Consumer Surplus = price buyer would be willing to pay less market price. Measures benefit to consumer of participating in a market

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1 Consumer Surplus = price buyer would be willing to pay less market price. Measures benefit to consumer of participating in a market Producer Surplus = market price less cost to seller Measures benefit to seller of participating in a market Allocatively efficient level of output : level of output where total surplus (consumer + producer) is maximized To left of QE, value to buyer > cost to sellers => efficient to increase output To right of QE, value to buyer < cost to sellers => efficient to reduce output If outputs less than competitive output: Value to buyer > Cost to seller (consumer + producer surplus) = total surplus would increase if output were increased Example (output < competitive output) Value to buyer = $100 Cost to seller = $60 Total surplus would increase by $40 if output increased by one

2 Question: How much, in total, would consumers and reducers pay to prevent this market from shutting down? Answer: Consumer Surplus + Producer Surplus = Total Surplus Application / Review Your brother gives you a "frequent flier" coupon, which allows you to pay $200 less than the regular airfare on any flight you choose to take. The coupon can be used any time, and you often fly. The cost of Toronto/Vancouver airfare is $500 for a regular ticket. You value the trip from Toronto to Vancouver at $400. Should you use the coupon, pay $300, and fly to Vancouver? Explain your answer. Marginal Benefit of Trip: $400 Marginal Cost of Trip: $500 Why is marginal cost $500? $200 coupon has an opportunity cost of $200, since it can be used in other flights Result: Do NOT take trip Insight If coupon could only be sued on the Toronto/Vancouver trip, its opportunity cost would be zero and you should take the trip The government REMOVES a $10 sales tax that had been levied on sellers. TRUE OR FALSE

3 If the market price does not change, we can conclude that the supply curve is perfectly elastic. Answer: False (Market price falls by $10) If P0 unchanged, DD must be perfectly elastic If Perfectly Elastic SS

4 Market price falls by $10 True or False If DD is perfectly elastic, and there is a reduction in supply, consumer surplus will fall. False If DD is perfectly elastic, consumer surplus is zero If DD is perfectly elastic at price of $10, consumers would buy zero if the price were above $10. Consumer Surplus = "willingness to pay" - price = 0 Squid costs $2/kg and octopus costs $1/kg. Jacques buys only octopus and gets 10 units of utility from the last kg he buys. Assuming that Jacques has maximized his utility, his marginal utility (in units) from the first kg of squid must be a) most than 10 b) less than 10 c) more than 20 d) less than 20 e) zero Octopus: Mu0 (last unit consumed) = 10 P0 = 1 MU0/P0 = 10 Squid: NOT consumed => MUs/Ps < 10 Ps = 2 Therefore, MUs (first unit) < 20 (Note: he chose not to consumer even one unit) A Pizza Puzzle A local pizza parlor offers an all you can eat lunch for $3. You pay at the door, and then the waiter brings you as many slices of pizza as you like. A large number of students enter the pizza parlour. As they enter, one half of these students are immediately awarded a "prize" - a refund of the $3. Question: Which group of students (those who did or those did not get the "pizza") does economic theory predict will eat the most slices of pizza? 1. Once student has paid $3 (regardless of whether student obtains refund) P = 0 2. Rational student consumes slices of pizza until MU = 0 3. Prediction: both groups will consume the same amount of pizza The Pizza Problem: Experimental Evidence (Cornell Students) 1. Students who did not receive the refund, on average, ate more slices of pizza 2. The prediction of economic theory (rational behaviour) was false

5 (Why? Perhaps students who did not receive the refund wanted to "punish" the pizza parlour by eating more slices and thus reducing its profits.) 3. Economics is the study of how rational individuals make decisions - but individuals are not rational in all situations. (The study of non-rational behaviour is called "behavioural economics.) Beetles Price Elasticity of Demand : 2 Income Elasticity of Demand : 1.5 (normal good > 0) TRUE/ FALSE If there is an increase in income, price will increase and, since (price) demand is elastic, total revenue will fall. False Since a normal good, demand will shift to right (increase in income), price AND quantity will increase, so total revenue increases TR1 = P1 * Q1 > TR0 = P0 * Q0 Elasticity of demand refers to movements along a demand curve and is NOT relevant when assessing shift in demand curve Downward - Sloping Linear Demand Curve: Elasticity is NOT Constant

MULTIPLE CHOICE. Choose the one alternative that best completes the statement or answers the question.

MBA 640 Survey of Microeconomics Fall 2006, Quiz 6 Name MULTIPLE CHOICE. Choose the one alternative that best completes the statement or answers the question. 1) A monopoly is best defined as a firm that