Module 2 Lecture 5 Topics


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1 Module 2 Lecture 5 Topics 2.13 Recap of Relevant Concepts Social Welfare Demand Curves 2.14 Elasticity of Demand Perfectly Inelastic Perfectly Elastic 2.15 Production & Cost Function 2.16 Profit Maximization 2.17 Equilibrium: Aggregate Demand 2.18 Equilibrium: Aggregate Supply 2.19 Competitive Equilibrium 2.13 RECAP OF RELEVANT CONCEPTS SOCIAL WELFARE Welfare economics is the study of the determinates of well being, or welfare, in society. Determinants of social efficiency, or size of the economic pie. Redistribution DEMAND CURVES Demand curve is the relationship between the price of a good and the quantity demanded. Demand curve is derived from utility maximization problem 1
2 Utility maximization gives various (P M,Q M ) combinations that can be mapped into price/quantity space. Figure 5.1 and Figure 5.2 illustrate this Consider the product space of two goods C and M. Utility maximization at various prices provide optimal combinations of (P M,Q M ) and (P C, Q C ) Deriving demand curves Figure 5.1 Figure 5.2 2
3 2.14 ELASTICITY OF DEMAND Elasticity of demand Percent change in quantity demanded for a percent change in price. Does Elasticity vary along the demand curve? Depends, normally yes PERFECTLY INELASTIC For a vertical demand curve elasticity of demand is zero quantity does not change as price goes up or down PERFECTLY ELASTIC For a horizontal demand curve elasticity of demand is negative infinity quantity changes infinitely for even a small change in price. =Price of demand Elasticity flatter demand curve. steeper demand curve. M 0 M 1 : in M for price of M falling from Figure 5.3 3
4 M 1 M 2 : in M for price of M falling from M 0 M 1 > M 1 M 2 is more elastic than Vertical perfectly in elastic demand curve (no change in Q, for change in Horizontal perfectly elastic demand curve, choose any 2.15 PRODUCTION & COST FUNCTION Now consider the production side for the good M Production function, where L = labor used in the production of M, K = Capital used in the production of M Let the specific functional form be Marginal Productivity >0 Diminishing Marginal Productivity < 0 Total costs of production, where r=rental on capital w = wage rate for labor. Marginal Cost: Diminishing Marginal Productivity implies rising Marginal Cost. Since each additional unit of Q means calling forth less & less productive labor at the same wage, cost of product at the margin PROFIT MAXIMIZATION Firms producing M will maximize profits to determine the optimal supply of M for a given price level P M. Supply curve: Derived from profit maximization problem. Profit maximization Marginal Revenue (MR)=Marginal Cost (MC) At any price, quantity supplied is such that MC = Price MC curve implies supply curve 4
5 A perfect competitive market implies P = MR = MC = AR 2.17 EQUILIBRIUM: AGGREGATE DEMAND Aggregate Demand: horizontal sum of individual demand curves. Consumer surplus is the benefit that consumers derive from a good, beyond what they paid for it. Each point on the demand curve represents willingnesstopay for that quantity. The difference between what they actually pay and their willingness to pay is the surplus enjoyed. Consumer surplus is determined by market price and the elasticity of demand. With more inelastic demand, demand curve is more vertical: so surplus is higher. For instance basic food in poor countries. Inelasticity arises from lack of good substitutes; hence there is enormous surplus from consuming that particular good EQUILIBRIUM: AGGREGATE SUPPLY Aggregate Supply: horizontal sum of individual supply curves. Producer surplus is the benefit derived by producers from the sale of a unit above and beyond their cost of producing it. Each point on the supply curve represents the marginal cost of producing it. Similar to consumer surplus, producer surplus is determined by market price and the elasticity of supply. With more inelastic supply curve, producer surplus is higher. Social Efficiency or total social surplus is the sum of the consumer s and producer s surplus, potential size of the pie COMPETITIVE EQUILIBRIUM Competitive equilibrium represents the point at which both consumers and suppliers are satisfied with the price/quantity combination. Social efficiency represents the net gain from trade between consumers and producers. Total surplus received by consumers and producers in the market sums up to social efficiency. 5
6 Figure 5.4 Figure 5.5 A= Consumer surplus. B= Producer surplus. More inelastic Aggregate demand, AD implies more consumer surplus, CS. More inelastic Aggregate supply implies Producer Surplus. 6
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