ECO101H1 Lecture Notes - Lecture 5: Economic Surplus, Demand Curve, Opportunity Cost

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ECO101H1 Full Course Notes

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Consumers, producers, and the efficiency of the markets. Welfare economics: studies how the allocation of resources affects economic well-being. Buyer"s willingness to pay: (for a good) the maximum amount the buyer will pay for that good. Wtp measures how much the buyer values the good. At any q, the height of the d curve is the wtp of the marginal buyer, the buyer who would leave the market if p were any higher. Consumer surplus: the amount a buyer is willing to pay minus the amount the buyer actually pays. If wtp < p, then cs = 0. Total cs equals the area under the demand curve above the price, from 0 to q. For a smooth curve, there would be a triangle: area = base * height / 2. Cost: the value of everything a seller must give up to produce a good (i. e. , opportunity cost).

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Use your knowledge about price-searching firms and two-part pricing to advise the company below. A company has a bar and is trying to decide on the cover charge (if any) and price for each drink. It has done a modest regression study in which it asked customers to classify themselves as light drinkers or heavy drinkers and to indicate the number of drinks they would typically consume during the evening. The estimate from the regression study is that a change in the price equal to $1 per drink causes light drinkers to change their consumption on average by 0.5 drinks per night. However, a change in the price of $1 causes heavy drinkers to change their consumption on average by 1.0 drinks per night. For both groups, a typical consumer will not consume anything once the price reaches $9 per drink. (They may instead go to another bar or not go to a bar at all.) Draw a demand curve for a typical light drinker and for a typical heavy drinker on the same diagram. Explain your diagram. Write equations for the curves in slope-intercept form.

If 300 people visit the bar on a typical evening, with 200 people being light drinkers and 100 people being heavy drinkers, draw an overall demand curve for all of the consumers combined. What is the slope and what is the intercept for this demand curve? Write an equation in slope-intercept form. If the marginal cost of making drinks (the alcohol, the bartender's labor, and the amortized cost of purchasing glasses and cleaning them repeatedly) is constant at $5 per drink, and if no cover charge is assessed, what is the best price to charge for drinks? How many drinks would be sold on a typical evening? What would your profits be? If you cut your price by $1 per drink and assess the maximum possible cover charge without causing a typical light drinker to refuse to enter the bar, would your profits improve? How high would the cover charge be? Calculate both the cover charge and your total profits. Would the new pricing increase profit?

Maybe the best price cut is not exactly $1. Write a profit equation. Profits equal to total revenue minus total cost. Total cost equals $5 times the number of drinks sold. Total revenue equals the price for drinks times the number of drinks sold, plus 300 people times the cover charge. The cover charge equals, for a light drinker, the triangle of consumer surplus above the price but below the demand curve for a light drinker. (The area of a triangle equals one half the base times the height.) You will take the derivative of the profit equation with respect to P or Q and set it equal to zero. For example, use the equation for the total demand curve and solve for Q in terms of P. Then in the profit equation substitute in an expression involving P in place of every Q that was in the original profit equation. Now you can take a derivative of profits with respect to P and set the derivative equal to zero. Eventually, you can solve for the exact best P, Q, and cover charge.

Review of the slope-intercept form: Y= a - bX; a = the intercept on the Y-axis and b = the absolute value of the slope (slope=(change in Y)/(change in X)) For a demand curve: P=a-b Q. The intercept on the vertical axis would indicate a price that is so high that the quantity demanded becomes zero. The slope is the ratio of a change in price divided by the change in quantity demanded; the extra credit problem gives you information to determine the slope for a light drinker and the slope for a heavy drinker.

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ECO101H1 Lecture Notes - Lecture 5: Economic Surplus, Demand Curve, Opportunity Cost

ECO101H1 Full Course Notes

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