1 Demand Supply and Equilibrium

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    The Context: Perfectly Competitive Markets

    Market: A group of buyers and sellers of a particular good or service

    can be defined narrowly or broadly (e.g., rice vs. food)

    at a given point in time (e.g., day, month, year)

    Perfect Competition:

    Enough buyers and sellers so that no one has an impact on the price

    typically with many buyers and sellers Perfect information about products

    No externalities

    Only buyer and seller are affected by a transaction

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    Willingness to Pay

    Willingness to pay (WTP): the maximumamount that a buyer will pay fora good

    Further distinctions are helpful

    Marginal willingness to pay (MWTP): WTP for one more unitof a good

    Total willingness to pay (TWTP): WTP for any number of units of a good

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    An Individuals Demand Curve

    A graph of an individuals MWTP curve is her demand curve

    Demand curve: gives the relationship between the priceof a good and thequantity demanded

    Law of demand: downward sloping curve reflects diminishing MWTP

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    An Individuals Demand Schedule

    A table that gives the relationshipbetween the price and quantity

    demanded

    Based on the individuals MWTP

    Price of X QuantityDemanded

    $5 0

    $4 1

    $3 2

    $2 3

    $1 4

    $0 5

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    Consider a Market with Two Individuals

    Price of X Individuals 1s

    Quantity Demanded

    Individual 2s

    Quantity Demanded

    Total

    Quantity Demanded

    $5 0 0 0

    $4 1 2 3

    $3 2 4 6

    $2 3 6 9

    $1 4 8 12

    $0 5 10 15

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    The Market (Aggregate) Demand Curve

    A horizontal summation of individual demand curves

    Tells the market quantity demanded at any given price

    Also tells the MWTP in the marketthe most someone is WTP for eachadditional unit of the good

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    A Note on Demand Semantics

    Changes in price result in changes in the quantity demanded

    Changes in demand imply shifts of the demand curve

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    Shifters of the Demand Curve

    1. Changes in income, + (-)

    Normal goods, + (-)

    Inferior goods, - (+)

    2. Changes in the price of related goods, + (-)

    Substitutes, + (-)

    Complements, - (+)

    3. Tastes and preferences4. Number of buyers in the market, + (-) implies + (-)

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    A Firms Marginal Cost (MC) of Production

    Marginal cost (MC): tells a firms incremental cost of producing anadditional unit of a good

    We assume it is increasing (for now)

    We ignore the total costs of production (for now)

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    A Firms MC of Producing Good X

    Quantity of X MC

    1 $2

    2 $3

    3 $4

    4 $5

    5 $6

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    An Firms Supply Curve

    A graph of a firms MC curve is its supply curve

    Supply curve: gives the relationship between the priceof a good and thequantity supplied

    Law of supply: upward sloping curve reflects increasing MC

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    A Firms Supply Schedule

    A table that gives the relationshipbetween the price and quantity

    supplied

    Based on the firms MC

    Price of X QuantitySupplied

    $1 0

    $2 1

    $3 2

    $4 3

    $5 4

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    Consider a Market with Two Firms

    Price of X Firm 1s

    Quantity Supplied

    Firm 2s

    Quantity Supplied

    Total

    Quantity Supplied

    $1 0 0 0

    $2 1 2 3

    $3 2 4 6

    $4 3 6 9

    $5 4 8 12

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    The Market (Aggregate) Supply Curve

    A horizontal summation of the individual firm supply curves

    Tells the market quantity supplied at any given price

    Also tells the MC in the marketthe lowest cost of producing eachadditional unit of the good

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    A Note on Supply Semantics

    Changes in price result in changes in the quantity supplied

    Changes in supply imply shifts of the supply curve

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    Shifters of the Supply Curve

    1. Changes in input prices, + (-) implies - (+)

    2. Changes in the technology of production, such that better

    (worse) implies + (-)

    3. Number of sellers in the market, + (-) implies + (-)

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    Equilibrium: Supply meets Demand

    The intersection of the supply and demand curves determines theequilibrium priceand quantity

    Market clearing condition: when the quantity supplied equals the quantitydemanded

    Given the equations for the supply and demand curves, you can solve

    algebraically for P* and Q*

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    Equilibrium Proof by Contradiction

    If P > P*, then there would be excess supply (a surplus)

    Firms would lower prices

    If P < P*, then there would be excess demand (a shortage)

    Consumers would pay more

    Must be true that P = P* and that QS= QD= Q*

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    Comparative Static Analysis

    Ceteris paribus : other things being equal

    An increase (decrease) in demand results in more (less) exchange at ahigher (lower) price

    An increase (decrease) in supply results in more (less) exchange at alower (higher) price

    Simultaneous shifts in supply and demand can generate ambiguouseffects