Welcome to week four of The Power of Markets. What will cover this week is analyzing how economists measure the impact of markets on consumers. By how much to do with a particular market make a consumer better off or worse off. Then, we'll look at price consumption curves and how they also provide information on prices considered of demand. And then, we'll apply consumer choice theory to two very relevant policy issues. First, health care reform. We'll analyze Obamacare and its likely impact in a couple of important dimensions. And then, we'll look at school choice and how does the provision of free public schools potentially lead to less consumption of schooling. Finally, we'll look at how to analyze investor preferences toward risk, and if you're advising individuals or making your own decision, how to allocate assets, how best to account for the different risk return profiles of assets. We'll close with an analysis of arbitrage opportunities. Whenever consumers have different valuations on a product, what opportunities exist to arbitraged away those differences? First session, let's turn to consumer surplus. This is an economist measure of how much market improves the welfare of consumers. I'm a big coffee drinker, espresso in particular. And let's look at the demand curve for somebody like myself who enjoys at the extreme, let's say, having six cups of espresso a day that costs $3 per cup. The demand curve as we found out a few weeks ago, the height of the demand curve at any quantity measures the value of that particular unit to a consumer. So, let's look at the stair-step demand curve of espresso can be bought only in units of cups, how much surplus value I would get relative to what I actually pay for the espresso? The first cup, one, I would be willing to pay based on this demand curve, $8, to obtain that cup. I only have to pay $3. So the surplus I get, the consumer surplus to me on that first cup, is the difference between the eight and the three. Or the hashed area of $5. But $3 is what I actually pay. For the second unit, I'd be willing to pay up to $7. And I still only pay three. So, I realized a surplus of $4. On the third unit, a surplus of $3. And so on, down to the sixth espresso per day, where what I would be willing to pay is exactly equal to what I have to pay. If we sum across all the hashed areas, the five plus the four plus the three plus the two plus the one, we get a total measure of consumer surplus. I end up paying $18 for those six cups. The sum benefits is $33. So $33 less the 18 that I actually pay, gives the measure of consumer surplus I realize, $15. If units can be bought in smaller increments, less than one cup, perhaps it's looking at an average per day where the amount consumed per day can vary but we go in smaller and smaller increments, then instead of a stair-step demand curve, we have a smoother line such as in figure 4.9. Consumer surplus is the area below the demand curve. Again, the demand curve height measures the maximum I'm willing to pay for each unit, down to the price I actually pay. The total cost is what I pay and the hashed area above that is the consumer surplus. Our measure of how much a consumer like me, derives from having espresso available at $3 price per unit. Now, let's look at what happens when conditions change the market. Let's say, we look at sugar consumption. And instead of a price of 25 cents per unit, the price drops 15 cents. Maybe trade becomes liberalized, or production costs get lowered, or there are other sources of sugar the production to develop in the world. The consumer surplus, in this case, would get expanded by the shaded area from the lower price, from the price decreased from 25 cents to 15 cents. The bottom of the consumer surplus triangle at 25 cents, it was triangled T, A, P, was the consumer surplus. That bottom gets padded by area - P, A, E, P prime. And to see that, think about the first Q units that I bought or that this consumer bought before, 25 cents. Now, because of the lower price on each of those first Q units, I'm 10 cents better off per unit. So, I've added that rectangle (P,A, C - P prime) to my consumer surplus. Plus the lower price also encourages this consumer to consume more sugar out to Q prime. And on each of the units now at the lower price between Q and Q prime, a consumer surplus is realized equal to the triangle A, E, C, The height of the demand curve relative to the cost that's actually paid. Finally, we can type consumer surplus measures back to the indifference curve budget constraint analysis that we laid out last week. Take the case again of espresso consumption and a budget line of AZ that has a slope of $3 per unit. Each additional espresso based on the market price cost $3. In this situation, the consumer would choose point W, striving to reach the highest possible indifference curve, U2 with the given amount of budget, the budget line AZ. And would end up consuming six units of espresso and devoting A1, the height of the vertical segment or the height of point W on the vertical axis on other goods, and in this case, we use the composite good convention of dollars overall spent on other goods. Now, how much worse off would this consumer from the indifference curve perspective be if I couldn't get any espresso? That would be a corner solution, a lower indifference curve, view one, that hits the budget line AZ right at the corner of point A, where I'm consuming no espresso and all the money gets devoted to other goods. How much my worse off in that type of situation? And to see this, and this is a rough approximation of the materials in the textbook cover why it's an approximation, but to see how we can derive the lose and consumer surplus if I don't get the opportunity to consume any espresso. You ask yourself the question on indifference curve you want at the corner solution, how much would I have been willing to pay for the first as a cup of espresso? That would be the drop from point A to point S or $8. That's the rate for that first step I'd be willing to trade off dollars on other goods for espresso. The move from S to T, slope is $7. I'd be willing to trade off $7 on other goods for one more unit of espresso. All the way down to a point R. If you sum everything I would've have been willing to pay for those first six units of espresso, the total would be $33. Or the difference between the height of the budget constraint on the vertical axis of A and how much I would be willing to drop in spending on other goods, a drop down to A2, in order to get out to six units of espresso. And yet, the market rate at which I'd have to pay to acquire espresso was almost $3 per unit. So at the market rate, I only have to give up $18 to get out a to point W on the budget constraint. So the surplus I would lose, where I'd not be able to buy espresso, would be the difference between the $33 and $18, if I were truly confined to the corner solution. Or the same $15 we calculated earlier. Now, let me just give you two examples where consumer surplus gets put to use. You look at entertainment. There was a study done in the 60s when most households had only three broadcast channels for entertainment. That the consumer surplus, in present dollars, was on the order of $200 billion. It was paid for by advertising and present real terms that amounted to about 3 billion per year. It was estimated in the 60s to the fourth channel would add 25 billion a year in value. So, that can help us explain why cable TV, there was such an impetus to develop additional channels, or through satellite TV, or through internet-based programming. And then, one last example in healthcare. Often the focus is on the cost to health care. And yet, we forget the important benefits that come from greater investments in health care. One factoid along these lines; between 1970 and 2000 as a country in the United States, we made $34 trillion and in additional investment in the healthcare. It's a huge cost increase. And yet, what is often neglected is that the estimated impact on benefits for improved health care totaled 95 trillion. Or a surplus in the sense of 61 trillion. On average over that 30 year period, the same study has estimated that $3.2 trillion in benefits and total benefits were created for each of the years on average. Roughly half the average gross domestic product over that period. The biggest benefit has come from improved heart care. Fewer people now die of a heart attack, greater longevity. Roughly half of the estimated benefits have come in the form of improved cardiac care. Further improvements in health, the cancer incidence reduction are also estimated to produce significant consumer surplus benefits. So, we'll focus on the cost, very important to also not neglect the consumer surplus, the benefits consumers derive above the cost they pay for goods.
