Market Equilibrium and Market Demand: Perfect Competition

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MarketEquilibrium and Market DemandPerfect
Competition

• Chapter 8

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Discussion Topics

• Derivation of market supply curve
• Elasticity of supply and producer surplus
• Market equilibrium under perfect competition
• Total economic surplus
• Adjustments to market equilibrium

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Remember the firms supply curve?
PMRAR
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PMRAR
Firms supply curve starts at shut down level of
output
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Profit maximizing firm will desire to
produce where MCMR
PMRAR
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Economic losses will occur beyond output OMAX,
where MC gt MR
PMRAR
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Building the Market Supply Curve
Market supply curve can be thought of as the
horizontal summation of the supply decisions of
all firms in the market. Here, at a price of
1.50, Gary would supply 2 tons of broccoli and
Ima would supply 1 ton, giving a market supply
of 3 tons.
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Building the Market Supply Curve

Market supply curve can be thought of as the
horizontal summation of the supply decisions of
all firms in the market. Here, at a price of
1.50, Gary would supply 2 tons of broccoli and
Ima would supply 1 ton, giving a market supply
of 3 tons.
Page 163
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Building the Market Supply Curve


Market supply curve can be thought of as the
horizontal summation of the supply decisions of
all firms in the market. Here, at a price of
1.50, Gary would supply 2 tons of broccoli and
Ima would supply 1 ton, giving a market supply
of 3 tons.
Page 163
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Merging Demand and Supply
Price
D
S
Market clearing price
PE
Quantity
QE
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Merging Demand and Supply
Price
D
S
PE
Chapters 3-5
Quantity
QE
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Merging Demand and Supply

• Factors that change
• demand
• Other prices
• Consumer income
• Tastes and preferences
• Real wealth effect
• Global events

D
Price
D
S
PE
PE
Quantity
QE
QE
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Merging Demand and Supply
Price
D
S
Chapters 6-7
PE
Quantity
QE
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Merging Demand and Supply
S

• Factors that change
• supply
• Input costs
• Government policy
• Price expectations
• Weather disease
• Global events

Price
D
S
PE
PE
Quantity
QE
QE
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Concept of Producer Surplus
Producer surplus is a fancy term economists use
for profit. We measure producer surplus as the
area above the supply curve and below the market
equilibrium price.
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Concept of Producer Surplus
Producer surplus is a fancy term economists use
for profit. We measure producer surplus as the
area above the supply curve and below the market
equilibrium price. Total economic surplus is
therefore equal to consumer surplus discussed in
Chapter 4 plus producer surplus.
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Market Price of 4
A
B
Product price
Producer surplus at 4 is equal to area ABC
F
G
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Suppose Price Increased to 6
Product price
Producer surplus at 6 is equal to area EDC
F
G
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The gain in producer surplus if the price
increases from 4 is equal to area AEDB
Producers are better off economically
by responding to this price increase by producing
output G
C
F
G
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Economic Welfare Concepts
We can use the concepts of market demand and
supply to assess the effects of events in the
economy have upon the economic well being of
consumers and products in a particular market
during a specific period. We do this using the
total economic surplus which is given by Total
economic Consumer Producer
surplus surplus surplus


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An Example of Economic Welfare Analysis
Assume a drought occurs that results in a
decrease in supply from S to S. Before this
happened, consumer surplus was area 345 while
producer surplus was equal to area 67. Total
economic equals area 34567
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An Example of Economic Welfare Analysis
After the decrease in supply, consumer surplus is
just area 3. They lose area 4 and area
5. Producers gain area 4 but lose area 7.
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An Example of Economic Welfare Analysis
Consumers are therefore worse off because of
the drought. Producers are also worse off if
area 4 is less than area 7. Society loses
area 57.
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Measuring Surplus Levels
D
7
Consumer surplus is equal to (10 x (7-4))2, or
15
S
Product price
4
1
10
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Measuring Surplus Levels
D
7
Consumer surplus is equal to (10 x (7-4))2, or
15
S
Product price
4
Producer surplus is Equal to (10 x (4-1))2, or
15
1
10
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Measuring Surplus Levels
D
7
Consumer surplus is equal to (10 x (7-4))2, or
15
S
Product price
4
Producer surplus is Equal to (10 x (4-1))2, or
15
1
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Total economic surplus is therefore 30
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Market Disequilibrium
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Market Surplus
At the price PS, producers would supply QS.
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Market Surplus
At the price PS, consumers would only want QD.
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Market Surplus
At the price PS, a market surplus equal QS QD
exists
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Market Shortage
At the price PD, producers would only supply QS.
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Market Shortage
Consumers want QD at this low price.
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Market Shortage
Consumers want QD at this low price.
At the price PD, a market shortage equal QD
QS exists
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Adjustments to Market Equilibrium
Markets converge to equilibrium over time unless
other events in the economy occur. One
explanation for this adjustment which makes sense
in agriculture is the Cobweb theory. This names
stems from the spider like trail the adjustment
process makes.
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Year Two Reactions
Producers use last years Price (P1) as their
expected price for year 2 will produce Q2 in
year 2. Due to surplus, this Q will then cause
Prices in year 2 to fall to P2
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Year Three Reactions
P3
P2
Producers now decide to produce less at the
lower price. This lower quantity pushes price up
to P3 in year 3.
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Cobweb Pattern Over Time
Market equilibrium
The market converges to market equilibrium
where demand intersects supply at price PE. In
some markets, this adjustment period may only be
months or even weeks rather than years assumed
here.
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Market-to-Firm Linkages
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Some Important Jargon
We need to distinguish between movement along a
demand or supply curve, and shifts in the demand
or supply curve.
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Some Important Jargon
We need to distinguish between movement along a
demand or supply curve, and shifts in the demand
or supply curve. Movement along a curve is
referred to as a change in the quantity demanded
or supplied. A shift in a curve is referred to
as a change in demand or supply.
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Increase in demand pulls up price from Pe to Pe
Decrease in demand pushes price down from Pe to
Pe
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Decrease in supply pulls up price from Pe to Pe
Increase in supply pushed price down from Pe to
Pe
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Merging Demand and Supply
Price
D
S
Chapters 6-7
PE
Chapters 3-5
Quantity
QE
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Firm is a Price Taker Under Perfect Competition
The Market
The Firm
Price
Price
D
S
AVC
MC
PE
QE
OMAX
Quantity
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If Demand Increases
The Market
The Firm
Price
D1
Price
D
S
AVC
MC
PE
QE
10 11
Quantity
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If Demand Decreases
The Market
The Firm
Price
Price
D
S
D2
AVC
MC
PE
QE
9 10
Quantity
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Firm is a Price Taker in the Input Market
Labor Market
The Firm
Price
Price
D
S
MVP
MIC
PE
QE
LMAX
Quantity
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Firm is a Price Taker in the Input Market
Labor Market
The Firm
Price
Price
D
S
MVP
PE
MIC
QE
LMAX
Quantity
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Effects of Increasing The Minimum Wage
Labor Market
The Firm
Price
Price
D
S
MVP
PMIN
MIC
QD
LMAX
QS
Quantity
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Summary

• Market equilibrium price and quantity are given
  by the intersection of demand and supply
• Producer surplus captures the profit earned in
  the market by producers
• Total economic surplus is equal to producer
  surplus plus consumer surplus
• A market surplus exists when the quantity
  supplied exceeds the quantity demanded.
• A market shortage exists when the quantity
  demanded exceeds the quantity supplied.

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Chapter 9 focuses on market equilibrium and
product prices under conditions of imperfect
competition.