[SQUEAKING] [RUSTLING] [CLICKING] JONATHAN GRUBER: OK, why
don't we get started? Today, we're going to
come full circle back to the first lecture. So in the first
lecture, we talked by-- we started by drawing
a supply and demand graph. We've now spent
the last few weeks explaining where supply and
demand curves come from. And now, we're going to talk
about the supply and demand curves. What do they know? Do they know things? Let's find out. So, no one? No one on that? AUDIENCE: [INAUDIBLE] JONATHAN GRUBER: OK, thank you. All right. So let's start by talking about
shocking the supply and demand curves. Shocking the supply
and demand curves. That was a BoJack Horseman
reference for those of you who missed that. OK, let's talk about shocking
the supply and demand curves. So let's start with a review of
the supply and demand framework that we introduced
in the first lecture. So let's go back to figure 9-1. We've got the market
for gasoline, OK? On the x-axis is big
Q. Quantity of gas is the market-level diagram. On the y-axis--
the price of gas. And as we said, the first
lecture-- the supply curve that's upward sloping,
representing the fact that higher prices
call forth more supply. We now know where
that comes from. We know that what happens is
when there's a higher price, firms can now afford to move up
the marginal cost curve, which is the supply curve. So we know where
that comes from. We have demand curve,
which is downward sloping. Higher prices lead
to less demand. We know where that comes from. We know that as the
price of a good rises, through both income
and substitution effects for normal goods,
consumers will want less of it, so whenever that comes from. So we now have derived these. And we're back where we
started in equilibrium. So let's actually start
by asking what happens. Let's start by asking,
as we move forward, how do we want to think
about these curves? And the way we
think about them is we want to think about
the demand curve, want to think about
these as willingness to pay and willingness
to supply curves. So think about the demand curve
as a willingness to pay curve. How much are you
willing to pay to get that next unit of the good? Or how much is the market
willing to pay to get the next unit of the good? OK? And the supply curve is
willing to supply, OK? An equilibrium is the point
where consumers' willingness to pay for the next
unit of the good meets the suppliers
willing to supply the next unit of the good. When those are equal,
we're in equilibrium. So that's where we start. Now, let's ask, what happens
as these curves shift? So, for example,
let's take this market and imagine the tastes change. Suddenly, everyone
wants to drive big cars. Everyone wants to
drive SUVs, OK? What does this do to
the market for gas? Well, so what does this do? Well, what it does--
yeah, go ahead. AUDIENCE: SUVs require
a lot more gasoline, so the demand goes up. JONATHAN GRUBER: Yes. SUVs are what we call
a complement as opposed to substitute-- are a complement for gasoline. When demand for SUVs goes
up, demand for gas goes up. So the demand curve
would shift out. So we would end up in a
situation like figure 9-2. But let's talk
through the dynamics. All you would see in the
market is quantity of gas sold would go up from Q1 to Q2. And price of gas would
go up from P1 to P2. Well, let's talk about
underneath, how we get there. What happens is
demand shifts up. People want more
gas, because they want to drive these
gas-guzzling cars. So demand shifts from D1 to D2. What does that mean? That means at the previous
equilibrium price-- if the price didn't
change, if the price stayed a P1, what would happen? Well, we'd no longer
be in equilibrium. Because people would--
firms would still be happy to supply
Q1 units of gas. But people would want
way more than that. We would have excess demand. If the price didn't change,
there would be excess demand. People would want more
than the Q1 units of gas. Suppliers will recognize
this and say, well, if people want more, we're
happy to produce more. But remember, we have to
respect the marginal cost curve and marginal cost of rising. If we're going to
produce more, we're going to have to charge more. We're going to have to
move up the supply curve. So a shift in the demand
curve makes firms move along the supply curve. Want to keep shifts and
movement along curves separate. A shift in demand
curve, meaning people are saying to gas
producers, we want more gas. Gas producers are like, great. We want to give you more
gas, but we're going to charge you more to do it. Because our marginal cost
curve is upward sloping, which is our supply
curve, as we learned. So the price rises. And we need to reach a
new equilibrium at E2. So we don't see these
steps in practice. In the end, we just
see the price change, but think about it as two steps. Demand shifts out,
creating excess demand. Providers, to meet that excess
demand, have to produce more. And to produce more, they're
going to charge a higher price. And that moves you
from E1 to E2, OK? So we have a shift in
demand, which caused a slide up the supply curve, OK? Now, let's think about
a different example. Imagine war breaks out
in the Middle East. Not too hard to
imagine, unfortunately. And as a result, the quantity-- so suppliers need to pay
more to get the oil that they use to make gasoline, OK? What does that do? We see that in figure 9-3. Now, what happens is
for every unit of gas, suppliers need to charge more. Their underlying marginal
costs have gone up, because they have to
pay more to get the oil. That's a variable cost
of production of gas. So their marginal
costs have gone up. Their marginal costs going
up mean their supply curve has shifted upwards, OK? For every unit of production,
their marginal cost is higher, because their
variable costs have gone up. Therefore, they're going
to need to charge a higher price to break even. OK, we're still in perfectly
competitive markets where nobody is
making any profit, OK? They're going to charge
more to break even. So now, let's once again
talk about the dynamics of what's happening. The dynamics are the
costs and the input to the suppliers went up-- oil, OK? Their marginal costs
shifts up to S2. So they want to
charge a higher price. So if we kept the
price the same as it was before, suppliers
would say, we don't want to sell Q1 anymore. We're not interested in selling
Q1 anymore at that old price. OK? That doesn't interest us. Therefore, consumers
want more than providers are willing to sell. And we once again
have excess demand. So in both cases, we
get excess demand. In the first case,
we got excess demand because consumers wanted more. The lower-- the
consumers' tastes shifted, so they wanted
more gas at every price. Now, we have excess demand
not because taste shift, but because costs go up. So providers don't want
to provide as much gas at every price. So what happens is
providers are going to say, fine, we're going to
charge a higher price, OK? And we'll slide up
the demand curve. Because as providers
charge a higher price, people want less gas. At a higher price,
you want less gas through the substitution effect. Because you'll buy other things
instead and for the income effect. Because you're
effectively poorer, because the price
of gas went up. For those reasons, you're going
to shift up the demand curve and reach a new
equilibrium at E2. So that's the
underlying dynamics of how shifts in
supply and demand lead to changes in
quantity and price, OK? So that's basically
what we're seeing. Questions about that? Yeah? AUDIENCE: [INAUDIBLE] JONATHAN GRUBER:
Great, great question. So what's the answer? What's the substitution
effect with gas? AUDIENCE: [INAUDIBLE]
not driving. JONATHAN GRUBER: Well,
you've answered yourself. It's not driving. It's taking the bus. It's driving less. It's walking or
taking your bike. So once again, when everything
about substitute effects, you want to think about
the next opportunities you could use instead, OK? Good question. Other questions? OK, so here's an
interesting point. Look at figure 9-2 and 9-3. In both cases, the
price went up, OK? In both cases,
the price went up. So we can't tell. If a price goes up, you
can't tell from that alone whether there was a
shift in demand or supply. So if I, for example, asked
you on an exam or your mom came home. Your mom asked you, hey,
if the price goes up, does that mean demand
shift or supply shifted? You say to your
mom, I don't know. I can't tell with
just that information. I need to know what
happened to quantity, too. OK? And then you say your
mom, good question. OK, so let's go
through the reasons why the supply and
demand curves shift. So why do curves shift? OK? Well, on the demand
side, there's at least six reasons why
demand curves would shift. So why do demand curves shift? OK, one reason is tastes change. I just used that reason-- tastes change. OK, people want
different things. OK? A second reason is
that income changes. Second reason-- because
people are richer or poorer. And so that makes them
want different quantities, even with the same tastes. A third reason is the
change in the price of a complementary or
substitutable good, OK? Now, that's different. I should separate. The actual example
before was this. Taste change is
slightly different. So change in price [INAUDIBLE]
is what I talked about. Taste change would be
literally for everything held being equal, I just wake
up one morning psyched to drive. That'd be a taste change, OK? So really, the example
I used was a change in the price of complimentary-- no, no, price didn't change. No, I go back. I go back. The example I used
was a taste change. People wanted more SUVs. But at the same time,
imagine a different change. Imagine that we're looking at
the demand for babysitters. And the price of
movies goes up, OK? Well, movies are complementary
with babysitters. You guys don't worry about this. You don't have kids
yet, but trust me. Movies are complement
to babysitters, that basically the more
you go to the movies, the more you need babysitters. So if the price
of movies goes up, that's going to lower my demand
for babysitters or vice versa. Imagine that how a change
in the price of movies affects the demand for Netflix,
while those are substitutable. As the price of
movies goes up, I'm going to want more Netflix
and less babysitters. So change in price of
complementary substitutable goods will also affect
my demand curve. Another thing that could
affect the demand curve is a change in the market size. So we will talk in
a couple lectures about international trade. If suddenly you're selling
goods to a much larger market, that will affect the
demand for your good. So preference haven't changed. Price haven't changed. You just suddenly got a
bunch of new customers. That will affect demand
for your good, OK? And the last thing that could
change, the most subtle way demand could change is
expectations of the future. So for example, imagine
you expect the price of gas to go up tomorrow. You might buy more gas today. And that'd be weird. [INAUDIBLE] look,
nothing changed today. Your taste didn't change,
prices-- nothing changed, but people buy more gas. What's going on? It's that they expect the
price to change in the future. So expectations of the
future can actually drive demand today, OK? We've all-- experiences in
various aspects of our lives, OK? So those are the reasons why
the demand curve can shift. There's a lot of reasons why
the demand curve can shift. For the supply curve, why
the supply curve shifts is much simpler. There's really only
two reasons, OK? One reason is changes
in input costs. And the second is a shift in
the technology and production. So the production function
changes or input costs change. That's pretty much why
supply curves shift, OK? So that gives you a
catalog of how to think about these curves shifting. I have a fun example
in the videos that go with this class,
which is that we all know Kim Kardashian is-- you may or may not know
she has more Instagram followers than there
are people in France. She got 80 million. It's up to about 100-plus
million Instagram followers. Kim Kardashian, a few
years ago, tweeted out a picture of herself in an
exercise corset, she called it. She basically
claimed-- a corset is this thing they used to
wear back when we didn't care about women much at all. And we just made them wear these
incredibly constrictive things to make them look skinnier, OK? They're basically
like a brace you'd wear to make you look
skinnier back in the old days. And Kim Kardashian
said, actually, if you wear a corset
when you exercise, it helps you lose weight. Well, actually, she's
totally fucking wrong, OK? It doesn't, OK? There is no-- it does
not help you lose weight, but she tweeted this out. And there was a massive increase
in demand for exercise corsets, OK? And the one company that made
them made scads of money. There was a huge demand shift
based on this Kim Kardashian tweet, OK? So tell me what happened next. Yeah? AUDIENCE: [INAUDIBLE] JONATHAN GRUBER: More
companies entered, OK? So what happened
was profits were being made on exercise corsets. So more companies started
making exercise corsets. And they came in and drove
those profits down, OK? So that's a classic
example of how demand shift and how the market
in the long run will respond to return
us to zero profits. Zero profits in the long
run-- in the short run, some corset companies
made a lot of money. They should-- they owe, Kim, OK? But in the long run,
profits go to zero. Yeah? AUDIENCE: With the expectations
where the demand curve shifts, is that when companies--
you're like, oh, there's these coupons for
limited kind of sales? Would that be an
example of demand? JONATHAN GRUBER: Yeah. And anything where you
basically-- well, no. But once that's on,
that's a price change. A limited time sale for good
is literally just a standard to price changed, OK? It's you think the sales are
going to happen in the future, so you buy less today. That's the expectations, OK? So that shifts in
demand supply curves. Let's now talk about what
determines the shapes of supply and demand curve. Now, what determines the shapes
of supply and demand curves? OK? So basically, the effect-- not what determines the shapes. We already talked about
what determines the shapes. We want to talk about the
role, the shapes the supply and demand curves play. Let me rephrase that. We already know what
determines the shapes. We covered that in the last
10 lectures or whatever. Now, we're talking
about the role that shapes play as
demand curves shift. So for example, let's
think about a [INAUDIBLE].. Figure 9-3 shows what
happens with a supply, the figure we're
just looking at, OK? Figure we're just
looking at, figure 9-3, shows what happens
when the supply shift with a standard downward,
sloping demand curve, OK? Which is that the price
goes up, quantity falls. However, imagine, instead, we
had perfectly inelastic demand. So, for example, for insulin. Then what would happen? Well, figure 9-4 shows if
demand is perfectly inelastic, quantity won't change. So if there's a supply-- if there's a shock that
shifts up the supply curve like war in the Middle East. So this is the question here. Why wouldn't gas
just be perfectly inelastically demanded? In fact, in the short
run, gas is actually pretty inelastically
demanded, OK? It's not perfectly inelastic,
but is pretty inelastic, OK? So in that case, you would
see just prices going up, and quantities wouldn't change. Now, in the long run, do we
think the elasticity for gas will be higher or lower in
the short run, the demand elasticity for gas? AUDIENCE: Higher. JONATHAN GRUBER: Higher. Somebody raise their
hand and tell me why. Somebody raise their
hand and tell me why. Somebody else besides people
who always answer questions. Yeah? AUDIENCE: People can shift
towards electric cars. JONATHAN GRUBER: Exactly. In the short run, all
you can do is drive less. And we got to drive to
work and stuff like that. And in the long run, I
can buy a different car. So this is an
example of long run versus short run, how it can
affect these elasticities, OK? Now, let's think instead about
a perfectly elastic demand, the demand for-- I don't know-- chachkies in a
market or something like that, OK? Perfectly elastic
demand in figure 9. It's always hard
to think of markets with perfect elastic demand. It's easier think
about firms that have perfectly elastic demand. It's hard to think
about markets. But think about a market
for a certain kind of candy with another kind of candy
that's just as good, OK? So those are markets, which are
fairly elastically demanded, OK? There you see when the supply
shifts, price doesn't change, only quantity does. And why is that? That's because demand
is probably elastic. You can change the price. If you try to raise
price by one penny, you'll lose the entire market. If you lower the
price by one penny, you gain the entire market. And then your
profits will go away, because your marginal cost
will be through the roof, OK? So with perfectly
elastic demand, you're going to get prices
fixed, but only quantity changes, OK? So basically, that's how we
think about these extremes. The bottom line is that's how
the shapes of supply and demand will affect the
response to shocks, OK? The more elastic is demand,
the more price shock will come through in
quantity and less in prices. The more inelastic is
demand, the more supply shock will come through in prices
and not in quantity, OK? Any questions about that? OK. So now, let's go on to what
we can do with these supply and demand curves. So now, we're the masters
of supply and demand curves. We know where they come from. We know why they
shape the way they do. We know what happens
when they shift. And we know what happens
how that shift depends on their shapes. So we own supply
and demand curves. Now let's go, what
can we do with them? And what we can do
with them is use them to take the next
step in this class from positive to
normative economics. So far, this class has
been completely focused on positive economics. Why do firms behave
the way they do? Why do consumers
behave the way they do? And we haven't talked at
all about whether it's a good thing or a bad thing. Well, we need a new
set of tools if we're going to move from
positive economics about why things--
the way things are to normative economics about
the way they should be, OK? And those set of tools-- we're going to derive from
supply and demand curves. And this is
critically important. Because, for example,
let's take where we ended the last lecture-- or the last lecture,
I think, talking about how with perfectly-- or
in the middle of last lecture, talking about in a perfectly
competitive market under a set of assumptions, all firms-- a
zero profit in the long run, OK? So you buy that. But you have to ask yourself,
is that a good thing or a bad thing? Is zero profits in the
long run good or bad? Well, on the one hand,
firms are cost minimizing. That's good. On the other hand, why would
anyone start a business? In the long run, they're
going to make no money. That's bad. So how do we think about
trading those things off? How do we think
about whether it's good or bad to have
long run zero profits? OK? This is the question. This set of questions
is what we turn to with the notion of
welfare economics. Welfare is going to be used
in two senses in this class. Mostly when I say
welfare, I'll mean as a measure of well-being. Mostly when I say welfare, I
mean welfare is well-being. Sometimes we say welfare. We mean cash payments
to poor people. That's welfare payments. That's not what I mean,
usually, when I say welfare. I'll try to distinguish
when I mean the other thing. When I say welfare,
I don't mean the way it's used in the
political debate, meaning cash payments
to poor people. I mean welfare is a
measure of well-being. And welfare economics is the
tools of normative analysis. The tools of welfare
economics are the tools of measuring well-being. And we're going to
start by talking about the concept
of consumer surplus. It's going to be the
first thing we're going to use when we talk about
welfare economics is consumer surplus, OK? Now, if we want to
measure well-being, however, we have a problem,
which is, how do you measure how happy I am? My utils But utils don't exist. So we've got a fundamental
challenge here, which is our indicator
of well-being is utility function, which
isn't a real thing, OK? We use it to derive decisions,
but we don't actually have a measure of
well-being that gives real meaningful inputs. So what do we do? We do a clever thing economists
thought of a long time ago, which is to use the concept
of compensating variation. The concept of
compensating variation. What does that concept-- means? That means instead of asking you
how happy you are, I ask you, how much would I have to
pay you to become less-- to become sadder? Or how much would you be
willing to pay to be happier? So I can't measure margin
utility in dollars. But I can measure
how many dollars you would pay to buy the
next good or how many dollars you'd pay me not to be
punched or whatever, OK? I can basically
measure those things by essentially asking
you, how much would you pay to be better off? Or how much would you be willing
to pay not to be worse off? And those are what we called
a compensating variation. We measure your well-being
by the money equivalent that you give to us in
expressing your preferences. And what we can then
define consumer surplus-- we'll define consumer
surplus, which is our first measure of
normative welfare economics, as the benefit that a consumer
gets from consuming a good, above and beyond the
price of that good. The benefit that a consumer gets
from consuming a good, above and beyond what they
paid for that good. That's consumer surplus. Surplus means extra, right? So it's your extra. It's how much more you
get than what you actually pay to get the good in
the first place, OK? So basically, consider my
daughter's demand for songs by Kendrick Lamar, OK? And to make life easy, let's
say this is pre-streaming and songs cost $1, OK? So she wants songs
by Kendrick Lamar. So that's actually-- yeah, she
wants songs by Kendrick Lamar, and there's no streaming. And the songs cost $1. So if my daughter is willing
to pay $1 for a Kendrick Lamar song and it costs $1, then
her consumer surplus is zero. The benefit she gets
from the song is $1. It costs $1 to hit zero. But if she was willing to pay
$2 for a Kendrick Lamar song and it only cost a $1, then
she's got $1 in surplus, OK? So basically, the key thing
is to define consumer surplus, we need two things-- the price and the
willingness to pay. Well, how the hell do we
get willingness to pay? Where does that come from? Someone raise their
hand and tell me. Yeah? AUDIENCE: Demand. JONATHAN GRUBER:
The demand curve. We already defined it. We already defined what
willingness to pay is. It's the demand curve. So consumer surplus is
simply defined as the area below the demand
curve, above the price. Because that tells you. The demand curve tells
you how much you're willing to pay for each unit. The price you face tells
you how much you had to pay. So any gap between them
is consumer surplus, OK? So let's go to figure 9-6. Let's do my daughter's demand
for Kendrick Lamar songs, OK? Let's say that her
demand is such that-- now, once again,
the trick here is we've drawn a
continuous demand curve. It's a discrete decision, so
bear with me-- the numbers. Bear with me, just
think about this. But roughly speaking,
she's willing to pay for the first Kendrick Lamar
song between $4 and $5, OK? For the next
Kendrick Lamar song, she's willing to pay
between $3 and $4 and so on. So this gives you--
so to make life easy, let's imagine she's willing to
pay $4 for the first Kendrick Lamar song, $3 for the
second Kendrick Lamar song, $2 for the third
Kendrick Lamar song, and $4 for the first
Kendrick, and-- I'm sorry-- $1 bucket for the
fourth Kendrick Lamar song, OK? So imagine that's
basically her demand curve. It's not quite that discrete,
but we can make it stepwise if you want-- just be ugly looking, OK? So that's her demand curve. So what does that mean? That means when she buys the
fourth Kendrick Lamar song, when she buys King Kunta
or whatever, that is zero surplus, OK? Zero surplus. She was willing to pay $1 for
"King Kunta," and it cost $1, so she's done, OK? However, what does that mean? That means when she
bought "Humble," which was her first choice
song, she gained a surplus. Because she paid $1 for that. But she was willing
to pay $4 for it. So she gained a surplus. And the surplus
is the difference between what she paid,
which is represented by the horizontal
line and a dollar, and what she was
willing to pay which is the main curve, which is $4. So she gained that surplus. Yeah? AUDIENCE: Let's
say as her father, you want to get her a gift-- all these Kendrick Lamar songs. And let's say it's special. I don't know-- $2,
something like that. Would the consumer
surplus be what you think she would want out
of it or what she-- JONATHAN GRUBER: Let
me come back to that. It's a great question. There's a famous
article about that. And I'll come back to
that in one minute. Let me finish this. The bottom line is
the surplus there is between what she was willing
to pay and what she had to pay, which in a continuous example
is this entire triangle. Think of being able to
buy fractions of songs-- little bits, ringtones
or whatever, OK? Fractures of songs, OK? Then this entire area under
the curve, above the price is her surplus. She was willing to pay
the points on the curve. She only had to pay
the flat line at $1. So the entire difference
is her surplus, OK? The key point is
this is all driven by diminishing margin utility. That is the reason her surplus
goes to zero eventually-- is eventually gets tired
of Kendrick Lamar songs, so it goes down. We have diminishing margin
utility for the songs. And that's why we get consumer
surplus as a triangle. It's the difference between
the downward sloping demand curve and the flat price line
that the consumer faces, OK? So the individual consumer
surplus-- individual consumer surplus, OK? It's her demands-- that
individual graph, OK? Individual graph. Her demand is downward sloping. And therefore, her
surplus difference between is the area under the demand
curve, above the price line. Yeah? AUDIENCE: If demand is
perfectly inelastic, is it infinite consumer circle? JONATHAN GRUBER:
Let's talk about that. Let's talk about-- actually,
I don't have it here. If demand was
perfectly inelastic, you're absolutely right. The consumer surplus
would be infinite. Because the area
under the demand curve above the price
line would be infinity. It'd be a rectangle
going up to infinity. Why is that? Why is the consumer
surplus infinite if demand is inelastic? AUDIENCE: Because they'd
pay anything for it. JONATHAN GRUBER: Because
they'd pay anything for it. So at any price, it's a bargain. In theory, if you're an
incredibly rich diabetic, you would pay an infinite
amount to have insulin. So at any price, you're
getting huge surplus. You're getting infinite surplus. Infinitely minus
anything is infinity. Likewise, what's
the consumer surplus if demand is perfectly elastic? Same person. AUDIENCE: Zero. JONATHAN GRUBER: What? Zero. Why? AUDIENCE: [INAUDIBLE] JONATHAN GRUBER:
That's graphically why. But intuitively, why? Why do you get no
surplus from a good where demand is fairly elastic? AUDIENCE: [INAUDIBLE] JONATHAN GRUBER: What makes a
perfectly elastic demand curve? AUDIENCE: [INAUDIBLE] JONATHAN GRUBER: Because-- why? Because there's substitutes
that you're indifferent towards. That's what gets the
perfectly elastic demand. So if I'm indifferent
between Jujyfruits-- god, you guys probably
don't know Jujyfruits. If I'm indifferent between-- God, I don't even know
what candy is anymore. Whatever. If I'm ever eating candy
A and candy B, and then I get no surplus for
consuming candy A, why? Because I'm equally
happy with candy B. So candy A gives me no surplus. What does the candy people eat? What do people eat? AUDIENCE: Jolly Rancher. JONATHAN GRUBER: What? AUDIENCE: Jolly Rancher. JONATHAN GRUBER: Jolly Rancher. I love Jolly Ranchers. AUDIENCE: M&M's and Skittles. JONATHAN GRUBER: OK. Well, no. But that's irrelevant, 'cause
Skittles are just disappointing M&M's. Let's be honest. When you get Skittles, you're
just pissed off they're not M&M's. Am I right? I mean, Skittles are
just disappointing M&M's, so we can't do that one. Let's do Jolly Ranchers
versus Skittles, maybe. Those are more comparable. Because M&M's are
better than everything. So basically, Jolly Ranchers
and Skittles-- since I'm indifferent to Jolly
Ranchers and Skittles, I get no surplus
eating the Skittles. Because I would equally
happy having a Jolly Rancher. So surplus is zero for a
perfectly elastic demand and good. It's infinite for a perfectly
inelastically demanded good, OK? Now, let's go back
to the question. There's a famous article
in economics called the "Deadweight
Loss of Christmas--" we're such an awful profession-- based about how
terrible gift-giving is. And why is gift-giving terrible? Because if you gave
people cash, they could get what
they want the most. But if you give
them a gift, it's by definition, lower
surplus than the cash. Because they could always
go out and buy that good with the cash. So by definition,
giving someone a gift makes them worse off than giving
them that same amount of cash. So this guy-- is he
interviewed all the students. I think was at Penn State. And he asked them how much their
parents' presents really worth to them. And he found the deadweight
loss of Christmas is hundreds of
billions of dollars. People would way rather
have cash than the parents-- but what did he get wrong? What did he get wrong? Why is that not
necessarily a bad thing? Yeah, you asked the first
question, so go ahead. AUDIENCE: You like the
surprise of opening a present. JONATHAN GRUBER: Maybe. But even ignoring that,
what else did he get wrong? Yeah? AUDIENCE: It's an emotional
connect if something my grandma bought me a-- JONATHAN GRUBER: That's
like the surprise. There's emotional connections. That's all well and good,
but that's not very big, OK? What's really big
that he missed? AUDIENCE: Because the
person who buys it-- they saw what they get from it. JONATHAN GRUBER: Yeah, he
missed the fact the person who gave it gets
utility from giving it. So in fact, the package
may be efficient, because you like the surprise
and the person gets utility. But if compare it to
dollars, it's inefficient. So it's a clever, clever
little exercise he did. OK, so basically, that's
individual consumer surplus. But in this course, we don't
care about individual consumer surplus. We care about market
consumer surplus. So let's turn to figures 9-7
and think about a market. Let's see about
the market for gas. Now, the mechanics
is the same here. But we're actually
now thinking not about the individual buying
1 gallon versus 2 gallons, but the market for gas. How many gallons in
aggregate will be bought? But the analysis is the same,
that basically the willingness to pay for gas is the demand
curve for gas, the market demand curve for gas. The price is the price. So the difference is the
area under the demand curve above the price. The idea here is for consumers
all the way to the left, they have to drive to work. They have to drive. They have to drive a lot. They're truck
drivers or whatever. They have to drive a lot. So for them, they have a huge
willingness to pay for gas. So they make a huge surplus. The more you want
something at a given price, the more surplus you get. Whereas you move to
the right, that's people who need to
drive less and less. Once you pass point A,
why does surplus go away? To the right of point A, why is
there no more consumer surplus? Yeah? AUDIENCE: [INAUDIBLE] JONATHAN GRUBER:
Didn't happen, because? AUDIENCE: Because [INAUDIBLE]. It's beyond. JONATHAN GRUBER: Your
willingness to pay is below the price, right? So a transaction-- so consumer
surplus can't go negative, but when negatives
just wouldn't buy it, especially with negative
consumer surplus, OK? When negative, you just
wouldn't buy it, OK? But as you get closer
and closer to A, then you actually do end up with
consumer surplus going to zero, OK? So that's the market
consumer surplus. So let's ask. Let's talk about a couple of
aspects of market consumer surplus. First question-- what
happens to consumer surplus when the price changes? Let's show that in figure 9-8. Let's say the price of gas goes
up from $3 to $3.50 a gallon. Consumer surplus
shrinks by a trapezoid. Consumer surplus used to be the
entire area below the demand curve. It used to be the entire area
is below the demand curve and above $3. It used to be that
whole triangle. Now, it's just
the empty triangle above the new price curve
and below the demand curve. So the new consumer surplus
is just the area above $3.50 on the main curve, so it's
the area not shaded in. What you've lost
is the trapezoid, that on the y-axis goes between
$3 and $3.50 and then along the line, goes from A to B. You've lost that trapezoid. Why is it a trapezoid? Why is the loss-- consumer
surplus a trapezoid? Because two things
have happened. What are the two things
that have happened that have reduced your consumer surplus? Get some more folks involved. Folks, go ahead. AUDIENCE: The quantity
supplied goes down as well. JONATHAN GRUBER: Well, not
just quantity supplied. Quantity sold goes down. Because you want less
supply, because you are-- so the first thing is
because the price gone up, you want less. That's the triangle you lost. You have given up units that
you used to get surplus on, used to derive surplus in all
the units from 900 to 1,000. So what happened here
is the price goes up. And a hundred fewer
people buy gas. That's the way
I've labeled this. That could be
people buy less gas. Let's make it easy. A hundred people buy gas. So a hundred people used to
buy gas, no longer buy gas. They're out of the gas market. They bike instead, OK? Now, they clearly were
not that sad to bike, or they would've had a
huge surplus from gas. But they're a
little sad to bike. It's a crappy day out. They rather be driving. And so they lost
surplus from the fact that now at the higher price,
they have to bike instead, but it's a little
bit of surplus. It's just a little triangle, OK? So there's a little
bit of surplus lost. Because some people who
were close to indifferent now have to bike
instead of driving. But why the big-- what's the big rectangle? Same person. What caused the big rectangle? AUDIENCE: The increase in price. JONATHAN GRUBER: Increase
in price for who? For the people who were
already buying it anyway. So the big losers
are the people who are going to drive
anyway and now just have to pay more for it. Because here's the key point. The people between A and B-- the last hundred people-- they were pretty
close to indifferent. They didn't lose that much
surplus from not driving. All the people to the
left of person 900-- they get big surplus
from driving. So their surplus simply
went down by this rectangle. They used to get the
difference between the demand curve and $3. Now, that's the difference
the demand curve and $3.50. It's just a pure loss. So when you raise a price,
the existing-- the people whose behavior doesn't
change are worse off. Some of those behavior change. They're a little worse
off, but not that much. So the triangle is small. The rectangle is big. The big loss is the
people who like gas a lot, but now have to pay
more for it, OK? Point one. Point two-- what determines
whether consumer surplus is large or small? Well, we cover this. It's elasticity of
demand, determines whether consumer surplus
is large or small. So, for example, figure 9-9
takes the gas market with a price of $3.00 and a thousand
people buying gas and uses two-- shows two
different demand curves, both of which go
through point A. So both demand curves yield
the equilibrium price of $3.00 and the equilibrium
quantity of a thousand, OK? So these two different
demand curves are just two different sets
of preferences, both of which yield the same
equilibrium outcome. And yet, under the
steeper demand curve, the consumer surplus is larger
than under the flatter demand curve. And that's for the
reason we talked about. That's for the reason. That's because with
a steeper demand curve, the more
inelastic demand, people want the good more. They basically-- they're
less willing to give it up as the price goes up. Therefore, at any price, they're
making more surplus off it. With a flatter
demand curve, people are basically closer
to indifferent with some other good. So they're not so sad
if the price goes up. Their surplus is smaller
from getting this good. They're seeing what
they were willing to pay and what they have to
pay is smaller, OK? So that's how we think
about consumer surplus. It's basically the excess
of your willingness to pay above what
you have to pay. So if the price goes up,
your surplus goes down. And surplus is larger, the more
inelastic is the demand curve. Yeah? AUDIENCE: [INAUDIBLE]
producers would want it, but consumers are having a zero
surplus, if that makes sense? Because they're at the point
where not only paying more, but they're selling
as much as they can? JONATHAN GRUBER:
Great question we'll talk about when we
talk about monopolies. Right now, why can't
producers do that? Why can't producers
exploit that? Because perfectly-- yeah? AUDIENCE: [INAUDIBLE] JONATHAN GRUBER: Exactly. That's a perfect answer to a
perfectly competitive question. Because they're
price takers, OK? So they can't do an
exploiting of consumers. They don't have that choice. Starting next lecture
or one lecture after, we'll talk about monopoly. Then they're price setters. Then they'll start
thinking about that. But right now, they can't,
because their price takers. AUDIENCE: [INAUDIBLE] JONATHAN GRUBER: I mean,
ultimately, that's what-- yeah, ultimately, they'd like to-- the surplus is just extra
money somebody has got. If you're a business owner,
why should consumers have it? You want it, OK? So that's consumer surplus. Any other question
about consumer surplus? OK. Now, let's move on. And let's talk about
producer surplus. Let's talk about
producer surplus, OK? Now, the idea here is the same. Consumer surplus
was the difference between the willingness to
pay for a good and its price. Producer surplus
is the difference between the willingness to
supply a good and its price. And how do we measure
willingness to supply? The supply curve. So as figure 9-10 shows, the
producer surplus for any given firm-- firms have an upward
sloping supply curve. And the market is
delivering them some price. So let's think about this firm. When they produce the first
unit-- this is a gas production firm, OK? A gas refiner, say. When they refine that
first gallon of gas, that costs them almost nothing. Because margin cost
is upward sloping. They've already
paid the fixed cost. They don't care
in the short run. So all I care about
is variable costs, OK? So at the end of the day,
this is not expensive. They are willing to produce that
first gallon really cheaply. They've already invested in
this giant refinery plant. Marginal costs are tiny. So they get a huge-- but at
the same time you pay them, you don't differentiate
what you pay per gallons. You plug the thing into your
car and you get the gas, OK? So they're getting $3 a gallon,
but they're not paying much to make that gallon. However, as they
make more gallons, their marginal cost increases. So the surplus they earn on
each gallon produced shrinks. The surplus they earn at
each gallon produced shrinks. And so eventually,
they get to a point where they are essentially
indifferent about producing the next unit of gasoline. That's at a price of
$3 and a quantity of-- should be little q, OK? That's the point
at which they are indifferent between producing
gas and not producing gas. Therefore, their
surplus is zero. So producer surplus
is the difference between the price line. And the upward sloping supply
curve is produced surplus. Now, in the long run,
we have a name for that. It's called profits, OK? So our consumer surplus is this
abstract, weird, theoretical concept. Produced surplus-- you
can get your hands around. It's profits. Basically, remember,
in the long run, marginal cost equals
average cost, right? Because in the long run, you
produce until marginal cost equals average cost. Therefore, the supply curve
is the average cost curve. Price minus average
cost is profits. Therefore, producer
surplus is profits. Let me say it again, a little
three-line proof for you. OK, in the long run, marginal
cost equals average cost. Second, the supply curve
is the marginal cost curve. Therefore, it's the
average cost curve. Third, profits is defined
as price minus average cost. Fourth, profits is
the shaded area. Now, in the short run,
that's not quite right. Because there's the whole
shutdown decision, which makes things awkward. But roughly speaking,
it's not terrible to think about producer surplus
as being profits. That's a shorthand
that largely works. If it ever doesn't work,
we'll let you know. But that's the shorthand. It should largely work, OK? Now, of course,
once again, we don't care about individual
firm's producer surplus. We care about the
market producer surplus, so let's go to figure 9-11. Figure 9-11 is basically
the market surplus curve. And the idea here is that
essentially to the left, you have a market supply curve
where basically, remember, the individual firm's
supply curve is always flat. But the market supply
curve doesn't have to be. It doesn't have to be flat, OK? The market supply curve-- well, no, let me back up. A market supply curve is
flat under a certain set of conditions. But now, let's imagine that
those conditions aren't true. For example, let's go back to-- I talked at the
end of last lecture about heterogeneous firms. Remember, we talked
about the cotton example. Some firms are more efficient
producers than others. If all firms are
identical and it's very competitive, of course,
the market supply curve is flat. So this graph would
be uninteresting. But in fact, imagine that
firms aren't identical. Some firms are more efficient
producers than others, OK? For example, in that
case, what you'll see is the most efficient
producer will earn the most surplus,
i.e., the most profit. They're all the way to the left. As you move to the
right, you're getting to less and less
efficient producers, OK? So profit is shrinking. So under the conditions
we started with last time, then price would
always equal supply. It'd be a flat supply
curve at the price and therefore, profits are zero. That is producer
surplus is zero. So we derived-- towards the end
of the last lecture, we said, in the long run, a perfectly
competitive market-- profit is zero. That's the same as saying
producer surplus is zero. And why is that? That's because in that
case, the price line is on top of the supply curve. Therefore, there's
no gap between them. So in the long run, a
perfectly competitive market-- there's zero produced of
surplus, means zero profit. In reality, we talked
about conditions why there would be an upward
sloping, long-run supply curve, like firms different,
how efficient they are. Or there's barriers
to entry, which means some firms can't come
in and drive profits to zero. Or there's an upward
sloping input price curve, meaning that basically the
more you want to produce, the more you have
to pay workers. For all those reasons, the
supply curve slopes up. And therefore, you can
get a producer surplus. You can get some profits,
even the long run, OK? So basically, what
we have here is a situation where as long as
the supply curve slopes up, you get a long-run
producer surplus, which is the difference between
the price and the supply curve, OK? And that is the same as profits. Questions about that? OK, let me cover one last point. Going back to last
lecture-- going to have time to get to your last lecture. Remember, we talked about three
reasons why, in the long run, even in a competitive
market, supply can slope up. We talked about
heterogeneous firms. That is firms with
different levels of efficiency of production. We talked about
barriers to entry. That is reasons why firms
can't enter and drive profits to zero. Because it's not
costless to enter. And we talked about upward
sloping, input supply curves. We talked about the fact
that as you produce more, you might have to pay
more for your inputs. And therefore, you
can't just charge when-- you have to charge higher
prices as you produce more. I want to highlight something
I said quickly last time, the difference between
these two and this one. In these two, there are profits. In these two, there
are profits, OK? Because in each of
these, there are reasons why the
market will not drive every firm to zero profit. Some firms remain in-- much
like Pakistan made profits on their cotton sales. Some firms remain in. Likewise, with the
barriers to entry, the firms that are
in the market that have gotten over those
barriers will make money, OK? In this case, the firm doesn't
necessarily make money, OK? What it does here
is it just pays. It takes that extra money and
pays it out to workers, OK? So whether or not an upward
sloping supply curve, doesn't necessarily mean
the firm makes profit. It could just be upward
sloping, because their input costs are rising, OK? So that's an important
distinction to keep in mind. So let's stop there with
that mind-blowing insight. Let's stop there. And we'll come back. And we'll talk more
about welfare economics.
