Theory of Markets Equilibrium Assuming Perfect Competition
Theory of Markets Equilibrium Assuming Perfect Competition Chapter 5
Topics • Development of market supply and demand curves • Producer and consumer ...
Theory of Markets Equilibrium Assuming Perfect Competition Chapter 5
Topics • Development of market supply and demand curves • Producer and consumer surplus • Market equilibrium – Supply = Demand
• Welfare economics • Market to firm linkages
From Chapter 2 - Market
Price
Supply P* Demand Q* Quantity
1
Chapter 2 - Market Demand Person 2
Market
50
50
50
40
+
30 20
40
=
30 20
Price / pound `
60
Price / pound `
60
10
10
40 30 20 10
0
0 0
5
0 0
10
5
10
0
5
Dozen ears of corn
Dozen ears of corn
10
15
Dozen ears of corn
Consumer Surplus • Triangle area given by points ABC = consumer surplus at a price = $ 6 12
A
Price `
10 8
B
C
6 4 2 0 0
2
4
6
8
10
12
14
16
18
20
22
24
Quantity
Chapter 4 Firm’s Short-Run Supply Curve •
MC curve above the AVC 30
MC
ATC
25
20
Dollars
Price / pound `
Person 1 60
AFC
15
10
AVC
5
0 0
20
40
60
80
100
120
140
160
Output - Corn Dozen
2
Market Supply Curve Price
Farm 1
Farm 2
Market
Quantity
Quantity
Quantity (in 1,000)
2
60
70
130
3
70
85
155
4
75
90
165 The market supply curve is the horizontal summation of the supply schedules for all producers in the market. At a price of $2, Farm 1 would produce 60 thousand bushels of corn while Farm 2 would produce 70 thousand. Therefore, the market supply is equal to 130 thousand bushels at a price of $2.
Building Market Supply Curve Farm 1
3.5
P r ic e
Market
Farm 2 4.5
4.5
4.5
3.5
3.5
+
2.5
=
2.5
1.5
1.5
1.5
55
80
105 130 155
55
Thousand bushels
2.5
80
105
130
155
55
80
105
130
155
Thousand bushels
Thousand bushels
Producer Surplus 6
• Economic returns above the firm’s marginal costs of production Supply = MC
5
Price = $4 / bushel
Price
4
What is the producers’ profit for the 3 millionth bushel?
3
2
Marginal cost – costs of producing the 3 millionth bushel
1
0 0
1
2
3
4
5
6
7
8
9
10 11 12 13 14 15 16 17 18 19
Quantity (millions of bushels)
3
Producer Surplus • Economic returns above the firm’s marginal costs of production 6 Receives a price of $4 for the 3 millionth bushel
S
Price
4
Price
Marginal cost of producing the 3 millionth bushel = $1 cost of last bushel
Profit or surplus of $4 - $1 =$3
5
3
2
1
0 0
1
2
3
4
5
6
7
8
9
10 11 12 13 14 15 16 17 18 19
Quantity (millions of bushels)
Producer Surplus – 6th Unit Receives a price of $4 for the 6 millionth bushel
6
Profit or surplus of $4 - $2 = $2
Price
4
Marginal cost of producing the 6 millionth bushel = $2 cost of last bushel
S
5
Price
3
2
1
0 0
1
2
3
4
5
6
7
8
9
10 11 12 13 14 15 16 17 18 19
Quantity (millions of bushels)
Total Producer Surplus • Area below the price line and above the supply curve Measure of area = Price x Q/2= 4 x 12 /2 = 24
6
5
S
Price
4
Price
3
Total Costs = Area below MC
2
1
0 0
1
2
3
4
5
6
7
8
9
10 11 12 13 14 15 16 17 18 19
Quantity (millions of bushels)
4
Producer Surplus • What happens to PS if price increases to $5? 6
S Price = 5
5
Price = 4
Price
4
3
2
1
0 0
1
2
3
4
5
6
7
8
9
10 11 12 13 14 15 16 17 18 19
Quantity (millions of bushels)
Change in Producer Surplus • Increases by blue area • What if price decreases from 5 to 4? 6
S Price = 5
5
Price = 4
Price
4
3
2
1
0 0
1
2
3
4
5
6
7
8
9
10 11 12 13 14 15 16 17 18 19
Quantity (millions of bushels)
Merge Supply and Demand • Adam Smith – 1723-1790 – An Inquiry into the Nature and Causes of the Wealth of Nations published in 1776
• Other events – Industrial Revolution, American Revolution, Scottish Enlightenment
• Life – Father died year he was born – Greek & Latin classics, French & English literature, science and philosophy – Absent minded
5
Merge Supply and Demand • Real source of wealth – production and exchange • Self - interest – Argued the voluntary self-interest of millions of individuals would create a stable, prosperous society without the need for central direction by the state – Consumers want to maximize CS – Producers want to maximize PS
• Invisible hand • Perfect competition assumptions + no externalities + no barriers to trade
Price = $5 Qsupplied = 13 million bu Qdemanded = 10 million bu
Price `
5 4 3
Market Surplus
2 1
D 0 8.5
9.5
10.5
11.5
12.5
13.5
14.5
15.5
Quantity millions of bushels
Market Equilibrium - Why 8 7
S Price = $1.5 6
Qsupplied = 9.5 million bu Qdemanded = 13.5 million bu
4 3
Market Shortage
2 1
D 0 8.5
9.5
10.5
11.5
12.5
13.5
14.5
15.5
Quantity millions of bushels
Surplus 8 7
S
6
Total surplus = consumer surplus + producer surplus
5
Price `
Price `
5
CS 4 3
PS 2 1
D
0 8.5
9.5
10.5
11.5
12.5
13.5
14.5
15.5
Quantity millions of bushels
7
Surplus 8 7
S
6
Total costs
Price `
5
CS 4 3
PS 2 1
D
0 8.5
9.5
10.5
11.5
12.5
13.5
14.5
15.5
Quantity millions of bushels
Jargon • Specific terms to distinguish between movement along a demand curve and a shift in a demand curve • Change in the quantity demanded is a movement along a demand curve - Cause • Change in demand is a shift in the demand curve - Causes
Jargon Supply Curve • Specific terms to distinguish between movement along a supply curve and a shift in a supply curve • Change in the quantity supplied is a movement along a supply curve - Cause • Change in supply is a shift in the supply curve - Causes
8
Economic Welfare Analysis • Deals with changes in either the supply or demand curves shifts • Interested in – Change in consumer surplus – Change in producer surplus – Change in total surplus
Increase in Demand A
8 7
Shifters in Demand
D
6
Price `
5
F
-Population -Tastes and preferences -Income -Prices of other goods
B
H
4
G
3
C
2 1
E
0 8.5
9.5
10.5
11.5
12.5
13.5
14.5
15.5
Quantity millions of bushels
Consumer Surplus A
8 7
Consumer Surplus Before GCD After FBA
D
6
Price `
5
F
B
H
Gain ABHD Lose GFHC Overall ?
4
G
3
C Why?
2 1
E
0 8.5
9.5
10.5
11.5
12.5
13.5
14.5
15.5
Quantity millions of bushels
9
Producer Surplus A
8 7
Producer Surplus Before ECG After EBF
D
6
Price `
5
F
B
H
Gain GCBF Lose --Overall Gain GCBF
4
G
3
C
2
E
1
Why?
0 8.5
9.5
10.5
11.5
12.5
13.5
14.5
15.5
Quantity millions of bushels
Total Surplus A
8 7
Total Surplus Before ECD After EBA
D
6
Price `
5
F
B
H
Gain ABCD Lose --Overall Gain ABCD
4
G
3
C
2
E
1 0
8.5
9.5
10.5
11.5
12.5
13.5
14.5
15.5
Quantity millions of bushels
PS and CS A
8 7
7
D
6
D
6
F
H
4 3
G
5
B
Price `
5
Price `
A
8
F G
3
C
2
H
4
B
C
2
E
1
E
1
0
0 8.5
9.5
10.5
11.5
12.5
13.5
14.5
Quantity millions of bushels
Before
15.5
8.5
9.5
10.5
11.5
12.5
13.5
14.5
15.5
Quantity millions of bushels
After
10
Decrease in Supply 8
Shifters in Supply
7
D
6
Price `
5 4
- Input costs - Technology - Government policy - Price expectations - Weather & disease - Global events
B
A H
3
G
2
F
C
1 0
E 8.5
9.5
10.5
11.5
12.5
13.5
14.5
15.5
Quantity millions of bushels
Consumer Surplus 8 7
Consumer Surplus Before GCD After ABD
D
6
Price `
5
B
A
4
Gain --Lose GCBA Overall Loss GCBA
H
3
G
2
F
C
1 0
E 8.5
9.5
10.5
11.5
12.5
13.5
14.5
15.5
Quantity millions of bushels
Producer Surplus 8 7
Producer Surplus Before ECG After FBA
D
6
Price `
5
B
A
4
Gain GHBA Lose FHICE Overall ?
H
3
G
2
F
I
C
1 0
E 8.5
9.5
10.5
11.5
12.5
13.5
14.5
15.5
Quantity millions of bushels
11
Total Surplus 8 7
Total Surplus Before ECD After FBD
D
6
Price `
5
B
A
4
Gain ---Lose FBCE
H
3
G
2
F
I
C
Overall Loss FBCE
1 0
E 8.5
9.5
10.5
11.5
12.5
13.5
14.5
15.5
Quantity millions of bushels
On Your Own • Be able to determine the change in consumer, producer, and total surplus for – Decreases in demand – Increases in supply – Any combination of supply and demand changes
Market-to-Firm Linkages
12
Firm is a “Price Taker” Under Perfect Competition The Market
Price
D
S
The Firm
Price AVC
MC
PE
P= MR
QE
OMAX Quantity
Key • Market demand curve is downward sloping • Demand curve faced by an individual firm is horizontal – why? – Perfect competition price takers • Small enough changes in output do not change price • Firm does not have any market power
• KNOW – foreshadowing next topics
If Demand Increases…… The Market Price
D
The Firm
D1
S
Price AVC
MC
PE
P= MR
QE
10 11
Quantity
13
If Demand Decreases…… The Market Price
D2 D
The Firm Price
S
AVC
MC P= MR
PE
QE
9 10
Quantity
Firm is a “Price Taker” in the Input Market Price
D
Labor Market S
Price
The Firm MVP MIC=P
PE
QE
L Quantity
Summary • • • • • •
Market demand and supply are summation of individual demand and supply curves 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
14
Next we will focus on market equilibrium and product prices under conditions of imperfect competition….
