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8/11/2019 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