Econ 101(Section 8X)

Lecture #8
Oct 4, 2021
Idea of Market Failure (Review)
Problem Session #3
Market Power (Introduction)
Next Week: Monday (Oct 11)
• Canadian Thanksgiving (Holiday)
• Instead, Monday’s class will be on Tuesday, Oct 12 (Regular Tuesday
classes will be cancelled at Columbia College)

• Join Zoom: Special Tuesday Meeting (Thanksgiving)

• Time: Oct 12, 2021 08:00 AM Vancouver
• https://columbiacollege.zoom.us/j/68145627357
What you need for today’s class

• 1. Paper and pen

• 2. Calculator
• 3. Downloaded (and printed out) copy of PS#3
(Market Failure)
Microeconomic Debate
Adam Smith Public Interest
• Don’t interfere in the market (laissez- • Demand can be wrong (tastes
faire) aren’t truly reflected), Supply can
• Demand and Supply are how be wrong (some costs are
consumers and owners of resources external to producers) and some
talk to each other to move resources to
their best use
companies have market power
• Interference blocks the message (kills • Market prices may not necessarily
the messenger) and we have to use direct resources to their best use
non-market allocative mechanisms • Government can and should
(with their drawbacks of black markets
& corruption) and some resources are correct the market and eliminate
misdirected to less valuable uses inefficiencies created by the
(DWL). market
Notice how economists make an argument…
• Is it a good idea to interfere in • What happens if we bring in a
the market (with a ceiling, floor, ceiling or floor when the market
etc.,)? is correct?
• What happens if we bring in a
• Build a simple mathematical ceiling or floor if the market has
model (D & S curves) failed?
Adam Smith Public Interest (Market Failure)
• Market can overproduce a product
• Ceilings & Floors reduce QTRADED below (Tastes are confused or costs to
Qe and resources are moved from society not taken into consideration)
best use to a less valued use (DWL) Ceilings and floor can reduce
production to its optimal level thus
eliminating the waste caused by the
overproduction and creating a net
gain for society
Types of market failure for PS #3

• Consumers lack self-control. If left • Producers think only about their own
free to make their own decisions, profit and neglect the external cost
consumers will buy too much (True they are imposing on others in society
demand is less than visible demand) (True cost is higher than costs that
• Examples: Drugs, Cigarettes, Junk producers react to)
food, etc., • Examples: Air pollution, Noise
pollution, Bad smells, etc.,
True Demand less than Visible Demand True Supply less than Visible Supply
• True CS: A-DH • CS: ABCD
• PS: CDE • True PS: F-CDE
• True Gains from Trade: ACE-H • True Gains from Trade: ABF-E
PROBLEM SESSION #3
ADAM SMITH
1. Let Qd=60-6P and Qs=4+2P
a. What is equilibrium P & Q? What is total expenditure by
consumers? Total revenue received by producers?
b. What is the consumer surplus (in dollars)? (The area under the
demand curve minus the total expenditure). Show this area in a
diagram.
c. What is the producer surplus (in dollars)? Show this area in a
diagram.
d. What is the total gains from trade (in dollars)? Show this area in
a diagram.
• a. Set Qd=Qs, 60-6P=4+2P,
8P=56, Pe=7, Qd=Qs=18
• Consumer
expenditure=Revenue= BC = PQ
=7(18)=126
• b. CS= A = 3(18)/2=27 (set
Qd=0=60-6P, P=10)
• c. PS = B = 7(18+4)/2=77
• d. Total Gains = CS+PS=104
2. What happens if the government sets a price floor at P=$8.
a. What is the quantity traded? What is the total expenditure by
consumers? Total revenue received by producers?
b. What is the consumer surplus (in dollars)? Show this area in a diagram.
c. What is the producer surplus (in dollars)? Show this area in a diagram.
d. What is the total gains from trade (in dollars)? Show this area in a
diagram.
• 2a. Qd=60-6(8)=12,
Qs=4+2(8)=20 min[12,20]=12
• b. CS= A = 2(12)/2=12
• c. PS = BDF, To find the “black
market price” set 12=Qs=4+2P,
P=4, then BD=4(12)=48,
F=4(4+12)/2=32, PS=48+32=80
• d. Total Gains = CS + PS = ABDF =
12+80=92
3. What is the difference between equilibrium and the price
floor?
a. Are the consumers happier or less happy? By how much
(in dollars) Show this area in a diagram.
b. Are the producers happier or less happy? By how much
(in dollars) Show this area in a diagram.
c. What is the change in total gains (in dollars). Show this
area in a diagram.
• 3a. ∆CS= -BC = -1(12+18)/2=-15
• b. ∆PS= B-E = 1(12)-3(6)/2=3
• c. DWL = -CE = -4(6)/2= -12

Equilibrium Floor ∆
CS ABC=27 A=12 -BC=-15
PS DEF=77 BDF=80 B-E=3
Total Gain ABCDEF=104 ABDF=92 -CE=-12
MARKET FAILURE
4. Suppose the true demand is Qd’=36-6P but when consumers buy
the item, they act as if Qd=60-6P.
a. What is the TRUE consumer surplus (in dollars) if people buy the
amount that is your answer to #1a? (The area under the true
demand curve minus the total expenditure in #1a). Show this area
in a diagram.
b. What is the TRUE producer surplus (in dollars). Show this area
in a diagram.
c. What is the TRUE total gains from trade (in dollars)? Show this
area in a diagram.
• 4a. True CS = Area under True D (red)
minus revenue at equilibrium Q (18)
• Area under True D = BCEF =
18(6+3)/2= 81
• (to find 3 set 18=True D=36-6P, P=3)
• Revenue= ABCDEF = 7(18)=126
• True CS=81-126=-45
• Also, True CS=-AD = -18(1+4)/2 = -45
• 4a. True CS = -AD = -45
• b. PS = ABE = 7(4+18)/2=77
• c. True Total Gains = CS + PS = -45 + 77 =
32
• OR –AD+ABE = BE-D
• BE= (Set true Qd=Qs, 36-6P=4+2P, P=4,
Q=12) 2(12)/2+4(12+4)/2)=12+32=44
• D=4(6)/2=12
• BE-D=44-12=32
d. If people had bought the amount that they really wanted to
buy (using the TRUE demand curve) what would the OPTIMAL
P and Q be?
e. What would the TRUE consumer surplus be (in dollars)?
f. What would the TRUE producer surplus be (in dollars)?
g. What would the TRUE gains from trade be (in dollars)?
Show this area in a diagram.
h. What is the waste caused by letting people buy what they
want to buy (#1a). Show this area in a diagram.
• 4d. Optimal Q where True D=S, 36-6P=4+2P,
P=4, Q=12
• e. True CS at optimal Q(12) is area under
True D above 4 = A = 2(12)/2=12
• f. PS at optimal point: BD = 4(4+12)/2= 32
• g. True total gains= ABD= 12+32=44
• h. DWL = True total gains at optimal point
(ABD=44) less true total gains at equilibrium
(32=ABD-F) = 32-44=-12
• So DWL = ABD-F -ABD= -F = -6(4)/2 = -12
5. Suppose the government decides to help the economy reach the
OPTIMAL P & Q by setting a price floor at P=$8.
a. What will the TRUE consumer surplus be because of the price floor?
b. What will the TRUE producer surplus be because of the price floor?
c. What will the total gains from trade be because of the price floor?
d. Are the consumers happier or less happy because of the price floor? By
how much (in dollars) Show this area in a diagram.
b. Are the producers happier or less happy because of the price floor? By
how much (in dollars) Show this area in a diagram.
c. What is the change in total gains (in dollars) caused by the price floor.
Show this area in a diagram.
 
• 5a. Price floor at P=8, Qd=12, Qs=20,
Qtraded=12
• True CS= Area under true D (for Q=12) minus
revenue
• Area under true D= FHIKL = 12(6+4)/2=60
• Revenue = BDFHIKL = 8(12)=96
• True CS = FHIKL-GDFHIKL= -BD = -12(2+4)/2 =
-36
• 5a. True CS = -BD = -36
• b. PS = BDFHK (BDF = 4(12)=48,
HK=4(12+4)/2)=32) = 48+32 = 80
• c. True Total Gains = -36+80 = 44

Equilibrium Floor ∆
True CS -DEG= 18(1+4)/2= -BD = -36 EG-B = 6(3+4)/2-
-45 1(12) = 21-12= +9
PS DEFHK=7(4+18)/2=7 BDFHK=80 B-E=1(12)-3(6)/2
=12-9=+3
True Total Gains FHK-G = 32 FHK = 44 +G = 4(6)/2=+12
What did the problem session illustrate?
• If market is correct (True Qd=60- • If the market fails (i.e. true
6P, True Qs=4+2P), maximum demand is not Qd=60-6P or true
gains from trade are at supply is not Qs=4+2P) then
equilibrium (Pe=7, Qe=18) equilibrium is NOT where we
• Any policy that is used (price have the maximum gains from
floor or price ceiling) will cause trade.
total gains to be smaller (i.e. will • If the market fails, then a
cause DWL) government policy (ceiling or
floor) can increase total gains
from trade
Another market failure: What is market power?
• The ability to raise prices and keep
most of your customers • Create a mathematical model to
• McDonalds vs BC Hydro show what price will maximize
• Not Either/Or but a spectrum
PS (price searcher)
(Columbia College, Skytrain) • If producer chooses this price,
• Price searcher (vs monopoly) the gains he make are less than
what consumers lose. There will
• Changes with circumstance (when be DWL
should university professors go on
strike?)
• Ephemeral (the more you use it,
the quicker you lose it) Taxis vs
Uber
New on the portal
• Problem Session #4 (Market Power)
• Reading Material #6 (How to solve
Market Power Problems)
Example from Reading Material #6
• Qd=26-(1/5)P, Qs=(1/4)P-1
• At equilibrium P=60, Q=14,
PS=14*(60-4)/2=392
• Is there a price at which the
producer can make even more
PS?
• PS = Revenue – Cost, so let’s
start by producing Q=0, then
Q=1, then Q=2 and find the Q
with the greatest PS = (Revenue
– Cost)
• If P= 130, Q=0 and TR=0. To sell
Q=1, you have to lower P to 125
and TR increases to 125. To sell
Q=2, you have to lower P to 120
and TR increases to 240. Is there
a pattern?
Q P TR ∆TR MR
0 130 0 130
125
1 125 125 120
115
2 120 240 110
105
3 115 345 100
Calculating the MR (marginal revenue) …. how does revenue change
when we try to sell more units?
• At Q= 4, P=110 & TR=440
• To sell one more unit (Q=5), we
have to lower the price by $5 to
$105. TR increases by 85 to 525
• The increase in TR can be
divided into two parts: The fifth
unit is sold for $105, but we lose
revenue on the first 4 units when
we lowered the price by $5.
∆TR=+104-20=+85
• Each time we want to sell one
more unit, we have to lower the
price by $5. The new unit (Q=6)
is sold at the lower price ($100)
and we lose $5 of revenue on all
the previous sales (-$25)
∆TR=100-25=75
Q P TR ∆TR MR
4 110 440
85
5 105 525 80
75
6 100 600
 Q P TR ∆TR MR
• Notice that the ∆TR decreases 4 110 440
twice as fast as the price -- to 85
sell one more unit, we lower the 5 105 525 80
price by $5 and each time the 75
revenue falls by $10 6 100 600
• If the revenue falls by 85
between Q=4 and Q=5 and it
falls by 75 between Q=5 and
Q=6, what is the MR right at
Q=5?
• Average of 85 and 75 is 80
• If Qd=26-(1/5)P we can also
express the demand curve as
Pd=130-5Q Q P=130-5Q TR ∆TR MR=130-10Q
• Since the revenue decreases 0 130 0 130
twice as fast as the price 125
MR=130-10Q 1 125 125 120

• OR, the MR is half the demand 115

2 120 240 110
curve
105
3 115 345 100
 • At P=100, Qd=6 (Qd=26-(1/5)P)
• Half of 6 is Q=3, so at Q=3, MR
must be 100
• Proof
Q P TR ∆TR MR
2 120 240
105
3 115 345 100
95
4 110 440

• At P=70, Qd=12. Half of 12 is

Q=6, so at Q=6, MR must by 70
• If MR falls twice as fast as P,
MR=130-10Q and 130-10(6)=70
To find the MR for any demand curve
• Qd=A-bP, Solve for P
• P=A/b – (1/b)Q
• MR is twice as steep so
MR=A/b-(2/b)Q
• Example: Qd=20-(1/8)P,
P=160-8Q, MR=160-16Q
• OR Qd=40-5P, P=8-(1/5)Q,
MR=8-(2/5)Q
Should our producer lower the price and sell
one more unit?
• Depends not just on MR but also • If MR>MC then PS will increase
on MC (Marginal Cost) • If MR<MC then PS will decrease
• If we lower the price and • MR=∆TR/∆Q (how revenue
revenue increases by 20 and cost changes when we increase sales
increases by 10, it was a good by one unit)
decision because PS will increase
by the difference • MC=∆TC/∆Q (how cost changes
when we increase sales by one
• But if we lower the price and MR unit)
increases less than MC, PS will
fall and that was a bad decision
How to measure MC (marginal cost)
• Cost is the area under the supply
curve
• The first unit produced has a
cost of 1*(4+8)/2=$6, The
second unit produced has a cost
of 2*(4+12)/2=$16
• The increase in cost for the first
unit was $6. For the second unit
$10
Qs=(1/4)P-1

Q P(supply) TC (area under S) ∆TC MC

0 4 0
6
1 8 1*(4+8)/2=6 8
10
2 12 2*(4+12)/2=16 12
14
3 16 3*(4+16)/2=30
MC IS the supply curve…..
• MC=∆TC/∆Q and is equal to the
supply curve
• Qs=f(P), but MC=f(Q)
• If Qs=(1/4)P-1, MC=4Q+4
• If Qs=4+8P, MC=(1/8)Q-1/2
• If Qs=-2+(1/5)P, MC=10+5Q
• So when Q=4, MC=30 CHECK: for Q=3,
TC=3*(10+25)/2=52.5 for Q=4, TC=80,
for Q=5, TC=112.5 Between 3&4,
∆TC=27.5, Between 4&5, ∆TC=32.5,
Average of 27.5&32.5=30
How to price search (find P for maximum
possible PS)….
• Step 1: Find MR and MC
equations (MR is half the
demand & MC is the supply)
• Step 2: Find Q where MR=MC
(when MR>MC, produce more;
when MR<MC, produce less –
want to produce where MR=MC)
• Step 3: Find P (Up on demand
curve)
• Step 1 If Qd=26-(1/5)P and
Qs=(1/4)P-1 then MR=130-10Q
and MC=4+4Q
• Step 2 Set 130-10Q=4+4Q or
Q=126/14=9 (Keep increasing Q
as long as MR>MC, but stop
when they are equal because no
more increase in PS is possible)
• Step 3 Pd=130-5Q so P=85
• PS=9*((85-4)+(85-40))/2=567
Proof this is the maximum PS
• PS is larger at Q=9 (567) than at Q Pd TR ∆TR Ps TC ∆TC PS
8 90 720 36 160 560
Q=8 or Q=10 (560)
45 38
• Also between Q=8&9 TR rises by 9 85 765 40 198 567
45 while TC rises by 38 (increase 35 42
in PS of 7) 10 80 800 44 240 560
• Between Q=9&10, TR rises by 35
while TC rises by 42 (PS
decreases by 7)
 But what does it mean for the economy?
Equilibrium Price ∆
Searcher
CS ABC=490 A=202.5 -BC=-287.5
PS DEF=392 BDF=567 B-E=175
Total Gain ABCDEF=882 ABDF=769.5 -CE=-112.5