Question

A pizza baker can bake pizzas at a constant marginal cost equal to twelve crowns. He likes his job, but unfortunately he lives on the planet Mars together with just one other person, a pizza eater. The communications with Earth are broken and will remain so for the next several decades. On the other hand, the pizza baker knows everything about the pizza eater, including his willingness to pay at the margin for each time period. Furthermore, the pizza eater never eats anything but pizza and so the pizza baker is his only source for food.

i. Describe why we can or cannot say that the pizza baker makes a profit from the pizza eater, as well as whether this depends on how much the pizza baker knows about the willingness to pay of the pizza eater.

ii. Contrast the above with a hypothetical, socially optimal, outcome. How, if at all, does the situation in part i differ from this social optimum?

Answer 1

Solution:

i) Given the scenario, the pizza baker will always make a profit from the pizza eater. Further, this depends entirely on the fact that pizza baker has a complete information about the willingness to pay of the pizza eater. This is because as the pizza baker knows the (maximum) willingness to pay of the pizza eater, he/she will always charge that amount to pizza eater leaving the bargaining power entirely in pizza baker's hands, as he/she is aware that eater will be willing to pay that much high price (higher than the marginal cost) as no negative surplus will be generated to the eater. The pizza baker can take complete advantage of this information he/she has, generating the maximum possible surplus (even converting eater's surplus to his/her own). In other words, entire market surplus would be of supplier, the pizza baker.

ii) Contrasting the above scenario with a socially optimal outcome, that is situation where the pizza baker would not know the exact willingness of pizza eater, and so will be forced to charge a lower price. As the pizza baker's marginal cost is 12 crowns, it will never charge below this price as then he/she will generate a negative surplus for himself/herself. As the pizza baker doesn't know the willingess of pizza eater, it will not have the power to charge whatever amount he/she desires, and pizza eater can always bargain and bring down the price level charged, upto the marginal cost. Thus, under such social optimal case, price charged equals the marginal cost, that is 12 crowns. With the constant marginal cost of this level, the supplier will have 0 surplus, and the entire market surplus would be of the consumer, the pizza eater.

Please note that in case the marginal cost was not constant, surplus would have been distributed between the two participants, implying social optimal does not favour consumers (as what the given scenario is indicating); it favours both participants in the market in an optimal manner. However, in the first case with supplier having complete information of willingness to pay of consumer, the situation is entirely favoured towards the supplier.