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Understanding Mutual Gains from Trade

Delve into the concept of mutual gains in trade through market exchange, exploring consumer and producer surpluses and the benefits of voluntary reliance on others. Gain insights on how market prices are determined and the importance of bargaining for optimal outcomes.

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Understanding Mutual Gains from Trade

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  1. Lecture 8Mutual Gains from Trade We rely on other people to produce things we want: • We are not forced to rely on others. • Why do we voluntarily rely on others through the market process? We must answer this question: • What are the gains from mutually beneficial exchange?

  2. Mutual gains—Simple Example • You buy food from a grocer because she is willing to sell to you at a price that is: • 1) less than the value you place on the good, and/or • 2) less than your costs of producing it yourself • Therefore, you gain from shopping at grocer (consumer surplus) • Grocer sells to you. You are willing to pay a price that is: • 1) more than the cost of producing the good, and/or • 2) more than the seller’s next best alternative • Therefore, grocer gains from selling to you (producer surplus) • We are joined together by mutual gains through market exchange

  3. The consumers’ perspective • Look at demand side of market and ask: What is the total value in use to consumers of the quality Q*? It is the total area under demand curve from 0 to Q* (OABQ*) • People usually do not have to give up all of this because suppliers will deliver at a price of P* Price A B P* Demand O Q*Quantity

  4. What Will the Price Be? • Price and value may have little relationship. -- Suppose you have a treasure chest with $10 million in it and you know you must get it open quickly or you lose the money. How much would you be willing to pay for a $5 tool to let you break the chest open? The difference in value to a user and price paid in exchange is consumers’ surplus.

  5. Consumer surplus • The gains from trade going to consumers: Total use value (ABQ*0) minus Total expenditures (P*BQ*0) equals Consumer surplus (ABP*) Price A B P* Demand 0 Q* Quantity

  6. The producers’ perspective Look at supply side of market and ask: What is the total cost to producers of the quantity Q*?” Three equal descriptions are: 1. minimum you would accept to produce Q* rather than Q=0 2. sum of the marginal costs from 0 to Q* 3. area under the supply curve from 0 to Q* • Producers usually do not have to settle for MC, because demanders will pay a price of P* Price Supply = MC P* B 0 Q* Quantity

  7. Producer surplusThe gains from trade going to the producer: • Total revenue (P*BQ*0) Minus • Total costs (0CBQ*) [Costs must be recovered or no production.] Equals • Producer surplus (P*BC) Price S = MC P* B C 0 Q* Quantity

  8. Putting It All Together Market Price Demand Supply Price Price A A S S B B P* P* P* B D D C C 0 0 0 Q* Quantity Q* Quantity Q* Quantity There are gains to suppliers and demanders — room for bargaining. Who gets producer and consumer surplus? Area ABC is up for grabs!

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