Chapter 4: Essential microeconomics of european integration
Preliminaries I: supply and demand diagrams
Positive analysis: price and quantity effects
Normative analysis: welfare effects
Example: cups of coffee - demand
Marginal utility curve shows how much extra joy a consumer gets from having one more cup
starting from any given number of cups already consumed
1. Buys very few cups of coffee today (c') → gain from buying an extra one is higher (mu’)
already bought lots of cups already (c’’) → gain from one more is lower (mu")
→ So the price should be lowered to convince the consumer to buy another
Allows us to work out how much the consumer would buy at any given price
- Buy up to the point where the last one bought is just worth the price (c*)
- At pm no one buys coffee (too expensive)
For supply curves, this optimisation is done by firms (see right graph)
Marginal = cost of one more unit of the good
- Marginal cost of production often declines with scale of productive
- The firm will supply goods up to MC = P under perfect competition
- Optimum at p* → q*
Welfare analysis: consumer and producer surplus
Consumers buy up to the point where the marginal utility = P
Consumer surplus = difference of willingness to pay for a good and the price that consumers
actually pay for it
- Increases as the price of a good falls and decreases as the price of a good rises
- Area under the demand curve up to P
,Producer surplus = total amount that a producer benefits from producing and selling a quantity of
a good at the market price
- TR - MC = producer surplus
P↑ ↑ producer surplus ↓ consumer surplus
P↓ ↓ producer surplus ↑ consumer surplus
Preliminaries II: introduction to open-economy supply and demand analysis
Import demand curve
Surplus → demand < supply
Shortage → demand > supply
Import supply curve = a reflection of how much it costs foreigners to supply the goods
- If imports of the good were banned: normal market equilibrium at P*
- Import demand is zero at P*
- At P' → shortage → P’ becomes domestic price and imports are required
- Consumption demand = C' domestic supply = Z'
- Import M' = C' - Z'
,The level of imports that corresponds to P' (line drawn across) = M’ (point 3)
- Doing the same for every import price →
Import demand curve (MDH) = amount of imports that the nation wants at any given
domestic price → curve
Welfare analysis
To what extent to which a policy raises or lowers a nation's wellbeing (measured through money)?
Eg. Consider increase in import price from p' to p"
At P* import = 0 and export = 0
At P” supply = Z” demand = C” Z” - C” = line C
At P’ supply = Z’ demand = C’ Z’ - C’ = line C + B + D (B + D = E)
Welfare = utility gained through the achievement of material goods and services
Import price and domestic price must change equally to ‘make up’ for the ‘loss’
Higher import price → domestic price rises by the same amount
Price increase → decreases consumer surplus by A + B + C + D (LEFT)
(area under demand curve to P)
→ increases producer surplus by A (LEFT)
(area above supply curve to P)
Import price increase → net loss to the country of B + C + D (LEFT)
(A cancels out → gain for producers / loss for consumers)
Net loss →C+E (E = B + D) (RIGHT)
, Trade volume effects & border price effects
- MDH curve shows marginal benefit of imports to home
Home loses areas C and E when the price of imports rises from p' to p"
- Price increase → home pays more for the units it imported at the old price
- Border price effect = area C
Eg. price increase was €1.2 per unit and M" was 100 → loss = €1.2 x 100
Home reduces its imports at the new price
- Import volume effect = area E = how much home loses from the drop in imports
- Marginal value of the first lost unit = height of the MDH curve at M"
- But since home had to pay p' for this unit → net loss = gap between P and the MDH curve
- If we add up the gaps for all the extra units imported, we get the area E
Why does MDH show the marginal benefit of imports to home:
1. MDH curve: difference between domestic demand and domestic supply
2. Domestic supply (= domestic MC) + domestic demand = domestic MU curve
3. Domestic MU - domestic MC = nation’s net gain of producing and consuming one more unit
4. An extra unit of import → higher consumption & lower domestic production → higher utility
and lower costs (shown in the MDH curve
Nations import up to the point where the marginal gain from doing so = MC
- Border price = MC → so border price is an indication of the marginal benefit of imports
Border price + T = domestic price
- Increase in price → less demand
- Increase in tariff doesn’t lead to same increase domestic price → border price decreases
(export less)
Preliminaries I: supply and demand diagrams
Positive analysis: price and quantity effects
Normative analysis: welfare effects
Example: cups of coffee - demand
Marginal utility curve shows how much extra joy a consumer gets from having one more cup
starting from any given number of cups already consumed
1. Buys very few cups of coffee today (c') → gain from buying an extra one is higher (mu’)
already bought lots of cups already (c’’) → gain from one more is lower (mu")
→ So the price should be lowered to convince the consumer to buy another
Allows us to work out how much the consumer would buy at any given price
- Buy up to the point where the last one bought is just worth the price (c*)
- At pm no one buys coffee (too expensive)
For supply curves, this optimisation is done by firms (see right graph)
Marginal = cost of one more unit of the good
- Marginal cost of production often declines with scale of productive
- The firm will supply goods up to MC = P under perfect competition
- Optimum at p* → q*
Welfare analysis: consumer and producer surplus
Consumers buy up to the point where the marginal utility = P
Consumer surplus = difference of willingness to pay for a good and the price that consumers
actually pay for it
- Increases as the price of a good falls and decreases as the price of a good rises
- Area under the demand curve up to P
,Producer surplus = total amount that a producer benefits from producing and selling a quantity of
a good at the market price
- TR - MC = producer surplus
P↑ ↑ producer surplus ↓ consumer surplus
P↓ ↓ producer surplus ↑ consumer surplus
Preliminaries II: introduction to open-economy supply and demand analysis
Import demand curve
Surplus → demand < supply
Shortage → demand > supply
Import supply curve = a reflection of how much it costs foreigners to supply the goods
- If imports of the good were banned: normal market equilibrium at P*
- Import demand is zero at P*
- At P' → shortage → P’ becomes domestic price and imports are required
- Consumption demand = C' domestic supply = Z'
- Import M' = C' - Z'
,The level of imports that corresponds to P' (line drawn across) = M’ (point 3)
- Doing the same for every import price →
Import demand curve (MDH) = amount of imports that the nation wants at any given
domestic price → curve
Welfare analysis
To what extent to which a policy raises or lowers a nation's wellbeing (measured through money)?
Eg. Consider increase in import price from p' to p"
At P* import = 0 and export = 0
At P” supply = Z” demand = C” Z” - C” = line C
At P’ supply = Z’ demand = C’ Z’ - C’ = line C + B + D (B + D = E)
Welfare = utility gained through the achievement of material goods and services
Import price and domestic price must change equally to ‘make up’ for the ‘loss’
Higher import price → domestic price rises by the same amount
Price increase → decreases consumer surplus by A + B + C + D (LEFT)
(area under demand curve to P)
→ increases producer surplus by A (LEFT)
(area above supply curve to P)
Import price increase → net loss to the country of B + C + D (LEFT)
(A cancels out → gain for producers / loss for consumers)
Net loss →C+E (E = B + D) (RIGHT)
, Trade volume effects & border price effects
- MDH curve shows marginal benefit of imports to home
Home loses areas C and E when the price of imports rises from p' to p"
- Price increase → home pays more for the units it imported at the old price
- Border price effect = area C
Eg. price increase was €1.2 per unit and M" was 100 → loss = €1.2 x 100
Home reduces its imports at the new price
- Import volume effect = area E = how much home loses from the drop in imports
- Marginal value of the first lost unit = height of the MDH curve at M"
- But since home had to pay p' for this unit → net loss = gap between P and the MDH curve
- If we add up the gaps for all the extra units imported, we get the area E
Why does MDH show the marginal benefit of imports to home:
1. MDH curve: difference between domestic demand and domestic supply
2. Domestic supply (= domestic MC) + domestic demand = domestic MU curve
3. Domestic MU - domestic MC = nation’s net gain of producing and consuming one more unit
4. An extra unit of import → higher consumption & lower domestic production → higher utility
and lower costs (shown in the MDH curve
Nations import up to the point where the marginal gain from doing so = MC
- Border price = MC → so border price is an indication of the marginal benefit of imports
Border price + T = domestic price
- Increase in price → less demand
- Increase in tariff doesn’t lead to same increase domestic price → border price decreases
(export less)
