanding economics.

The Problem of Scarcity

Think about all the things you consume: food, shelter, clothing, transportation, healthcare, and entertainment. How do you acquire those items? You do not produce them yourself. You buy them. How do you afford the things you buy? You work for a wage. Or if you do not, someone else does on your behalf. Yet most of us never have enough to buy all the things we want. This is because of scarcity. So how do we solve the problem of scarcity?

Every society, at every level, must make choices about how to use its resources. Families must decide whether to spend their money on a new car or a vacation. Towns must choose whether to put more of the budget into police and fire protection or into the school system. Nations must decide whether to devote more funds to national defence or to protecting the environment. In most cases, there just isn’t enough money in the budget to do everything. So why do we not each just produce all of the things we consume? The simple answer is most of us do not know how, but that is not the main reason. Think back to pioneer days, when individuals knew how to do many more practical tasks than we do today, from building their homes, to growing crops, to hunting for food, or repairing their equipment. Most of us do not know how to do all—or any—of those things. It is not because we could not learn. Rather, we do not have to. The reason why is something called the division and specialization of labor, a production innovation first put forth by Adam Smith in his book, The Wealth of Nations (See Figure 2).

Figure 2. Adam Smith. Adam Smith introduced the idea of dividing labor into discrete tasks. (Credit: Wikimedia Commons)

The Division of and Specialization of Labor

The formal study of economics began when Adam Smith (1723–1790) published his famous book The Wealth of Nations in 1776. Many authors had written on economics in the centuries before Smith, but he was the first to address the subject in a comprehensive way. In the first chapter, Smith introduces the division of labor, which means that the way a good or service is produced is divided into a number of tasks that are performed by different workers, instead of all the tasks being done by the same person.

To illustrate the division of labor, Smith counted how many tasks went into making a pin: drawing out a piece of wire, cutting it to the right length, straightening it, putting a head on one end and a point on the other, and packaging pins for sale, to name just a few. Smith counted 18 distinct tasks that were often done by different people—all for a pin!

Modern businesses divide tasks as well. Even a relatively simple business like a restaurant divides up the task of serving meals into a range of jobs like top chef, sous chefs, kitchen help, servers to wait on the tables, a greeter at the door, janitors to clean up, and a business manager to handle paychecks and bills—not to mention the economic connections a restaurant has with suppliers of food, furniture, kitchen equipment, and the building where it is located. A complex business like a large manufacturing factory, such as the shoe factory shown in Figure 3 can have hundreds of job classifications.

Figure 3. Division of Labor. Workers on an assembly line are an example of the divisions of labor. (Credit: Nina Hale/Flickr Creative Commons)

Economics looks at how rational individuals make decisions. An important part of being a rational decision maker is considering opportunity costs. In our introductory section we identified the concept of scarcity. Normally we are quite good at considering scarcity when it comes to resources and money. What we are less good at considering is scarcity of time.

Consider the following image that shows the number of weeks an average human lives. Sometimes it kind of feels like our lives are made up of a countless number of weeks. But there they are—fully countable—staring you in the face. This isn’t meant to scare you, but rather to emphasize that a rational consumer doesn’t ignore time, but incorporates it into the analysis of any decision they make.

So how do you ‘spend’ your time? In economics, we want to place a value on each different opportunity we have so we can compare them.

What if your friends were to ask you if you want to go out to the club? How much do you value it? As economists, we want to measure the happiness you will get from this experience by finding your maximum willingness to pay. Let’s say that for a 5 hour night at the club, the MOST you are willing to pay is $100. Seem high? If you have gone clubbing, this is likely close to what you paid for it.

Suppose the costs of going clubbing are $50 ($15 cover, $20 for drinks and $15 for a ride home). With that analysis it seems like you should go, but so far we have only considered the explicit costs of the experience. An explicit cost represents a clear direct payment of cash (whether actual cash or from debit, credit, etc). But what about our time? We must consider time as another cost of the action.

How do we measure time? Simple – what else could we be doing with that time? Assume you also work as a server at the campus pub, where you get paid $15 an hour (including tips). This makes it easy to put a dollar amount on your time. For 5 hours of clubbing, you are forgoing the opportunity to earn $75 ($15 * 5). This is your implicit cost for clubbing, or the cost that has been incurred but does not result in a direct payment.

It is important to note that the implicit costs are the benefit of the next best option. There are an infinite number of things we could be doing with our time, from watching a movie to studying economics, but for implicit costs we only consider the next best. If we took them all into account our costs would be infinite.

Consider the two options side by side.

Table 1.2a

This shows us something interesting. Even though we are willing to pay $100 to go out clubbing, our ‘happiness’ from working is greater. A rational consumer would chose to work. The $75 we could be earning from working is equal to our implicit costs of going out since, rather than going clubbing, we could be making money for the 5 hours. To truly consider costs we must always consider our opportunity costs which include the implicit and explicit costs of an action.

Table 1.2b

In this example if you were to go clubbing opportunity costs are:

Explicit Costs (cover, drinks and ride home) : $50

Implicit Costs (forgone income from 5 hours) : $75

Opportunity Costs : $125

Should you go clubbing? You are only willing to pay $100, and your opportunity costs are $125 so no!

Does this mean you should never go out? Not at all. You just may be surprised that your willingness to pay may be well over $100.

Scarcity

This consideration of opportunity cost is rooted in an understanding that all resources are scarce. The first image paints a compelling picture of the scarcity of time, and our financial resources are also scarce. Being a rational decision maker means considering the scarcity of all resources associated with an action. As decision makers, we have to make trade-offs on what we do with finite resources.

This leads us to a fairly simple conclusion. We should do something if the benefits outweigh the costs. The key insight is that the costs we are referring to are opportunity costs, which consider the next best alternative use of our resources.

Making Decisions

We have now looked at how to analyze two options, but how do we make the decision? We can lay the process out in three steps:

1. Find your willingness to pay (or wage you would earn) from the option you are considering and the next best alternative
2. Subtract the explicit costs from each option to find your happiness
3. Choose the option with that makes you happier

If we want to change this into the process for a binary decision (yes or no):

1. Add up all the benefits of an action
2. Subtract all costs explicit and implicit
3. If benefits > costs, this is the right choice

It is important to note that not all decisions are binary.

Sunk Costs

Just as it is important to understand the costs that should be considered in decision making, it is important to understand what costs should not. Consider the two options you may have when you wake up – do you work out or sleep in? Have you ever convinced yourself to get out of bed by reminding yourself that you paid $60 for your monthly gym membership? Well, you fell victim to a common logical fallacy.

A sunk cost is a cost that no matter what is unrecoverable. As such it should have no impact on future decision making. This may sound strange, but consider the your two options using the analysis learned above for making decisions.

Following our steps we find the maximum willingness to pay for each option, subtract the explicit costs, and compare the happiness from each. It does not matter that we spend $60 on a gym membership because no matter what we do we can’t get that money back. With this willingness to pay reflected in the table, the better option is to Sleep-In, with an opportunity cost of $20.

Notice that the $60 is not included as an explicit costs because it is not an additional cost we have to incur as a result of working out. Since we have already paid the $60, it is no longer something we consider.

Why Buy a Gym Membership?

(Credit: “Scott Webb”/Unsplash Creative Commons)

 

Why would one ever buy a gym membership? Well in this case, it might be a bad idea. The ‘willingness to pay’ represents how badly someone might want to go to the gym. If you knew that every morning you would wake up and value sleeping more than working out, then a gym pass might not be for you.

If that was the case you would need to find a way to increase your willingness to go to the gym, for example, if you committed to a work out plan with a friend, the social cost of sleeping in may be high, incentivizing you to get out of bed.

The important lesson here is to be mindful of your future motivation when you are incurring a sunk cost.

Sunk Costs & Business

Sunk costs aren’t exclusive to gym memberships, in fact, the sunk cost fallacy is common in big business and government. Ever heard the expression “we’ve invested too much in this project to back out now?” Even if you have not, it sounds fairly logical – unfortunately it is not.

Consider a mining company that has invested $5 million in the infrastructure of a mine. After new information, they learn of another, richer mine site that they can mine for $4 million, with projected revenues of $8 million. The current mine site will cost $1 million to extract the remaining resources ($4 million projected revenue). What should the company do?

At shown the total profits from the new site are higher, so despite the fact they have invested $5 million in the old site, they should abandon it and mine the new. The conclusion:

Sunk costs are irrelevant for decision making.

“Economics is the painful elaboration of the obvious” – Anonymous.

That quote might seem quite relevant when the biggest conclusion of our last section was that you should do something if the benefits outweigh the costs. While sometimes economics can seem obvious, it is important to first understand how a rational consumer should behave before seeing how we fail to meet that standard.

Marginal Analysis

In the last section we showed how to make a binary decision, but not all decisions fit that category. Many are ‘how much’ decisions. For example, if you have decided to go clubbing, how many drinks do you buy? This is a decision where we use marginal analysis. Marginal analysis is the process of breaking down a decision into a series of ‘yes or no’ decisions. More formally, it is an examination of the additional benefits of an activity compared to the additional costs incurred by that same activity.

To make a decision using marginal analysis, we need to know the willingness to pay for each level of the activity. As mentioned, this is also known as the marginal benefit from an action.

To decide how many drinks to buy, you have to make a series of yes or no decisions on whether to buy an additional drink. In Table 1.3a the marginal benefit is diminishing. This means that you are willing to pay more for the 1st drink than the next. Your friends are all drinking, so you are likely willing to pay quite a lot for your 1st drink. By the 4th, you may feel as though you do not need another.

So how many drinks will you buy if the cost is $7? To make this decision, we must use marginal analysis for each level. This means comparing our marginal benefit with marginal cost of an additional unit of activity. In this case marginal cost is just equal to $7.

For the 1st Drink: MB = $20 > MC = $ 7, you should buy the drink.

For the 2nd Drink: MB = $12 > MC = $ 7, you should buy the drink.

For the 3rd Drink: MB = $6 < MC = $ 7, you should not buy the drink.

With this simple process we can easily see that you will buy 2 drinks, unless there is a price change.

Net Benefit

What is our net benefit from the actions, or how much ‘happiness’ have we gained? To calculate, all we have to do is add up our benefits and subtract our costs.

Total Benefit = $20 + $12 = $32

Total Cost = $7 + $7 = $14

Net Benefit = $32 – $14 = $18

It is important to recognize that our act of marginal analysis has maximized this benefit. Consider what would happen if we purchased 3 drinks.

Total Benefit = $20 + $12 + $6 = $38

Total Cost = $7 + $7 + $7 = $21

Net Benefit = $38 – $21 = $17

Note that although total benefit is more than it was previously, net benefit is lower. Looking closer we can see that net benefit fell because our total costs rose ($14 –> $21) by more than our total benefits ($32 –> $38). As a quick rule:

When total benefits rise more than total costs, then the action is logical.

When total costs rise more than total benefits, then the action is illogical.

This is why we look at the marginal net benefit of a decision, rather that the total. It is as though all the previous actions are ‘sunk’. We can calculate the marginal net benefit of a decision by subtracting marginal cost from marginal benefit. Marginal net benefit of the first drink is $13 ($20 – $7), the 2nd is $5 ($12 – $7), and the third is -$1 ($6 – $7). As long as the marginal net benefit is positive, we should increase our activity!

Summary

Marginal analysis is an essential concept for everything we learn in economics, because it lies at the core of why we make decisions. We have just scratched the surface of it now, but will go more in depth in Topic 3. For now, we will turn our attention to a slightly different topic – trade.

Credit: University of Victoria

Interesting things have been happening in the chemistry labs of UVic. Professor Fraser Hof and Philips Brewery chemist Euan Thomson have been collaborating to revolutionize the craft brewing process.

The project was inspired by a very different invention from Hof’s lab—the only one of its kind. “We created a tool for profiling the proteins in cancer cells,” said Hof. “And I realized that it could also be used to profile the proteins in brewer’s yeast.”

Read more about the beer chemistry collaboration.

In Topic 1 we talked about the opportunity costs of an action. Let’s explore how opportunity costs might impact decisions on what to research.

Assume that the government provides $50,000/year for the department to conduct cancer research,  and the costs of operating the research lab is $30,000. Philips offers $70,000/year to do beer research, but researching beer would increase costs by $5,000.

1. What is the opportunity cost of conducting cancer research? Break this into implicit and explicit costs.

2. What option will the department choose? What are the opportunity costs of this choice?

3. What is the total economic profits from this choice?

4. If the cancer lab was offered $30,000 to shut down what would be the opportunity cost?

5. What is the minimum amount the government would have to provide for the department to conduct cancer research?

6. Why must the government pay the lab more money for the same work as before? What does this show us about how opportunities effect compensation?

Academic pursuits often have high private opportunity costs – its why professors are so well paid.  If they’re paid too little, the brightest PhDs will turn to industry instead of academia and universities will suffer. In order to attract experts from industry, the university needs to have the resources to compensate them.

Read more about professor compensation.

Consider an Economics prof who could be making $80,000 in the private sector, and a Business prof that could be making $100,000. Assume the individuals value the added prestige and benefits from being a prof at $20,000.

7. All else equal, how much will you have to pay each professor to entice them to teach?

In this case study we have shown how microeconomic concepts of opportunity costs can be used to understand current events and practical examples. Do you have an example you think would make a good case study? Contact economics103@uvic.ca to propose your story.

1. What is the opportunity cost of conducting cancer research? Break this into implicit and explicit costs.

We are given the information that the government provides $50,000/year for the department to conduct cancer research,  and the costs of operating the research lab is $30,000. Philips offers $70,000/year to do beer research, but researching beer would increase costs by $5,000.

The best way to find our cost breakdown is to put this information into a table, where we can make a side by side comparison of the two options. In the cancer research column, we have a total revenue of $50,000 from government funding, minus explicit operating costs of $30,000. This leaves us with accounting profits of $20,000.

Likewise, in the beer research column, we have total revenue of $70,000 from Philips, minus $30,000 + $5,000, or $35,000 in explicit operating costs. This leaves us with accounting profits of $35,000.

Since we are looking at the opportunity costs of cancer research, we don’t have to worry yet about which option the department will choose. Since we know opportunity cost is explicit + implicit costs, all we need is the implicit cost of the next best option. In this case, when we conduct cancer research we forgo $35,000 of profits. This means:

Explicit Costs (lab operating costs): $30,000

Implicit Costs (forgone profits from Philips): $35,000

Opportunity Costs (Implicit + Explicit): $65,000

2. What option will the department choose? What are the opportunity costs of this choice?

Since we have already calculated the accounting profits and know that Cancer research gives $20,000 of profits, whereas beer provides $35,000, we know that the department will choose beer research.

Finding opportunity costs is the same process as before, except now our explicit costs are the operating costs of the beer lab, and our implicit costs are the forgone profits from cancer research.

Explicit Costs (lab operating costs): $35,000

Implicit Costs (forgone profits from Cancer research): $20,000

Opportunity Costs (Implicit + Explicit): $55,000

3. What is the total economic profits from this choice?

Economic profits are the difference between total revenue and all the costs of an action, implicit and explicit. With a total revenue of $70,000 from Philips, our economic profits are equal to $70,000 minus our previously calculated opportunity costs. Since $70,000 – $55,000 = $15,000, our economic profits from beer research are $15,000.

4. If the cancer lab was offered $30,000 to shut down what would be the opportunity cost?

If the department was offered $30,000 to shut down, this just creates another option. Remember that opportunity cost includes the implicit costs of the next best alternative. This means we must determine whether is is better for the lab to shut down, or to work with Philips.

We know that the accounting profits from a partnership with Philips are equal to $35,000. Since shutting down has no explicit costs, the accounting profits are only $30,000. This means that partnering with Philips is still our next best alternative. Opportunity costs will therefore be the same as in question 1 and equal to $65,000.

5. What is the minimum amount the government would have to provide for the department to conduct cancer research?

If the government wants the department to continue to conduct cancer research, they have to pay them enough so that the accounting profits of either types of research are the same. Working backwards, we know that beer research provides $35,000 in accounting profits. This means that

Total Revenue from Cancer Research – $30,000 must equal $35,000 to ensure that the department is indifferent. To cover the explicit ($30,000) and implicit ($35,000) costs of cancer research, the government would have to pay $65,000 (an additional $15,000 to the original $50,000).

6. Why must the government pay the lab more money for the same work as before? What does this show us about how opportunities effect compensation?

The answer to question 5 gives us an interesting insight about how opportunity costs can affect compensation. Whereas before the department may have been content accepting $50,000 in funding, now, knowing they can earn more elsewhere, will require more. This can result in funding being increased with no change to the actual quality of work.

7. All else equal, how much will you have to pay each professor to entice them to teach?

With the information given, we are told that an Economics prof could be making $80,000 in the private sector, and a business prof that could be making $100,000. Like in question 5, we know that to entice them to academia, the accounting profits must be equal. We also know that academia comes with an added prestige factor of $20,000. Putting the economist in our table:

Notice that explicit costs are denoted by ‘x’ to represent that, while we don’t know how much they are, they are assumed to be the same. This cost would represent the cost of living associated with either job.

We know that for the economist to be indifferent, accounting profits must be equal. This means that

$20,000 + C – x = $80,000 – x

Solving for C we find C = $60,000. This means that the economist would need to be paid $60,000 to join academia.

Doing the same process for the business prof, we would find they would have to be paid $80,000 to join academia. This can help explain why profs from different departments can have very different compensation. Ultimately, it depends on the job prospects they would have outside of the academic sphere.

Exercises 1.2

1. Which of the following statements about opportunity cost is TRUE?

I. Opportunity cost is equal to implicit costs plus explicit costs.
II. Opportunity cost only measures direct monetary costs.
III. Opportunity cost accounts for alternative uses of resources such as time and money.

a) I, II and III.
b) I
c) III only.
d) I and III only.

2. Which of the following statements about opportunity costs is TRUE?

I. The opportunity cost of a given action is equal to the value foregone of all feasible alternative actions.
II. Opportunity costs only measure direct out of pocket expenditures.
III. To calculate accurately the opportunity cost of an action we need to first identify the next best alternative to that action.

a) III only.
b) I and III only.
c) II only.
d) None of the statements is true.

3. Suppose that you deciding between seeing a move and going to a concert on a particular Saturday evening. You are willing to pay $20 to see the movie and the movie ticket costs $5. You are willing to pay $80 for the concert and the concert ticket costs $50. The opportunity cost of going to the movie is:

a) $5.
b) $30.
c) $35.
d) $65.

4. Suppose that you are willing to pay $20 to see a movie on Saturday night. A ticket costs $10, and the next-best alternative use of your time would be to go to dinner with a friend. The cost of the dinner is $20 and you value the experience of having dinner with your friend at $60. The opportunity cost of seeing the movie is equal to:

a) $50.
b) $30.
c) $20.
d) $10.

5. Suppose that you are willing to pay $50 to see a movie on Saturday night. A ticket costs $15, and the next-best alternative use of your time would be to go to a concert which costs $80 and you value at $100. The opportunity cost of seeing the movie is equal to:

a) $15.
b) $20.
c) $35.
d) $70.

6. Suppose you play a round of golf costing $75. The golf takes four hours to play. If you were not playing golf you could be working and earning $40 per hour. The opportunity cost of your golf game is:

a) $75.
b) $235.
c) $155.
d) $160.

7. Suppose you have bought and paid for a ticket to see Lady Gaga in concert. You were willing to pay up to $200 for this ticket, but it only cost you $110. On the day of the concert, a friend offers you a free ticket to the opera instead. Assuming that it is impossible to resell the Lady Gaga ticket, what is the minimum value you would have to place on a night at the opera, in order for you to choose the opera over Lady Gaga?

a) $200.
b) $110.
c) $90.
d) $0.

8. Suppose that you are willing to pay $350 to see Leonard Cohen play at the Save-On-Foods Arena. Tickets cost $100, and the next-best alternative use of your time would be to work in paid employment earning $50 over the evening. The opportunity cost of seeing Leonard Cohen is equal to:

a) $50.
b) $100.
c) $150.
d) $200.

9. I am considering loaning my brother $10,000 for one year. He has agreed to pay 10% interest on the loan. If I don’t loan my brother the $10,000, it will stay in my bank account for the year, where it will earn 2% interest. What is the opportunity cost to me of the loan to my brother?

a) $200.
b) $800.
c) $1,000.
d) $1,200.

10. In January, in an attempt to commit to getting fit, I signed a year-long, binding contract at a local gym, agreeing to pay $40 per month in membership fees. I also spent $300 on extremely stylish gym clothes. This morning, I was trying to decide whether or not to actually go to the gym. Which of the following was relevant to this decision?

a) The $40 that I paid the gym this month.
b) The $300 I spent on gym clothes.
c) The fact that I also had to write a 103 midterm exam today.
d) All of the above were relevant.

11. Suppose you have bought and paid for a ticket to see Kanye in concert. You were willing to pay up to $350 for this ticket, but it only cost you $100. On the day of the concert, a friend offers you a free ticket to Lady Gaga instead. You can resell your Kanye ticket for $80. What do your sunk costs equal?

a) $0.
b) $20.
c) $80.
d) $100.

12. Which of the following statements about sunk costs is FALSE?

I. Sunk costs are those that cannot be recovered, no matter what future action is taken.
II. Because sunk costs cannot be recovered, they are irrelevant for future decision-making.
III. The presence of sunk costs can affect future decision-making, if they are large enough.

a) II and III only.
b) II only.
c) III only.
d) I and III only.

13. As a member of UVic’s University Club, I pay $30 per month in membership fees. In a typical month I spend about $50 on beer at the Club. Every month I also have the option of attending a meeting of the whiskey club (open only to Club members), at a cost per meeting of $15, payable at the beginning of each meeting. Given this, what do my monthly SUNK COSTS equal?

a) $15.
b) $30.
c) $45.
d) $95.

Exercises 1.3

1. According to marginal analysis, optimal decision-making involves:

a) Taking actions whenever the marginal benefit is positive.
b) Taking actions only if the marginal cost is zero.
c) Taking actions whenever the marginal benefit exceeds the marginal cost.
d) All of the above.

2. Jane’s marginal benefit per day from drinking coke is given in the table below. This shows that she values the first coke she drinks at $1.20, the second at $1.15, and so on.
If the price of coke is $1.00, the optimal number of cokes that Jane should drink is:

a) 1.
b) 2.
c) 3.
d) 4.

Dehaas, Josh. Macleans. “Professors pay ranked highest to lowest.” May 4, 2012.  http://www.macleans.ca/education/uniandcollege/professor-pay-ranked-from-highest-to-lowest/

Jeevanandam, Vimala. The Ring. “Buzz builds over beer chemistry collaboration.” November 3, 2016. https://www.uvic.ca/ring/news/research/2016+brewery-yeast-hof+ring

Investopedia. “Utility.” http://www.investopedia.com/terms/u/utility.asp

Smith, Adam. The Wealth of Nations. March 9, 1776.

Statistics Canada. “Labour Force Characteristics.” 2016. http://www.statcan.gc.ca/tables-tableaux/sum-som/l01/cst01/econ10-eng.htm

Urban, Tim. Wait But Why. “Your Life in Weeks.” May 7, 2014. http://waitbutwhy.com/2014/05/life-weeks.html

Figure 1. Apple or Samsung iPhone? Though the iPhone is widely recognized as an Apple product, 26% of the phone’s parts are supplied  by rival phone-maker, Samsung. In international trade, there are often “conflicts” like this as each party specializes on what it does best. (Credit: modification of work by Yutaka Tsutano Creative Commons)

We live in a global marketplace. The food in your kitchen might include fresh fruit from Chile, cheese from France, and bottled water from Scotland. Your wireless phone may have been manufactured in Taiwan or Korea. Your clothes are possibly designed in Italy and manufactured in China. As a worker, if your job involves farming, machinery, airplanes, cars, or scientific instruments, the odds are high that a hearty proportion of your company’s sales—and hence the money that pays your salary—comes from export sales. We are all linked by international trade, which has grown dramatically in the last few decades and plays an increasingly important role in the global economy.

Recall that Macroeconomics is the study of how the aggregate economy behaves. Though trade can often be a Marco issue (examining exchange rates, interest rates, trade agreements etc.), it is fundamentally rooted in Microeconomics. Resource allocation is the decisions individuals, businesses, and governments make with scarce resources. In the example above, both Taiwan and China decide what amounts of phones and microchips they would each like to produce. Though this interplay between micro- and macroeconomics is complicated, there are fundamentally three resources allocation questions at the core of microeconomics:

1. What goods and services should a society produce, given its scarce resources?
2. How should the production of these goods and services take place?
3. Who should consume these goods and services?

These questions are all normative, meaning they are subjective and value-based as opposed to positive, fact-based questions. We need normative criteria to evaluate these questions – an idea that will be developed later in this chapter.

In this topic, we will focus on answering the second question “how should the production of these goods and services take place,” as we evaluate how countries can gain from trade and allocate resources most efficiently.

The fires in Fort McMurray were a natural disaster that could not have been anticipated. The devastation severely impacted the economy of Alberta, not to mention the lives of many of its habitats. Although there are many unpredictable aspects to our world, economics develops a simplified framework to make analysis despite these unknowns. (Credit: DarrenRD/ Wikimedia Commons/ CC-BY-SA-4.0)

Think of all the different variables that can impact trade. A country’s interest rate influences the flow of financial capital; its exchange rate encourages or discourages the purchase of goods and services. The weather can impact the production of goods, and politics can create tension between countries. Many of these examples are macro issues that will impact our micro analysis. How can we navigate such complex economic issues to make normative judgments? The answer is economic models.

An economic model is a simplified framework that is designed to illustrate complex processes. Oftentimes in introductory Microeconomics, these models seem oversimplified because they hold certain variables constant. While one should remain aware of this, these models are still useful. Holding some information constant can help us understand a concept without being overwhelmed by a vast number of influencing factors. Economic models are the building blocks of most modern economic theory. By understanding these models, we can develop a mindset to understand the economic world.

Model of Production

If you were stranded on an island with only pineapples and crabs, how much of each would you produce? Would this change depending on how difficult each one was to harvest? (Credit: Pablo Garcia Saldaña/Unsplash)

An economic model is only useful when we understand its underlying assumptions. For this model, imagine the following scenario:

You are stranded on a tropical island alone. On this island, there are only two foods: pineapples and crabs. In other words, you face a trade-off: any time you spend harvesting pineapples is time that cannot be spent looking for crabs. You are forced to make a decision on how to allocate the scarce resource of time.

While this is an extreme example, it is reflective of a common problem in production. Since there are only a certain number of hours in the day, time is a scarce resource. This scarcity limits the amount of total production.

Figure 2.2a displays a table showing several different combinations of goods that can be harvested in a given week. The table is very logical – if you spend all your time catching crabs, you will have no pineapples. Notice that you can produce either all crabs, all pineapples, or a mix of the two.

Assume you choose to only catch crabs. How many would have to be given up in order to obtain ten pineapples? In this example, only one. This is an important concept; even though our scarce resource is time, we can measure the cost of a good, in this case, pineapples, in terms of the foregone good, in this cases crabs.

This concept is called the Marginal Opportunity Cost of an action. In this case, since you have to give up one crab to produce 10 pineapples, the marginal opportunity cost for one pineapple is 1/10 of a crab.

Figure 2.2a

Notice how the marginal cost changes as you harvest more pineapples. To produce the next ten pineapples, it costs two crabs, and the next ten costs four. This continues until there are no more crabs to give up. While marginal opportunity cost is not always increasing, it is intuitive to think that the more pineapples you pick, the harder they will be to find, and therefore the more time you will have to give up to harvest 10 more. 

Production Possibility Frontier

While much useful analysis can be conducted with a chart, it is often useful to represent our models graphically. A Production Possibility Frontier (PPF) is the graphical representation of Figure 2.2a. It represents the maximum combination of goods that can be produced given available resources and technology. Each point represents one of the combinations from Figure 2.2a. In our example, while we would love to produce 50 pineapples and 50 crabs, this is out of our realm of possible production. In other words, it is not a point on our PPF.

Figure 2.2b

Using our terminology from before, each point along our PPF (i.e. Point A) is efficient (in a one-person world) since there is no way to get more pineapples without giving up some crabs and vice-versa. There are no Pareto Improvements in the current situation.

If we are inside the PPF (i.e. Point B), we are not fully using our resources. In this case, we can produce more pineapples without having to give up any more crabs. This point is inefficient.

Points outside the PPF (i.e. Point C), while preferable, are unattainable given constraints in resources and time. 

Using our analysis of Marginal Opportunity Cost (MC) from before, we see that the Slope (absolute value) of the PPF is the Marginal Cost of the good on the horizontal axis. Recall that slope is calculated using rise over run. By calculating the slope from (20,18) to (30,14), we see the MC is 4/10 of a crab for one pineapple (or 4 crabs for 10 pineapples as represented in our chart). As we move down the PPF, the slope and MC increase.

Figure 2.2c

Given our scarce resources and time, we can efficiently produce any point along the PPF. Now, we face the same problem as before. How do we determine which bundle to choose? Is it better to produce 50 pineapples and 0 crabs, 21 crabs and 0 pineapples, or a mix of the two? This depends entirely on preferences. Perhaps you are allergic to crabs and they provide you no value, or maybe you have a desired ratio of crabs to pineapples. Since the bundles along the PPF are all efficient, we cannot pass judgment on which is best.

Applications

The Island Example – Brexit

Former British Prime Minister David Cameron defending the ‘stay’ side of the Brexit debate. (Credit: World Economic Forum/ Flickr/ CC-BY-SA-2.0)

While our discussion so far has referred to a deserted island scenario, the same concepts are easily relatable to a country’s production. On a much larger scale, countries face trade-offs in production. The island situation can be likened to a country with a policy of autarky – a state of economic independence or self-sufficiency. The United Kingdom’s decision to leave the European Union (commonly known as Brexit) metaphorically makes it more of an island. The country will have to face more trade-offs with the goods it can produce. As we will see in the next section, trade can reduce these trade-offs and allow countries to reach points outside their PPF.

 

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Shifting a PPF

As we will see in Topic 2.3, trade allows countries, individuals, or firms to reach points outside their PPF. In addition to trade, there are some other factors that shift a countries PPF, allowing an change in attainable output. These factors include:

• A Shift in Technology – If you were to invent a computer system that showed the location of crabs and pineapples on the island, you would be able to produce more of both goods, shifting the PPF outward.
• More Education or Training – If you were to become more skilled at harvesting pineapples or crabs, your attainable output would increase, shifting the PPF outward.
• Natural Disaster – If disaster strikes, and pineapples or crabs become less plentiful, your attainable output would decrease, shifting the PPF inward.

These are not the only factors that could shift the PPF, but they are the most common. What is important to recognize is that a PPF represents what is attainable, and that is subject to change.

In 1817, David Ricardo, a businessman, economist, and member of the British Parliament, wrote a treatise called On the Principles of Political Economy and Taxation. In this treatise, Ricardo argued that specialization and free trade benefit all trading partners, even those that may be relatively inefficient. To see what he meant, we must be able to distinguish between absolute and comparative advantage. (Credit: Wikimedia/ Public Domain)

The American statesman Benjamin Franklin (1706–1790) once wrote: “No nation was ever ruined by trade.” Many economists would express their attitudes toward international trade in an even more positive manner.

The evidence that international trade confers overall benefits on economies is very strong. Trade has accompanied economic growth in Canada and around the world. Many economies that have shown the most rapid growth in the last few decades—for example, Japan, South Korea, China, and India—have done so by dramatically orienting their economies toward international trade. To understand the benefits of trade, or why we trade in the first place, we need to understand the concepts of comparative and absolute advantage.

Production Possibilities with Trade

In the previous section, we stated that points outside the PPF were not possible given our constraints. With trade, these constraints can change. Continuing the example from Chapter 2.2, suppose another person, Jamie, becomes stranded on the island with you. You could choose to avoid him and live your own separate lives, or you could work together to improve each other’s well-being. It turns out Jamie has different skills than you – he is better at producing both crabs and pineapples. (See Figure 2.3a)

Figure 2.3a

Figure 2.3b

In this case, where one person or group is better at producing both goods, we say they have an Absolute Advantage in the production of the good. In this example, Jamie has the absolute advantage in the production of both goods. This means Jamie’s entire PPF lies outside of yours. (See Figure 2.3b)

Why would Jamie want to trade with you if he is better at producing both goods? We mentioned before that preferences determine where you would produce. For this example, assume that you want to produce and consume the following:

Without Trade

You: 20 pineapples and 18 crabs

Jamie: 50 pineapples and 10 crabs.

Between the two of you, you are producing 70 pineapples and 28 crabs. Is this efficient? Recall that a situation is efficient if there are no available Pareto Improvements. If we can get more pineapples and crabs without having to give anything up, then the situation is inefficient.

By simply changing both yours and Jamie’s production points, we see that this is inefficient. If you were to produce 30 pineapples and 14 crabs while Jamie was to produce 40 pineapples and 18 crabs, the aggregate production would be 70 pineapples and 32 crabs – four more crabs than before! It is now clear that the previous situation was inefficient. You can trade 10 of your pineapples for 6 crabs, which leaves the following allotment of resources:

With Trade

You: 20 pineapples and 20 crabs

Jamie: 50 pineapples and 12 crabs

Each of you walks away with two more crabs than before.  This is what we mean when we talk about gains from trade. Both you and Jamie are now able to produce at a point outside your PPF’s. To understand where these extra crabs come from, we must first explore the concept of comparative advantage.

Figure 2.3c

Application

(Credit: Chad Teer/ Wikimedia/ CC-BY-2.0)

It’s All About Oil

A country has an absolute advantage in producing if it uses fewer resources to produce. Absolute advantage can be the result of a country’s natural endowment. For example, extracting oil in Saudi Arabia and other Middle Eastern countries is essentially just a matter of drilling a hole. Producing oil in countries like the United States can require considerable exploration and costly technologies for drilling and extraction. This case of absolute advantage has been a key contributing factor towards much of the chaos in the Middle East. The United States and other countries will go to great extents to defend their oil interests, and will sometimes meddle in other country’s affairs in devastating ways.

Comparative Advantage

Let’s look further into these gains from trade.

When you increase your production of pineapples from 20 to 30, you have to give up 4 crabs. This means your marginal cost is 0.4 crabs for 1 pineapple.

When Jamie decreased his production of pineapples from 50 to 40, he gained 8 crabs. This means his marginal cost was 0.8 crabs for 1 pineapple.

The gains from trade arise from this difference in marginal cost. Since it is more expensive for Jamie to produce pineapples (MC of 0.8 versus your MC of 0.4) he should produce fewer pineapples and more crabs. The economic agent with the lower marginal cost of producing a good has the comparative advantage in producing that good. In this case, you have the comparative advantage in producing pineapples, and Jamie has the comparative advantage in producing crabs. This specialization in production results in gains from trade, as each person or country can focus on what it can produce at the lowest cost.

Note that even though Jamie had the absolute advantage in both goods, his marginal cost of producing crabs was still higher, since marginal cost is based on a trade-off between the two goods. We can liken this example to a trade between Canada and a developing country. Canada may be better at producing both computers and textiles (the absolute advantage) but the advantages we have in producing computers are far greater. Any hour we have to give up to produce textiles comes at a much higher cost to us than it would to a developing country, giving us the comparative advantage at producing computers, and the developing country the advantage at producing textiles. The island example is no different. Even though Jamie is better at producing pineapples, what Jamie is really an expert at is producing crabs, so having to give up time spent catching crabs comes at a high cost.

In this example, marginal costs are changing. This means that depending on where individuals produce, they may have a different comparative advantage. Recall that marginal cost is the slope of the PPF, so as each individual produces more pineapples, the pineapples become more expensive to produce. This is known as the law of diminishing returns which states that as additional increments of resources are added to producing a good or service, the marginal benefit from those additional increments will decline. This example has introduced a lot of different concepts – moving forward, our examples will be simpler, and linear.

Linear PPF’s

Most of the examples will deal with linear PPF’s. This makes problems considerably easier, since in the case of a linear PPF (in which the marginal cost will be constant), one individual will always have the comparative advantage in one good. This means that comparative advantage is the same at any point on the PPF, and can be easily calculated.

We have changed Jamie and your skill set to be linear in Figure 2.3d.

Now we can use our tools of efficiency and trade to determine if certain points are efficient. In Figure 2.3d various points have been shown to reflect possible points of production for you (blue) and Jamie (green).  Remember, we have no information about preferences. The first step is to find who has the comparative advantage for which good. For a linear PPF, this just means finding the slope.

Jamie

Jamie’s PPF has the slope of 40/50 or 0.8 Crabs for 1 Pineapple.

This means his opportunity costs are:

0.8 Crabs for 1 Pineapple.

1.25 Pineapples for 1 Crab (the inverse of the slope)

You

Your PPF has the slope of 25/50 or 0.5 Crabs for 1 Pineapple.

This means your opportunity costs are:

0.5 Crabs for 1 Pineapple.

2 Pineapples for 1 Crab 

Who Has the Comparative Advantage

Comparing the opportunity costs, it costs Jamie 0.8 Crabs to produce 1 Pineapple, whereas is costs you only 0.5 Crabs. This means:

You have the comparative advantage in producing Pineapples.

Remember that the 0.8 and 0.5 crabs represent the cost of pineapples in terms of crabs. It is similar to saying “It costs Jamie $0.80 to buy a Pineapple, it costs you $0.50, who should buy it?” In a PPF, cost is denoted in terms of the other good, not dollars.

Furthermore, it costs Jamie only 1.25 Pineapples to produce 1 Crab, whereas is costs you 2 Pineapples  This means:

Jamie has the comparative advantage in producing Crabs.

This is true for every point on our PPF. Now we will examine each of the points using this information.

Jamie Produces @ Point E, You Produce @ Point B

In this combination, Jamie produces only Pineapples and you produce only Crabs. This situation is clearly inefficient since each player is producing a good the other can produce for less. By changing production and trading goods, both parties stand to benefit.

Jamie Produces @ Point C, You Produce @ Point D

Recognizing that the last combination was inefficient, Jamie begins producing more Crabs and you begin producing more Pineapples. Although this seems to adhere to the comparative advantage, each of you are still producing goods that the other can produce for less. Jamie is still producing 20 Pineapples, and you are still producing 10 Crabs. As we saw before, if you both specialize in what you are comparably good at, then there will be even more gains from trade. This means that the situation is inefficient.

Jamie Produces @ Point A, You Produce @ Point E

Realizing the previous points were inefficient, Jamie produces only Pineapples and you produce only Crabs. In this situation both players are producing only the good they have the comparative advantage in. This situation is certainly efficient, as there are no production changes that can be made that result in more than 40 Crabs, and 50 Pineapples.

Jamie Produces @ Point A, You Produce @ Point D

What if we want 50 Crabs? Is there no way to produce this efficiently? There is. Point A/Point E is not the only efficient point possible. This is because of preferences. If in total, you and Jamie prefer only 40 Crabs, then Point A/ Point E would be the efficient point where you would produce, but if you and Jamie desire 50 Crabs, that would not be the preferred combination. If you desire 50 Crabs, then the person who has the comparative advantage in Crabs (in this case Jamie) should produce all 50 Crabs, or produce as many Crabs as possible. In this case, Jamie can only produce 40, which leaves the remaining 10 to be produced by you. Although Jamie could produce these 10 Crabs more efficiently, he is constrained by his production ability. This means that Point A/Point D is also an efficient combination of goods, since there is no way to acquire 50 Crabs which results in more than 30 Pineapples being produced.

Jamie Produces @ Point A, You Produce @ Point B

It should logically follow that this combination is also efficient. Even though you have the comparative advantage at producing Pineapples, if the Pineapples are poisonous and no one wants any, both you and Jamie will produce only Crabs! There is no other way to produce 65 Crabs where you will have any Pineapples left.

To simplify the analysis above you can use the following rule for linear PPF’s

If at least one player is maximizing their comparative advantage, then the situation is efficient

This simple rule occurs since any combination where both players produce a mix of goods is a combination where players stand to gain from more specialization and trade. These gains only end when at least one player has exhausted the gains from specialization, and is producing only the good they are comparatively better at.

Summary

In summary, the PPF is a model we can use to represent the production of one or more parties. Trade allows parties to consume at points outside their PPF when they maximize comparative advantage. The party with the lower opportunity cost will have the comparative advantage in the production of a good. Even though a party might have the absolute advantage in the production of both goods, since comparative advantage is based on opportunity costs, other parties can still retain comparative advantage. Parties can achieve gains from trade by specializing in the good they are comparably good at, to the extent that consumers want that good.

Conclusion

In Topic 2, we have explored the production possibility model in depth, looking at a simplified version of trade and deepening our understanding of opportunity costs. Now, we can take our knowledge of basic economic modelling and our comprehension of costs and examine one of the most important of microeconomics: supply and demand.

UKIP Leader Nigel Farage MEP was a strong proponent of the ‘leave side’ in Britain’s referendum to stay or leave the EU. (Credit: Gage Skidmore/ Flickr/ CC BY-SA 2.0)

Some have said that June 23rd, 2016 will go down as Britain’s independence day, but many others have been less positive about Britain’s decision to leave the European Union. Financial markets, facing new found uncertainty, plunged. The pound fell hard against the dollar to a 30-year low of $1.32. This decision has caused ripples in the world economy, noticeably in Europe where Britain provided strong consumption for European goods. The Brexit vote caused uncertainty in many of the world’s markets.  If Britain, long a champion of free trade, can vote to revoke a regional trade deal, how much faith can businesses worldwide put in other international economic agreements? 

Read more about Brexit’s impact on the world economy.

In Topic 2 we talked about competitive advantage and the gains from trade. To illustrates some of the affects of Brexit consider Rolls Royce, designer, distributer, and manufacturer of power systems for aviation and former owner of car brands like Bentley. Rolls Royce sold Bentley (now owned by Volkswagon) in 1971, let’s assume they want to re-enter the market with ‘Rolls Royce’ branded vehicles.

Assume Rolls Royce can produce two things, aircraft parts, which they sell to firms like Airbus, Boieng etc. Or car parts, which they can uses to manufacture cars.

In 1971, Rolls Royce sold rights to Bentely following financial problems stemming from the costs of developing the RB211 jet engine. (Credit: Rachel Patterson/ Flickr/ CC BY-NC-ND 2.0)

1. Rolls Royce can produce either 50 car parts, 100 aircraft parts, or a combination or both. Represent cars parts on the y-axis and aircraft parts on the x-axis. Draw Rolls Royce PPF on the diagram below.  Assume the PPF is linear.

2. For Rolls Royce, what is the marginal opportunity cost of 1 aircraft part? 1 car part?

3. If Rolls Royce needs to produce 40 aircraft parts, how many car parts can they make?

After exploring the market, Rolls Royce finds that Volkswagon is also producing both car parts and aircraft parts and may be open to trade. Rolls Royce wants to consider the benefits of trading with this firm.

4. Volkswagon can produce either 120 car parts, 40 aircraft parts, or a combination or both. Represent cars parts on the y-axis and aircraft parts on the x-axis. Draw Volkswagon’s PPF on the diagram below, and redraw Rolls Royce’s PPF from question 1. Assume both PPFs are linear.

5. For Volkswagon, what is the marginal opportunity cost of 1 aircraft part? 1 car part?

6. Who has the absolute advantage in the production of aircraft parts? Car parts?

7. Who has the comparative advantage in the production of aircraft parts? Car parts? Why?

8. Assume each firm needs 20 aircraft parts and cannot trade. How many car parts is each able to produce after making 20 aircraft parts? What is the total amount of car parts produced?

9. If the market is opened up to trade, represent the efficient production of 40 aircraft parts on the PPF.  What is the total number of car parts produced now?

Vehicles and aircraft are two of Britain’s largest exports, together making up 17.7% of the total. Although final assembly of many cars occurs in Britain, the supply chains often span the globe. Bumpers for some Bentley Bentaygas, for example, are made in Europe but then sent to Crewe for inspection before going to Germany for specialist painting. After that, they return to the UK for final assembly. Brexit would mean imposing tariffs (taxes on imports) on much of this supply chain, making it more expensive for Rolls Royce if they wanted to trade with Volkswagon. We will talk more about tariffs and how they are affect the market in Topic 4, assume for now that Brexit completely restricts trade.

Read more about Brexit’s effect on the UK car industry.

10. Explain why Brexit makes both companies worse off with reference to question 8 and 9.

In this case study we have shown how microeconomic concepts of production possibilities can be used to understand current events in the news. Do you have a story you think would make a good case study? Contact economics103@uvic.ca to propose your story.

1. Rolls Royce can produce either 50 car parts, 100 aircraft parts, or a combination or both. Represent cars parts on the y-axis and aircraft parts on the x-axis. Draw Rolls Royce PPF on the diagram below.  Assume the PPF is linear.

The best way to draw a PPF is to find how many of each good the firm can produce if they produce that good only. In this case we are told Rolls Royce can either produce 50 car parts, 100 aircraft parts, or a mix. This means we know the point (0, 50) and (100, 0) are on our PPF. Simply label these points and connect them to find Rolls Royce’s PPF.

2. For Rolls Royce, what is the marginal opportunity cost of 1 aircraft part? 1 car part?

Remember that the marginal opportunity cost of the good on the x-axis, in this case aircraft parts, is simply the slope of the PPF. Taking the slope we find that we must trade 50 car parts for every 100 aircraft parts, this means that the marginal opportunity cost of one aircraft part is 0.5 car parts.

The marginal opportunity cost of the good on the y-axis, in this case car parts, is equal to the inverse of the slope. This means we must trade 100 aircraft parts for every 50 car parts. The marginal opportunity cost of one car part is 2 aircraft parts.

3. If Rolls Royce needs to produce 40 aircraft parts, how many car parts can they make?

Since there is no opportunities for trade, this is a relatively simple problem. All you have to do is draw a line up from 40 aircraft parts, and see how many car parts Rolls Royce can make with the remaining resources.

Looking at the diagram you can see that when Rolls Royce produces 40 aircraft parts, they can produce 30 car parts.

Rolls Royce can produce a maximum of 100 aircraft parts, and for every 10 they give up they can make 5 car parts. If they are only producing 40 aircraft parts they have given up 60. The trade off in the production of 60 aircraft parts allows them to produce 30 car parts.

4. Volkswagon can produce either 120 car parts, 40 aircraft parts, or a combination or both. Represent cars parts on the y-axis and aircraft parts on the x-axis. Draw Volkswagon’s PPF on the diagram below, and redraw Rolls Royce’s PPF from question 1. Assume both PPFs are linear.

Again, the best way to draw a PPF is to find how many of each good the firm can produce if they produce that good only.  Based on the information we are given, we know the points (0, 120) and (40, 0) are on Volkswagon’s PPF. Simply label these points and connect them to find Volkswagon’s PPF. 

5. For Volkswagon, what is the marginal opportunity cost of 1 aircraft part? 1 car part?

Taking the slope of Volkswagon’s PPF, we find that we must trade 120 car parts for every 40 aircraft parts, this means that the marginal opportunity cost of one aircraft part is 3 car parts for 1 aircraft part.

The marginal opportunity cost of the good on the y-axis, in this case car parts, is equal to the inverse of the slope. This means we must trade 40 aircraft parts for every 120 car parts. The marginal opportunity cost of one aircraft part is 0.33 aircraft parts for 1 car part.

6. Who has the absolute advantage in the production of aircraft parts? Car parts?

The firm that can produce the greater number of each good has the absolute advantage in that goods production. Since Rolls Royce can produce 100 aircraft and Volkswagon only 40, Rolls Royce has the absolute advantage in aircraft parts. Since Volkswagon can produce 120 car parts and Rolls Royce only 50, Volkswagon has the absolute advantage in car parts.

7. Who has the comparative advantage in the production of aircraft parts? Car parts? Why?

Representing the marginal opportunity costs of each company on a table we can produce the following:

Recall that the firm with the lower opportunity cost has the comparative in the production of the good. In this case Rolls Royce only has to give up 0.5 car parts for 1 aircraft part, whereas Volkswagon has to give up 3! This means Rolls Royce has the comparative advantage in aircraft parts. Volkswagon only has to give up 0.33 aircraft parts for 1 car part, whereas Roll Royce has to give up 2. This means Volkswagon has the comparative advantage in car parts.

This means that when possible, Rolls Royce should specialize in the production of aircraft parts, since they have lower opportunity cost of producing them.

*Note that in this example each firm has both the competitive and absolute advantage in their good, but this need not be the case. One firm could have the absolute advantage at both goods, but there would still be mutually beneficial trades available. 

8. Assume each firm needs 20 aircraft parts and cannot trade. How many car parts is each able to produce? What is the total amount of car parts?

If the firms cannot trade with eachother then this exercise is identical to Question 3, just with two firms. All we have to do is draw a line up from 20 aircraft parts, and see how many car parts each can produce.

As shown in the diagram above, Rolls Royce can produce 40 car parts, and Volkswagon can produce 60 car parts for a total of 100.

9. If the market is opened up to trade, represent the efficient production of 40 aircraft parts on the PPF.  What is the total number of car parts produced?

If the market is open to trade and we need 40 aircraft parts, they won’t be produced as they were in Question 8. When we are told how much of a specific good we want, the firm with the comparative advantage in that good will produce as much of that good as they can (up to the total). In this case Rolls Royce has the comparative advantage in aircraft parts so they will produce all 40. Notice that when Rolls Royce produces 40 aircraft parts, they are still producing 30 car parts – that is fine. We can not say that Rolls Royce should produce more than 40 because if we only want 40 aircraft parts, there is no reason to produce more (no one will buy them, there is no use for them, etc.). The remaining resources should be used to produce car parts.

If Rolls Royce is producing 40 aircraft parts, they are also producing 30 car parts. Since we do not need anymore aircraft parts, Volkswagon can focus on what they are comparatively better at and produce 120 car parts. This is the most efficient way for the firms to produce 40 aircraft parts and results in a total of 150 car parts (120 car parts from Volkswagon + 30 car parts from Roll Royce).

Note that this follows the rule in Topic 2.3 where we stated that if at least one player is maximizing their comparative advantage, then the situation is efficient (in this case Volkswagon is maximizing).

10. Explain why Brexit makes both companies worse off with reference to question 8 and 9.

Comparing the total number of parts with and without trade we see that the total number of goods are:

Without Trade: 40 Aircraft Parts, 100 Car Parts

With Trade: 40 Aircraft Parts, 150 Car Parts

Trade results in a Pareto improvement as the total number of car parts increases. This means that Brexit results in both companies having less car parts, which means less revenue.

Policy restricting trade has made it so neither company can focus on what they are comparatively good at. If Rolls Royce wants to produce cars, they have to produce the car parts themselves at higher costs. This is why we say there are ‘gains from trade’ as whether you were the British company or the German company, both parties stand to benefit.

Exercises 2.2

1. Consider the PPF diagram below.

Given the PPF illustrated, what is the opportunity cost of moving from B to A?

a) 5 coconuts.
b) 10 fish.
c) 5/10 fish
d) 10/5 coconuts.

The following TWO questions refer the diagram below, which illustrates the PPF for a producer of two goods, x and y.

2. Which of the following statements is TRUE?

I.    The marginal cost of producing x is higher at high levels of x than it is at low levels of x.
II.   The marginal cost of producing y is higher at high levels of y than it is at low levels of y.
III.  The marginal cost of producing both x and y is constant in the level of production.

a) I only.
b) II only.
c) III only.
d) I and II only.

3. If this economy is operating at point A, which of the following statements is TRUE?

I.   The opportunity cost of producing more x is zero.
II.  The opportunity cost of producing more y is zero.
III. Point A is inefficient.

a) III only.
b) I and II only.
c) I and III only.
d) I, II, and III.

The following TWO questions refer to the PPF diagram below.

4. What is the MARGINAL cost of producing good y?

a) 1/4 of a unit of x.
b) 1/4 of a unit of y.
c) 4 units of x.
d) 4 units of y.

5. What is the cost of producing FOUR units of good y?

a) 16 units of x.
b) 4 units of x.
c) 1/4 of a unit of x.
d) 40 units of x.

6. Consider a PPF drawn with x on the horizontal axis and y on the vertical axis. Which of the following concepts can be used to explain why this production possibility frontier could be flat at relatively lows levels of x and steep at relatively high levels of x?

a) Increasing marginal costs.
b) Scarcity
c) Sunk costs.
d) Trade

7. Which of the following concepts can be used to explain why production possibility frontiers slope downwards.

a) Scarcity
b) Sunk costs.
c) Trade
d) Increasing marginal costs.

Exercises 2.3

1. The following question refers to the table below, which shows the maximum number of goods X and Y that producers A and B can produce in one day.

Which of the following statements in TRUE?

a) Producer A has the comparative advantage in producing X.
b) Producer A has the comparative advantage in producing Y.
c) Producer B has the absolute advantage in producing X and Y.
d) No producer has the comparative advantage in producing either X or Y.

2. Consider the PPF diagram drawn below, for two countries that are free to trade with one another.

Which of the following production combinations is/are INEFFICIENT?

I.   Country 1 produces at point C and country 2 produces at point D.
II.  Country 1 produces at point E and country 2 produces point at B.
III. Country 1 produces at point E and country 2 produces at point A.

a) II only.
b) I only.
c) I and II only.
d) I, II and III.

3. The diagram below illustrates the PPFs for two countries that produce wine and cheese. With no trade, country 1 produces at point A on its PPF and country 2 produces at point B.

Assume that the two countries now begin to trade with one another. Which of the following will NOT occur (relative to the case with no trade).

a) Country 1 will produce less cheese.
b) Country 2 will export wine.
c) Country 1 will import cheese.
d) Country 2 will produce more cheese.

4. Which of the following statements about production and trade is FALSE?

I.  If a country has an absolute advantage in producing a good, then it also has the comparative advantage in the production of that good.
II. Rich countries will generally have the comparative advantage in the production of all goods.
III. If a country has the absolute advantage in the production of a good, then this country will be made better off by specializing in the production of that good.a) I only.
b) I and II only.
c) I, II and III.
d) III only.

The following THREE questions refer to the diagram below, which illustrates the PPFs for two countries who are free to trade.

5. What is the marginal opportunity cost (MC) of producing good x in each country?

a) 2 units of good y in country 1 and 4 units of good y in country 2.
b) 1/2 a unit of good y in country 1 and 1/4 of a unit of good y in country 2.
c) 2 units of good y in country 1 and 1/4 of a unit of good y in country 2.
d) 1/2 a unit of good y in country 1 and 4 units of good y in country 2.

6. What is the marginal opportunity cost (MC) of producing good y in each country? 

a) 2 units of good x in country 1 and 4 units of good x in country 2.
b) 1/2 a unit of good x in country 1 and 1/4 of a unit of good x in country 2.
c) 2 units of good x in country 1 and 1/4 of a unit of good x in country 2.
d) 1/2 a unit of good x in country 1 and 4 units of good x in country 2.

7. Suppose that aggregate production of x across the two countries is equal to 100 (that is, country one’s production of x plus country two’s production of x equals 100 units). If these 100 units of x are being produced efficiently, then aggregate production of y will equal: 

a) 200 units of y.
b) 400 units of y.
c) 600 units of y.
d) 800 units of y.

8. The diagram below illustrates the identical PPFs of two countries.

Initially, there is no trade allowed between the two countries, and each country produces at point A. If trade is opened up, which of the following will occur?

I.   Country 1 will export coal to country 2.
II.  Country 2 will produce more clothing.
III. Country 1 will produce less coal.

a) I and II only.
b) III only.
c) II and III only.
d) None of the above.

9. The table below shows the maximum amounts of coffee and salmon that Brazil and British Colombia can produce if they just produce one good.

Assuming constant marginal costs:

a) Brazil has a comparative advantage in coffee production
b) In Brazil, the marginal cost of salmon production is 2 units of coffee.
c) In BC, the marginal cost of coffee production is 1½ units of salmon.
d) All of the above are correct.

10. The diagram below illustrates the PPFs for two countries that produce two goods. The two countries are free to trade with one another.

Which of the following production combinations are efficient?

a) Country 1 is at point C; country 2 is at point D.
b) Country 1 is at point A; country 2 is at point B.
c) Country 1 is at point C; country 2 is at point A.
d) All of the above are efficient.

Campbell, Peter. Financial Times. “UK car industry fears effects of Brexit tariffs on supply chain.” October 16, 2016. https://www.ft.com/content/c397f174-9205-11e6-a72e-b428cb934b78

The Economist. “Slicing an Apple.” August 10, 2011. http://www.economist.com/blogs/dailychart/2011/08/apple-and-samsungs-symbiotic-relationship

The Economist. “Unfavourable Trade Winds.” May 26, 2016. http://www.economist.com/news/britain/21695544-it-would-be-hard-britain-negotiate-good-trade-deals-post-brexit-unfavourable-trade-winds

Encyclopaedia Britannica. “David Ricardo.” March 1, 2016. https://www.britannica.com/biography/Vilfredo-Pareto

Encyclopaedia Britannica. “Vilfredo Pareto.” January 23, 2014. https://www.britannica.com/biography/Vilfredo-Pareto

Krugman, Paul R. Pop Internationalism. The MIT Press, Cambridge. 1996.

Krugman, Paul R. “What Do Undergrads Need to Know about Trade?” American Economic Review 83, no. 2. 1993. 23-26.

Ricardo, David. “On the Principles of Political Economy and Taxation.” Library of Economics and Liberty.http://www.econlib.org/library/Ricardo/ricP.html.

Rolls-Royce. “Rolls-Royce history timeline.” https://www.rolls-royce.com/about/our-story/rolls-royce-history-timeline.aspx

Workman, Daniel. World’s Top Exports. “United Kingdom’s Top 10 Exports.” April 20, 2017. http://www.worldstopexports.com/united-kingdoms-top-exports/

Topic Objectives

Topic 3: Supply, Demand & Equilibrium

In this topic, you will learn about:

• Assumptions of the competitive market model: all agents are price takers, homogeneous products.
• Demand & supply: determinants of demand & supply, demand & supply curves, consumer and producer surplus, divisibility, the “laws” of demand and supply, movements along versus shifts of demand and supply curves.
• Normal & inferior goods, complements & substitutes, individual demand and supply v market demand and supply
• Equilibrium prices and quantities, price as a mechanism for equilibration.

In Chapter Two we looked at comparative advantage, and how a country could gain from trade by specializing in the production of goods for which they had the lower opportunity cost. Contrasting this with reality we will notice a number of things. Firstly, transactions are conducted and denominated in dollars, not other goods, and typically there will be more than one buyer and one seller interacting in the market. This is a typical competitive market, which is a market form we will explore in depth in this topic.

Figure 1. Farmer’s Market. Organic vegetables and fruits that are grown and sold within a specific geographical region should, in theory, cost less than conventional produce because the transportation costs are less. That is not, however, usually the case. (Credit: modification of work by Natalie Maynor/Flickr Creative Commons)

An auction bidder pays thousands of dollars for a dress Whitney Houston wore. A collector spends a small fortune for a few drawings by John Lennon. People usually react to purchases like these in two ways: their jaw drops because they think these are high prices to pay for such goods or they think these are rare, desirable items and the amount paid seems right.

Gasoline prices are effected by demand and supply shocks both locally and globally. (Credit: Philippa McKinlay/ Flickr/ CC BY-NC-ND 2.0)

When economists talk about prices, they are less interested in making judgments than in gaining a practical understanding of what determines prices and why prices change. Consider a price most of us contend with weekly: that of a litre of gas. Some of you may remember the sharp fall in gas prices in 2015, which worsened when sanctions were lifted from Iran in January of 2016 . What caused the price of a barrel to fall from almost $110 to just $15? To explain these price movements, economists focus on the determinants of what gasoline buyers are willing to pay and what gasoline sellers are willing to accept.

As it turns out, the price of gasoline in June of any given year is nearly always higher than the price in January of that same year; over recent decades, gasoline prices in midsummer have averaged about 10 cents per gallon more than their midwinter low. The likely reason is that people drive more in the summer, and are also willing to pay more for gas – but that does not explain how steeply gas prices fell. Other factors were at work during those six months, such as increased competition between Saudi Arabia and Iran, an oversupply in production from years of heavy investment, and other shocks to the supply and demand of oil.

This chapter introduces the economic model of demand and supply—one of the most powerful models in all of economics. The discussion here begins by examining how demand and supply determine the price and the quantity sold in markets for goods and services, and how changes in demand and supply lead to changes in prices and quantities.

Click to Learn More About Demand and Supply Shocks to the Price of Oil

An Economic Model of Demand and Supply

Recall that an economic model is a simplified framework that is designed to illustrate complex processes. The first model we looked at in Topic 2 was the Production Possibility Frontier, which outlined efficient production under autarky and under trade. We mentioned that although these models can seem oversimplified, holding certain variables constant to analyze the most important ones is an effective way to build a basis of understanding. For demand and supply, we must remain conscious of the model’s simplifications to understand its limitations and strengths. The next model we will explore is the competitive market model.

Assumptions of the Competitive Market Model

1. Product Homogeneity

Shrek used to pitch Vidalia onions (Credit: truthinadvertising.org)

Under product homogeneity, all goods offered for sale are identical in the eyes of the economic agent. Say, for example, you go to the farmer’s market and consider buying onions. Suppose there are two different farms selling identical onions. In this case, the product is “homogeneous,” as you, the consumer, have no preference over which onion to buy and will simply go with whichever is cheaper. Instances of perfect homogeneity are actually quite rare, as firms strive to differentiate themselves from their competitors. Farms may position themselves as more organic, or more local. One onion firm even used Shrek to differentiate its onions, playing off the line “ogres are like onions, we have many layers.”

2. No Buyer Power

Under the assumption of buyer power, no single consumer has the power to influence the price at which they purchase a good. For example, your choice whether or not to buy a Coke is not going to cause Coca Cola to change its prices, since Coca Cola has many other consumers who would will purchase. If you are buying a car, you likely have some degree of buyer power, since your purchase results in substantial revenue for the car lot. In a perfectly competitive market, consumers have no buyer power.

3. No Supplier Power

Under this assumption, no single producer has the power to influence the price at which they sell a good. Consider a small manufacturer attempting to negotiate prices with multinational retail corporation Walmart. The manufacturer will likely have to take the price or go somewhere else. Compare that to Apple supplying an Apple Specialist store, in this case Apple has a lot of power and can likely dictate prices to the retailer. In a perfectly competitive market, producers have no supplier power.

Are These Realistic Assumptions?

Some of these assumptions are not too far from reality. In fact, the economic climate in which firms operate ranges from instances like these of perfect competition to monopolies, in which one firm sets its own prices. By first understanding the model on one end of the extreme, we can begin to understand the spectrum.

In 3.2, we will look at potential buyers on the demand side.

In 3.3, we will look at potential sellers on the supply side.

Then, looking at how they interact, we will determine where the market equilibrium lies in 3.4.

Let’s first focus on what economists mean by demand.

Summary

The model to examine supply and demand is called the competitive market model. In the competitive market, we assume products are homogeneous, and there is no supplier or buyer power.

The Law of Demand

Economists use the term demand to refer to the amount of some good or service consumers are willing and able to purchase at each price. Demand is based on needs and wants, and while consumers can differentiate between a need and a want, from an economist’s perspective, they are the same thing. Demand is also based on ability to pay. If you cannot pay for it, you have no effective demand. This concept of a consumer’s willingness to pay (WTP) serves as a starting point for the demand curve. A consumer’s Willingness to Pay is equal to that consumer’s Marginal Benefit (MB). This is useful information if we want to use Marginal Analysis.

As we learned in Topic 1, Marginal Analysis or “thinking on the margin” is how consumers decide whether or not to buy an additional unit. It is the process of considering the additional benefits and costs of an activity to make a decision. Therefore, when we say a consumer is willing to pay x dollars for another good, we are stating that the consumer believes they will receive x amount of benefit. As long as the consumer’s marginal benefit is greater than their marginal cost, they will purchase the good. Therefore, the maximum amount a consumer is willing to pay is equal to their marginal benefit.

What a buyer pays for a unit of a good or service is called price. The total number of units purchased at that price is called the quantity demanded. A rise in price of a good or service will almost always decrease the quantity demanded of that good or service. Conversely, a fall in price will increase the quantity demanded. Economists call this inverse relationship between price and quantity demanded the law of demand. The law of demand assumes that all other variables that affect demand (to be explained in Topic 4) are held constant.

Filling up your gas tank costs money. How does the price of gas affect the amount you drive? (Credit: Christopher/ Flickr/ CC BY-NC 2.0)

Let’s look at these concepts in more detail with an example. Assume that your car holds 50L of gas and that at the average price of gas you would generally use about a tank of gas each month. This amount allows you to comfortably drive to school and back, run errands, and use the car on weekends for trips. As discussed above, this usage will change as price changes.

Demand Schedules and Curves

As a student on a tight budget, the price of gas will have a large influence on the amount you drive. When the price of gasoline goes up, you will look for ways to reduce your driving by combining errands, commuting by carpool or transit, biking and walking more, and driving less on weekends and holidays. So, what would happen if the price of gas was $3.5/litre? Though you would likely be outraged that prices had risen so high, would you stop driving altogether? Perhaps, but perhaps not. Assuming there are some cases where your marginal benefit for driving is so high that you are willing to pay this high premium, we can estimate that you might use about one tank over the semester. This is about one quarter of the driving you are used to. This shows that for the first 50L of gas you consume, you are willing to pay a high price, in this case $3.5/L.

Figure 3.2a

If, from the high price of $3.5, the price falls to $2.4, you will drive more. At this price you may use 100L of gas, or about two tanks, over the course of a semester. Using this we can make a demand schedule, as shown in Figure 3.2a, for a typical student. This illustrates the law of demand. For the first tank of gas you were willing to pay a high price of $3.5/L, but for the second tank you were only willing to pay $2.4/L. As price falls, the quantity you demand increases.

This analysis can be continued for the third, fourth, and fifth tanks of gas. To create a more visual representation, we can plot the quantities of gas a student is willing to buy at varying prices on a graph as shown in Figure 3.2b. Once again, we see that as the price falls, quantity demanded increases.

Figure 3.2b

If we join the points together as in Figure 3.2c, we produce a demand curve – a graphical representation of our demand schedule. This is the same as a Marginal Benefit Curve, as it shows the consumers marginal benefit at a given quantity.

Figure 3.2c

The Ceteris Paribus Assumption

In section 3.1, we mentioned that we hold certain variables constant to analyze the ones that are most important. In the case of the demand curve (and the supply curve, as we will soon see), we are examining a relationship between two, and only two, variables: quantity on the horizontal axis and price on the vertical axis. The assumption behind a demand or supply curve is that no economic factors other than the product’s price are changing. Economists call this assumption ceteris paribus, a Latin phrase meaning “other things being equal.” Any given demand or supply curve is based on the ceteris paribus assumption that all else is held equal.  If all else is not held equal, then the laws of supply and demand will not necessarily hold.

With the information about our demand curve and with the ceteris paribus assumption, we can determine what quantity our student will consume at a given price. So, what if our price is $0.9? This is fairly close to what you would expect to pay for gas in the current market. Alas, by examining the demand curve in Figure 3.2d, we see what we had discussed earlier. The student will travel about 200 km per semester, using about a tank of gas each month. We determine this by looking at where price is equal to the student’s marginal benefit, or where the price line intersects the demand curve.

Figure 3.2d

In Topic 1, we determined that a consumer will purchase something as long as MB > MC. Since the price of gas is constant in this example, the student’s marginal cost is constant as well. Why does the student not consume 50L of gas? At 50L, the student’s MB is $3.5, which is greater than the MC of $0.9. Likewise, the MB at 100 and 150L is also greater. At 200L, the MB is equal to the marginal cost of $0.9, so the student will purchase 200L. Any more and MB will fall below MC, meaning the cost of the action outweighs the benefits.

Consumer Surplus

Notice that for the first 150L of gas purchased, the student’s MB is greater than his MC. In Topic 1, we discussed that this difference is equal to the marginal net benefit. By examining the marginal net benefit at each level of consumption, we can measure a consumer’s total net benefit from their purchase, or their consumer surplus. Consumer surplus is the difference between the consumer’s willingness to pay and the amount they actually pay for a given quantity, or the total benefits minus the total costs of consumption.

Looking at Figure 3.2e, we can see that the benefit from each 50L increase is diminishing. For the first 50L, where our marginal benefit from consumption is $3.5/L, our total benefit is equal to area A, or $175, whereas our next 50L only give us a additional benefit of area B, or $120. Regardless, these 50L still increase our total benefit from $175 to $295. Our total cost from the first 50L is $0.9/L or $45

Notice that for the first 150L of gas purchased, the student’s MB is greater than his MC. In Topic 1, we discussed that this difference is equal to the student’s marginal net benefit. By examining the marginal net benefit at each level of consumption, we can measure a consumer’s total net benefit from their purchase, or their consumer surplus. Consumer surplus is the difference between the consumer’s willingness to pay and the amount they actually pay for a given quantity, or the total benefits minus the total costs of consumption.

We can break down how this corresponds to consumer surplus with marginal analysis. For the first 50 units of production, with total benefit of $175 and total cost of $45, our consumer surplus is equal to $130. We continue this analysis in Figure 3.6f. As long as our MB is greater than our MC, consumer surplus will continue to increase.

Figure 3.6f

Take special note of total benefits and total costs at the consumption level of 250. Recall that we determined the optimal level of production was when MB = MC. With our price of $0.9, this occurred when quantity demanded was equal to 200L. Students often get confused when looking at the table above and point out that at 250L, total benefits are greater than total costs, and reason that the consumer should continue to consume beyond 200L, but remember, it is not the total benefits and costs that matter in marginal analysis. For example, if you were willing to pay $1 for a Coke but it costs $3, it doesn’t matter how many Cokes you purchased previously, or the benefit or costs of those former Cokes. All that matters are the costs and benefits for the next unit of consumption. This is the heart of marginal analysis.

Bringing the marginal analysis together, we can look holistically at consumer surplus. Recall that consumer surplus is just the difference between the consumers willingness to pay (the blue line) and the cost to the consumer (the red line). By calculating this area (shown shaded in green in Figure 3.2g) we can easily find consumer surplus without having to look separately at Total Benefits and Total Costs.

Figure 3.2g

Consumer Surplus with Changing Prices

We have now examined the consumer surplus when price is $0.9/L, but what if our price changes? Suppose that price suddenly rises to $2.4/L. By the law of demand, we have established that this increase in price will cause a decrease in quantity demanded, but it is also important to explore how consumer surplus changes. Consumer surplus can be used to analyze changes in consumer well-being as market conditions change, making it a useful tool to analyze how society is impacted.

Figure 3.2h

In Figure 3.2h, we see that consumer surplus decreases from $240 to $55. This fall is caused by two factors. First, the student is buying less gas. As discussed before, when price is $2.4/L, the student will combine errands, etc. to decrease the amount they drive. Second, the gas they continue to buy (100L) is now more expensive than before. We can summarize these two changes easily. When prices increase, consumer surplus decreases because:

1. The quantity that the consumer consumes decreases.
2. The price of the goods the consumer continues to buy increases.

Completing the Demand Curve

The last component of the demand curve to discuss is the divisibility of goods. In our example above, how would quantity demanded change if price increased from $0.9/L to $1.0/L? In our example, it falls from 200L demanded to 150L demanded! What about a price increase from $0.9/L to $1.6/L? Again our quantity demanded falls from 200L to 150L. Does this mean the price increase from $1.0/L to $1.6/L means nothing? This problem is due to the fact that we only examined five possible points on our curve. In reality, the demand curve has an infinite number of relationships between price and quantity

If we were to plot the quantity demanded for every possible price of gasoline, we find a smoothed-out curve like the one shown in Figure 3.2i. When we do this, we fin the quantity demanded for $1.0/L of gas is different than the quantity demanded for $0.99/L of gas. In reality, the average consumer may not change his or her consumption of gas in response to such a minor price change, and may have a demand curve that looks more like the staircases presented earlier, but when you bring together the millions of Canadian gas purchasers with varying willingness to pay, different reactions to prices changes, etc. the divisibility of goods becomes more plausible.

Figure 3.2i

Summary

In this section, we examined the market from the eyes of the consumer and introduced consumer surplus to explain how a consumer reacts to price changes. In section 3.4, we will examine the market from the eyes of the producer and introduce the concept of producer surplus. With a strong understanding of consumer and producer surplus, we can examine the impact that changes in the market have on society. Before we get there, we must examine the other determinants of demand that can impact our demand curve.

Learning Objectives

By the end of this section, you will be able to:

• Understand the difference between demand and quantity demanded
• Know the four main determinants of demand
• Explain demand shifts from both horizontal and vertical perspectives
• Create an aggregate demand curve given individual curves

(Credit: Olenka Kotyk/Unsplash)

A Better Bus System

In section 3.2, we explored how the price of gasoline affected quantity demanded, but what about other factors that affect our choices? In May 2016, New York’s Metropolitan Transit Authority introduced high-tech buses equipped with Wi-Fi and USB ports to charge phones and other devices. These improvements encourage people to substitute away from cars, decreasing the demand for gasoline regardless of price. As we will see in this section, there are many determinants of demand. The four we will explore in detail are:

1. Income
2. Prices of Related Goods
3. Tastes and Preferences
4. Expectations

As you will see, changes in these factors affect the interaction of price and quantity on every point of our demand curve, resulting in a shift of the entire curve. First, let’s clear up some terminology.

Is demand the same as quantity demanded?

In economic terminology, demand is not the same as quantity demanded. When economists talk about demand, they mean the relationship between a range of prices and the quantities demanded at those prices, as illustrated by a demand curve or demand schedule. When economists talk about quantity demanded, they mean only a certain point on the demand curve, or one quantity on the demand schedule. In other words, a change in quantity demanded is very different than a change in demand.

A change in demand refers to a shift in the demand curve that affects the whole diagram and the interactions between price and quantity.

A change in quantity demanded refers to a movement along the demand curve, exploring different points along the same curve.

We examined changes in quantity demanded in Topic 3.2. In this section, we discuss changes in demand.

1. Income

The first determinant of demand we will explore is income. If you were to land a job with a top salary tomorrow, how would that affect your demand for different items? Perhaps you would exchange your old Honda Accord for a Porsche, or go on a shopping spree at a high-end clothing store. Though having more money means you can buy more goods, there are some goods that you may actually buy less of. In introductory microeconomics, we classify goods into two types: inferior goods and normal goods. For inferior goods, as your income rises your demand falls. For normal goods, as income rises your demand rises

Consider Kraft Dinner and steak. On a student budget, Kraft Dinner or similar low-cost items can be a dietary necessity, but as your income increases, you will likely eat less of these low-quality foods. This makes Kraft Dinner an inferior good. On the other hand, as your income increases, you will likely consume more steak and other fine dining foods, making them normal goods. Note that what we consider to be inferior or normal is relative. A millionaire food connoisseur may regard a food you view as a delicacy as an inferior good that they would only eat if they couldn’t afford such a luxurious lifestyle. Regardless, income is still an important factor in our decision making and it is useful to make generalizations about how the market responds when incomes change.

(Credit: Above: Mike Mozart/ Flickr/ CC BY 2.0, Below: Benjamin Horn/ Flickr/ CC BY 2.0)

So what effect does income have on the demand curve? Assume we have an increase in income for our consumers of gasoline. With more money you may be less conscious about the amount of gas you use – perhaps you will finally buy an expensive parking pass and drive more. Assuming that gasoline is a normal good, this is going to result in an increase in demand. In Figures 3.3a and 3.3b, we depict two different ways to view this shift.

Vertical Shift – Figure 3.3a

The first way to look at a demand shift is to examine how a consumer’s willingness to pay (WTP) changes. With your original income, you were willing to pay $0.9/L to use 100L of gas per semester (note this is simplified from the example in 3.2 to be linear). When income triples, it is estimated we are willing to pay $3.3/L. Recall that demand is determined by preferences and ability to pay, so for a normal good WTP will increase as income rises. Notice that this increase is uniform at any point along the demand curve. Whereas you were WTP only $1.7/L for 50 units, you are now WTP $4.1/L. All across the demand curve, our willingness to pay has increased by$2.4/L.

Figure 3.3a

Horizontal Shift – Figure 3.3b

The second way to view a demand shift is to look at how a consumer’s quantity demanded changes at each point along the curve. At a price of $0.9/L, the student initially has a quantity demanded of 100L. After income increase this has risen to 250L. This way of viewing the demand shift is why we call the change a shift in ‘demand’ instead of quantity demanded as the quantity demanded at every point along the curve has changed.

Where the individual actually chooses to consume depends on the supply curve. In 3.2, we examined a demand curve with a constant price. As we will see when we examine the supply curve, shifts often affect both the final price and quantity in the market.

Figure 3.3b

The following table summarizes the different effects income changes can have on our demand curve. Note that the best way to learn these concepts is to think of examples and practice shifting the demand curve. You can refer to the table to ensure you are on the right track!

Figure 3.3c

2. Price of Related Goods

So far, we have only looked at one good in isolation. In reality, there are many goods in the marketplace that interact with each other in unique ways. Some goods seem to pair nicely, whereas others compete. These interactions have specific classifications in economics. With reference to the good we are analyzing in our demand curve:

Complement goods are goods that a consumer likes to consume with a given good. For example, peanut butter and jelly. Demand for complements is positively correlated with the other goods price. If jelly increases in price, we will purchase less peanut butter.

Substitute goods are goods that a consumer could consume instead of a given good. For example, peanut butter and almond butter. Demand for substitutes is negatively correlated with the other goods price. If almond butter increases in price, we will purchase more peanut butter.

Like income, the impact of market price fluctuations on our demand curve depends on whether the two goods are substitutes or complements. The following table summarizes how our demand for a given good can be impacted by price fluctuations of other goods.

Figure 3.3d

Taking Advantage of Complements

(Credit: dbgg1979/ Flickr/ CC BY 2.0)

Businesses are well-versed in the knowledge of complements and substitutes, and often use consumer behavior to their advantage. Consider common displays of complementary products, such as a display of marshmallows, chocolate, and graham crackers, each a component of the summer-beloved S’more. A business may put graham crackers are on sale, but not the chocolate. If the graham crackers were displayed alone on sale, the quantity demanded of the good would rise, according to the law of demand. By displaying the goods together, this business is reminding consumers that graham crackers are a complement to chocolate. This will make consumers also more likely to purchase chocolate, even though price has not changed.

3. Tastes and Preferences

Our tastes and preferences change over time. In our gasoline example, assume you start dating someone who drives an electric car and constantly reminds you of the impact your gasoline consumption has on the environment. You will likely begin to follow some of their habits and purchase less gasoline. Marketing departments constantly try to influence your preferences, and sometimes even create them. That’s because the more you prefer a product, the more you will demand it!

4. Expectations

The last determinant of demand we will explore is perhaps the most nuanced. It is that the expectation of the future price of a good can affect how much consumers will demand it today. For example, if you are a frequent shopper at Hudson’s Bay, you will be aware of the company’s regular sales. With sales so frequent, you may be reluctant to purchase any non-discounted item. Since the actual date of the sale is unknown, this is a motivator to wait, decreasing demand today. To really emphasize this point, consider Steam, a digital distribution platform developed by Valve Corporation that sells PC video games online and provides a platform for users to interact. Steam has performed well, with its sales constituting 50%–70% of the US$4 billion market for downloaded PC games. If you are a Steam user, you understand the role of expectations play when purchasing games. Since Steam holds regular holiday-themed sales where they blow out a large portion of their catalog with discounts as high as 80% off there is always the expectation that you can buy the game for a lower price later. This is an even stronger motivator as consumers know exactly when to look for the sales. This will decrease demand for the game when there are no promotions.

If you expect the good to become more expensive, your present demand will increase.

If you expect the good to become less expensive your present demand will decrease.

How soon you expect prices to change will affect the power of expectations. We all know the new iPhone is going to be cheaper six months down the road than when it first comes out, but there are certain benefits to having the product when it first hits the shelves. Firms work hard to create a perceived obsolescence in order to sell goods when they are new. For example, if you fear clothes may go out of style, you are influenced to purchase them immediately rather than wait for sales.

Market Demand

So far, while we have hinted at the market as a whole, the majority of our analysis has looked at one consumer and their demand curve. In reality, we know the market is made up of many consumers, each with individual preferences and willingness to pay. To illustrate market demand (also known as aggregate demand), we can start with two demand curves. In Figure 3.3e below, two individual demand curves for gasoline are illustrated in green and blue. These demand curves could be different for a number of reasons, consumer B could have higher income, could enjoy driving more, or any other determinant of demand that would make his willingness to pay higher. Notice first that the slopes of the demand curves are the same, and while this need not be the case, it makes analysis simple.

To find the aggregate demand line, you simply pick two prices on the individual demand curves and add up the quantity demanded from each consumer. For example, at the price of $1.3/litre, consumer A has quantity demanded of  100 litres/semester, whereas consumer B has quantity demanded of 200 litres/ semester. In aggregate consumer A + consumer B have quantity demanded of 300 litres/semester – this gives us point C on the graph of aggregate demand. Likewise at the price of $3.7/litre, consumer A has quantity demanded of  50 litres/semester, whereas consumer B has quantity demanded of 150 litres/semester resulting in 200 litres of aggregate demand (50+150).

Figure 3.3e

Now you have two points on the market demand curve, with this, you can connect the two points to give the whole curve.

Note that market demand behaves in the same way as individual demand: it is shifted by external forces like income, prices of related goods, preferences, and expectations. When examining demand from now on, we will, for the most part, be analyzing market demand to determine equilibrium.

Summary

We now know that a demand curve is constructed by considering a consumers willingness to pay and different quantities, and the aggregate demand curve is the sum of all consumers demand curves. While price changes influence our quantity demanded, shocks such as changes in income, price changes of related goods, changes in tastes, and expectations can shift our demand, resulting in a different willingness to pay at every level. Now that we understand demand, we can turn to supply and its determinants.

(Credit: Alaythia Cakes)

Now that we have examined demand and its determinants, let’s look at supply. For the most part, the analysis is similar. Let’s start with an example.

The Cupcake Business

When the store “Cupcakes” came to Vancouver in 2002, the cupcake industry was very different than it is today. The start-up was the only one in town and had the ability to set the price as it saw fit. Over 10 years later, the industry has changed. It is now common to see multiple cupcake shops in each city. New York even has a cupcake ATM where customers can buy cupcakes after the store closes. To understand the supply side of the market, let’s look at a cupcake business that operated in a far more competitive market model than the ones mentioned above – Alaythia Cakes. Alaythia Cakes, a small-town business that primarily sold its products at a weekly farmer’s market, was looking to bring its products to the provincial stage with distribution in grocery stores. Compared to the overall market, Alaythia Cakes was a small player, and when negotiating with brands like Save on Foods, Thrifty Foods, and Costco, it found that it had little to no power in negotiating price, since the grocery chains had access to many other cupcakes suppliers (no supplier power).

Opportunity Cost in the Real World

In Topic 2, we looked at the production possibilities of a person on an island, denominating costs in the marginal opportunity cost of an action. Let’s take that island example and apply it to a firm. While Alaythia Cakes was looking to expand, its production possibilities are limited by the owner and the capacity of the staff. The business can choose to produce and sell cookies, cupcakes, or a mix of both. Assume that:

Figure 3.4a

For the first 5 cupcakes, the MC = 0.8 cookies (4 cookies/5 cupcakes)

For the second 5 cupcakes, the MC = 1.6 cookies (8 cookies/5 cupcakes)

For the third 5 cupcakes, the MC = 2.4 cookies (12 cookies/5 cupcakes)

With this information, we can derive the supply curve, but first we need to denominate the marginal cost in the correct medium of exchange – dollars. Let’s assume the current market price for cookies is $0.50 per cookie. Then, for the first 5 cupcakes, implicit costs are $0.50 x 0.8 = $0.4. All we are doing is changing the way we describe cost from ‘cookie terms’ to ‘dollar terms.’ Is this all our costs? Recall in Topic 1 that the opportunity costs of an action include all implicit and explicit costs. In this case, an explicit cost would include the actual cost of flour, eggs, etc. Let’s assume that the explicit costs of a cupcake are $0.5. This means:

MC of 1st 5 cupcakes = $0.5 (explicit) + $0.4 (implicit) = $0.9 

MC of 2nd 5 cupcakes = $0.5 (explicit) + $0.8* (implicit) = $1.3

MC of 3rd 5 cupcakes = $0.5 (explicit) + $1.2* (implicit) = $1.7

*the implicit costs were calculated by multiplying the implicit costs denominated in cookies by $0.5.

The Supply Curve

To create the supply curve, we need to graphically represent our information. Using price on the y-axis, and quantity on the x-axis, we can plot the marginal cost points to produce Figure 3.4b.

Figure 3.4b

As with demand, we simply join the points in stair-step fashion to create our curve as shown in Figure 3.4c. We can now use our supply curve to examine how our quantity supplied interacts with price, and how this will affect producer surplus.

Figure 3.4c

Now, let’s use these tools to determine quantity supplied. Suppose after meeting with the managers of Save-On-Foods, Thrifty Foods, etc. the manager of Alaythia Cakes has determined the best price they can get for the cupcakes is $2.3. By looking at where price intersects the supply curve, we can determine what quantity of cupcakes Alaythia Cakes will supply. Looking at Figure 3.4d, the MC of units 15 to 20 is $2.1, which is less than the price, but the MC of units 20 to 25 is $2.5, which is greater than price. Therefore, Alaythia Cakes will produce 20 cupcakes when the market price is $2.3.

Figure 3.4d

Producer Surplus

Just like consumer surplus, it is important to examine a producer’s net benefit from a certain action. Whereas consumer surplus is the difference between what the consumer is willing to pay and the price they pay, producer surplus is the difference between what the producer is paid (revenue), and the variable cost of production. Our variable costs are represented by our implicit and explicit costs.

To break down producer surplus, let’s look at the total revenue and total variable costs of producing 20 cupcakes.

Figure 3.4e

Total Revenue

If the market price of a cupcake is $2.3 and we are producing 20 cupcakes, what is our total revenue? The problem is simple. If you are making $2.3 for every cupcake, and you sell 20, your total revenue will be $46. On the graph, this always corresponds to a rectangle bounded by the price and the quantity supplied (the blue shaded region).

Total Variable Cost

To find total variable cost we need to add the MC at each level, calculating the area under the supply curve (the red shaded region). The calculation of cost for Figure 3.4e is:

Marginal cost of the 1st 5 cupcakes = $0.9 x 5 cupcakes = $4.5

Marginal cost of the 2nd 5 cupcakes = $1.3 x 5 cupcakes = $6.5

Marginal cost of the 3rd 5 cupcakes = $1.7 x 5 cupcakes = $8.5

Marginal cost of the 4th 5 cupcakes = $2.1 x 5 cupcakes = $10.5

Total variable costs ($4.5 + $6.5 + $8.5 + $10.5) = $30

Producer Surplus

Bringing all this information together we can calculate producer surplus. Since Total Revenue – Total Variable Costs = Producer Surplus (PS), our PS is equal to $46 – $30 = $16. This corresponds to the area  between the price producers receive, and their costs, shown in green in Figure 3.4f.

Figure 3.4f

Producer Surplus with Changing Prices

Determining producer surplus with changing prices closely mirrors that of consumer surplus during changing prices, but in order to get comfortable with the terminology, we will analyze the effects separately.

Suppose the manager of Alaythia Cakes had been happily selling cupcakes to the grocery stores at $2.3, but one morning, all the grocery stores told him that the best price they could give him was now $1.4/cupcake. According to the law of supply, we know this decrease in price will cause a decrease in quantity supplied, but how does our producer surplus change? Calculating the change in the green area in Figure 3.4g, we see that producer surplus falls from $16 to $3. This change is due to two factors. Firstly, at the lower price, the business can no longer sustain production of 20 units as MC > P, so it decreases the quantity supplied to 10 units. This causes the firm to lose the $4 of producer surplus it was receiving from selling units 10-20. Second, the firm is now receiving a lower price for the units it continues to produce, a total of $0.9 fewer dollars on 10 units, resulting in the other $9 decrease in producer surplus.

Figure 3.4g

In short, when there is a fall in price, producer surplus decreases for two reasons:

1. The quantity produced decreases
2. The price the producer receives for the remaining goods decreases

Completing the Supply Curve

The last step we have in the derivation of supply is recognizing that there is divisibility of goods. In the stair-step example, we are implicitly assuming that we can only trade cupcakes and cookies in 5 cupcake increments. Of course, this is not actually the case. The more divisibility we introduce, the more our supply curve smooths out until it is a straight line.

Figure 3.4h

In our analysis of the interaction between supply and demand (equilibrium), we will continue to use smoothed out supply and demand curves. Not only are these curves based on more realistic assumptions, they also lead to greater versatility for mathematical analysis.

Summary

In this section, we examined the market from the eyes of the producer and introduced producer surplus to explain how a firm reacts to price changes. We showed that a change in producer surplus is due to a change in quantity and a change in price, and learned that most supply curves are smoothed out by the divisibility of goods. Before we look at the equilibrium, let us finish the supply picture by looking at some other determinants of supply.

(Credit: EZ Frost)

It’s as Easy as Cake

In section 3.4 we looked at the impact of price on the supply curve, but there are many other factors that affect a company’s decision to produce. For example, new innovations are always coming out to make cake decorating and baking easier, whether it is machines like the one shown above, or faster and better mixers. These inventions save time and energy at different levels of production. External forces like these impact our supply curve. The four supply shocks we will examine in detail include:

1. Input Prices
2. Technology
3. Expectations
4. Number of Producers

Whereas changes in price change quantity supplied, these factors shift supply. This is distinctly different from changes in quantity supplied as these shocks affect the price-quantity interaction at every point on our curve.

Input Prices

Perhaps the most obvious shock to the supply curve is the cost of inputs. Also known as ‘Factors of Production’, these are the combination of labor, materials, and machinery used to produce goods and services. Our cupcake supply curve was based on the assumption of specific implicit and explicit costs which are prone to change. Any changes to these costs will affect our marginal costs at every point.

Changes in Explicit Costs

Changes in explicit costs are the easiest to conceptualize. We determined that the explicit cost of our cupcake supplies was around $0.50 each. What if icing sugar, an input to cupcakes, becomes more expensive? This will raise our marginal costs at all points of production, causing an upward shift in our supply curve.

Changes in Opportunity Costs

Opportunity cost is more of an abstract concept to think about in terms of input prices. Essentially, if cookies become more profitable to produce, our supply model considers the higher opportunity cost as an increase in our cost of making cupcakes. Suppose the market price for cookies increases from the original $0.50 to $1.00. Now, our MC will be as follows:

MC of 1st 5 cupcakes = $0.5 (explicit) + $0.8 (implicit) = $1.3 (increased from $0.9)

MC of 2nd 5 cupcakes = $0.5 (explicit) + $1.6 (implicit) = $2.1 (increased from $1.3)

MC of 3rd 5 cupcakes = $0.5 (explicit) + $2.4 (implicit) = $2.9 (increased from $1.7)

Notice this increase in marginal cost occurs at all levels, meaning the change will shift the entire supply, changing the quantity supplied at every point.

How does the supply curve actually change? In our discussion of demand, we explained that you could view a demand shift as vertical, as consumers’ willingness to pay changes at every quantity demanded; or as horizontal, as the amount consumers buy changes at every price level. There is a similar process for supply.

Vertical Shift – Figure 3.5a

The first way to view a shift in supply is as a vertical shift. Recall that supply represents the producer’s MC at each point of production. Assuming that in the original supply curve our MC of producing 15 units is $1.60, if costs increase by a dollar, we will see the marginal cost increase to $2.60. Since input prices increase by a dollar regardless of our production level, the entire curve will shift up by $1.00.

Figure 3.5a

Horizontal Shift – Figure 3.5b

The next way to view a supply shift is slightly less intuitive. In Figure 3.5b, when the price of cupcakes is $1.80, our quantity supplied is equal to five cupcakes. Consider how this will change with a $1.00 decrease in input prices. Originally, we produced 5 cupcakes because our price was equal to marginal costs at that level When our costs fall, our price is still $1.80, but our costs are $0.90. Since P>MC, it is efficient to produce more than 5 units. Using marginal analysis, we find it is efficient to produce 17 units at this price.

Whereas before, it was only viable to produce 5 units at the price of $1.80, we can now produce up to 17 units efficiently. This causes the supply curve to shift right.

Figure 3.5b

Most shocks will cause a uniform shift as can be explained vertically or horizontally. Technology, expectations, and the number of producers will all shift the supply curve in the same way as depicted.

Technology

As mentioned at the beginning of the section, changes in technology will also shift the supply curve. Why is that the case? Technology changes have a direct impact on the cost of production. If suddenly a new innovation allows you to cut your work time in half, you will cut down your costs of labor. If technology allows you to conserve wasted resources, then your input prices will decrease, These changes will increase supply, shifting the curve to the right. Technological Decay is a less common case where technological progress is reversed. What if the city banned the use of a certain cupcake icing machine because the noise was bothering other residents? This would cause you to go back to the less efficient practice of icing by hand, thereby increasing your costs. In summary:

• Improvements in technology will lower costs of production and increase supply
• Decay in technology will increase costs of production and decrease supply

Expectations

Like demand, expectations of the supply price affect production decisions. Production decisions are a lot like playing the stock market; if we are producing cupcakes and cookies to sell to the store tomorrow, we have to produce based on the current, incomplete knowledge we have about those prices. Normally, you will be confident that these prices will stay relatively stable, but if you have reason to believe the prices of cupcakes will drastically rise in the morning, you may devote more of your attention to producing them. Expectations are usually based on some form of evidence or signal and can cause supply shifts quite suddenly. In summary:

• If the firm expects prices to rise, supply will increase
• If the firm expects prices to fall, supply will decrease

Number of Producers

The final determinant of supply is the number of producers. So far, we have examined just one firm. Recall in section 3.3 we showed that the competitive market is characterized by many potential buyers, and added up individual demand curves to produce aggregate demand. Likewise, the market is made up of many other producers. By adding all the suppliers together, we get aggregate supply. This can affect total supply. If for example, four new firms enter the cupcake market, whereas Alaythia Cakes was producing just 5 cupcakes, now the firms each produce 5 cupcakes for a total of 25 (assuming that the individual supply curves are the same, which need not be the case). In summary:

• When more firms enter the market, supply will increase
• When firms leave the market, supply will decrease

Summary

The four supply shocks have been summarized in the table below. Once again, the best way to learn these shifts is not to memorize them, but to practice shifts on the diagram to view their effects.

Figure 3.5c

(Credit: Richard Hsu/ Flickr/ CC BY-ND 2.0)

 Equilibrium

Equilibrium is formally defined as a state of rest or balance due to the equal action of opposing forces. In economics, these forces are supply and demand. As we will see, when supply and demand are not in balance, economic forces will work until the balance is restored.

Figure 3.6a shows the competitive market for hot dogs, with aggregate demand in blue and aggregate supply in yellow. As price rises, quantity demand for hot dog falls, and quantity supplied rises. There are two important points on this diagram. First is equilibrium quantity (Q_E). Q_E is where the quantity supplied is equal to the quantity demanded. It is important to recognize this value and the mechanism that leads us there. There is only one price that corresponds with equilibrium quantity, and that is equilibrium price (P_E). The question remains, how do we arrive at equilibrium? Let’s first consider what occurs when the price is too high.

Figure 3.6a

When Price is Higher than Equilibrium

What if the price is above our equilibrium value? How will the equal and opposite forces bring it back to equilibrium? There are a number of reasons why the price may be too high. One common example that we will explore in greater depth in Topic 4 is the price floor. Regardless of the cause, we see in Figure 3.6b that a price above equilibrium will result in quantity supplied being greater than quantity demanded. This excess supply is also known as a surplus. There are too many sellers who are enticed by the high price, and not enough buyers. Consider a hot dog vendor, Paul, in this situation. Though Paul would be happy to receive the high price of $5 from the customers who buy the good, he will find that he will be unable to sell all the hot dogs he cooks, since 500 hotdogs are being made, and only 100 sold. This will result in wasted product, and a surplus of 400 hotdogs in the market. If vendors were forced to stay in this market, the quantity supplied would fall to 100, as vendors would quickly reduce production to what customers are willing to purchase.

Figure 3.6b

In order to sell all his hot dogs, Paul could start offering the hot dogs for a cheaper price until he is able to sell everything he produces. In this case, every vendor has the incentive to drop their price, since (all else equal) consumers will purchase the product with the lowest price. As price falls, two things occur:

• There is a decrease in quantity supplied (a movement along the supply curve)
• There is an increase in quantity demanded (a movement along the demand curve)

Notice that both supply and demand are forces that bring the market back to equilibrium. When price is at equilibrium of $3, no vendor has the incentive to decrease their price, since this would result in them selling hotdogs at a loss.

When Price is Lower than Equilibrium

What if price is lower than equilibrium? This is depicted in Figure 3.6c with a market price of $1.0. When price is too low, the quantity demanded is greater than quantity supplied.  This excess demand is known as a shortage. In this situation, the low price causes an excess of buyers. When we have a shortage, the consumers who are able to buy the good are happy, but due to the low price, not enough will be produced and not every consumer will get thier hands on a hotdog.

Figure 3.6c

At $1.0, 500 hot dogs are demanded, but only 100 are being produced. This means there are many consumers who are willing to pay more than the $1 for a hotdog, but are unable to find one. So, how do the 100 hot dogs get allocated? Perhaps it will be on a first come first serve basis, but frustrated consumers will likely start to offer a higher price to the hot dog stands and outbid other consumers. This will drive price back to the equilibrium level. As a price rises, two things occur:

• There is an increase in quantity supplied (a movement along the supply curve)
• There is a decrease in quantity demanded (a movement along the demand curve)

Again, both supply and demand are forces that bring the market back to equilibrium.

External Market Shocks & Equilibrium

In Topic 3.3 and 3.5, we explored the determinants of demand and supply, and examined the impact of different external shocks on the demand and supply curve. How will these shocks affect equilibrium? Suppose the price of a hamburger, a substitute for hot dogs, rises. We learned in Topic 3.3 that when the price of a substitute increases, our demand for hot dogs will increase. In Figure 3.4d below, we see the initial effects of the demand shift. (recall that a demand shift changes the relationship between quantity demanded and quantity supplied at every point!)

Figure 3.6d

Whereas supply and demand were in equilibrium at Q_E1 at the initial price of $3, the demand shift has caused Q_D > Q_S. As discussed, this causes a shortage (see left side of Figure 3.6e). Like before, the equal and opposite effects of supply and demand will cause a movement along both the supply and demand curve until we return to our equilibrium at Q_E2 (right side of Figure 3.6e).

Figure 3.6e

Notice the effects of the demand shift on our overall equilibrium. Both equilibrium price and quantity are now higher. Understanding these final effects is extremely important to understanding the supply and demand model.

What if two curves shift?

We have viewed the separate effects of demand and supply shifts, but what happens if both shift at once? Assume that in addition to an increase in the price of hamburgers, there is a decrease in the number of hot dog stands in the market, causing a decrease in supply. How do these two shocks change our equilibrium? The effects are depicted in Figure 3.6f.

Figure 3.6f

Our two effects, an increase in demand and a decrease in supply, each have thier own effects. The increase in demand causes both the price and quantity to increase, whereas the decrease in supply causes the price to increase and quantity to decrease. What does this mean for our equilibrium? Summarizing these effects:

Price: Demand causes increase, Supply causes increase.

Quantity: Demand causes increase, Supply causes decrease.

If both the supply and demand shifts are causing the price to rise, our prices will clearly rise; however, the change in quantity is not so simple. If one shift causes quantity to rise and another causes it to fall, what is the overall effect? In Figure 3.6f, there appears to be no change in quantity, but this is because the two shifts are depicted as equal and opposite. In reality, unless we know the magnitude of the curve shifts, we cannot say much about the change in quantity. In other words, the resulting quantity change is inconclusive. Figure 3.6g summarizes the results from different combinations of curve shifts.

Figure 3.6g

Remember, the best way to understand these impacts is through practice not memorization.

Market Surplus

In this topic, we have outlined the importance of using consumer surplus and producer surplus to measure net benefits for consumers and producers. Recall consumer surplus is the difference between what consumers are willing to pay and what they actually pay, whereas producer surplus is the difference between what the producer is paid and the marginal costs of production. Oftentimes, we want to look holistically at the market and calculate market/private surplus, a measure of the net benefits accruing to all participants in the market. This includes our consumer surplus, producer surplus, and, as we will explore in Topic 4, government revenue/expenditure.

For our hot dog market, using our market surplus definition of consumer surplus + producer surplus + government, we can see in Figure 3.6g that the market surplus is equal to the green and yellow areas. 

Figure 3.6h

To calculate market surplus, simply find the area of the shaded regions.

The area of a triangle is (base x height)/2.

Consumer surplus (green)= (300 x 3)/2 = $450

Producer surplus (yellow) = (300 x 3)/2 = $450

Market Surplus = $450 + $450 = $900

While adding up the surplus of every party is simple with just consumers and producers, it gets more complicated as more players enter the market. In Figure 3.6i, a different process is outlined. Since the demand curve is the marginal benefit curve, it represents the marginal benefits at each quantity level. (We know that this is distributed between consumers and producers) Therefore, the area under our marginal benefit curve represents our total market benefits. Likewise, the supply curve is the marginal cost curve and represents the marginal costs at each quantity level. The area under the marginal cost curve represents our total market costs.

Figure 3.6i

With our total benefits (blue) and our total costs (red), we can easily determine our total market surplus is the green area in Figure 3.6j below. To calculate:

Total Benefits: $1350

Total benefits correspond to the blue area in Figure 3.6i. This area is made up of a rectangle with dimensions 300 x $3 and a triangle with base 300 and height of $3. The area is (300 x $3) + (300 x $3)/2.

Total Costs: $400

Total costs correspond to the red area in Figure 3.6i. This area is made up of a triangle with a base of 300 and height of $3. The area is (300 x $3)/2.

Total Market Surplus: $900

Total market surplus can be calculated as total benefits – total costs. Alternatively, we can calculate the area between our marginal benefit and marginal cost, constrained by quantity. This is the equivalent of finding the difference between the marginal benefits and the marginal costs at each level of production. In Figure 3.6j, this is the green area, with base of $6 and height of 300.

Figure 3.6j

Market Surplus and Efficiency

Market surplus is certainly a useful way to measure the net benefits to players in the market, but it can also be used to measure efficiency. By comparing market surplus in different situations, we can confirm whether an equilibrium is efficient. (Recall efficiency is a situation where we cannot make one person better off without making another worse off.) With this in mind, we can infer that an equilibrium is efficient if it maximizes market surplus.

In Figure 3.6k, we have a market that is producing 200 hot dogs – 100 less than our equilibrium. Is this efficient? Well, if we calculate the green shaded region below, we find that it is $800, which is $100 less than before. By simply increasing production back to our original level, we make both consumers and producers better off without making anyone worse off. The difference in green regions from Figure 3.6j and Figure 3.6k is called Deadweight Loss, because it is cost to society made by an inefficiency. As a whole, the market could be made better off by increasing quantity.

Figure 3.6k

Summary

In this section we completed the construction of our competitive market model, bringing together supply and demand. The equal and opposite forces of supply and demand lead the market to a single equilibrium price and quantity, which is generally self sustaining. Looking at shocks introduced in earlier sections, we saw that external events can change our equilibrium, and combinations of shocks can sometimes lead to ambiguous effects. Using consumer and producer surplus, we developed a criteria for efficiency – market surplus – that can be used to calculate deadweight loss.. Market surplus and deadweight loss will be a key focus of Topic 4, where we look at the impact of government intervention in the market.

1. Label Figure CS3 a. with the Equilibrium price and quantity, and label supply and demand curves as either renters or landlords.

Since Landlords supply the housing units, they represent the supply side of the market, labeled S1.

Since Renters demand the housing units, they represent the demand side of the market, labeled S2.

The equilibrium E₁ occurs at the intersection of supply and demand, in this case @ E_P1 = $600, E_Q1 = 15,000 rental units.

2. Explain why a housing market at equilibrium could still have a vacancy rate of 4%.

In a perfect equilibrium, the housing market would have no vacancies. However, one of the requirements of a perfect equilibrium is a instant transmission of information. In the real market, this is not the case. Because of this, even if there is an equal amount of supply and demand, it is difficult for renters to match up with landlords. This means that when someone leaves the rental market, it takes time before that vacancy is filled.  Therefore even when supply = demand there can be a positive vacancy rate in the market. Depending on the speed of information transfer, there will be an equilibrium vacancy rate that represents healthy market conditions – without further information we could assume this rate is around the Canadian average of 3.3%. This means that a vacancy rate of 0.6% would have to represent a shortage of housing from disequilibrium.

3. Assume 3000 landlords decide to switch from renting to Airbnb, show the impact of the changes on Figure CS3 b. Label the new equilibrium price and quantity.

The decrease in landlords causes a decrease in supply. We can find the exact magnitude of the shift by looking at how much quantity supplied decreases for each price level. In this case, we are told to assume that quantity supplied decreases by 3000 rental units at every price. This causes a shift from S₁ to S₂.

The new equilibrium E₂ results from the intersection between S₂ and D₁, in this case @ E_P2 = $650, E_Q2 = 13,000 rental units.

4. Assume 9000 new renters enter the market instead of mortgaging homes, show the impact of the changes on Figure CS3 b.  Explain the impact of both the shock from Airbnb and the shock from less housing buyers on equilibrium price and quantity. Do the shocks work together or oppose one another?

The increase in renters in the market causes an increase in demand. Again, the magnitude of the shift is given to us. We are told that quantity demanded increases by 9000 rental units at every price. this causes demand to shift from D₁ to D₂.

The new equilibrium E₃ results from the intersection between S₂ and D2, in this case @ E_P3 = $800, E_Q3 = 18,000 rental units.

We can see that compared to E_P1 = $600, E_Q1 = 15,000 rental units, E₃ has seen a increase in price and quantity. Breaking down the two effects:

The decrease in supply caused price to rise and quantity to fall.

The increase in demand caused price to rise and quantity to rise.

We can see that the effects on price worked together, but the effects on quantity opposed. The end result of an increase in quantity is because the demand shock was greater than the supply shock. In this topic we explained that unless you know which effect is greater, the result of opposing shocks are inconclusive. In this case we can say with certainty that quantity has increased because we know the exact size of the shocks.

5. Assume price remains at the original equilibrium , calculate the magnitude of the shortage or surplus of housing that results. Explain the impact this shortage will have the behaviour of landlords.

If price remains at the original equilibrium E₁ of $600, Quantity Demanded @ D₂ is 24,000 and Quantity Supplied @ S₂ is 12,000. This means that there will be a 12,000 unit shortage in rental housing (24,000 – 12,000). As mentioned in the case study, this will cause pressure for prices to increase. Since landlords cannot raise prices for existing tenants, they will be incentivized to find ways to evict tenants. For the spots that are up for rent, bidding wars will ensue.

6. Assume the government wants to bring price back to it’s original level, if it costs $50,000 to increase the number of rental units by one, how much will this cost the government?

In order to shift supply from S₂ to a supply curve that intersects with D₂ at an equilibrium price of $600, the government has to find a way to increase the supply of rental housing by 12,000 units. If it costs $50,000/unit, this would cost the government $600 million.

7. Read the Executive Summary of the Alliance of BC Students White Paper on Student Housing. What is the ABCS proposing that could help decrease price in the market? How would this affect supply and/or demand?

The ABCS white paper draws attention to the fact that universities are currently restricted from accruing debt to build more student housing. They recommend that the government remove this restriction, explaining that the increase in housing for students will take them out of the competitive market above. Depending on how you view the market this could be explained as an increase in supply or a decrease of demand. If you consider student housing as a separate market, this effect would decrease demand as it takes student out of the market. If you consider it as the same market, it would increase supply as it increases the amount of housing available.

Alliance of BC Students. Where’s The Housing White Paper. 2016. https://abcstudentsdotca.files.wordpress.com/2016/10/absc-housingwhitepaper.pdf

Bula, Frances. The Globe and Mail. “AirBnb Not to Blame for Vancouver’s Difficult Rental Market, Company Says.” September 28, 2016. http://www.theglobeandmail.com/news/british-columbia/most-airbnb-hosts-make-less-profit-than-those-who-rent-long-term-report/article32095594/

Bula, Frances and Sully Dhillon. The Globe and Mail. “British Columbia Reveals $500-million Affordable-Housing Plan.” November 22, 2016. http://www.theglobeandmail.com/news/british-columbia/bc-says-2900-affordable-housing-units-to-be-built-within-two-years/article32983738/

CBC Radio West. “Grand Forks Teen Baker Runs Successful Company.” November 8, 2012. http://www.cbc.ca/radiowest/2012/11/08/grand-forks-teen-baker-runs-successful-company/index.html

Chang, Lulu. Digital Trends. “High-tech MTA buses with Wi-Fi are now rolling around New York City.” May 19, 2016. https://www.digitaltrends.com/cars/mta-high-tech-bus/

Chiang, Oliver. Forbes. “The Master of Online Mayhem.” February 9th, 2011. https://www.forbes.com/forbes/2011/0228/technology-gabe-newell-videogames-valve-online-mayhem.html

Dyck, Darryl. The Globe and Mail. “Cities Take Aim at AirBnb.” July 11, 2016. http://www.theglobeandmail.com/news/british-columbia/concerns-about-airbnb-impact-on-rentersspread/article30845642/

Jordan, Miriam and Lauren A. E. Schuker. The Wall Street Journal. “The Onion’s Best Friend Is an Ogre.” June 28, 2010. https://www.wsj.com/articles/SB10001424052748704123604575323433042544568

Lawrence, April. CHEK News. “Bidding Wars Taking Place in ‘Vicious’ Greater Victoria Rental Market.” August 15, 2016. http://www.cheknews.ca/bidding-wars-greater-victoria-rental-market-207772/

Shea, Courtney. The Globe and Mail. “Sweet News for Canadian Cupcake Lovers.” April 23, 2013. http://www.theglobeandmail.com/life/food-and-wine/food-trends/sweet-news-for-canadian-cupcake-lovers/article11510344/

Sprinkles Cupcake ATM. YouTube. March 16, 2012. https://www.youtube.com/watch?v=mgzxHNq8Bek

(Credit: Melo McC/ Flickr/ CC BY-NC-ND 2.0)

That Will Be How Much?

Imagine going to your favorite coffee shop and having the waiter inform you the pricing has changed. Instead of $3 for a cup of coffee with cream and sweetener, you will now be charged $2 for a black coffee, $1 for creamer, and $1 for your choice of sweetener. If you want to pay your usual $3 for a cup of coffee, you must choose between creamer and sweetener. If you want both, you now face an extra charge of $1. Sound absurd? Well, that is the situation Netflix customers found themselves in 2011 – a 60% price hike to retain the same service.

In early 2011, Netflix consumers paid about $10 a month for a package consisting of streaming video and DVD rentals. In July 2011, the company announced a packaging change. Customers wishing to retain both streaming video and DVD rental would be charged $15.98 per month – a price increase of about 60%. In 2014, Netflix also raised its streaming video subscription price from $7.99 to $8.99 per month for new U.S. customers. The company also changed its policy of 4K streaming content from $9.00 to $12.00 per month that year.

How did customers of the 18-year-old firm react? Did they abandon Netflix? How much will this price change affect the demand for Netflix’s products? The answers to those questions will be explored in this chapter with a concept economists call elasticity.

Click to read the rest of the Netflix story

Anyone who has studied economics knows the law of demand: a higher price will lead to a lower quantity demanded. What you may not know is how much lower the quantity demanded will be. Similarly, the law of supply shows that a higher price will lead to a higher quantity supplied. The question is: How much higher? This topic will explain how to answer these questions and why they are critically important in the real world.

To find answers to these questions, we need to understand the concept of elasticity. Elasticity is an economics concept that measures the responsiveness of one variable to changes in another variable. Suppose you drop two items from a second-floor balcony. The first item is a tennis ball, and the second item is a brick. Which will bounce higher? Obviously, the tennis ball. We would say that the tennis ball has greater elasticity.

But how is this degree of responsiveness seen in our models? Both the demand and supply curve show the relationship between price and quantity, and elasticity can improve our understanding of this relationship.

The own price elasticity of demand is the percentage change in the quantity demanded of a good or service divided by the percentage change in the price. This shows the responsiveness of the quantity demanded to a change in price.

The own price elasticity of supply is the percentage change in quantity supplied divided by the percentage change in price. This shows the responsiveness of quantity supplied to a change in price.

Our formula for elasticity, , can be used for most elasticity problems, we just use different prices and quantities for different situations.

Why percentages are counter-intuitive

Recall that the simplified formula for percentage change is , also written as .

Suppose there is an increase in quantity demanded from 4 coffees to 6 coffees. Calculating percentage change () there has been a 50% increase in quantity demanded. Using the same numbers, consider what happens when quantity demanded decreases from 6 coffees to 4 coffees, () this change results in a 33% decrease in quantity demanded.

Right away, this should raise a red flag about calculating the elasticity between at two points, if percentage change is dependant on the direction (A to B or B to A) then how can we ensure a consistent elasticity value?

Figure 4.1a

Let’s calculate elasticity from both perspectives:

Moving from A to B: 

%ΔPrice: The coffee price falls from $4.50 to $3.00, meaning the percentage change is = -33%. Price has fallen by 33%.

%ΔQuantity: The quantity of coffee sold increases from 4 to 6, meaning the percentage change is  = 50%. Quantity has risen by 50%

Elasticity:  = 1.5*

 

Moving from B to A: 

%ΔPrice: The coffee price rises from $3.00 to $4.50, meaning the percentage change is = 50%. Price has risen by 50%.

%ΔQuantity:
The quantity of coffee sold falls from 6 to 4, meaning the percentage change is  = -33%. Quantity has fallen by 33%

Elasticity:   = 0.67

These two calculations give us different numbers. This type of analysis would make elasticity subject to direction which adds unnecessary complication. To avoid this, we will instead rely on averages.

*Note that elasticity is an absolute value, meaning it is not affected by positive of negative values.

Mid-point Method

To calculate elasticity, instead of using simple percentage changes in quantity and price, economists use the average percent change. This is called the mid-point method for elasticity, and is represented in the following equations:

The advantage of the mid-point method is that one obtains the same elasticity between two price points whether there is a price increase or decrease. This is because the denominator is an average rather than the old value.

Using the mid-point method to calculate the elasticity between Point A and Point B:

This method gives us a sort of average elasticity of demand over two points on our curve. Notice that our elasticity of 1 falls in-between the elasticities of 0.67 and 1.52 that we calculated in the previous example.

Point-Slope Formula

In Figure 4.1a we were given two points and looked at elasticity as movements along a curve. As we will see in Topic 4.3, it is often useful to view elasticity at a single point. To calculate this, we have to derive a new equation.

Since we know that a percentage change in price can be rewritten as 

and a percentage change in quantity to

we can rearrange the original equation as 

which is the same as saying

This gives us our point-slope formula. How do we use it to calculate the elasticity at Point A? The P/Q portion of our equation corresponds to the values at the point, which are $4.5 and 4. The ΔQ/ ΔP corresponds to the inverse slope of the curve. Recall slope is calculated as rise/run.

In Figure 4.1, the slope is = 0.75, which means the inverse is 1/0.75 = 1.33. Plugging this information into our equation, we get:

= 1.5

This analysis gives us elasticity as a single point. Notice that this gives us the same number as calculating elasticity from Point A to B. This is not a coincidence. When we are calculating from Point A to Point B, we are actually just calculating the elasticity at Point A, since we are using the values on Point A as the denominator for our percentage change. Likewise from Point B to Point A, we are calculating the elasticity at Point B. When we use the mid-point method, we are just taking an average of the two points. This solidifies the fact that there is a different elasticity at every point on our line, a concept that will be important when we discuss revenue.

Not Really So Different

Even though mid-point and Point-Slope appear to be fairly different formulas, mid-point can be rewritten to show how similar the two really are.

= 

Remember that when a fraction is divided by a fraction, you can rearrange it to a fraction multiplied by the inverse of the denominator fraction.

=

Notice that compared to point-slope: , the only difference is that point-slope is the inverse of the slope multiplied by a single point, whereas mid-point is the inverse of the slope multiplied by multiple points. This reinforces the conclusion that mid-point represents an average.

Other Elasticities

Remember, elasticity is the responsiveness of one variable to changes in another variable. This means it can be applied to more that just the price-quantity relationship of our market model. In Topic 3 we discussed how goods can be inferior/normal or substitutes/complements. We will examine this even further when we introduce consumer theory, but for now we can develop our understanding by applying what we know about elasticities.

Own-price elasticity of supply (e_P^S)

Our analysis of elasticity has been centred around demand, but the same principles apply to the supply curve. Whereas elasticity of demand measures responsiveness of quantity demanded to a price change, own-price elasticity of supply measures the responsiveness of quantity supplied. The more elastic a firm, the more it can increase production when prices are rising, and decrease its production when prices are falling. Our equation is as follows:

Own-price elasticity of supply can be calculated using mid-point and point-slope formula in the same way as for e_P^D.

Cross-price elasticity of demand (e_XP^D)

Whereas the own-price elasticity of demand measures the responsiveness of quantity to a goods own price, cross-price elasticity of demand shows us how quantity demand responds to changes in the price of related goods. Whereas before we could ignore positives and negatives with elasticities, with cross-price, this matters. Our equation is as follows:

Consider our discussion of complements and substitutes in Topic 3.3. We defined complements as goods that individuals prefer to consume with another good, and substitutes as goods individuals prefer to consume instead of another good. If the price of a complement rises our demand will fall, if the price of a substitute rises our demand will rise. For cross-price elasticity this means:

A complement will have a negative cross-price elasticity, since if the % change in price is positive, the % change in quantity will be negative and vice-versa.

A substitute will have a positive cross-price elasticity, since if the % change in price is positive, the % change in quantity will be positive and vice-versa.

This adds another dimension to our discussion of complements/substitutes. Now we can comment on the strength of the relationship between two goods. For example, a cross-price elasticity of -4 suggests an individual strongly prefers to consume two goods together, compared to a cross-price elasticity of -0.5. This could represent the cross-price elasticity of a consumer for a hot dog, with respect to ketchup and relish. The consumer might strongly prefer to consume hot dogs with ketchup, and loosely prefers relish.

Income elasticity of demand (e_N^D)

In Topic 3 we also explained how goods can be normal or inferior depending on how a consumer responds to a change in income. This responsiveness can also be measured with elasticity by the income elasticity of demand. Our equation is as follows:

As with cross-price elasticity, whether our elasticity is positive or negative provides valuable information about how the consumer views the good:

A normal good will have a positive income elasticity, since if the % change in income is positive, the % change in quantity will be positive and vice-versa.

A inferior good will have a negative income elasticity, since if the % change in income is positive, the % change in quantity will be negative and vice-versa.

The value of our elasticity will indicate how responsive a good is to a change in income. A good with an income elasticity of 0.05, while technically a normal good (since demand increases after an increase in income) is not nearly as responsive as one with an income elasticity of demand of 5.

Summary

Elasticity is a measure of responsiveness, calculated by the percentage change in one variable divided by the percentage change in another.

Both mid-point and point-slope formulas are important for calculating elasticity in different situations. Mid-point gives an average of elasticities between two points, whereas point-slope gives the elasticity at a certain point. These can be calculated with the following formulas:

Base Formula	Mid-Point Formula	Point-Slope Formula

Since elasticity measures responsiveness, it can also be used to measure the own-price elasticity of supply, the cross-price elasticity of demand, and the income elasticity of demand. These can be calculated with the following formulas:

Own-Price Elasticity of Supply	Cross-Price Elasticity of Demand	Income Elasticity of Demand

In Topic 4.1, we introduced the concept of elasticity and how to calculate it, but we didn’t explain why it is useful. Recall that elasticity measures responsiveness of one variable to changes in another variable. If you owned a coffee shop and wanted to increase your prices, this ‘responsiveness’ is something you need to consider. When you increase prices, you know quantity will fall, but by how much?

Elasticities can be divided into three broad categories: elastic, inelastic, and unitary. An elastic demand is one in which the elasticity is greater than one, indicating a high responsiveness to changes in price. Elasticities that are less than one indicate low responsiveness to price changes and correspond to inelastic demand. Unitary elasticities indicate proportional responsiveness of either demand or supply, as summarized in the following table:

If . . .	Then . . .	And It Is Called . . .
		Elastic
		Unit Elastic
		Inelastic
Elastic, Inelastic, and Unitary: Three Cases of Elasticity

If we were to calculate elasticity at every point on a demand curve, we could divide it into these elastic, unit elastic, and inelastic areas, as shown in Figure 4.2a.  This means the impact of a price change will depend on where we are producing. Feel free to calculate the elasticity in any of the regions, you will find that it indeed fits the description.

Figure 4.2a

To demonstrate, we have calculated the elasticities at a point in each of the zones:

Point A =  = Elastic

Point B = = Inelastic

Point C =  = Unit Elastic

In reality, the only point we need to find to determine which areas are elastic and inelastic is our point where elasticity is 1, or Point C. This isn’t as hard as it may seem. Since our formula is equal to the inverse of our slope multiplied by a point on the graph, it will only equal 1 when our point is equal to the slope of our graph. For a linear graph, this only occurs at the middle point, which is (4.5, 3.325) in this case.

Why is This Useful?

When Starbucks runs a buy one get one free promotion, they effectively lower the price of a drink by 50%. The company sells more drinks, but at a lower price. Elasticity determines whether or not this promotion will be profitable. Of course, promotions are not always intended to be profitable in the short term. Oftentimes, firms will cut prices to increase awareness of their new products, as Starbucks does with its holiday drinks. (Credit: Starbucks)

So far, we have determined how to calculate elasticity at and between different points, but why is this knowledge useful?

Consider a coffee shop owner considering a price hike. The owner has two things to account for when deciding whether to raise the price, one that increases revenue and one that decreases it. Elasticity helps us determine which effect is greater. Referring back to our table:

1. When you increase price, you increase revenue on units sold (The Price Effect).
2. When you increase price, you sell fewer units (The Quantity Effect).

These two effects work against each-other. To determine which outweighs the other we can look at elasticity:

When our point is elastic our  meaning if we increase price, our quantity effect outweighs the price effect, causing a decrease in revenue. 

When our point is inelastic our  meaning if we increase price, our price effect outweighs the quantity effect, causing a increase in revenue. 

This information is summarized in Figure 4.2b:

Figure 4.2b

The first thing to note is that revenue is maximized at the point where elasticity is unit elastic. Why? If you are the coffee shop owner, you will notice that there are untapped opportunities when demand is elastic or inelastic.

If elastic: The quantity effect outweighs the price effect, meaning if we decrease prices, the revenue gained from the more units sold will outweigh the revenue lost from the decrease in price.

If inelastic: The price effect outweighs the quantity effect, meaning if we increase prices, the revenue gained from the higher price will outweigh the revenue lost from less units sold.

The effects of price increase and decrease at different points are summarized in Figure 4.2c.

Figure 4.2c

What about Expenditure

You will notice that expenditure is mentioned whenever revenue is. This is because a dollar earned by the coffee shop corresponds to a dollar spent by the consumer. Therefore, if the firm’s revenue is rising, then the consumer’s expenditure is rising as well. You must understand how to answer questions from both sides.

Summary

Elasticity is used to measure the responsiveness of one variable to another. This responsiveness can be labelled as elastic (e > 1), unit elastic (e = 1), and inelastic (e < 1). We can apply this to the demand curve, with unit elastic corresponding to the middle of the demand curve (x-intercept/2 , y-intercept/2). Everything to the left is elastic and everything to the right is inelastic. This information can be used to maximize revenue or expenditure, with the understanding that when elastic, the quantity effect outweighs the price effect, and when inelastic, the price effect outweighs the quantity effect.

(Credit: University of Victoria Students’ Society)

Textbook or Burger?

In Topics 4.1 and 4.2, we looked at elasticity on a single demand curve and examined how responsive consumer are to price changes at various levels of production. But what about responsiveness across firms? Across industries? We know that in certain industries, such as the textbook industry, consumers are less responsive to change than others. How is the quantity demanded for textbooks affected by an increase in price? If the textbook for a course rose from $100 to $150, what would you do? Most students will buy the book anyway, since it is a required course material. Publishers are increasingly using different strategies to ensure the market stays inelastic or unresponsive to price change, such as bundling the textbook with mandatory course access codes. Compare this situation with the price of a burger. If the price of a burger rises from $8 to $12, you may purchase lunch from a different restaurant or start packing lunch from home. The market for textbooks and burgers are very different. In this section, we will explore the relative elasticity of different markets.

 Perfectly Elastic and Perfectly Inelastic

To begin the conversation about relative elasticity, it helps to first look at the extremes.

Perfectly Elastic

Imagine a product where if the price increased, even slightly, you wouldn’t buy any it anymore. Sound familiar? That’s because we introduced this concept in Topic 3, as one of the assumptions of a perfectly competitive market. One of the examples we used was identical hot dog stands, side by side, where the only difference was price. If quality is the same, the rational consumer will always purchase the hot dog that is a lower price. From the perspective of the stand, they know that if they increase price even slightly, they will sell 0 units. This means that E_D = ∞.

Using point-slope at any point in Figure 4.3a, we can confirm this.

We know that is equal to the inverse of the slope. In the demand curve in Figure 4.3a, when the ΔP>0 then ΔQ is equal to ∞. This means that = ∞. 

Figure 4.3a

Perfectly Inelastic

At the other end of the spectrum, consider a market where the firm can continue to increase prices with no change in quantity. If you were poisoned and had to buy the antidote, would you be responsive to price change? Probably not. This is an example of a situation where demand is nearly perfectly inelastic. If you increase the price, quantity demanded does not change. This means that E_D = 0.

We can confirm this by using point-slope at any point in Figure 4.4a.

In the demand curve in Figure 4.3a, when the ΔP>0 then ΔQ is equal to 0. This means that = 0. 

Figure 4.3b

 Relative Elasticity

The concepts of perfectly elastic and perfectly inelastic lead us into a discussion of relative elasticity. In 4.1 and 4.2, we examined a single demand curve, and looked at the numerical value of elasticity along that demand curve. However, elasticity can also be useful when comparing demand curves. Even though each demand curve has an inelastic, elastic, and unit elastic section, the comparison of the curves can show which markets are relatively more responsive to price changes. This is an important concept to understand for when we look at the impacts of a policy change.

Figure 4.3c

Figure 4.3c illustrates two curves. One is relatively more inelastic and the other is relatively more elastic. The best way to determine which is more elastic or inelastic is to compare each curve to the extremes. The curve more resemblant of perfect elasticity is relatively more elastic, the curve more resemblant or perfect inelasticity is relatively more inelastic.  Note this is different than saying one is elastic and the other inelastic! To emphasize this point, read the section “Bears and Elasticity.”

Bears and Elasticity

(Credit: Wapster/ Flickr/ CC BY 2.0)

A bear jumps out of a bush and starts chasing two hikers. They both start running for their lives, but then one of them stops to put on his running shoes.

His friend says, “What are you doing? You can’t outrun a bear!”

His friend replies, “I don’t have to outrun the bear; I only have to outrun you!”

If both friends are trying to get away from the bear and you learn that one of them is fast, does this information tell you who gets eaten? No! It only matters which one is faster, or fast relative to the other. Relative elasticity is the same. In fact, we cannot pass judgement if one is elastic or inelastic unless we are referencing to another.

The concept of relative elasticity is not based on the calculations in 4.1 and 4.2, as each demand curve has an inelastic, elastic and unit elastic region. Demand curves take the shape of anything between perfectly elastic and perfectly inelastic, and you can only judge relative elasticity in reference to other curves.

What About Supply

The same concepts and principles can be applied to supply. There is fairly significant variation across different industries, with some relatively more elastic than others.

Factors That Influence Relative Elasticity

So what causes this difference in relative elasticity? For the most part, external factors which influence responsiveness.

Demand

1. Availability of substitutes

The availability of substitutes is a strong factor in determining the elasticity of a good. If there are many close substitutes, then it is fairly easy for consumers to find a suitable alternative to a good if prices rise.

2. Necessity of a good

In addition, the extent to which a good is a necessity or a luxury greatly influences its elasticity. Essentials, such as soap, flour, sugar, etc. are generally purchased in the same quantity regardless of price. On the other hand, consumers are very price conscious when it comes to luxury goods (such as comforts, jewelry, etc.).

3. Income

The necessity of a good depends quite heavily on the customer’s income. Someone with low income might be more price conscious (elastic) when purchasing a new sofa compared to someone with higher income. Generally the larger percentage of your income a good takes up, the more sensitive you will be to price changes.

Supply

What causes supply to be more or less elastic?

1. Availability of resources

If a company’s production is dependent on scarce resources, the company is less responsive to changes in price. Even if prices are high and the firm wants to increase production, it wont be able to without the proper inputs.

2. Technological innovation

Innovation tends to lead to more efficient production. If a firm benefits from top notch production technology, it will be more able to respond to an increase in price with an increase in production.

3. Barriers to entry

If there are few barriers to entry in an industry, an increase in price can cause a large increase in production as new firms quickly enter the market.

Time: The Ever-Constraining Factor

Both the elasticity of supply and demand are impacted by time. For the consumer, how much time they have to make a consumption decision. For the producer, how much time it has to produce the good and build inventory. Regardless of whether we are talking about supply or demand, an increase in time always increases the elasticity of a good by increasing the ability to act and make informed decisions.

Summary

Whereas hard labels such as elastic, unit elastic, and inelastic can be used to describe specific sections of supply and demand curves (based on a calculated value), when comparing two curves everything is relative. Using the knowledge of perfect elasticity and perfect inelasticity, we can compare two curves on the basis of elasticity to determine how responsive the general consumer group, industry, etc. is to price changes. A flatter curve is relatively more elastic than a steeper curve. Availability of substitutes, a goods necessity, and a consumers income all affect the relative elasticity of demand. The availability of resources, technological innovation, and the barriers to entry all affect the relative elasticity of supply. Time affects elasticity of either curve.

Now that we have the tools of supply, demand and elasticity, we will use them to understand how government policy affects the market.

After two years of the first Soviet five year plan, Joseph Stalin announced that the plan would be completed in four years. In response, his propagandist Guminer launched a campaign with a poster reading “2+2=5: Arithmetic of a counter-plan plus the enthusiasm of the workers.” (Credit: Q5e3t1/ Wikimedia Commons/ CC-BY-SA-4.0)

A Five Year Plan

The Soviet Union began its first 5-year plan in 1928, an economic strategy to launch the country into the industrial revolution. The strategy involved heavily enforced quotas aimed at developing heavy industry and collectivizing agriculture. The five-year plans had mixed results. Although some of the plans were successful at meeting their goals, such as a build-up in military strength, consumer goods were neglected. Collectivism led to famine and the death of millions.

So far, we have looked at our competitive market model with the assumptions of free-market, or no government intervention. Five-year plans do not adhere to these assumptions, resembling a command and control economy where the government takes an active role in managing the market. While we won’t go as far as command and control in this topic, we will look at some policies the government might implement and the overall effects they have on the economy.

 

Read more about the Soviet Five-Year Plans

 

Why the Government Intervenes

So far, we have assumed that the only players in the market are the government, consumers, and firms. This means that market surplus (consumer surplus + producer surplus + government revenue/expenditure) is our sole measure of efficiency.

We have already learned that competitive markets maximize market surplus. This means that any government intervention that changes our equilibrium will inevitably decreases market surplus, resulting in deadweight loss and an inefficient outcome.

If intervention leads to an inefficient outcome, why would the government intervene? Several reasons are outlined below

1. Government Revenue

The government may decide to implement a policy to generate revenue. When we explore taxes, we will see that policies that generate revenue in inelastic markets are especially appealing.

2. Politics

Not all policy is good for society. Special interest groups will sometimes get what they ask for, even if their demands create inefficiencies. Sometimes politicians care more about what will get them votes, than what is good for society.

3. Equity

The government does not always prioritize efficiency. Policies like price ceilings are often intended to help consumers in low-income brackets. Equity is a topic that is explored in more depth in upper level economics. Efficient outcomes can result in a small group accumulating all the wealth. Often this is not viewed as the best outcome.

4. Externalities

In Topic 5, we will see that not all costs are incorporated in our models. For our gasoline market, why did we not consider pollution? There are many externalities and external costs that are not accounted for by firms and consumers. Once these are incorporated into our model, there are clear arguments to be made for government intervention.

Policy Implements

There are many different policies that governments can use to alter the market. Some are much more complicated than others, but many fall into four broad classes we will explore in detail:

4. 1. Price Controls
   2. Quantity Controls
   3. Taxes and Subsidies
   4. Tariffs

We looked at an example of the government regulating prices, and concluded that the change in quantity is what causes the deadweight loss. What if the government regulates quantity directly? It should be fairly obvious that this will cause a deadweight loss, but the distribution of surplus will be different.

Figure 4.6a

In Figure 4.7a, we show the market for oil. The equilibrium quantity is 3.5 million barrels of oil. A policy to reduce quantity is called a quota, a government imposed restriction on the number of goods bought and sold. If the government sets a quota of 2 million barrels, both consumers and producers have to reduce consumption and production to that level. The main difference in this policy is that price does not change. The quota only sets a restriction on quantity, so the price remains at the equilibrium level of $2.9/gallon.

Figure 4.6b

Market Surplus

Before

The market surplus before has not been depicted, as the process should be routine. Ensure you understand how to find the following values:

Consumer Surplus = $3.675 million

Producer Surplus  = $5.075 million

Market Surplus = $8.75 million

After

The market surplus after the policy, as shown in Figure ____.

Consumer Surplus (Blue Area) = $3.0 million

Producer Surplus (Red Area)= $4.1 million

Market Surplus = $7.1 million

Comparing market surplus before and market surplus after, we should note an important difference – both consumer and producer surplus have decreased because the quota caused a reduction in quantity.  Since price has not changed, there is no transfer in surplus from one party to another.

Notice that the producer bears the greater burden of the quota. This is due to relative elasticity. We will discuss how relative elasticity affects the distribution of deadweight loss in Topic 4.9.

Summary

A quota is the simplest of the government policies we will look at. It is a straightforward way for the government to restrict production. We will see later that while this policy decreases market surplus, it can be useful for other reasons.

What about a upper limit quota?

Taxes are not the most popular policy, but they are often necessary. We will look at two methods to understand how taxes affect the market: by shifting the curve and using the wedge method. First, we must examine the difference between legal tax incidence and economic tax incidence.

Legal versus Economic Tax Incidence

When the government sets a tax, it must decide whether to levy the tax on the producers or the consumers. This is called legal tax incidence. The most well-known taxes are ones levied on the consumer, such as Government Sales Tax (GST) and Provincial Sales Tax (PST). The government also sets taxes on producers, such as the gas tax, which cuts into their profits. The legal incidence of the tax is actually irrelevant when determining who is impacted by the tax. When the government levies a gas tax, the producers will pass some of these costs on as an increased price. Likewise, a tax on consumers will ultimately decrease quantity demanded and reduce producer surplus. This is because the economic tax incidence, or who actually pays in the new equilibrium for the incidence of the tax, is based on how the market responds to the price change – not on legal incidence.

Tax – Shifting the Curve

In Topic 3, we determined that the supply curve was derived from a firm’s Marginal Cost and that shifts in the supply curve were caused by any changes in the market that caused an increase in MC at every quantity level. This is no different for a tax. From the producer’s perspective, any tax levied on them is just an increase in the marginal costs per unit. To illustrate the effect of a tax, let’s look at the oil market again.

If the government levies a $3 gas tax on producers (a legal tax incidence on producers), the supply curve will shift up by $3. As shown in Figure 4.8a below, a new equilibrium is created at P=$5 and Q=2 million barrels. Note that producers do not receive $5, they now only receive $2, as $3 has to be sent to the government. From the consumer’s perspective, this $1 increase in price is no different than a price increase for any other reason, and responds by decreasing the quantity demanded for the higher priced good.

Figure 4.7a

What if the legal incidence of the tax is levied on the consumers? Since the demand curve represents the consumers’ willingness to pay, the demand curve will shift down as a result of the tax. If consumers are only willing to pay $4/gallon for 4 million gallons of oil but know they will face a $3/gallon tax at the till, they will only purchase 4 million gallons if the ticket price is $1. This creates a new equilibrium where consumers pay a $2 ticket price, knowing they will have to pay a $3 tax for a total of $5. The producers will receive the $2 paid before taxes.

Figure 4.7b

Note that whether the tax is levied on the consumer or producer, the final result is the same, proving the legal incidence of the tax is irrelevant.

Tax – The Wedge Method

Another method to view taxes is through the wedge method. This method recognizes that who pays the tax is ultimately irrelevant. Instead, the wedge method illustrates that a tax drives a wedge between the price consumers pay and the revenue producers receive, equal to the size of the tax levied.

As illustrated below, to find the new equilibrium, one simply needs to find a $3 wedge between the curves. The first wedge tested is only $0.7, followed by $1.5, until the $3.0 tax is found.

Figure 4.7c

Market Surplus

Like with price and quantity controls, one must compare the market surplus before and after a price change to fully understand the effects of a tax policy on surplus.

Figure 4.7d

Before

The market surplus before the tax has not been shown, as the process should be routine. Ensure you understand how to get the following values:

Consumer Surplus = $4 million

Producer Surplus  = $8 million

Market Surplus = $12 million

After

The market surplus after the policy can be calculated in reference to Figure 4.7d

Consumer Surplus (Blue Area) = $1 million

Producer Surplus (Red Area)= $2 million

Government Revenue (Green Area) = $6 million

Market Surplus = $9 million

As with the quota – both consumer and producer surplus decreased because of a reduced quantity. The difference is, since the price is changing, there is redistribution. This time, the redistribution is from consumers and producers to the government. Remember, only a change in quantity causes a deadweight loss. Price changes simply shift surplus around between consumers, producers, and the government.

Transfer and Deadweight Loss

Let’s look closely at the tax’s impact on quantity and price to see how these components affect the market.

Figure 4.7e

Transfer – The Impact of Price

Due to the tax’s effect on price, areas A and C are transferred from consumer and producer surplus to government revenue.

Consumers to Government – Area A

Consumers originally paid $4/gallon for gas. Now, they are paying $5/gallon. The $1 increase in price is the portion of the tax that consumers have to bear. Despite the fact that the tax is levied on producers, the consumers have to bear a share of the price change. The size of this share depends on relative elasticity – a concept we will explore in the next section. This is because a decrease in price to producers means quantity supplied is falling, and in order to maintain equilibrium, quantity demanded must fall by an equal amount. This price change means the government collects $1 x 2 million gallons or $2 million in tax revenue from the consumers. This is a straight transfer from consumers to government and has no effect on market surplus.

Producers to Government – Area C

Originally, producers received revenue of $4/gallon for gas. Now, they receive $2/gallon. This $2 decrease is the portion of the tax that producers have to bear. This means that the government collects $2 x 2 million gallons or $4 million in tax revenue from the producers. This is a transfer from producers to the government.

As calculated, the government receives a total of $6 million in tax revenue, which is taken from consumers and producers. This has no impact on net market surplus.

Deadweight Loss – The Impact of Quantity

If we just considered a transfer of surplus, there would be no deadweight loss. In this case, though, we know that price changes come with a change in quantity. A higher price  for consumers will cause a decrease in the quantity demanded, and a lower price for producers will cause a decrease in quantity supplied. This reduction from equilibrium quantity is what causes a deadweight loss in the market since there are consumers and producers who are no longer able to buy and supply the good.

Consumer Surplus Decrease – Area B

Due to the increase in price, many consumers will switch away from oil to alternative options. This decrease in quantity demand of 1.5 million gallons of oil causes a deadweight loss of $1 million.

Producer Surplus Decrease – Area D

Producers, who now receive only $2.00/gallon for their production, will also decrease quantity supplied by 1.5 million gallons of oil. It is no coincidence that the size of the decrease is the same. When you create the wedge between consumers and producers, you are finding the quantity where the full amount of the tax is incurred but the market is still at equilibrium. Remember that quantity demanded must equal quantity supplied or the market will not be stable. This mirrored decrease in quantity ensures this is still the case. Notice, however, that the impact of this quantity drop causes a larger decrease in producer surplus than consumer surplus totalling $2 million. Again, this is due to elasticity, or the relative responsiveness to the price chance, which will be explored in more detail shortly.

Together, these decreases cause a $3 million deadweight loss (the difference between the market surplus before and market surplus after).

Subsidy

While a tax drives a wedge that increases the price consumers have to pay and decreases the price producers receive, a subsidy does the opposite. A subsidy is a benefit given by the government to groups or individuals, usually in the form of a cash payment or a tax reduction. A subsidy is often given to remove some type of burden, and it is often considered to be in the overall interest of the public. In economic terms, a subsidy drives a wedge, decreasing the price consumers pay and increasing the price producers receive, with the government incurring an expense.

In Topic 3, we looked at a case study of Victoria’s competitive housing market where high demand drove up prices. In response, the government has enacted many policies to allow low-income families to still become homeowners. Let’s look at the effects of one possible policy. (Note the following policy is unrealistic but allows for easy comprehension of the effect of subsidies).

Figure 4.7f

In the market above, our efficient equilibrium begins at a price of $400,000 per home, with 40,000 homes being purchased. The government wants to substantially increase the number of consumers able to purchase homes, so it issues a $300,000 subsidy for any consumers purchasing a new home. This drives a wedge between what home buyers pay ($250,000) and what home builders receive ($550,000).

With all government policies we have examined so far, we have wanted to determine whether the result of the policy increases or decreases market surplus. With a subsidy, we want to do the same analysis. Unfortunately, because increases in surplus overlap on our diagram, it becomes more complicated. To simplify the analysis, the following diagram separates the changes to producers, consumers, and government onto different graphs.

Figure 4.7g

Producers

The producers now receive $550,000 instead of $400,000, increasing quantity supplied to 60,000 homes. This increases producer surplus by areas A and B.

Consumers

The consumers now pay $250,000 instead of $400,000, increasing quantity demanded to 60,000 homes. This increases consumer surplus by areas C and D.

Government

The government now has to pay  $300,000 per home to subsidize the 60,000 consumers buying new homes (this policy would cost the government $18 billion!!) Graphically, this is equal to a decrease in government to areas A, B, C, D and E.

Result

Our total gains from the policy (to producers and consumers) are areas A, B, C and D, whereas total losses (the cost to the government) are areas A, B, C, D, and E. To summarize:

Areas A, B, C and D are transferred from the government to consumers and producers. 

Area E is a deadweight loss from the policy.

There are two things to notice about this example. First, the policy was successful at increasing quantity from 40,000 homes to 60,000 homes. Second, it resulted in a deadweight loss because equilibrium quantity was too high. Remember, anytime quantity is changed from the equilibrium quantity, in the absence of externalities, there is a deadweight loss. This is true for when quantity is decreased and when it is increased.

http://www.investopedia.com/terms/s/subsidy.asp

Summary

Taxes and subsidies are more complicated than a price or quantity control as they involve a third economic player: the government. As we saw, who the tax or subsidy is levied on is irrelevant when looking at how the market ends up. Note that the last three sections have painted a fairly grim picture about policy instruments. This is because our model currently does not include the external costs economic players impose to the macro-environment (pollution, disease, etc.) or attribute any meaning to equity. These concepts will be explored in more detail in later topics.

In our examples above, we see that the legal incidence of the tax does not matter, but what does? To determine which party bears more of the burden, we must apply the concept of relative elasticity to our analysis.

Maxwell Nicholson

(Credit: David Masters/ Flickr/ CC BY 2.0)

Buttery Elasticity

For many years the U.S dairy market was inelastic, but times have changed, and dairy demand is not as inelastic as it once was, says Sara Dorland, managing partner with Seattle-based Ceres Dairy Risk Management. Higher prices can have a direct effect on the consumption of dairy products.

“Historically a good amount of our product went to the U.S. government, which kept prices stable, especially for skim products,” says Dorland, who holds an MBA in business and finance. “Therefore, once every few years, butter or cheese would have a run-up and fall back down. As a result, milk and dairy product prices played within a rather tight range, a factor that contributed to our belief that demand was rather inelastic. Today, that is not the case as the government is no longer one of our best customers.”

This means that the quantity demanded in the dairy market is becoming more responsive to changes in price in the U.S. Compare this to the Canadian market and you will see a very different story. Due to a supply management system that is operated by farmer-run provincial marketing boards, the Canadian dairy market remains very inelastic as high tariffs and quota requirements restrict market entry. This limits the number of producers in the market and reduces consumer choice, causing a very inelastic demand curve like we saw with the textbook industry.

Relative elasticity is important when looking at how markets respond to a price change. Two of the policies we looked at, taxes and price controls, caused deadweight loss and redistribution among market players. As we will illustrate in this chapter, the relative elasticity of a market will determine which party bears a greater burden of tax policy.

Read the rest of the story here.

https://www.vice.com/en_ca/article/blame-canadas-dairy-cartel-for-our-expensive-milk-and-cheese-867

http://www.theglobeandmail.com/news/politics/canadas-dairy-industry-is-a-rich-closed-club/article25124114/

http://www.agweb.com/article/why-dairy-demand-has-become-more-elastic-naa-catherine-merlo/

In Topic 4.3, we discussed some of the many factors that cause supply and demand to be relatively more or less elastic. Now, we will explore the impact that this has on relative policy burden and deadweight loss.

Elasticity and Deadweight Loss

Let’s continue to look at the dairy market. How would a $2.25 per unit tax on the American and Canadian dairy market impact different market players? In our analysis, let’s make the assumption that the Canadian and American markets both start with an equilibrium price of $4/jug and equilibrium quantity of 8 million. This is obviously not realistic, but it allows us to analyze the effects of elasticity holding other factors constant. The only difference in this scenario is the elasticity of the demand curve. Demand in the American market is relatively more elastic than the Canadian market. The tax has been shown on both diagrams and the deadweight loss depicted

Figure 4.8a

At first glance, it is difficult to determine which deadweight loss is greater. Since deadweight loss is the result of a quantity change, we can ignore the redistributive effects of the tax and look exclusively at the lost surplus to consumers and producers who are no longer buying/selling the good.

Deadweight loss to American – Relatively more Elastic

The $2.25 tax causes a wedge between what consumers pay (now $4.25) and what producers receive (now $2.00). This wedge causes a decrease in equilibrium quantity from 8 million milk jugs to just 4 million. Calculations for deadweight loss are shown below:

= = $4.5 million

Deadweight loss to Canadian – Relatively more Inelastic

For Canadians, the $2.25 tax causes a different wedge between what consumers pay and what producers receive. Consumers now pay $4.75 and producers receive $2.50 This wedge causes a different decrease in equilibrium quantity from 8 million milk jugs to 5 million. Notice that this decrease in quantity is less than the American market. Calculations for deadweight loss are shown below:

=  = $3.375 million

It should be no surprise that, as else constant, the deadweight loss is greater for the market that experiences the larger decrease in equilibrium quantity. Notice that although the triangles are different shapes, the base of each triangle is the same, and equal to the $2.25 tax. The only difference is the height, which is equal to the decrease in quantity from equilibrium. This leads us to our first principle of relative elasticity:

For a more elastic market a price change causes a greater decrease in quantity therefore a policy in a more elastic market will cause a greater deadweight loss.

Policy Burdens and Elasticity

We have determined that the more elastic a market is, all else equal, the market will have a greater deadweight loss. How does relative elasticity affect the share of the burden producers and consumers bear?

Figure 4.8b

Visually, it seems quite clear that in the American market, where demand is more elastic, consumers bear a smaller burden. Let’s test this mathematically.

American Market

Deadweight Loss to Consumers:

= $0.5 million

Deadweight Loss to Producers:

= $4 million

Total Deadweight Loss:

$4.5 million

This means that consumers bear 11.11% of the tax burden and producers bear 88.89%.

Canadian Market

Deadweight Loss to Consumers:

= $1.125 million

Deadweight Loss to Producers:

= $2.25 million

Total Deadweight Loss:

$3.375 million

This means that consumers bear 33.33% of the tax burden and producers bear 66.67%.

As we speculated, consumers bear a smaller burden in the US market, and in both cases a smaller burden than the producers. This leads us to our second principle of relative elasticity.

As supply (demand) grows relatively more inelastic, producers (consumers) bear a greater burden of the tax.

As supply (demand) grows relatively more elastic, producers (consumers) bear a smaller burden of the tax.

Recall in Topic 4.7, we examined the difference between legal and economic tax incidence and determined that who the tax was levied on is irrelevant for who bears the burden. Now, we have the tools to determine who will bear the greater burden. Just as we can examine a demand curve being more or less elastic, we can examine the relative elasticity of demand compared to supply. In both instances of this hypothetical this dairy market, producers bear over 50% of the tax, meaning in box cases, supply is relatively more elastic than demand. 

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(Credit: jaymethunt/ Pixabay/ CC0 Public Domain)

The Wooden Wall to Exports

Canadian lumber is one of the most well-known Canadian exports next to maple syrup and bacon. This means relations with Canada’s biggest trading partner, the United States, can substantially help or harm the industry. An expired deal in 2015, with a one-year grace period, means that renegotiations will impact lumber sales for years to come. The problem – the U.S. may increase its tariff (a common trade policy) from 15% to up to 25%, in response to what they say are unfair subsidies from the Canadian government.

How would this increase affect consumers? How would it affect American and Canadian producers? We will explore the incidence of trade policy, specifically tariffs, in this section.

Read more about the Canada-US lumber deals.

In Topic 2, we briefly looked at the Production Possibility Frontier, a trade model that looks at the production of two goods. As we know, trade is far more complicated than that. With our supply and demand model and the policy tools we have explored, we can analyze a piece of this complex topic by looking at the impact of trade policy on each domestic.

Trade policy is often motivated by the desire to protect the domestic industry and workers since imports are typically cheaper than domestic counterparts. Imports create unwanted competition for the firms and give domestic jobs to other countries. The preventative policy can take a number of forms, from direct price controls to quotas or taxes on imported goods. In this section, we will focus on one of the more common forms of trade policy: tariffs.

Tariffs

A tariff is defined as a tax on imported goods. The easiest way to show how it works is with an example. Below, we have continued the example from the beginning of this section: the US lumber market. In the domestic market, the domestic equilibrium price and quantity are $1,000/board feet, and 40 million board feet, respectively. This is denoted as PD = $1,000 and QD = 40 million. In this case, the world price, or PW is substantially lower than the domestic price. While this is not always the case, there is no incentive to import if PW is greater than PD (This model assumes that imports are identical to domestic products in every respect except for price).

With access to imports with prices as low as $400, American consumers will purchase significantly more lumber. Their quantity demanded will increase to 70 million units (40 million more than the domestic equilibrium). These consumers are significantly better off with the new access to cheap lumber.

Domestic producers, on the other hand, lose a large degree of surplus from the imports. Whereas before they supplied 40 million board feet of lumber at $1000, now they can only supply 10 million board feet. This is because many domestic firms are no longer able to compete with the foreign production and will either leave the market or decrease production.

With domestic production of 10 million and total production of 70 million, 60 million board feet of lumber are imported from Canada.

Figure 4.9a

With such a significant portion of lumber production being imported, the government may choose to introduce a protectionist policy to restrict foreign competition, due to severe pressure from domestic producers. One important clarification about our model at this point is that the only surplus America cares about is domestic. Any producer surplus to Canadian firms is irrelevant in American decision making.

Suppose the government enacts a $400 tariff on imports to restrict competition. A tariff is a tax imposed on important goods or services. This creates an equilibrium price equal to $800 (world price + the $400 tariff). While this price is still below the domestic equilibrium, more domestic firms are now able to compete. In the new equilibrium, total quantity is 50 million board feet, 30 million of which are domestic. This means that imports have dropped from 60 million to 20 million board feet.

Figure 4.9b

In this situation, domestic producers are better off, as they are now able to sell 20 million more units. Consumers, on the other hand, are worse off, as they face a higher price. The government is better off with revenue collected by the tariff. In Figure 4.10c, we have broken down the effects of the tariff on each of the market players.

Figure 4.9c

Consumers

Consumers originally purchased 70 million board feet at $400 each, and now purchase 50 million at $800 each.

The change in surplus is represented by a decrease in areas A + B + C + D

Producers (Domestic)

Domestic producers now sell 20 million more units for $400 more than previously (note that the tariff only applies to imports, not domestic production).

The change in surplus is represented by an increase in area A

Government

The government charges a $400 tariff on the 20 million remaining imported board feet.

The change in surplus is represented by an increase in area C

Net Result

The government and producers gained areas A and C as a result of the tariff, but consumers lost areas A, B, C, and D. Overall, the policy created a deadweight loss equal to area B and D.

Conclusion

In chapter 4, we looked at a number of policies that resulted in gains for some market players, but overall deadweight loss for society. We explored price and quantity controls, taxes and subsidies, and trade policy. In all cases except for subsidies, the policies reduced equilibrium quantity to a point where MB > MC. This means that although the net marginal benefits from an additional unit were greater than the net marginal costs, the policy was restricting the market from returning to equilibrium

Why would the government implement policies that decrease market surplus? One possible reason we addressed is politics. In our example of trade policy, the domestic producers of lumber pressured the government to increase protection against foreign competition. This protectionist stance is quite common. Though trade is beneficial for society overall, many workers can lose jobs in the short run to foreign competition. In addition, when the people who stand to gain from a policy are concentrated and vocal, the majority is often ignored.

One of the most common reasons for policy, which we will discuss in detail in Topic 5, is that the market does not take into account all the costs it imposes on society. This does not mean the model is flawed, we just need to add another layer: externalities.

(Credit: Todd Brown/ Pinterest)

Fast food saw an increasing shift to automation in 2016, with Mcdonalds widely adopting “Create your Taste” electronic kiosks where customers could place their order. Many customers are finding that automation adds consistency, gives greater opportunities for customization, and reduces human error. Publications including Forbes, Business Insider, and more report that the fight for higher minimum wages has expedited this shift. Corporate leaders such as former President and CEO of McDonalds USA argue the success of “The Fight for 15” in states such as California has resulted in the closure of many small businesses, unable to pay the rising costs of labour and lacking the resources to switch to machines.

Read former McDonald CEO comment on “The Fight for 15.”

Read more about small businesses impacted by rising minimum wage.

In Topic 3 we explored the impact of government intervention in the market, and showed how policies that change quantity from equilibrium cause deadweight losses. To explore this further, let’s consider the labour market for fast food and the possible impact of a minimum wage.

1. A supply and demand curve for the fast food labour market is presented below, label the equilibrium price and quantity.

2. What is consumer and producer surplus? Market surplus?

3. Assume the government passes policy introducing a $15 minimum wage. Label the new quantity demanded, and quantity supplied. Is there a shortage or a surplus of labour? 

4. What are the two effects of the minimum wage on workers? What is the net change in surplus?

5. What is the deadweight loss from this policy?

Remember that positive economics and efficiency is independent of equity. The argument is not that redistributing wealth is unnecessary, but that perhaps a minimum wage policy is not the best mechanism to do it. Even so there is debate about whether minimum wage does cause the inefficiency as suggested above.  A series of rigorous studies by the Institute for Research on Labor and Employment at the University of California, Berkeley, comparing neighbouring counties in the U.S. located on different sides of a state border with different minimum wage levels between 1990 and 2006 found no adverse employment effects from higher minimum wages. One key argument is that an increase in minimum wage boosts spending in the economy, which may create jobs.

Read more arguments defending minimum wage policy.

(Credit: INeverCry/ Flickr/ CC-BY-SA-2.0)

How can we represent this in our model? Well in the diagram above, we made assumptions about the elasticity of the market, where an increase in the price of labour caused a relatively large drop in the quantity of labour demanded. What if firms were less responsive to such price changes?

6. A new supply and demand curve for the fast food labour market is presented below with a more inelastic supply curve, label the new equilibrium price and quantity. 

7. Assume the government again passes policy introducing a $15 minimum wage. Label the new quantity demanded, quantity supplied. Is there a shortage or a surplus of labour? By how much?

8. What is the deadweight loss from this policy? How does this compare to before?

How does automation impact the elasticity of the firms demand curve? Consider McDonald’s USA CEO Ed Rensi’s statement:

“I was at the National Restaurant Show yesterday and if you look at the robotic devices that are coming into the restaurant industry — it’s cheaper to buy a $35,000 robotic arm than it is to hire an employee who’s inefficient making $15 an hour bagging French fries — it’s nonsense and it’s very destructive and it’s inflationary and it’s going to cause a job loss across this country like you’re not going to believe.” 

Former CEO for the U.S. operations of McDonald’s Corporation, Ed Rensi, speaks with Fox Business News on the impact of the $15 minimum wage.

Rensi is adamant that economics happens at the margin; he is not suggesting that a increase in minimum wage will cause everyone to switch to automation, but that it incentives more and more to consider it as a viable alternative.

 9. Comment on how automation effects the elasticity of demand for labour. Would easy access to automation make demand relatively more or less elastic? 

In this case study we have shown how microeconomic concepts of policy and elasticity can be used to understand current events in the news. Do you have a story you think would make a good case study? Contact economics103@uvic.ca to propose your story.

1. A supply and demand curve for the fast food labour market is presented below, label the equilibrium price and quantity. 

Since Firms demand the labour, they represent the demand side of the market.

Since Job Searchers supply the labour, they represent the supply side of the market.

The equilibrium occurs at the intersection of supply and demand, in this case @ E_P = $10/hr, E_Q = 4.8 million workers employed.

2. What is consumer and producer surplus? Market surplus?

Consumer Surplus

It is important to understand that firms are the consumers in this situation since they demand and ‘consume’ labour. Recall consumer surplus is the difference between willingness to pay and the wage they pay paid. This is equal to the area labelled CS represented by the blue triangle in the figure above.

= $24 million

Producer Surplus

In this contexts the producers are the job searchers/workers since they ‘produce’ labour for the firms to buy. Producer surplus is the difference between the marginal cost of labour (commuting, opportunity cost, etc) and the wage.

= $24 million

Market Surplus

Market surplus is just consumer surplus + producer surplus.

$24 million + $24 million = $48 million

3. Assume the government passes policy introducing a $15 minimum wage. Label the new quantity demanded, and quantity supplied. Is there a shortage or a surplus of labour? 

A minimum wage is the same as a price floor, a government policy that restricts price from falling below the mandated level. In this case price is wage. At a wage of $15/hour quantity of labour demanded = 2.4 million, whereas quantity of labour supplied = 7.2 million. The resulting unemployment represents a surplus of workers in the market.

4. What are the two effects of the minimum wage on workers? What is the net change in surplus?

When you have a price change from equilibrium two things happen – a transfer and a deadweight loss. In this example the two mean very different things for consumers.

The transfer

There are clear benefits for the minimum wage if you keep your job. For the 2.4 million workers in this situation who go from receiving a wage of $10/hour to $15/hour, their surplus increases. This increase is represented by the highlighted red region labelled +PS.

($15-$10)*(2.4) = +$12 million

The deadweight loss

The workers who lose their jobs from the policy are less happy. In this case 2.4 million workers are now unable to find work. Note that these are the workers who faced the highest marginal cost of labour, the decrease in surplus is represented by the grey region labelled -PS.

= -$6 million.

The net change in surplus for workers is +$6 million ($12 million – $6 million)

5. What is the deadweight loss from this policy?

Even though workers gain from the policy, we cannot forget about the firms!

Although the breakdown of the firms is not represented, we know that the ‘transfer’ from question 4 was coming out of the pockets of firms. For deadweight loss, this is irrelevant since is is just a redistribution of surplus. 

What we are interested in are the firms who are no longer employing workers, going out of business because workers are too expensive. This is represented by the darker of the two grey regions.

= $6 million

Adding the two DWL areas together, we find the minimum wage resulted in inefficiencies of $12 million ($6 million + $6 million)

6. A new supply and demand curve for the fast food labour market is presented below with a more inelastic supply curve, label the new equilibrium price and quantity. 

The new equilibrium occurs where the supply curve intersects the new demand curve, in this case @ E_P = $10/hr, E_Q = 2.4 million workers employed.

Note that the equilibrium is the same, but the slope has changed, meaning the demand curve crosses through different points at every other quantity.

7. Assume the government again passes policy introducing a $15 minimum wage. Label the new quantity demanded, quantity supplied. Is there a shortage or a surplus of labour? By how much?

At a wage of $15/hour quantity of labour demanded = 3.6 million, whereas quantity of labour supplied = 7.2 million. The resulting unemployment represents a surplus of workers in the market.

Note that quantity of labour demanded has not fallen by as much as firms are less responsive to the change in wage.

8. What is the deadweight loss from this policy? How does this compare to before?

Again we see a deadweight loss as workers lose jobs and firms go out of business. This is equal to the area in grey, labelled DWL.

= $4.8 million.

By changing our assumptions of elasticity we see our deadweight loss has fallen from $12 million to $4.8 million. This demonstrates the importance of the assumptions we make, and ensuring that you reveal your assumptions when conducted economic analysis.

 9. Comment on how automation effects the elasticity of demand for labour. Would easy access to automation make demand relatively more or less elastic? 

All the rhetoric around the increasing accessibility of automation points to the fact that firms demand curves are becoming relatively more elastic. Whereas before there may have been little choice but to have someone at the till, now they can be fairly easily replaced by a machine. This is imporant to recognize when considering the impacts of minimum wage policy, as changing technology can change the assumptions on which we base our models.

Exercises 4.1

1. Use the demand curve diagram below to answer the following question.

What is the own-price elasticity of demand as price increases from $2 per unit to $4 per unit? Use the mid-point formula in your calculation.

a) 1/3.
b) 6/10.
c) 2/3.
d) None of the above.

2. Suppose that a 2% increase in price results in a 6% decrease in quantity demanded. Own-price elasticity of demand is equal to:

a) 1/3.
b) 6.
c) 2
d) 3.

3. If own-price elasticity of demand equals 0.3 in absolute value, then what percentage change in price will result in a 6% decrease in quantity demanded?

a) 3%
b) 6%
c) 20%.
d) 50%.

4. Suppose you are told that the own-price elasticity of supply equal 0.5. Which of the following is the correct interpretation of this number?

a) A 1% increase in price will result in a 50% increase in quantity supplied.
b) A 1% increase in price will result in a 5% increase in quantity supplied.
c) A 1% increase in price will result in a 2% increase in quantity supplied.
d) A 1% increase in price will result in a 0.5% increase in quantity supplied.

5. Suppose that a 10 increase in price results in a 50 percent decrease in quantity demanded. What does (the absolute value of) own price elasticity of demand equal?

a) 0.5.
b) 0.2.
c) 5.
d) 10.

6. If goods X and Y are SUBSTITUTES, then which of the following could be the value of the cross price elasticity of demand for good Y?

a) -1.
b) -2.
c) Neither a) nor b).
d) Both a) and b).

7. If pizza is a normal good, then which of the following could be the value of income elasticity of demand?

a) 0.2.
b) 0.8.
c) 1.4
d) All of the above.

8. If goods X and Y are COMPLEMENTS, the which of the following could be the value of cross price elasticity of demand?

a) 0.
b) 1.
c) -1.
d) All of the above could be the value of cross price elasticity of demand.

Exercises 4.2

Use the demand curve diagram below to answer the following TWO questions.

1. What is the own-price elasticity of demand as price decreases from $8 per unit to $6 per unit? Use the mid-point formula in your calculation.

a) Infinity.
b) 7.0
c) 2.0.
d) 1.75

2. At what point is demand unit-elastic?

a) P = $6, Q = 12.
b) P = $4, Q = 8.
c) P = $2, Q = 12.
d) None of the above.

3. Which of the following statements about the relationship between the price elasticity of demand and revenue is TRUE?

a) If demand is price inelastic, then increasing price will decrease revenue.
b) If demand is price elastic, then decreasing price will increase revenue.
c) If demand is perfectly inelastic, then revenue is the same at any price.
d) Elasticity is constant along a linear demand curve and so too is revenue.

4. Suppose BC Ferries is considering an increase in ferry fares. If doing so results in an increase in revenues raised, which of the following could be the value of the own-price elasticity of demand for ferry rides?

a) 0.5.
b) 1.0.
c) 1.5.
d) All of the above.

5. Use the demand diagram below to answer this question. Note that P × Q equals $900 at every point on this demand curve.

Which of the following statements correctly describes own-price elasticity of demand, for this particular demand curve?

I. Demand is unit elastic at a price of $30, and elastic at all prices greater than $30.
II. Demand is unit elastic at a price of $30, and inelastic at all prices less than $30.
III. Demand is unit elastic for all prices.

a) I and II only.
b) I only.
c) I, II and III.
d) III only.

6. Suppose that, if the price of a good falls from $10 to $8, total expenditure on the good decreases. Which of the following could be the (absolute) value for the own-price elasticity of demand, in the price range considered?

a) 1.6.
b) 2.3.
c) Both a) and b).
d) Neither a) or b).

7. Consider the demand curve drawn below.

At which of the following prices and quantities is revenue maximized?

a) P = 40; Q = 0.
b) P = 30; Q = 5.
c) P = 20; Q = 10.
d) P = 0; Q = 20.

Exercises 4.3

1. Which of the following does NOT affect the magnitude of own-price elasticity of demand?

a) The length of the time horizon over which we are looking at the change in consumer behaviour.
b) The availability (or lack thereof) of close substitutes for the good in question.
c) The amount by which quantity supplied will change as price changes.
d) All of the above affect the own-price elasticity of demand.

2. If a demand curve is VERTICAL, then own-price elasticity of demand for this good is equal to:

a) Infinity.
b) Zero.
c) One.
d) None of the above.

3. If – given consumer preferences – a certain good has many close substitutes available, then:

a) The demand for that good will be relatively inelastic, compared to goods for which there are few close substitutes.
b) The supply of that good will be relatively inelastic, compared to goods for which there are few close substitutes.
c) The demand for that good will be relatively elastic, compared to goods for which there are few close substitutes.
d) The supply of that good will be relatively elastic, compared to goods for which there are few close substitutes.

4. If – given consumer preferences – a certain good has few close substitutes available, then:

a) The demand for that good will be relatively inelastic, compared to goods for which there are many close substitutes.
b) The supply of that good will be relatively inelastic, compared to goods for which there are many close substitutes.
c) The demand for that good will be relatively elastic, compared to goods for which there are many close substitutes.
d) The supply of that good will be relatively elastic, compared to goods for which there are many close substitutes.

Exercises 4.5

The following TWO questions refer to the supply and demand curves illustrated below.

1. A price ceiling of P3 causes:

a) A deadweight loss triangle whose corners are ABC.
b) A deadweight loss triangle whose corners are ACD.
c) A deadweight loss triangle whose corners are BEC.
d) A deadweight loss triangle whose corners are CDE.

2. A price floor of P1 causes:

a) Excess demand equal to the distance AB.
b) Excess supply equal to the distance AB.
c) Excess supply equal to the distance DE.
d) Excess demand equal to the distance DE.

3. Which of the following statements about price ceilings is TRUE? (Assume the price ceiling is set below the unregulated equilibrium price.)

a) Price ceilings make sellers worse off.
b) Price ceilings make buyers better off.
c) Both a) and b) are true.
d) Neither a) nor b is true).

4. Which of the following statements about minimum wages is true?

a) Minimum wage laws may make some workers better off and others worse off.
b) Minimum wage laws make employers worse off.
c) Both a) and b) are true.
d) None of the above are true.

5. Consider diagram below, which illustrates the market for low-skilled labour.

Suppose that the equilibrium quantity is reduced from Q1 to Q2 units, through the introduction of a price floor. Which of the following correctly describes the resulting decrease in MARKET surplus?

a) Market surplus will decrease by a – c.
b) Market surplus will decrease by by e + c.
c) Market surplus will decrease by a + b + e + c.
d) Market surplus will decrease by b – e.

6. Consider diagram below, which illustrates the market for low-skilled labour.

If the government introduces a minimum wage law set at $9 per hour, then, in the new equilibrium, which of the following statements is TRUE?

I. There will be 11,000 workers willing to work who cannot find work, given the wage.
II. The number of workers employed will decrease by 11,000.
III. The number of workers that employers are prepared to hire will decrease by 5,000.

a) I only.
b) I and II only.
c) I, II, and III.
d) I and III only.

7. Suppose that the BC government wishes to reduce the quantity of beer sold in the Province by 20%. It has calculated that this goal can be achieved EITHER through a price floor set at $2 per six-pack of beer OR a price ceiling of $20 per six-pack of beer. Assume that the current price of beer is $10 per six-pack. Which of the following statements about these policies is TRUE?

a) The deadweight loss from the price floor will be greater than the deadweight loss from the price ceiling.
b) The deadweight loss from the price ceiling will be greater than the deadweight loss from the price floor.
c) There is insufficient information to determine which policy will have the large deadweight loss.
d) None of the above statements is true.

8. Consider the supply and demand diagram below. Assume no externalities.

If a price floor of $20 is introduced, then which area will represent the deadweight loss?

a) e.
b) e + d.
c) e + b + d.
d) The deadweight loss will be zero.

9. If a price ceiling (set below the initial equilibrium price) is introduced in a market, then:

a) Producer surplus definitely decreases.
b) Consumer surplus definitely increases.
c) Neither a) nor b) are true.
d) Both a) and b) are true.

10. In Canada, the prices of most medical services are regulated by the Provinces (that is, they are subject to price ceilings). This type of regulation is likely to result in which of the following (relative to an unregulated market)?

a) An increase in the quantity of medical services provided.
b) Consumption of medical services such that the marginal benefit is less than the marginal cost.
c) Lower incomes for providers of medical services.
d) Higher tax revenues for Provincial governments.

Exercises 4.6

1. Which of the following CANNOT reduce the equilibrium quantity sold in a market?

a) A price ceiling.
b) A price floor.
c) A quota.
d) All of the above can decrease equilibrium quantity sold.

Exercises 4.7

Refer to the supply and demand curves illustrated below for the following THREE questions. Consider the introduction of a $20 per unit tax in this market.

1. Which areas represent the loss to consumer AND producer surplus as a result of this tax?

a) k + f.
b) j + g.
c) k + j.
d) k + f + j + g.

2. Which areas represent the gain in government revenue as a result of this tax?

a) k + f.
b) j + g.
c) k + j.
d) k + f + j + g.

3. Which areas represent the deadweight loss associated with this tax?

a) f + g.
b) k – g.
c) j – f.
d) k + f + j + g.

4. Assume that the marginal cost of producing socks is constant for all sock producers, and is equal to $5 per pair. If government introduces a constant per-unit tax on socks, then which of the following statements is FALSE, given the after-tax equilibrium in the sock market? (Assume a downward-sloping demand curve for socks.)

a) Consumers are worse off as a result of the tax.
b) Spending on socks may either increase or decrease as a result of the tax.
c) Producers are worse off as a result of the tax.
d) This tax will result in a deadweight loss.

5. Refer to the supply and demand diagram below.

If an subsidy of $3 per unit is introduced in this market, the price that consumers pay will equal ____ and the price that producers receive net of the subsidy will equal _____.

a) $2; $5.
b) $3; $6.
c) $4; $7.
d) $5; $8.

6. If a subsidy is introduced in a market, then which of the following statement is TRUE? Assume no externalities

a) Consumer and producer surplus increase but social surplus decreases.
b) Consumer and producer surplus decrease but social surplus increases.
c) Consumer surplus, producer surplus, and social surplus all increase.
d) Consumer surplus, producer surplus, and social surplus all decrease

Use the diagram below to answer the following TWO questions.

7. If a $6 per unit tax is introduced in this market, then the price that consumers pay will equal ____ and the price that producers receive net of the tax will equal _____.

a) $10; $4.
b) $9; $3.
c) $8; $2.
d) $7; $1.

8. If a $6 per unit tax is introduced in this market, then the new equilibrium quantity will be:

a) 20 units.
b) 40 units.
c) 60 units.
d) None of the above.

9. Which of the following statements about the deadweight loss of taxation is TRUE? (Assume no externalities.)

a) If there is a deadweight loss, then the revenue raised by the tax is greater than the losses to consumer and producers.
b) If there is no deadweight loss, then revenue raised by the government is exactly equal to the losses to consumers and producers.
c) Both a) and b).
d) Neither a) nor b).

10. Which of the following correctly describes the equilibrium effects of a per-unit tax, in a market with NO externalities?

a) Consumer and producer surplus increase but social surplus decreases.
b) Consumer and producer surplus decrease but social surplus increases.
c) Consumer surplus, producer surplus, and social surplus all increase.
d) Consumer surplus, producer surplus, and social surplus all decrease.

11. Which of the following correctly describes the equilibrium effects of a per unit subsidy?

a) Consumer price rises, producer price falls, and quantity increases.
b) Consumer price falls, producer price falls, and quantity increases.
c) Consumer price rises, producer price rises, and quantity increases.
d) Consumer price falls, producer price rises, and quantity increases.

12. Refer to the supply and demand diagram below.

If an output (excise) tax of $5 per unit is introduced in this market, the price that consumers pay will equal ____ and the price that producers receive net of the tax will equal _____.

a) $5; $10.
b) $6; $11.
c) $7; $12.
d) $8; $3.

13. Consider the supply and demand diagram below.

If a $2 per unit subsidy is introduced, what will be the equilibrium quantity?

a) 40 units.
b) 45 units.
c) 50 units.
d) 55 units.

Consider the supply and demand diagram below. Assume that: (i) there are no externalities; and (ii) in the absence of government regulation the market supply curve is the one labeled S1.

14. If a $5 per unit tax is introduced in this market, which area represents the deadweight loss?

a) a.
b) a + b.
c) b + c.
d) a + b + c.

Exercises 4.8

1. Suppose a tax is levied in a market in which demand is downward sloping and supply is perfectly elastic. Which of the following statements is/are TRUE? (Assume no externalities.)

I. Producer surplus decreases.
II. The deadweight loss is zero.
III. Consumers bear all the burden of the tax.

a) II only.
b) I and II only.
c) I, II, and III.
d) III only.

2. Which of the following statements about tax incidence and relative elasticities is TRUE?

If demand is relatively inelastic and supply is relatively elastic, then consumers bear more of the burden of a tax.
If supply is perfectly inelastic, then producers bear none of the burden of a tax, no matter what the value of own-price elasticity of demand.
If the relative elasticities of demand and supply are the same, the tax burden is shared equally across consumers and producers.

a) II only.
b) I and III only.
c) I, II, and III.
d) III only.

3. The diagram below illustrates the supply curve for a good, and two possible demand curves for that good.

If a price floor (set above the initial equilibrium price) is introduced in this market then:

a) The deadweight loss will be smaller, if demand is D1 than if demand is D2.
b) The decrease in quantity will be smaller, if demand is D1 than if demand is D2.
c) Neither a) nor b) are true.
d) Both a) and b) are true.

4. In which of the following cases will the deadweight loss from taxation be zero?

a) If demand is perfectly elastic.
b) If demand is unit elastic.
c) If demand is perfectly inelastic.
d) Either a) or c) will result in zero deadweight loss from taxation.

5. Which of the following statements about the economic incidence of taxation is TRUE?

I. If demand is elastic, producers will bear a greater burden of the tax than consumers.
II. If supply is perfectly inelastic, producers will bear all the burden of the tax.
III. If the supply curve is perfectly elastic, consumers will bear none of the burden of the tax.

a) II only.
b) I and II only.
c) II and III only.
d) I, II and III.

6. Which of the following correctly describes the equilibrium effects of a per-unit tax, in a market with NO externalities?

a) Consumer and producer surplus increase but social surplus decreases.
b) Consumer and producer surplus decrease but social surplus increases.
c) Consumer surplus, producer surplus, and social surplus all increase.
d) Consumer surplus, producer surplus, and social surplus all decrease

7. Suppose that the price of a good increases. The increase in produce surplus will be:

a) Larger if demand is relatively elastic than if demand is relatively inelastic.
b) Smaller if demand is relatively elastic than if demand is relatively inelastic.
c) Smaller if supply is relatively elastic than if supply is relatively inelastic.
d) Larger if supply is relatively elastic than if supply is relatively inelastic.

Exercises 4.9

Use the diagram below, illustrates the domestic supply curve (SD) and demand curve for a good, to answer the following THREE questions. Assume that the world price is equal to $20 per unit, and initially there are no trade restrictions in place.

1. If a tariff of $10 per unit is introduced in the market, then, at the new equilibrium:

a) Consumers will pay a price of $20, quantity sold will be 60 units, of which 40 are imported.
b) Consumers will pay a price of $30, quantity sold will be 40 units, of which 30 are produced domestically.
c) Consumers will pay a price of $20, quantity sold will be 60 units, of which none are produced domestically.
d) Consumers will pay a price of $30, quantity sold will be 40 units, of which none are imported.

2. If a tariff of $10 per unit is introduced in the market, then the government will raise ____ in tariff revenue.

a) $400.
b) $300.
c) $200.
d) $100.

3. If a tariff of $10 per unit is introduced in the market, then the deadweight loss will equal:

a) $50.
b) $100.
c) $150.
d) None of the above.

The following two questions refer to the diagram below, which illustrates the domestic supply curve (SD) and demand curve for a good. Assume that the world price is equal to $5 per unit, and that initially there are no trade restrictions.

4. If a tariff of $10 per unit of imports is introduced, which area represents the deadweight loss?

a) a + f.
b) c + e.
c) a + b + c + e + f + g.
d) a + b + d + h + g + f.

5. If a tariff of $10 per unit of imports is introduced, which area represents the tariff revenue raised?

a) d.
b) d + h.
c) h.
d) b + h + g.

Use the diagram below – which illustrates the domestic supply and demand curves for a good – to answer the following TWO questions. Assume that the world price is equal to $2.

6. If there are no trade restrictions in place, what will be the equilibrium quantity of IMPORTS?

a) 40.
b) 50.
c) 60.
d) None of the above.

7. If a tariff of $2 is introduced, then:

a) Imports will decrease and social surplus will increase.
b) Imports will decrease and consumer surplus will increase
c) Imports will decrease and domestic producer surplus will increase.
d) All of the above will occur.

8. The diagram below illustrates the domestic supply curve (SD) and demand curve for a good. Assume that the world price is equal to $5 per unit.

If imports of this good are banned altogether, which area represents the deadweight loss?

a) a + b.
b) e.
c) c+d.
d) a + b + c + d + e.

9. The diagram below illustrates the domestic supply curve (SD) and demand curve for a good. Assume that the world price is equal to $10 per unit, and initially there are no trade restrictions.

If a tariff of $10 per unit is introduced, by how much to imports decrease?

a) 10 units.
b) 20 units.
c) 30 units.
d) 40 units.

Britten, Liam. The Globe and Mail. “Vancouver Wants Province to Tax Airbnb Rentals Like Hotels.” June 27, 2016. http://www.cbc.ca/news/canada/british-columbia/airbnb-tax-vancouver-1.3655343

The Economist. “Undoing the Mess.” October 10, 2011. http://www.economist.com/blogs/schumpeter/2011/10/netflix

Limitone, Julia. FoxBusiness. “Fmr. McDonald’s USA CEO: $35K Robots Cheaper Than Hiring at $15 Per Hour.” May 24, 2016. http://www.foxbusiness.com/features/2016/05/24/fmr-mcdonalds-usa-ceo-35k-robots-cheaper-than-hiring-at-15-per-hour.html

Investopedia. “What factors influence a change in demand elasticity?” April 3, 2015. http://www.investopedia.com/ask/answers/040315/what-factors-influence-change-demand-elasticity.asp?ad=dirN&qo=investopediaSiteSearch&qsrc=0&o=40186

Investopedia. “What factors influence a change in supply elasticity?” April 3, 2015. http://www.investopedia.com/ask/answers/040315/what-factors-influence-change-supply-elasticity.asp

Lobo, Rita. World Finance. “In Defence of… Minimum Wage.” February 22, 2013. http://www.worldfinance.com/contributors/in-defence-of-minimum-wage

Malmo, Christopher. Vice. “Blame Canada’s Dairy Cartel for Our Expensive Milk and Cheese.” September 4, 2014. https://www.vice.com/en_ca/article/blame-canadas-dairy-cartel-for-our-expensive-milk-and-cheese-867

McKenna, Barrie. The Globe and Mail. “Canada’s Dairy Industry is a Rich, Closed Club. June 25, 2015. http://www.theglobeandmail.com/news/politics/canadas-dairy-industry-is-a-rich-closed-club/article25124114/

Merlo, Catherine. AGWeb. “Why Dairy Demand Has Become More Elastic.” March 5, 2015. https://www.agweb.com/article/why-dairy-demand-has-become-more-elastic-naa-catherine-merlo/

Montgomery, Marc. Radio Canada International. “Canada-US Lumber Deal, Back Again, Still Bad for Canada.” September 19, 2016. http://www.rcinet.ca/en/2016/09/19/canada-us-lumber-deal-back-again-still-bad-for-canada/

Rensi, Ed. Forbes. Thanks To ‘Fight For $15’ Minimum Wage, McDonald’s Unveils Job-Replacing Self-Service Kiosks Nationwide.” November 29, 2016. https://www.forbes.com/sites/realspin/2016/11/29/thanks-to-fight-for-15-minimum-wage-mcdonalds-unveils-job-replacing-self-service-kiosks-nationwide/#104cea084fbc

Figure 1. Environmental Debate. Across the country, countless people have protested, even risking arrest, against the Keystone XL Pipeline. (Credit: modification of image by “NoKXL”/Flickr Creative Commons)

In 1969, the Cuyahoga River in Ohio was so polluted that it spontaneously burst into flame. Air pollution was so bad at that time that Chattanooga, Tennessee was a city where, as an article from Sports Illustrated put it: “the death rate from tuberculosis was double that of the rest of Tennessee and triple that of the rest of the United States, a city in which the filth in the air was so bad it melted nylon stockings off women’s legs, in which executives kept supplies of clean white shirts in their offices so they could change when a shirt became too gray to be presentable, in which headlights were turned on at high noon because the sun was eclipsed by the gunk in the sky.”

The problem of pollution arises for every economy in the world, whether high-income or low-income, and whether market-oriented or command-oriented. Every country needs to strike some balance between production and environmental quality. This topic begins by discussing how firms may fail to take certain social costs, like pollution, into their planning if they do not need to pay these costs. Traditionally, policies for environmental protection have focused on governmental limits on how much of each pollutant could be emitted. While this approach has had some success, economists have suggested a range of more flexible, market-oriented policies that reduce pollution at a lower cost.

In Topics 3 and 4 we introduced the concept of a market. In particular, we closely examined perfectly competitive markets. We observed how producers and consumers of a good interacted to reach equilibrium. We also demonstrated that any policy that was introduced (i.e. quota, price control, tax, etc.) moved the market away from the surplus maximizing equilibrium and created a deadweight loss.

Our assumption throughout this analysis, however, was that there was no third party impacted by the interaction of producers and consumers. We can now add the concept of Externalities to our supply and demand model to account for the impact of market interactions on external agents. We will find that the equilibrium that is optimal for consumers and producers of the good may be sub-optimal for society. We will learn that the all-regulation-is-bad-regulation conclusion from earlier is not always the case – in many situations, we can improve societal outcomes with policy. Before we get to this conclusion, let’s first unpack this concept of externalities.

Externalities

For the purpose of this analysis, the following terminology will be used:

• Our topic three demand curve is equivalent to the marginal private benefit curve.
• Our topic three supply curve is equivalent to the marginal private cost curve. 

We now want to develop a model that accounts for positive and negative externalities. To do so, we must consider the external costs and benefits. External costs and benefits occur when producing or consuming a good or service imposes a cost/benefit upon a third party. When we account for external costs and benefits, the following definitions apply:

• When we add external benefits to private benefits, we create a marginal social benefit curve. In the presence of a positive externality (with a constant marginal external benefit), this curve lies above the demand curve at all quantities.
• When we add external costs to private costs, we create a marginal social cost curve. In the presence of a negative externality (with a constant marginal external cost), this curve lies above the supply curve at all quantities.

When we were considering private markets, our objective was to maximize market surplus or total private benefits minus total private costs. Our new objective considering all impacted agents in society is to maximize social surplus or total social benefits minus total social costs.

A Negative Externality

Much of the work we will do is with negative externalities. As we will see in the next section, pollution is modelled as a negative externality. Economists illustrate the social costs of production with a demand and supply diagram. For example, consider Figure 5.1a, which shows a negative externality. Notice that there are external costs but no external benefits. Graphically, this means that the marginal social cost (MSC) curve lies above the marginal private cost (MPC) curve by an amount equal to the marginal external cost (MEC) and the marginal private benefit (MPB) and marginal social benefit (MSB) are equivalent.

Let’s undergo an analysis of this diagram to understand how we need to shift our thinking from Topic 3 and 4 to Topic 5.

Figure 5.1a

Let’s first pretend we know nothing about externalities and ignore MSC. Market equilibrium in this diagram occurs at the intersection of supply and demand, or the intersection of MPC and MSB (which is equivalent to MPB). This occurs at Q₁. Now we know that total private benefits at the market equilibrium are equal to a+b+c+e+f and we know that total private cost at the market equilibrium equals c+f.

The market surplus at Q₁ is equal to (total private benefits – total private costs), in this case, a+b+e. [(a+b+c+e+f) – (c+f)].

Now, let’s introduce some of the concepts we’ve learned in this section to our analysis. To get a true picture of surplus, we need to account for the external cost of production. Recall that social surplus is the difference between total social benefits and total social cost. Social surplus is sometimes referred to as aggregate net benefits. Since there is no positive externality, social benefit and private benefit are equal. Thus, as before, it is equal to a+b+c+e+f.

Total social cost at the market equilibrium is equal to b+c+d+e+f, and includes all the areas under our MSC curve up to our quantity. Notice that this is larger than total private cost by b+e+d. This should make sense as we are analyzing a negative externality where, by definition, the private cost to producers is smaller than the social cost of their actions. The difference is these two values is equal to the external costs.

The social surplus at Q₁ is equal to total social benefits – total social costs. In this case, a-d. [(a+b+c+e+f) – (b+c+d+e+f)].

In Topic 3 and 4, we saw that the market equilibrium quantity maximized market surplus and that any move away from this quantity caused a deadweight loss. Let’s see if this conclusion holds when we introduce externalities.

Recall that deadweight loss (DWL) is defined at maximized surplus – actual surplus. In Layman’s terms, it is where we want to be in a perfect world minus where we are now. In some sense, it is a quantification of inefficiency.

Consider our diagram of a negative externality again.  Let’s pick an arbitrary value that is less than Q₁ (our optimal market equilibrium). Consider Q₂.

Figure 5.1b

If we were to calculate market surplus, we would find that market surplus is lower at Q₂ than at Q₁ by triangle e.

The market surplus at Q₂ is equal to area a+b. [(a+b+c) – (c)].

What about social surplus? Total social benefit at Q₂ is equal to a+b+c. Total social cost at Q₂ is equal to b+c.

The social surplus at Q₂ is equal to area a [(a+b+c) – (b+c)].

This result is interesting. By moving to a quantity lower than our optimal market equilibrium, we raised social surplus. Compared to Q₁ we have increased our social surplus by area d. This means that d was a deadweight loss from being at the optimal market  level of production. That is to say, the optimal market level of production was inefficient for society. By leaving the market unregulated and letting the interaction of producers and consumers set quantity and price, society as a whole is worse off than if quantity had been restricted by policy for example. This means that there is an opportunity for government intervention to make society better off.

Why is this the case? Well, at Q₁, we see that our MSC is greater than our MSB. Using marginal analysis, we know that when MC > MB, we need to reduce our quantity to maximize surplus.

How do you know which quantity maximizes surplus?

• When looking for the market equilibrium (sometimes called the unregulated market equilibrium), we want to select the quantity where demand = supply or where marginal private benefit = marginal private cost. Diagrammatically, this will happen where MPB intersects MPC.  The quantity where this occurs will always maximize market surplus.
• When looking for the social surplus maximizing equilibrium, we want to select the quantity where marginal social benefit = marginal social cost. Diagrammatically, this will happen where MSB intersects MSC. The quantity where this occurs will always maximize social surplus.

Pareto Improvements and Potential Pareto Improvement

At this point, there may be some confusion around our analysis. The market (or private agents) were worse off in the move from Q₁ to Q₂, but society was made better off. How is this possible? What criteria are we using to judge if our action to restrict quantity is appropriate?  Recall our definition of efficiency from earlier topics. We defined Pareto-efficiency as an outcome where no one can be made better off without making someone worse off. As it turns out, we need two additional definitions to fully understand the movement from an inefficient to an efficient allocation.

The first term we need to become familiar with is a Pareto Improvement. A Pareto Improvement is a change such that someone is made better off without making anybody worse off. Consider the following example. You only like peanut butter and jelly sandwiches, but your mom has packed you a PB & J and a Nutella sandwich. Your friend has no sandwiches in their lunch bag but loves sandwiches. Since you do not value Nutella sandwiches, if you give your friend your Nutella sandwich, you would make them better off without making yourself worse off (remember, you don’t place any value on Nutella sandwiches). This scenario describes a Pareto Improvement.

The second term we need to introduce is a Potential Pareto Improvement. The definition of a Potential Pareto Improvement has three parts:

1. As opposed to a Pareto Improvement, a Potential Pareto Improvement may have people who gain and people who lose.
2. The individuals who gain from the change gain by enough that in theory some of their gains could be taken to compensate those who lose such that we again have a scenario where people are made better off without making anybody worse off.
3. The compensation just needs to be possible. It does not have to occur for a change to be a Potential Pareto Improvement.

Note that all Pareto Improvements are necessarily Potential Pareto Improvements but not all Potential Pareto Improvements are necessarily Pareto Improvements. 

It should also be noted that if social surplus increased, at the very least Potential Pareto Improvement occurred. Pareto Improvements almost never exists and thus do not form that basis of decision making in the policy process. More often than not the choices we make are based on Potential Pareto Improvements.

Let’s illustrate a Potential Pareto Improvement and compare it to a Pareto improvement with the following illustration.

Figure 5.1c

Private Agents

Let’s first consider private market participants. In the move from Q₁ to Q₂, private agents reduce their costs by f (they are producing less so costs should be less; f is the area underneath the marginal private cost curve between Q₂ and Q₁) but also decrease their benefit by e+f (the area under the marginal private benefit curve between the two quantities of interest). On balance, they are worse off by e. when they move from Q₁ to Q₂.

External Agents

In the move from Q₁ to Q₂, the external cost imposed declines by d+e, meaning they are better off by d+e. Remember when looking for external costs, we are looking under the MSC curve but above the MPC curve.

To determine whether this is a Potential Pareto Improvement, we need to find out whether the gains from the winners exceed the losses to others. In our example, the gain by external agents is indeed larger than the loss to private agents (d+e > e).  Therefore, in theory, we could take e from the external agents and give it to the private agents and make them equally as well off as they were at the market equilibrium. External agents would still be better off by d. Thus, a Potential Pareto Improvement has been realized.

This resolves the tension we brought up at the beginning of this section and explains how we can increase social surplus by changing the quantity from the market equilibrium.

Positive Externalities

As we mentioned previously, a positive externality occurs when the market interaction of others presents a benefit to non-market participants. The analysis of positive externalities is almost identical to negative externalities. The difference is that instead of the market equilibrium quantity being too much, the market will generate too little of Q. Let’s look at an example. Consider the following diagram of a market where a positive externality is present.

Figure 5.1d

Notice first that MPC curve is the same as MSC curve because there are no external costs. Second, the MSB curve lies above the MPB curve at all quantities because each unit of private consumption generates a spill-over benefit to non-market participants. The area in between MSB and MPB is the external benefit. Remember that MPB + MEB = MSB.

Let’s briefly explore this diagram as we did for negative externalities. The market equilibrium occurs where MPB = MPC. That occurs at Q₁.

The market surplus at Q₁ is equal to total private benefits – total private costs, in this case b. [(b+c) – (c)].

The social surplus at Q₁ is equal to total social benefits – total social costs, in this case a+b. [(a+b+c) – (c)].

As before, suppose we increased the quantity in this market to Q₂.

The market surplus at Q₂ is equal to b-f. [(b+c+g) – (c+f+g)].

The social surplus at Q₂ is equal to a+b+d. [(a+b+c+d+f+g) – (c+f+g)].

Note that social surplus has increased despite the fact that market participants are worse off. Thus, a Potential Pareto Improvement must have occurred. We can see this is the case by noticing that d+f is the amount that non-market participants gained by the increase in production and that f is the loss to market participants from excess production. In theory, we could take f from the external agents and give it to the market participants so they would be indifferent to the situation before and after the change. Thus, we know that d is the deadweight loss in the presence of a positive externality, due to under production.

Okay, but what’s an example of a Positive and a Negative Externality?

As an example of a Negative Externality: Suppose a banana farmer uses pesticides on their crop and some of this pesticide runs off into a nearby stream that is the primary water supply of a downstream community. The farmer and the banana consumers do not account for the negative impact the operations have on the stream. In other words, there is a spillover cost inherent to this market interaction.

As an example of a Positive Externality: suppose a bee keeper’s hives are located near another farmer’s orchard. The bees fly to the orchard and pollinate the crop resulting in a spillover benefit for the orchard farmer.

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Learning Objectives

By the end of this section, you will be able to:

• Explain how policy can improve societal outcomes when markets do not function perfectly.
• Compare and demonstrate how different environmental policies work to reduce pollution.

A Source of Market Failure

Recall from our analysis in Topic 5.1 that reducing the quantity in the market from the optimal market level of production to the socially optimal level of production raised social surplus. In Topic 4, we saw a variety of policies that changed the quantity from the market equilibrium and resulted in a deadweight loss. Why the difference?

In Topic 3 and 4, our supply and demand models relied on the assumption that the market was perfectly competitive and that there were no externalities. With these assumptions, the market would naturally optimize both the market and social surplus because there would be no external costs.

Recognizing that externalities do exist, our market no longer naturally optimizes, since external costs do not impact market participants and thus are not taken into account for their decision.

Figure 5.2a

Recall this diagram of a negative externality. We found that social surplus at the optimal market quantity (or competitive equilibrium) was a-d. We then found that at the socially optimal level of production, the social surplus was a. We concluded that d was the deadweight loss from being at the competitive equilibrium and not addressing the externality. Since the market did not naturally maximize societal welfare, the unaddressed externality results in a market failure.  Since our market equilibrium quantity differs from our social equilibrium quantity, we have a deadweight loss. When left unaddressed, externalities cause competitive markets to fail.

Correcting or ‘Internalizing’ an Externality

Now we know that an externality is a form of market failure that arises because market participants do not account for factors external to the market. This makes the market quantity is too low or too high relative to the socially optimal level of production. Fortunately, in Topic 3 and 4, we learned a variety of policies that influence the number of goods exchanged in a market. We can use these to set quantity where MSB =MSC. If we create policy correctly, we can bring the market back to the social surplus maximizing level of output.

We can either set the appropriate quantity directly through a quota, price floor, or price ceiling. More commonly, governments address the externality through a tax or subsidy. In this case, the government introduces a tax that will make market participants act as if they care about participants outside the market. In economic jargon, this is called internalizing the externality. A tax that addresses a negative externality by taxing the good instead of the actual external cost is called a Pigouvian Tax. We work through an example below.

Consider the following diagram of a perfectly competitive market with a negative externality present.

Figure 5.2b

Notice in the diagram above that at the socially optimal level of production, external costs do not equal zero. At Q^E, external costs are m+c+h+k+g+n. When we introduce a tax that takes us to Q*, external costs are equal to m+c+h. A common misconception is that introducing a tax in this market eliminates external costs. This is incorrect. In some sense, we are aiming for an “optimal” level of external cost. To get a sense for this, consider the manufacturing industry. We could get external costs (like the adverse effects of carbon dioxide emissions) to equal zero if we stopped production entirely, but then we would have a world with little energy.

Secondly, consider a world where the externality is not constant like in the previous example. Perhaps it is increasing in the level of production like the diagram below.

Figure 5.2c

At this point, you should be able to convince yourself that the equilibrium quantity is 100 and the socially efficient level of output is 80. The intuition behind the policy response is the same as before, but we have to be careful about the amount of the tax as the marginal external cost is changing. We want to set the level of the tax equal to the marginal external cost at the socially efficient level of output. This value is 8-3 or $5. We know that setting a tax equal to $5 will bring us to 80 units, where social welfare is maximized.

Third, notice that we have been indirectly targeting pollution with the policies we have discussed. We have taxed the good to reduce pollution. There is no incentive to innovate our production processes and make them “greener” because no matter how green your good is, you will still have to pay the tax. In the next section, we look at policies that address this and directly target pollution.

In the previous section, we looked at externalities and policies to correct the market failures they cause. In this section, we look at mechanisms to directly target pollution.

Model Background:

Why do firms pollute? The economist’s answer is because there is a benefit to pollution – production implies pollution and production allows the firm to generate revenue. In an unregulated world, firms can maximize their profits by using the cheapest production method available. It is not an unreasonable assumption to say that the cheapest method is likely the “dirtiest” method. When producing, firms are weighing the MB of pollution (revenue) against the MC. In an unregulated world, the MC of pollution is zero, so firms will emit the maximum level of pollution that their production method allows for. The problem is that when a firm only looks at its own cost and benefits, the societal cost of pollution is ignored. Thus, we have a role for government intervention in addressing this market failure. In analyzing the decisions of firms directly around emission or pollution, we use the abatement model.

Figure 5.3a

The graph above illustrates the marginal benefit of pollution (MPB), or equivalently, the marginal cost of abatement (MCA) for a firm. Abatement, a term describing the reduction of pollution, is almost always costly. On the vertical axis, we have cost and/or benefit in dollar terms. On the horizontal axis, we have pollution. Recall that in the absence of regulation, the firm will emit at P^MAX. Assume this firm decides to reduce its emissions to P₁. In this case, it would need to pay large amounts of money for abatement, since there would be a hefty cost associated with cleaning up its production. The area under the MCA curve between P^MAX and P₁, shown above as the red triangle, represents this cost.

It is important to note something about marginal cost of abatement. As shown in the diagram above, it is likely to be low at relatively high levels of P and high at relatively low levels of P. Consider a coal-fired power plant to understand why this is true. When the firm is making no efforts to reduce pollution, there are relatively cheap things it can do to reduce its pollution, like installing a smokestack scrubber.  This concept is commonly referred to as “low-hanging fruit.” When this firm is polluting only a small amount, it is much costlier to reduce pollution by an additional unit. An extreme example is that the coal-fired power plant would need to convert to a wind farm.

In theory, we could map the marginal social cost of pollution onto the above graph, find the intersection and force the firm to reduce its emissions to this optimal level. However, there is a heavy information burden for this to happen. In order for this to occur, we would need to know social cost information and the cost of abatement for the firm. This is at best impractical and at worst impossible. In reality, we estimate the appropriate pollution reduction and create a policy to get us there.

There are three that we will consider: pollution standards, a pollution tax, and a cap-and-trade system.

In creating any policy, we want to consider three criteria:

First, we want to ensure low-cost opportunities for abatement are chosen over high-cost opportunities whenever possible. This will result in pollution reduction at the least cost. 

Second, ideally, we want a system with a low informational burden. As we have discussed, assigning a cost to environmental impact is very difficult. If we can design a system that does not depend on these imprecise estimates, we can still get to a beneficial outcome.

Lastly, we want to think about distribution: Who is paying the cost for this policy and who is benefiting?

Pollution Standards

The most rudimentary policy available is called a pollution (or emission) standard. This policy directly limits the amount of pollution a firm is allowed to emit. In effect, the policymaker tells the firms that they all must restrict their emission to, for example, 350 units. The upside of this policy is that it ensures the government will reach its pollution reduction target. The bad news is that the reduction is unlikely to occur at least cost. Consider the Figure 5.3b, which shows two firms and their associated MCA below.

Figure 5.3b

We can see that Firm 1 (with MCA₁) has higher abatement costs over at all levels of P compared to Firm 2 (with MCA₂).

Suppose the government wants to reduce pollution from P^MAX = 1600 (800 from each firm) by 900 units. It decides to divide the abatement burden evenly between the two firms (450 each) so a pollution standard is set at 350 units. This means that each firm may only emit 350 units. This is shown on the diagram above.

From this policy, the government gets the desired reduction of emission by 900 units but not at least cost. Observe in the diagram that at a pollution level of 350 units, Firm 1 has a MCA of around $22 and Firm 2 has a MCA equal to around $11. This means that Firm 1 is willing to pay up to $22 for one more unit of pollution, and Firm 2 is willing to accept at least $11. If there was a way for Firm 1 to pay Firm 2 for some of its pollution allowance, then both parties could gain. This is not possible under the pollution standards regime.

Cap and Trade

A scheme where Firm 1 can buy pollution allowances from Firm 2 exists, and is called Cap and Trade.  Under cap and trade, the government sets a certain pollution level and then provides permits that firms can purchase, sell, and trade. In effect, the government is creating a market for pollution and limiting the available pollution to the number of permits it provides. This allows the market to allocate emissions reduction efficiently.

Suppose the government wants the same 900-unit reduction in emissions and to reduce emissions to 700 units. Its first step is to create 700 permits. The second and more difficult decision is to decide how many permits each firm will get initially. Let’s assume each firm is given half the permits.

Figure 5.3c

Figure 5.3c is the same diagram we had in our pollution standard scenario. As we noted, the MCA’s are not equal, and there is an incentive for Firm 1 to pay Firm 2 for some of its pollution allowance. Specifically, Firm 1 is willing to pay its MCA for an additional unit of pollution ($22), and Firm 2 is only willing to accept (WTA) more than its MCA ($11). Clearly, there are beneficial exchanges available.

What happens when a trade occurs? We can see that as pollution level changes, the MCA for each firm will change as well.

Figure 5.3d

When Firm 1 increases its pollution by 100 units and Firm 2 decreases its pollution by 100 units, the parameters for a beneficial exchange have changed. Now, Firm 1 is only willing to pay up to $17 to pollute, and Firm 2 must be paid at least $14.

We can see that transactions will continue to occur until the WTP = WTA, or the MCA for each firm is the same. This occurs at $15.

Figure 5.3e

What prices will permits trade at?

If there are a range of prices in which beneficial transactions can occur, for example in Figure 5.3c at any price between $11 and $22, what price will the permits trade at? Remember that in a perfectly competitive market, the price is set by the market. This means that the price of permits will equal the MCA at the equilibrium. Why? Our buying firms will be willing to pay somewhere between $22 and $15, and our selling firms need to be paid somewhere between $11 and $15. If you are a firm looking to sell your permit and you try to sell for more than $15, the buying firm will look elsewhere, knowing that other firms will sell for $15. If you are a buying firm and you offer less than $15, the selling firm will go elsewhere, knowing it can receive at least $15. Therefore, the equilibrium price of permits is $15.

The conclusion? We can easily find the permit price by finding the point where the marginal costs of abatement are the same, and the total amount of emissions is equal to the number of permits. By identifying this point, we will also be able to tell who is the buyer and seller of permits in each situation.

How Cap and Trade Minimizes Costs

We can look at how each firm assesses the benefits and costs of selling and buying permits and conclude that the exchange is mutually beneficially and results in a Pareto improvement. Having an open market for trading permits ensures that if one firm is more efficient at reducing emissions, it will sell permits to a firm that is less efficient. This ensures that pollution reduction is done in the most efficient way possible.

Consider Figure 5.3, which shows the benefits and costs of pollution for Firm 1 compared to the benefits and costs of abatement for Firm 2.

Figure 5.3f

Clearly, issuing permits results in efficient emission reductions. In this policy, the government has to set a quantity, and allows the market to set the price of pollution.

Pollution Tax

There is one more method the government can use to directly curb pollution. Whereas with cap and trade, the government has to set the quantity of emissions, a pollution tax allows it to set the price.

Setting the price can be more difficult. If the government wants to reduce emissions to 700 units, it will have to set a tax rate that incentivizes firms to do so. With the diagrams above, this might not seem so difficult, but normally the government will not know the MCA of the firms.

All that considered, if the government has the information, a pollution tax can have much the same effect as cap and trade. If the government sets the pollution tax at $15, consider how Firm 1 behaves:

Figure 5.3g

Without the tax, the firms both maximize their pollution. Once the $15 tax is set, the firms each compare the costs of abatement with the cost of paying the tax. In Figure 5.3d, we can see that it costs Firm 1 more to pay the tax than it does for them to reduce pollution from 800 units to 500 units.

This does not mean it will reduce pollution entirely. Consider Firm 1’s decision when it is emitting 500 units of pollution:

Figure 5.3h

In this case, we see the cost of abatement is higher than the cost of the tax. This means that the firm will pay the tax. Notice that this causes Firm 1 to reduce emissions to the same level as under cap and trade. Doing the same analysis for Firm 2 would lead us to the same conclusion. This means that a pollution tax also causes firms to reduce emissions in the most efficient way possible.

(Credit: United Nations Photo/ Flickr/ CC BY-NC-ND 2.0)

The world’s first large scale application of cap and trade to control pollution was approved by the Bush administration in November 1990. Since then, it has been hailed by many as a landmark event in environmental regulation. Introduced under the Clean Air Act Amendments of 1990, the policy was launched to combat the growing threat of acid rain. It has been estimated that using this policy rather than command and control regulations saved the economy $1 billion a year. A new report from Harvard Environmental Economics Program concludes that the program was a great success by almost all measures.  The legislation  capped emissions at 8.95 million tons annually, allowing power plants to slash SO2 in the most efficient way.

At the beginning of the program, the government allocated allowances, denominated in tons of SO2 emissions, to power plants covered by the law, according to formulas contained in the legislation. If annual emissions at a regulated facility exceeded the allowances allocated to that facility, the facility owner could either buy allowances or reduce emissions, whether by installing pollution controls, changing the mix of fuels used to operate the facility, or by scaling back operations. If emissions at a regulated facility were reduced below its allowance allocation, the facility owner could sell the extra allowances or bank them for future use. These opportunities created incentives to find ways to reduce emissions at the lowest cost.

Read a full report about the full effects of this cap and trade program.

Let’s examine this program, and compare it to a program in the EU that was less successful. Assume there are only two firms in the market and  Firm 1 and Firm 2 face abatement curves as shown below:

1. How much will the firms pollute before policy intervention?

2. If the government implemented a cap and trade system, distributing a total of 12 million permits, with 6 million to each firm, who would sell and who would buy permits?

3. How much would the seller be willing to accept, and how much will the buyer be willing to pay?

4. What is the equilibrium price of permits, and the equilibrium quantity of Sulpher Dioxide production? After the exchange of permits on the open market, how much does each firm emit?

5. What are the total benefits and total costs to each firm from trading permits? Show that the trade was a Pareto Improvement.

Instead of cap and trade, a common policy is for the government to set a carbon tax. As a reminder, a carbon tax imposes a tax on each unit of emissions and gives firms an incentive to reduce pollution whenever doing so would cost less than paying the tax. As such, the quantity of pollution reduced depends on the chosen level of the tax.

6. What is the correct tax level to receive the same result as in question 2?

7. How much revenue will the government raise from the tax?

8. What assumptions does the government have to make under cap and trade? What about under the carbon tax?

The SO2 allowance-trading program was highly effective. SO2 emissions from electric power plants decreased 36 percent (from 15.9 million to 10.2 million tons) between 1990 and 2004. The program’s long-term goal of reducing annual nationwide emissions to 8.95 million tons was achieved in 2007.

Not all cap and trade programs have been effective. The EU Emissions Trading System for example has been largely unsuccessful. The cap was set at 16 billion tonnes, or roughly half the European Union’s total carbon emissions. Unfortunately the government overestimated the demand for carbon, and to make things worse a recession reduced industrial demand. 

Read more about the failure of the EU Emissions Trading Scheme.

Assume Firm 1 and Firm 2 face abatement curves as shown below:

9. If the government implemented a cap and trade system, distributing a total of 16 million permits, how much will emissions be reduced by as a result of this policy?

Once the cap and trade program was implemented, it was hard to adjust it. The EU later attempted to take 900m tonnes of carbon allowances off the market and reintroduce them when it was hoped demand would be stronger, but the attempt failed to pass through European parliament. 

Another way to correct the program would be for the government to buy the permits off the firms themselves.

10. If the government wanted to reduce emissions by 50% by purchasing permits, what is the minimum amount they would have to pay? 

As you can see, while it may seen a cap and trade program would be easy to readjust if quantity assumptions are wrong, in reality implementing a policy and communicating it to the firms can be quite difficult.

In this case study we have shown how microeconomic concepts of abatement and carbon-tax can be used to understand past policy strategies. Do you have a example you think would make a good case study? Contact economics103@uvic.ca to propose your story.

1. How much will the firms pollute before policy intervention?

Without policy intervention, there is no benefit for a firm to decrease its pollution. Even though reducing the first few units costs relatively little, the firm maximizes profits by polluting its full amount of pollution, where the costs of abatement are 0. This results in Firm 1 polluting 10 million tons of Sulpher Dioxide, and Firm 2 polluting 20 million tons, for a total of 30 million tons.

2. If the government implemented a cap and trade system, distributing a total of 12 million permits, with 6 million to each firm, who would sell and who would buy permits?

Since we know that each firm is given 6 million permits, we need to compare the marginal cost of abatement for each firm at that level. Drawing a line up from 6 million we see that for Firm 1, their marginal cost of abatement is $350, whereas Firm 2 faces a cost of $200. Since Firm 1 values pollution more that Firm 2, there are mutually beneficial exchanges where Firm 1 buys permits from Firm 2.

3. How much would the seller be willing to accept, and how much will the buyer be willing to pay?

At 6 million permits, we can see that Firm 1 is willing to pay up to their marginal cost of abatement, or $350, and Firm 2 is willing to accept at least enough to cover their lost benefit from polluting, or $200. Notice that after Firm 1 buys a permit from Firm 2, this relationship changes – Firm 1 will be willing to pay slightly less, and Firm 2 will need to be paid slightly more.

4. What is the equilibrium price of permits, and the equilibrium quantity of Sulpher Dioxide production? After the exchange of permits on the open market, how much does each firm emit?

To find the equilibrium price and quantity, we need to find a price level for permits such that the marginal cost of abatement for both firms is equal. By looking at our previous graph, and following what happens each time Firm 1 buys a permit from Firm 2, we see that Firm 1’s marginal cost falls and Firm 2’s marginal cost rises until they are equal.

The transactions continue until Firm 1 has 8 million permits and Firm 2 has 4 million units. At this point the marginal costs of abatement are equal so no mutually beneficial transactions exist. Equilibrium quantity is 12 million, as regulated by the government, and the market price for permits is $300.

5. What are the total benefits and total costs to each firm from trading permits? Show that the trade was a Pareto Improvement

For Firm 1, buying more permits gives them the benefit of polluting more, which is equal to the reduction of the costs of abatement as shown in the green area. The cost is the amount they have to pay Firm 2, which is equal to the market price of the permit ($300) multiplied by the number they purchase as shown in the red area.

Note that while Firm 1 is technically willing to pay more than $300, in the perfectly competitive market for permits we usually deal with, if Firm 2 tries to charge any more than $300, Firm 1 will purchase permits from another firm.

Calculating costs and benefits:

Benefits (green area):

[$300 x (8-6)] + [($350-$300) x (8-6)]/2

=$650 million

Costs (red area):

[$300 x (8-6)]

=$600 million

Surplus:

$650 million – $600 million

=$50 million

For Firm 2, selling permits means they will have to pollute less. This cost of abatement is equal to the red area below, and is the down side for selling permits. This cost is outweighed by the benefit of selling permits at the market price of $300. The revenue Firm 2 receives is depicted in the green area.

Calculating costs and benefits:

Benefits (green area):

[$300 x (6-4)] + [($350-$300) x (6-4)]/2

=$600 million

Costs (red area):

[$200 x (6-4)] + [($300-$200) x (6-4)]/2

=$500 million

Surplus:

$600 million – $500 million

=$100 million

We can see that since both firms benefited from the trade, that this is indeed a Pareto improvement from when they were each emitting 6 million tons of Sulpher Dioxide. The total surplus gain is equal to $150 million ($50 million + $100 million).

6. What is the correct tax level to receive the same result as in question 2?

The tax level to give us the same result as before is equal to the market price of permits. This price incentives the same action from Firms 1 and 2, but rather than making trades with each other, they are making decisions on whether or not to abate on the margin with consideration of the tax. They will abate as long as there marginal cost of abatement is lower than the tax rate.

7. How much revenue will the government raise from the tax?

The government earns $300/ton of Sulpher Dioxide emitted. Since total emissions are 12 million tons, the government will make $3.6 billion. ($300 x 12 million)

8. What assumptions does the government have to make under cap and trade? What about under the carbon tax?

Under cap and trade the government has to make assumptions and decide on the quantity to cap emissions, whereas under a carbon tax, the government has to make assumptions and decide on the price to tax emissions. If the government wants to reduce emissions by 50%, with a carbon tax it would have to know the marginal cost of abatement for each of the firms. With cap and trade, they just need to know how much firms are emitting. Of course, as mentioned in the following explanation of the EU policy, sometimes emissions will change as a result of changing demand, which can make it difficult to set the right quantity under cap and trade.

9. If the government implemented a cap and trade system, distributing a total of 16 billion permits, how much will emissions be reduced by as a result of this policy?

In this case, since we don’t know the initial distribution of the permits, we can skip right to the result of the cap and trade. Knowing that firms will trade permits until the marginal cost of abatement is equal, we need to find a horizontal line where the total amount of pollution sums to 16 billion tons of Carbon. As shown in the graph below, this occurs at a price of $0/permit. This means that the government actually gave out enough permits for the firms to continue to pollute at the levels they had before the cap and trade program, rendering the policy ineffective.

10. If the government wanted to reduce emissions by 50% by purchasing permits, what is the minimum amount they would have to pay? 

After trades, we know that Firm 1 will end up with 12 billion permits, and Firm 2 will end up with 4 billion permits. If the government wants to reduce emissions by 50% they will have to purchase 8 billion permits to make the new pollution levels 8 billion. We can quickly identify that the equilibrium price for 8 billion permits is $15, so one way the government could reduce pollution is offer $15 to the firms.

Notice however that the government could get away with paying less. As long as they pay the firms for the marginal cost of abating to 8 billion tons of Carbon, the firms will be indifferent to abating or not.

Calculating the total abatement costs:

Firm 1 – Abating from 12 billion to 6 billion (Area A):

$15 x (12 – 6) = $90 billion

Firm 2 – Abating from 4 billion to 2 billion (Area B):

$15 x (4 – 2) = $30 billion

Total Costs to the Government 

$90 billion + $30 billion = $120 billion

As shown, trying to purchase permits out of the market can become quite expensive.

BBC News. “Keystone XL Pipeline: Why is it So Disputed.” January 24, 2017. http://www.bbc.com/news/world-us-canada-30103078

Chan, Gabriel, Robert Stavins, Robert Stowe, and Richard Sweeny. Harvard Environmental Economics Program. The S0₂ Allowance Trading System and the Clean Air Act Amendments of 1990. January 2012. https://www.hks.harvard.edu/m-rcbg/heep/papers/SO2-Brief_digital_final.pdf

The Economist. “ETS, RIP.” April 20, 2013. http://www.economist.com/news/finance-and-economics/21576388-failure-reform-europes-carbon-market-will-reverberate-round-world-ets

Johnson, Willian Oscar. Sports Illustrated. “Back on Track.” April 30, 1990. https://www.si.com/vault/1990/04/30/121923/back-on-track-earth-day-success-story-the-chattanooga-choo-choo-no-longer-spews-foul-air

Figure 1. Investment Choices. Higher education is generally viewed as a good investment, if one can afford it, regardless of the state of the economy. (Credit: modification of work by Jason Bache/Flickr Creative Commons)

Microeconomics seeks to understand the behavior of individual economic agents, such as individuals and businesses. Economists believe that individuals’ decisions, such as which goods and services to buy, can be analyzed as choices made within certain budget constraints. Generally, consumers are trying to get the most for their limited budget. In economic terms, they are trying to maximize total utility, or satisfaction, given their budget constraint.

Everyone has their own personal tastes and preferences. The French say: à chacun son goût, or “Each to his own taste.” An old Latin saying goes, De gustibus non est disputandum or “There’s no disputing about taste.” If people’s decisions are based on their own tastes and personal preferences, however, then how can economists hope to analyze the choices consumers make?

An economic explanation for why people make different choices begins with accepting the proverbial wisdom that tastes are a matter of personal preference. But economists also believe that the choices people make are influenced by their incomes, by the prices of goods and services they consume, and by factors like where they live. This chapter introduces the economic theory of how consumers make choices about what to buy.

The analysis in this chapter will dive deeper into the demand side of our supply and demand model, which will help us develop a deeper understanding of all the impacts of a price change beyond a simple difference in quantity demanded.

Our Demand Model So Far

So far, we have learned the basics of demand. Our demand curve represents the marginal benefit to consumers. When our quantity increases, our marginal benefits fall. Why is that? We talked briefly about consumers preferring a bundle of goods, and referred back to our production possibility frontier where consumers had to make trade-offs relative to other goods. Essentially, marginal benefit reflects:

-how much we like a good in absolute sense, and

-how much we like a good relative to other goods.

This brings us to the two components of the demand model that we will explore in this chapter:

1. What goods can we afford?

This question will be answered with an analysis of the consumer’s budget line, which shows all the combinations of goods consumers can purchase using their full budget.

2. What goods do we like?

This question will be answered with an analysis of the consumer’s indifference curve, which shows all the bundles of goods that give the consumer the same amount of happiness, or utility.

By determining where these two curves are tangent to each other, we can determine where a consumer will consume at each price level.

Before we can use these tools, we need to understand all the components, we will start by exploring what goods consumers can afford, given their budget lines.

 The Budget Line

To understand how households make decisions, economists look at what consumers can afford. To do this, we must chart the consumer’s budget constraint. In a budget constraint, the quantity of one good is measured on the horizontal axis and the quantity of the other good is measured on the vertical axis. The budget constraint shows the various combinations of the two goods that the consumer can afford. Consider the situation of José, as shown in Figure 6.1a. José likes to collect T-shirts and movies.

In Figure 6.1a, the number of T-shirts José  will buy is on the horizontal axis, while the number of movies he will buy José is on the vertical axis. If José had unlimited income or if goods were free, then he could consume without limit. But José, like all of us, faces a budget constraint. José has a total of $56 to spend. T-shirts cost $14 and movies cost $7.

Plotting the budget constraint is a fairly simple process. Each point on the budget line has to exhaust all $56 of José’s budget. The easiest way to find these points is to plot the intercepts and connect the dots. Each intercept represents a case where José spends all of his budget on either T-shirts or movies.

If José spends all his money on movies, which cost $7, José can buy $56/$7, or 8 of them. This means the y-intercept is the point (0,8). Here, José buys 0 T-shirts and 8 movies.

If José spends all his money on T-shirts, which cost $14, José can buy only 4 of them ($56/$14). This means the x-intercept is the point (4,0). Here, José buys 4 T-shirts and 0 movies.

By connecting these two extremes, you can find every combination that José can afford along his budget line. For example, at point R, José buys 2 T-shirts and 4 movies. This costs him:

T-Shirts @ $14 x 2 = $28

Movies @ $7 x 4 = $28

Total = $24 + $28 = $56

This point indeed exhausts José’s budget.

Figure 6.1a

Budget Constraints

We now know that José must purchase at some point along the budget line, depending on his preferences. Note that any point within the budget line is feasible. José can spend less than $56, but this is not optimal as he can still buy more goods. Since T-shirts and movies are the only two goods, there is no ability in this model for José to save. This means that not spending his full budget is essentially wasted income. On the other hand, any point beyond the budget line is not feasible. If José only has $56, he cannot spend more than that. Notice that areas in the green zone are not necessarily more optimal than points along the budget line. The optimal point depends on José’s preferences, which we will explore when we discuss José’s indifference curve.

Figure 6.1b

Slope

Though we can easily just connect the X and Y intercepts to find the budget line representing all possible combinations that expend José’s entire budget, it is important to discuss what the slope of this line represents. Remember, the slope is the rate of change. In economics, the slope of the graph is often quite important. In this situation, the slope is QY/QX. If we want to represent slope in terms of prices it is equal to Px/PY. This can seem unintuitive at first, as we are used to seeing slope as Y/X., but the reason this is not true for prices is because the y-axis represents quantity, not price. As we saw above, as price doubles, the quantity the consumer could previously purchase is halved.

If José is making $56:

When the price of movies is $7, he can buy 8 of them

When the price of movies is $14, he can buy 4 of them

Since price and quantity have this inverse relationship, we can use either Px/PY or QY/QX to find the slope. Since price is often the information given, it is important to remember that the slope can be calculated either way.

What Does Slope Mean?

The meaning of the budget line’s slope or price ratio is the same as the slope of a PPF. (The difference between these two curves is that the PPF shows all the different combinations given time a time/production constraint, whereas a budget line shows different combinations given budget constraint. Otherwise, the two graphs are basically the same). This means the slope of the curve is the relative price of the good on the x-axis in terms of the good on the y-axis. The price ratio of 2 means that José must give up 2 movies for every T-shirt. Likewise, the inverse slope of 1/2 means that José must give up 1/2 a T-shirt per movie.

When Income Changes

Because budget and prices are prone to change, José’s budget line can shift and pivot. For example, if José’s budget drops from $56 to $42, the budget line will shift inward, as he is unable to purchase the same number of goods as before.

To plot the new budget line, find the new intercepts:

Budget: $42

Price of movies: $7

Price of T-shirts: $14

Maximum number of movies (y-intercept): $42/$7 = 6

Maximum number of T-shirts (x-intercept): $42/$14 = 3

Figure 6.1c

As a result of the shift, José’s budget line has shifted inward, leaving less consumption opportunities available.

When Price Changes

In addition to income changes, sometimes the prices of movies and T-shirts rises and falls. Suppose, from our original budget of $56, movies double in price from $7 to $14. Again, to plot the new graph, simply find the new intercepts:

Budget: $56

Price of movies: $14

Price of T-shirts: $14

Maximum number of movies (y-intercept): $56/$14 = 4

Maximum number of T-shirts (x-intercept): $56/$14 = 4

Figure 6.1d

As a result of the pivot, José has fewer consumption opportunities available and the slope of the line changes. This has two effects:

The Size Effect: There are fewer opportunities for consumption (as a result of the price change, the purchasing power of José’s dollar has fallen).

The Slope Effect: The relative price of movies is now higher, while the relative price of T-shirts is now lower.

When Price and Income Change

The last type of change is when both price and income change. Suppose the price of movies increases from $7 to $12 and José’s budget increases to $63. To plot the new budget line, follow the same steps as before:

Budget: $63

Price of movies: $12

Price of T-shirts: $14

Maximum number of movies (y-intercept): $63/$12 = 5.25

Maximum number of T-shirts (x-intercept): $63/$14 = 4.50

Figure 6.1e

These changes have interesting effects. José now has access to some new consumption opportunities, but many others are now unavailable. While the slope effect has clearly made the relative price of T-shirts lower, the size effect is uncertain. These effects are implicit in the income and substitution effects we will explore shortly.

Conclusion

Though we understand the different ways by which consumers can exhaust their income, we have not yet discussed how to determine which bundles of goods different consumers prefer. To finish our analysis, let’s take a look at Indifference Curves.

Understanding Preferences

Rational consumers will spend all of their income, meaning they will produce somewhere along their budget line. The point they produce ultimately depends on preferences. Consider again the situation of José, who can buy T-shirts or Movies.

Figure 6.1a – Redisplayed

If José likes T-shirts but hates movies, he will spend all of his money on T-shirts and nothing on movies. In other words, he will select bundle P.

If José likes movies but hates T-shirts, he will spend all of his money on movies and none on T-shirts. In other words, he will select bundle T.

Usually, consumers prefer a mix of both goods. Where they consume depends on the strength of their preferences, measured by a concept known as utility. Utility, an economic term that was introduced by Daniel Bernoulli, refers to the total satisfaction received from consuming a good or service. Utility measures our happiness derived from consumption. Using the concept of utility, we can graph our preferences.

Graphing Preferences

In Topic 6.1, we looked at how to represent a consumer’s choices graphically with a budget line, with each point showing a different way for the consumer to spend all of their budget. Now, we want to represent their preferences on the same diagram.

An indifference curve maps the consumption bundles that the consumer views as equal. The consumer is equally as happy to consume at any point along the indifference curve.

Consider Figure 3.2a, where several possible consumption points are laid out. With the knowledge we have, what can we say about José’s consumption choices? Assuming José is at point A, would he prefer another bundle more?

Point C – At point C José consumes more movies and T-shirts. Since more goods make José happier, he is better off at point C.

Point B – At point B, José consumes more movies, but fewer T-shirts. Because we do not know José’s preferences, we cannot say whether José is better or worse off.

Point D – At point D, José consumes more T-shirts, but fewer movies. Because we do not know José’s preferences, we cannot say whether José is better or worse off.

Figure 6.2a

Perfect Substitutes

Let’s start with a simple example of José’s preferences and assume he views T-shirts and movies as nearly perfect substitutes. If the two goods were perfect substitutes, José would be indifferent between Movies and T-shirts. Let’s assume instead that José likes T-shirts twice as much as movies – José is equally as happy with 4 T-shirts as he is with 8 movies.

At point A, to keep utility constant, if José is to lose 1 T-shirt, he has to gain 2 movies to stay on the same indifference curve.

What information does this give us regarding José preferences between A, B, C and D?

Point C – Again, since José has more movies and T-shirts at point C, his utility has increased, and he is on a higher indifference curve.

Point B – At point B, José has one less T-shirt, but 2 more movies. As outlined, this means his utility is unchanged, and he is on the same indifference curve.

Point D – At point D, José has 1 more T-shirt, but 3 fewer movies. Since José only views T-shirts as two times more valuable than movies, his utility has decreased, and he is on a lower indifference curve.

Figure 6.2b

It is important to recognize that there is an infinite amount of indifference curves. We can graph an IC for point D, and an IC for point C.

Since very point on an indifference curve represents equal utility, we can be confident that every point on IC2 is superior to every point on IC1, and every point on IC1 is superior to every point on IC0.

Figure 6.2c

To maximize his utility, José will choose to consume on the highest possible indifference curve that he can afford.

What Does Slope Mean?

The slope of the indifference curve is the marginal rate of substitution (MRS). The MRS is the amount of a good that a consumer is willing to give up for a unit of another good, without any change in utility. In the example above, our MRS is equal to -2. This means that the maximum amount of movies José is willing to give up to get one T-shirt is 2. If he were to give up any more, he would be on a lower indifference curve. Likewise, if he were to give up any less, he would be on a higher indifference curve.

Since indifference curves are downward sloping, they have a negative slope. Because we know the definition of MRS, keeping the negative sign is unnecessary. We can just use the absolute value of the slope to simplify the analysis.

Convex Preferences

Thinking about José’s preferences, it may seem odd to simply state that he values T-shirts twice as much as movies. What if José has no T-shirts and 8 movies? In this case, perhaps he would be willing to give up more movies to obtain a T-shirt. This intuition that consumers prefer variety leads us to an indifference curve that is strictly convex. At low levels of x, we prefer it more than at high levels of x and vice versa for good y.

Figure 6.2d

Figure 6.2d shows an example of José’s convex preferences. Notice how the MRS changes depending on the consumption. When José has few T-shirts, he is willing to give up more movies in exchange for one more shirt. Conversely, when José has many T-shirts, he is not willing to give up as many movies to obtain one more T-shirt.

Graphically, when José has 1 T-shirt and 4 movies, he is willing to give up to 3 movies in exchange for 1 T-Shirt. (MRS = 3)

When José has 4 T-Shirts and 1 Movie he is only willing to give up 1/2 a movie in exchange for 1 T-Shirt. (MRS = 1/2)

In this example, José has diminishing MRS. In other words, the more of one good he consumes, the smaller the MRS becomes for that good.

Conclusion

We said earlier that José wants to be on the highest indifference curve possible, given his budget. By putting our budget line and indifference curve on the same diagram and maximizing José’s utility given his constraints, we can find exactly where he will consume.

If we think about the indifference curves in a slightly different way, we see that MRS describes marginal benefit. Since MRS represents the maximum amount of y we are willing to give up in exchange for one unit of x, it also represents how much value our consumer places on x in terms of y.

This means the indifference curve tells us the marginal benefit of good x in terms of good y, and the budget line tells us the marginal cost of good x in terms of good y. As discussed in Topic 1, using marginal analysis, our consumer will continue to purchase more of a good until the marginal benefit is equal to the marginal cost. This means

if MRS > Px/Py, the consumer will consume more x and less y.

If MRS < Px/Py, the consumer will consume less x and more y.

If MRS = Px/Py, the consumer will not change their consumption.

Recall that MRS is the slope of the indifference curve, and Px/Py is the slope of the budget line. This means that if the slope of the indifference curve is steeper than that of the budget line, the consumer will consume more x and less y.

Figure 6.3a shows José’s budget line and possible indifference curves. As Point A, MRS is greater than Px/Py, so José should consume more x and less y to maximize his utility.

Figure 6.3a

Moving along the budget line (shown in black), we see this action indeed allows José to consume on a higher indifference curve. At point B, MRS = Px/Py, so this is the utility maximizing point, given José’s constraints. Notice that since Point A and Point B are on the same budget line, José could increase utility without a change in expenditures.

In summary, the consumer will consume at the point where the indifference curve and the budget line are tangent, meaning the slopes are equal.

When Prices Changes

We now have all the pieces to develop our model for consumer theory. In Topic 3, we examined the law of demand, which showed that as the price increased our quantity demanded of the good decreased. Now, let’s look at how our consumption choices react to a change in price based on our indifference curve and budget line.

Figure 6.3b

Consider a market with 100 consumers like José, each with budgets of $56 and preferences as illustrated in Figure 6.3b.

The graph shows the final effect of a price increase on T-shirts. Suppose T-shirts have increased from $14 to $28.

The easiest way to graph a price change is to assume José spends all of his money on T-shirts to see how the intercept will change. Following the price increase, he can only purchase 2 T-shirts. ($56 budget / $28/T-shirt) Because we are imagining a market with 100 consumers like José, all in all, 200 T-shirts will be bought. The price increase causes the budget line to pivot inwards and changes the price ratio from Px/Py = 2 to Px/Py = 4.

Since we know the price of movies has not changed, we know that José can still purchase 8 movies and can show the new graph with our knowledge of these points.

In our example, this causes consumers to change consumption from 200 T-Shirts and 400 Movies (Point A) to around 70 T-Shirts and 500 Movies (Point C). Why is this the case? Can we tell from this graph whether the two goods are compliments or substitutes? Normal or inferior?

To answer these questions, we can decompose the consumer’s response into two parts:

Substitution Effect

Breaking up the effects of a price change involves back-tracking from our final effect. To find the substitution effect, we must do a thought experiment and ask “where would the consumer’s optimal bundle be if they were given back enough money to consume along their original indifference curve?”

At point C in Figure 6.3b, our current budget of $56 brought us to a lower IC. To analyze the SE, we must hold well-being constant and return to our original IC. To do so, we must increase each consumers budget by $23, so we can go back to IC1 at Point B. This is an important step because it shows us how the consumer would respond to the differences in relative prices, holding purchasing power constant. Note the $23 amount is the exact income increase it would take to bring us back tangent with the original indifference curve.

We stated that the substitution effect is purely due to changes in relative prices. To examine its effect, we must compare the two points along our original IC: our first consumption bundle, Point A, and our new consumption bundle, Point B, which represents how our consumer behaves if they feel no poorer. This means the substitution effect is the change from Point A to Point B.

Figure 6.3c

Substitution always has the same effect. People will substitute away from the good which has increased in price because it is relatively more expensive. Since the price ratio is Px/Py, when the price of x increases, Px/Py will be greater. Whereas before Px/Py = MRS, now Px/Py is > MRS. This means the consumer will buy less x and more y until MRS = Px/Py again.

Income Effect

To find our SE we had to hypothetically give the consumer some income to bring them back to their original IC. Though this exercise is simply to show the effect of a price change while holding purchasing power constant, in reality, this sometimes actually happens! Take, for example, a government tax rebate. This is often done to ensure that government increasing prices doesn’t cause consumers to be any worse off than before.

Price increases reduce a consumer’s purchasing power, making them unable to be as happy as they were before. At Point C, although our budget is unchanged at $56, we are not able to stay on IC1 without a large increase in income (back to Point B). The income effect is represented as the movement from Point B, where we are able to consume at the same level of utility as before, to Point C, where the decrease in purchasing power is also represented. This isolates the change to a consumer’s purchasing power, holding relative prices constant.

Figure 6.3d

In Figure 6.3d, we see that the individual consumes more T-shirts and movies following an increase in income. In Topic 3, we said that if QD increases when income increases, the good is normal, and if QD decreases when income decreases, it is inferior. This means that both T-shirts and movies are normal goods. This is not always the case. If QD of either good fell after the income increase, it would be inferior.

The Final Effect

To determine the final effect, we need to bring together the income effect and the substitution effect.  The SE brought us from Point A to Point B, and the IE from Point B to Point C. We generalize the sum of these effects using X and Y.

Figure 6.3e

Substitution Effect: x decreases, y increases

Income Effect: x decreases, y decreases

With this information, we know the consumer will consume less x, but we are uncertain whether they will consume more or less y. By looking at the movement from Point A to Point C on the graph, we can see the final effect shows the consumer wanting more y and less x.

This provides us with some useful information. Recall in Topic 3, we determined that if two goods are substitutes, when the price of one increases, the demand for the other will increase; whereas if they are complements, when the price of one increases, demand for the other will decrease. In this case, movies and T-shirts are substitutes.

What We Have Learned

Let’s summarize the information we have learned from a simple consumer theory analysis of a price increase. After a price increase in T-shirts from $14 to $28:

• Consumers buy more Movies and Less T-Shirts
• Both Movies and T-Shirts are normal goods (income effect)
• Movies and T-Shirts are substitutes (final effect)

We want to be able to determine these three things for every consumer problem you are given.

Substitutes vs Compliments

To determine whether two goods are substitutes or complements, we look at the final effect, not the substitution effect. Why call it the substitution effect then? Because to determine the final effect, we must find whether the income effect or the substitution effect is more powerful.

• When the substitution effect overpowers the income effect, the goods are substitutes. (Figure 6.4f)
• When the income effect overpowers the substitution effect, the goods are complements. (Figure 6.4g)

Figure 6.3f

Figure 6.3g

Normal vs Inferior

You should already have a good understanding of how to tell whether a good is normal or inferior based on the income effect. In the example above, we determined that both goods were normal since when we removed the hypothetical income boost, both QD for x and QD for y fell.

Let’s look at a case where prices are decreasing. In Figure 6.4h, the IC and BL are shown for a market where the price of x has fallen, pivoting the budget line from BL1 to BL2. In this case, we must take away the hypothetical income to isolate the SE, bringing us from Point A to Point B. The income effect is simply what happens when we reverse our thought experiment, and either remove the hypothetical income, or in this case, give it back.

Figure 6.3h

Figure 6.4h presents 3 regions. Whether the goods are inferior or normal will determine where the new IC and Point C end up.

Region 1: Q_D for X decreases, Q_D for Y increases
Good X is inferior, Good Y is normal

Region 2: Q_D for X increases, Q_D for Y increases
Good X is normal, Good Y is normal

Region 3: Q_D for X increases, Q_D for Y decreases
Good X is normal, Good Y is inferior

Conclusion

Consumer theory helps us see how individual consumers behave in a large market. With the model, we can determine whether goods are substitutes or complements, normal or inferior, and use the final effects to see how consumers respond to price changes. In Topic 3, we showed how movements along the demand curve result from changes in prices. In the next section, we will show how this model can be used to derive demand curves.

The Foundations of Demand Curves

Changes in the price of a good cause the budget constraint to shift, and new indifference curves to form. In this way, the logical foundations of demand curves—which show a connection between prices and quantity demanded—are based on the underlying idea of individuals seeking utility. Figure 6.4a shows a budget constraint with a choice between housing and “everything else.” (Putting “everything else” on the vertical axis can be a useful approach in some cases, especially when the focus of the analysis is on one particular good.) The preferred choice on the original budget constraint that provides the highest possible utility is labelled M0. The other three budget constraints represent successively higher prices for housing of P1, P2, and P3. As the budget constraint continues to rotate inwards, the utility-maximizing choices are labelled M1, M2, and M3, and the quantity demanded of housing falls from Q0 to Q1 to Q2 to Q3. Note that indifference curves have not been represented to keep the graph easy to follow. M0, M1, M2, and M3 represent the points where IC0, IC1, IC2, and IC3 are tangent to the changing budget lines.

Figure 6.4a

So, as the price of housing rises, the budget constraint shifts to the left, and the quantity consumed of housing falls, ceteris paribus (meaning, with all other things being the same). This relationship – the price of housing rising while the quantity of housing demanded falls – is graphed on the demand curve. Indeed, the vertical dashed lines stretching between the top and bottom show that the quantity of housing demanded at each point is the same in both (a) and (b). The shape of a demand curve is ultimately determined by the underlying choices made to maximize utility subject to a budget constraint. While economists may not be able to measure utility, they can certainly measure price and quantity demanded.

Conclusion

In chapter 6, we explored the inner workings of the demand curve and showed how consumers strive to maximize their utility given their budget constraints. This analysis shows us how to determine whether a good is normal or inferior, and whether two goods are substitutes or compliments. Next, we will examine the back-end of the supply curve with an in-depth analysis of producer theory.

Canadian Prime Minister Justin Trudeau has announced that a minimum carbon tax will be imposed on the provinces. (Credit: Alex Guibord/ Flickr/ CC BY-ND 2.0)

In October of 2016, Justin Trudeau made an announcement that Saskatewan Premier Brad Wall called a betrayal. Trudeau told premiers to adopt a carbon tax or cap-and-trade plan or Ottawa will impose its own levy – a minimum of $50 a tonne by 2022 – and return the revenue the provinces. The problem was not so much the policy, but that it signals Trudeau’s determination to impose federal control in jurisdictions previously under the control of the provinces. 

Although federal-provincial relations were strained, the policy is moving forward. In this case study, we will explore the impacts of this policy from a consumer theory perspective.

The specific policy that was announced was as follows: the floor price will start at $10 a tonne in 2018, and go up by $10 a year for the next four years. Provinces with a pre-existing policy must make up the difference. It is estimated that a $50 carbon tax would drive up pump prices by 11 cents a litre.

Read more about the Liberal Carbon Tax plan

Assume a households budget is $180, that the price of gas is $0.90 and that the price of all other goods is $1.38.

1. Draw the household’s budget line on the diagram below. If they were to buy only one good or the other, how many total L of gas could they buy? How many of all other goods?

2. Indicate where the household will consume. How many litres of gas? How many of all other goods? Label this Point A.

3. Assume the government was to tax gas consumption by $0.11, draw the new budget line on the graph above.

You should notice that the $0.11 increase causes a very minor shift in the budget line, which would make the rest of the problem rather difficult. In order to consider the effects of the tax let’s pretend the province has decided to tax carbon by doubling the price. 

4. Redraw the households original budget line on the diagram below, and draw a new budget line where the price of gas has doubled. 

5. Indicate where the household will consume. How many litres of gas? How many of all other goods? Label this Point B.

6. Is the household better off or worse off as a result of the tax? How do you know?

In Topic 5 we explored how government intervention can be useful to solve externalities, but we also know that a tax does not represent a Pareto improvement for all parties. In this case, many consumers are worse off as the policy brings them to a lower indifference curve. In a potential Pareto improvement, we have the necessary gains to compensate the losers, and in the Liberal policy, they give all the tax revenue back to the provinces to help correct household losses. If the province wanted, they could use that money to compensate the losers.

Not everyone gains from a gas tax. Although it may be a potential parato improvement, the government must consider the losers from the policy. (Credit: qian/ Flickr/ CC BY-NC-SA 2.0)

7. How much money does the government collect from each household from the gas tax?

8. If the government compensates each household until they are indifferent to the gas tax, where will the households consume? Label this Point C. Does this still reduce pollution?

9. How much money would the government have to give to each household to make them indifferent about the tax? 

10. Indicate the Income Effect, the Substitution Effect and the Final Effect of the tax (without compensation) with reference to the 3 points (A, B & C)

11. How could this policy represent a potential Pareto improvement if the revenue the government receives is not enough to compensate the households?

Notice that this analysis does not pass judgement on whether the government is doing too much or not enough for the environment. As an economist, you can evaluate policy to determine whether they are the best method to achieving a certain objective, without making comment on the objective.

In this case study we have shown how microeconomic concepts of environmental policy and consumer theory can be used to understand current events in the news. Do you have a story you think would make a good case study? Contact economics103@uvic.ca to propose your story.

1. Draw the household’s budget line on the diagram below. If they were to buy only one good or the other, how many total L of gas could they buy? How many of all other goods?

In order to draw the budget line the best method is to find how many of each good the household could buy if they purchased only one good. In this case the household has a budget of $180, the price of gas is $0.90 and the price of all other goods is $1.38.

Purchase only gas: $180/$0.90 = 200. This is our X-intercept.

Purchase only other goods: $180/$1.38 = 130. This is our Y-intercept.

Plotting the intercept and connecting the dots:

2. Indicate where the household will consume. How many litres of gas? How many of all other goods? Label this Point A.

The place where the household will consume is where the IC is tangent to the budget line, or where MRS = Px/Py. At this point the benefits of an extra litre of gas are equal to the costs, so the household cannot gain from any change in consumption.

On the graph below, we see households consume at Point A, consuming 125L of gas and 50 Other Goods.

3. Assume the government was to tax gas consumption by $0.11, draw the new budget line on the graph above.

Again to draw the budget line the best method is to find how many of each good the household could buy if they purchased only one good. In this case the only thing that has changed is our price of gas has increased from $0.90 to $1.01.

Purchase only gas: $180/$1.01 = 178. This is our X-intercept.

Purchase only other goods: $180/$1.38 = 130. This is our Y-intercept.

Plotting the intercept and connecting the dots:

Notice the new budget line has been left unlabelled as it will not be used for the rest of the analysis. You can see now the reason we move forward with the assumption that price has doubled, as drawing new indifference curves and budget shifts on this diagram becomes very difficult!

4. Redraw the households original budget line on the diagram below, and draw a new budget line where the price of gas has doubled. 

Using the same steps to draw the budget line, except now the price of gas has doubled from $0.90 to $1.80.

Purchase only gas: $180/$1.80 = 100. This is our X-intercept.

Purchase only other goods: $180/$1.38 = 130. This is our Y-intercept.

Plotting the intercept and connecting the dots:

5. Indicate where the household will consume. How many litres of gas? How many of all other goods? Label this Point B.

On the graph below, households consume where BL2 is tangent to IC2 at Point B, consuming 50L of gas and 70 Other Goods.

6. Is the household better off or worse off as a result of the tax? How do you know?

We can see that the household is worse off as a result of the tax since they are consuming on a lower indifference curve. Remember the household views every point along an indifference curve as equal, so operating at a point on a lower indifference curve means you are worse off.

7. How much money does the government collect from each household from the gas tax?

The government collects $0.90 for every L of gas that is consumed, in question 5 we identified that households consume 50L after the tax. This means that the government collects $0.90*50 = $45 from each household.

8. If the government compensates each household until they are indifferent to the gas tax, where will the households consume? Label this Point C.

In order to find this information we have to shift the new budget line (BL₂) until it is tangent to the original indifference curve. In question 6 we emphasized that if households are on a lower indifference curve they are worse off, and that the consumer is indifferent between points on its indifference curve. In the figure below we can see BL₂ gradually shift out as the government gives more and more to the household. This continues until the budget line + compensation is tangent to the original indifference curve at Point C.

At Point C, households consume 100L of gas and 80 Other Goods.

What is very important to note here is that even though the government compensated the households for their losses, they have still reduced consumption of gas by 25L. This shows that the policy can be effective at reducing pollution without making households worse off.

9. How much money would the government have to give to each household to make them indifferent about the tax? 

To find out how much the government must give each household, the best method is to find how much money the household needs to afford Point C. If other goods cost $1.38 and gas costs $1.80, then we can simply multiply the consumption bundle by the prices

1.38 * 80 + 100* 1.80 = $290.50.

Since the household still only has a budget of $180, the government must compensate the difference ($290.50 – $180). This means that the government must give each household $110.50 for them to remain indifferent about the gas tax.

10. Indicate the Income Effect, the Substitution Effect and the Final Effect of the tax (without compensation) with reference to the 3 points (A, B & C). What is the final effect of the entire policy (with compensation)?

In Topic 6 we have mentioned numerous times that to isolate the income effect and substitution effect we have to give back the ‘hypothetical’ income to see how a household would behave if they had no reduction in purchasing power. In this exercise (question 9) we calculated how much this income would have to be, so that the government could remove the effects. This means that the final effect of the tax + compensation (Point A to Point C) is just the substitution effect and that the government’s compensation is the income effect. In summary:

Just Tax

Substitution Effect:  Point A to Point C

Income Effect:   Point C to Point B

Final Effect:  Point A to Point B

Tax + Compensation

Substitution Effect:  Point A to Point C

Income Effect:   N/A

Final Effect:  Point A to Point C

11. How could this policy represent a potential Pareto improvement if the revenue the government receives is not enough to compensate the households?

We can notice that the government collects $45 but gives out $110.50 from this policy, making them lose $65.60. First off we can recognize that this tax in no way helps the firms, in fact it will make them worse off as less consumers buy gas. How then can this policy ever increase social surplus?

If we remember from Topic 5, households, firms, and government are not the only players we need to consider, but also the marginal external cost of actions. In this case the government may be losing money, but they are reducing the amount of pollution and benefiting the environment. Without information about the value we place on this reduction of pollution, we cannot determine whether this policy is increasing social surplus.

McCarthy, Shawn and Daniel LeBlanc. The Globe and Mail. “Liberal Government’s Carbon Tax Plan Provokes Anger from Provinces.” October 3, 2016. http://www.theglobeandmail.com/news/politics/liberals-to-set-carbon-price-at-10-a-tonne-in-2018-rising-to-50-by-2022/article32206937/

UNESCO Institute for Statistics. “Statistics in Brief / Profiles” Accessed August 2013. http://stats.uis.unesco.org/unesco/TableViewer/document.aspx?ReportId=121 &IF_Language=en&BR_Country=5580.

U.S. Bureau of Labor Statistics. 2015. “Consumer Expenditures in 2013.” Accessed March 11, 2015. http://www.bls.gov/cex/csxann13.pdf.

(Credit: Jim Surkamp/ Flickr/ CC BY-NC 2.0)

The Assembly Line – A Cost Revolution

In 1908, the automobile industry changed forever. The first automobiles date back to the 15th century when Leonardo da Vinci was creating designs and models for transport vehicles. Karl Benz, a German inventor, developed the first gas-powered automobile in 1885 and the first American car manufacturer opened in 1893. However, until 1908, the automobile was a luxury enjoyed only by the rich. It was not a technological innovation that changed the industry, but rather a revolution on costs.

Henry Ford, an American car manufacturer, developed a method that steadily reduced the cost of the automobile: the assembly line. Rather than having workers involved with each component of the manufacturing of a vehicle, workers specialized in certain areas. This example illustrates the marginal product of labour, a concept we will explore in this section. We will see that the MPL will rise as you add more workers, as each new worker helps make the assembly line more efficient than before.

The Model T, known popularly as the “Tin Lizzie” has become an American folkloric symbol, as it was a turning point in allowing the majority of Americans to afford the automobile. By 1927, over 15 million Model-T’s had been produced.

This innovation in production shows that the economics of the firm has an important bearing on the overall market and allows us to understand how costs affect supply.

Read more about the Model-T 

In Topic 6, we explored the underlying behaviours of the demand curve, and how consumers make consumption decisions based on preferences and budget constraints. Now, we will examine the underlying behaviours of individual firms in our supply curve.

First, let’s review some of the assumptions we have made about supply curves in perfectly competitive markets:

• Producers will increase production if MB (or price) is greater than the MC
• Producers will reduce production if MB (price) is less than MC
• Producers maximize profits where MB = MC
• The supply curve represents the aggregate MC of all firms

So far, we have shown the supply, or marginal cost curve, as linear and upward sloping.  In this topic, we will give greater consideration to the workings of a firm, and how firms respond to demand/supply shocks.

Different firms face different kinds of costs. A list of the costs involved in producing cars will look very different from the costs involved in producing  fast-food meals. However, the cost structure of all firms can be broken down into some common types.

To start, we want to look at the costs of a single firm in the short run. These costs come from the different inputs required to produce a good, whether that is machines, labour, ingredients, rent, etc. By short run, we mean that there is at least one input that cannot be changed. This input (or inputs) is classified as a fixed cost since in the short term there is nothing we can do to avoid this cost except quit producing altogether.

When a firm looks at its total costs of production in the short run, a useful starting point is to divide total costs into two categories: fixed costs (ones that cannot change) and variable costs (ones that can change).

To guide our understanding of fixed and variable costs, consider Henry Ford once more. When Ford was opening his first factory, he had to consider different categories of costs.

Fixed Costs

Ford’s fixed costs are his expenditures that do not change regardless of his level of production. Whether he produced a lot or a little, his fixed costs are the same.

The first step for Ford to open his factory is finding the factory space. Ford must find someone who is willing to sell or rent him space. His first offer comes from Tom, who will only rent to Ford if Ford signs a 1-year lease for $20,000. Ford, with little negotiating power, agrees and signs the lease.

Once Ford signs the lease, the rent for the year costs him $20,000 regardless of how much he produces. This lease has now become a sunk cost since there is nothing Ford can do to get his money back. Fixed costs can take many other forms: for example, the cost of machinery or equipment to produce the product, research and development costs, even an expense like advertising to popularize a brand name. The level of fixed costs varies according to the specific line of business. For instance, manufacturing computer chips requires an expensive factory, but a local moving and hauling business can get by with almost no fixed costs at all if it rents trucks by the day when needed. Since Fords cost is fixed for a whole year, this is the length of his ‘short-run.’ During that period, since the lease expense is sunk, it should not affect his decision making.

Variable Costs

Ford’s variable costs are incurred in the act of producing—the more he produces, the greater the variable cost.

After signing the lease for the factory and purchasing machines, Ford now has to buy the raw materials and find workers to produce his cars. The more Ford wants to produce, the more workers and raw materials he will have to buy. For this reason, his variable costs are increasing as his production increases.

Marginal Product of Labour

For now, let’s diverge from the Ford example and consider an industry that is more labour intensive: barbershops. In the service industry, one of the most important variable costs is labour. How do we measure the cost of labour? It is not as simple as the hourly wage.

Consider a barbershop called “The Clip Joint.” For The Clip Joint, the variable costs include hiring barbers. Assume this cost is $80 per barber each day. The quantity of haircuts the barbershop can produce will increase as it hires additional barbers. Consider Table 1, which depicts the number of haircuts each new barber can produce. Notice that the first barber can only do 15 haircuts a day, whereas the next can cut 22.

This represents the Marginal Product of Labour, or the change in output that results from employing an extra unit of labour. The table can be depicted on a graph, with MPL on the y-axis and the # of Barbers on the x-axis. On the graph, we notice that at a certain level of barbers, our marginal gains from an extra barber begin to fall.

Figure 7.1a

To understand the reason behind this pattern, consider that a one-man barber shop is a very busy operation. The single barber needs to do everything: say hello to people, answer the phone, cut hair, clean up, and run the cash register. A second barber reduces the level of disruption from jumping back and forth between these tasks, and allows a greater division of labor and specialization. The result can be greater increasing marginal returns. However, as other barbers are added, the advantage of each additional barber is less, since the specialization of labor can only go so far. The addition of a sixth or seventh or eighth barber just to greet people at the door will have less impact than the second one did. This is the pattern of diminishing marginal returns. As a result, the total costs of production will begin to rise more rapidly as output increases. At some point, you may even see negative returns as the additional barbers begin bumping elbows and getting in each other’s way. In this case, the addition of still more barbers would cause the output to decrease.

This pattern of diminishing marginal returns is common in production. As another example, consider the problem of irrigating a crop on a farmer’s field. The plot of land is the fixed factor of production, while the water that can be added to the land is the key variable cost. As the farmer adds water to the land, output increases. But adding more and more water brings smaller and smaller increases in output until at some point the water floods the field and reduces output. Diminishing marginal returns occur because we are ultimately constrained by some fixed factor.

Marginal Costs

How do we represent the MPL as a variable cost? Remember that the cost of hiring a barber is equal to $80/day. We want to find the cost per each additional unit of output. This is quite easy. If the first barber costs $80 to hire and can do 15 haircuts per day, then the marginal cost per haircut is equal to $5.33/haircut (Wage/MPL). This can be calculated for every level of output.

From this data, we can graph the marginal cost. Notice that when marginal cost falls, it is because the inputs of production (in this case labour) are becoming more productive (MPL is increasing). When marginal cost is rising, inputs are becoming less productive.

Figure 7.1b

Average Variable Costs

We now have the first piece of producer theory. With marginal costs, we can use marginal analysis to find whether increasing our inputs will be profitable. This is certainly important. In business, however, we often want to be able to answer “how much does a single haircut cost to produce”. Right now, our answer is “it depends” since our costs vary based on the number of barbers. Sometimes, we want to ignore this variation and calculate the average variable cost. Average variable cost is calculated by taking the total costs from every barber up to that point and dividing it by the total number of haircuts those barbers cut collectively.

Our average variable cost can be represented on the same graph as our marginal cost curve, helping us build our producer theory diagram even further.

Figure 7.1c

Notice that the marginal cost line intersects the average cost line exactly at the bottom of the average cost curve— this occurs at a cost of $4.0. The reason why the intersection occurs at this point is built into the economic meaning of marginal and average costs. If the marginal cost of production is below the average cost of producing previous units, as it is for the points to the left of where MC crosses AVC, then producing one additional unit will reduce average costs overall—and the AVC curve will be downward-sloping in this zone. Conversely, if the marginal cost of production for producing an additional unit is above the average cost of producing units, as it is for points to the right of where MC crosses AVC, then producing a marginal unit will increase average costs overall—and the AVC curve must be upward-sloping in this zone. The point of transition, between where MC is pulling AVC down and where it is pulling it up, must occur at the minimum point of the AVC curve.

When MC begins to increase, notice that AVC does not immediately increase. As long as marginal cost is below average cost, it causes AVC to decrease. When MC intercepts AVC and begins to rise, it causes AVC to increases. As we will see, AVC_MIN is very important in the short run. See the application “Average Can Fall While Marginal Increases: Grades” to solidify this interaction.

Average Can Fall While Marginal Increases: Grades

(Credit: bitjungle/ Flickr/ CC BY-SA 2.0)

This concept can seem confusing at first, but it in fact quite intuitive. Consider how you calculate your grades. If you are normally an A student and have an 80% average in Microeconomics, you will likely be disappointed if you received a 50% on a Midterm. Say, on the next midterm, you receive 65% – this is better than the 50% from last time but is still bringing you down from the A average you had hoped for. This is similar to the case of MC and AVC. MC is like the midterm grades – even when it is increasing, if it is still below your average, it will continue to bring it down, and when it is greater than average, it will bring it up.

Average Product of Labour

Backtracking slightly, the same analysis can be done for the Average Product of Labour, which can also be used to derive the AVC curve. Consider the graph below which represents the interaction between MPL and APL.

Figure 7.1d

Notice that the maximum point on the APL happens at the same point (4.5 barbers) as the minimum point on AVC in Figure 7.1c. This is because when on average barbers are most productive, costs/haircut are lowest. Comparing the APL/MPL graph to the AVC/MC graph we see that the curves are inversely related.

Average Total Costs

We now have MC and AVC represented in our producer theory model. How do we represent fixed costs? Let’s assume the Clip Joint has fixed costs equal to $150 per day. average total cost is an average of our total variable cost and total fixed costs. As such, it can be found by (total VC + FC)/Q. Expanding this equation, we see it is equivalent to VC/Q+FC/Q which is AVC + AFC. Since we already have our AVC, all we have to do is add the FC/Q at each level of production.

Notice that we have changed the units on the x-axis of our producer theory graph from # of Barbers to # of Haircuts. Although in this example MC would be a constant $5.33 from 0 haircuts to 15 haircuts and constant $3.64 from 15 haircuts to 37 haircuts, in a larger market, this curve would be smoothed out. The following has been smoothed out to represent a different MC for each haircut.

Figure 7.1e

So what is our ATC when we are producing 50 haircuts? Our AVC is $4.00. Our AFC at this point will be quite high at $150/50 = $3. This means our ATC is $4.00 + $3.00 = $7.00. Consider how AFC changes as we increase Q:

Q = 10 –> AFC = $150/10 = $15

Q = 20 –> AFC = $150/20 = $7.5

Q = 30 –> AFC = $150/30 = $5

Q = 150 –> AFC = $150/150 = $1

Since the only effect of an increase of inputs is spreading FC out amongst more units, AFC is always falling as Q increases.

Since AVC = ATC – (FC/Q), at low levels of Q, FC/Q is high. This means AVC is < ATC by a significant amount.

At high levels of Q, FC/Q is low. This means AVC is < ATC by a small amount.

As Q increases, FC/Q approaches 0 and AVC and AFC converge, as seen on Figure 7.1e

Why are total cost and average cost not on the same graph?

Total cost, fixed cost, and variable cost each reflect different aspects of the cost of production over the entire quantity of output being produced. These costs are measured in dollars. In contrast, marginal cost, average cost, and average variable cost are costs per unit. In the previous example, they are measured as cost per haircut. Thus, it would not make sense to put all of these numbers on the same graph, since they are measured in different units ($ versus $ per unit of output).

It would be as if the vertical axis measured two different things. In addition, as a practical matter, if they were on the same graph, the lines for marginal cost, average cost, and average variable cost would appear almost flat against the horizontal axis, compared to the values for total cost, fixed cost, and variable cost. Using the figures from the previous example, the total cost of producing 40 haircuts is $296, but the average cost is $296/40, or $7.4. If you graphed both total and average cost on the same axes, the average cost would hardly show.

A Variety of Cost Patterns

The pattern of costs varies among industries and even among firms in the same industry. Some businesses have high fixed costs, but low marginal costs. Consider, for example, an Internet company that provides medical advice to customers. Such a company might be paid by consumers directly, or perhaps hospitals or healthcare practices might subscribe on behalf of their patients. Setting up the website, collecting the information, writing the content, and buying or leasing the computer space to handle the web traffic are all fixed costs that must be undertaken before the site can work. However, when the website is up and running, it can provide a high quantity of service with relatively low variable costs, like the cost of monitoring the system and updating the information. In this case, the total cost curve might start at a high level, because of the high fixed costs, but then might appear close to flat, up to a large quantity of output, reflecting the low variable costs of operation.

For other firms, fixed costs may be relatively low. For example, consider small businesses that rake leaves in the fall or shovel snow off sidewalks and driveways in the winter. For fixed costs, such firms may need little more than a car to transport workers to customer’s homes and some rakes and shovels. Still other firms may find that diminishing marginal returns set in quite sharply. If a manufacturing plant tried to run 24 hours per day, seven days a week, little time remains for routine maintenance of the equipment, and marginal costs can increase dramatically as the firm struggles to repair and replace overworked equipment.

Every firm can gain insight into its task of earning profits by dividing its total costs into fixed and variable costs, and then using these calculations as a basis for average total cost, average variable cost, and marginal cost. However, making a final decision about the profit-maximizing quantity to produce and the price to charge will require combining these perspectives on cost with an analysis of sales and revenue, which in turn requires looking at the market structure in which the firm finds itself. Before we turn to the analysis of market structure in other topics, we will analyze how a perfectly competitive firm makes decisions in the short- and long-run

Key Concepts and Summary

In the short-run, a firm’s total costs can be divided into fixed costs, which a firm must incur before producing any output, and variable costs, which the firm incurs in the act of producing. Fixed costs are sunk costs; that is, because they are in the past and cannot be altered, they should play no role in economic decisions about future production or pricing until out short run’s time horizon is up. Variable costs typically show diminishing marginal returns, so that the marginal cost of producing higher levels of output rises.

Marginal cost is calculated by taking the change in total cost (or the change in variable cost, which will be the same thing) and dividing it by the change in output for each level. Marginal costs are typically rising. A firm can compare marginal cost to the additional revenue it gains from selling another unit to find out whether its marginal unit is adding to its profit.

Average total cost is calculated by taking total cost and dividing by total output at each different level of output. Average costs are typically U-shaped on a graph.

Average variable cost is calculated by taking variable cost and dividing it by the total output at each level of output. Average variable costs are also typically U-shaped.