Market Equilibrium and Market Demand: Perfect Competition

MarketEquilibrium and Market Demand:

Perfect Competition

Chapter 8

Discussion Topics

Derivation of market supply curveElasticity of supply and producer surplusMarket equilibrium under perfect

competitionTotal economic surplusAdjustments to market equilibrium

2

Page 131

Remember the firm’ssupply curve?

Remember the firm’ssupply curve?

P=MR=AR

3

Page 131

P3=MR3=AR3

Firm’s supply curve starts at shut down output levelWhere MR < AVC

Firm’s supply curve starts at shut down output levelWhere MR < AVC

P1=MR1=AR1

P2=MR2=AR2

Profit maximizing firm will desire to produce where MC=MR

Profit maximizing firm will desire to produce where MC=MR

Economic losses occurwhere MC > MR

Economic losses occurwhere MC > MR

4444444444

Page 132

Building the Industry Supply Curve

Market supply curve: The horizontal summation of the supply decisions of all firms in the marketAt a price of $1.50, Gary would

supply 2 tons of broccoli

Market supply curve: The horizontal summation of the supply decisions of all firms in the marketAt a price of $1.50, Gary would

supply 2 tons of broccoli

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Page 132


Market supply curve: The horizontal summation of the supply decisions of all firms in the marketAt a price of $1.50, Ima would

supply 1 ton of broccoli

Market supply curve: The horizontal summation of the supply decisions of all firms in the marketAt a price of $1.50, Ima would

supply 1 ton of broccoli

6


Market supply curve: The horizontal summation of the supply decisions of all firms in the marketAt a price of $1.50 market supply would be 3 tons

Page 1327

Determining Market Equilibrium

With the above we have identified the Market Supply Curve

Previously we derived the Market Demand CurveHorizontal summation of individual demand

curves

We can combine these concepts to identify what is referred to as the Market Equilibrium

8

Price

Quantity

D S

PE

QE


Market clearing priceMarket clearing price

Market Supply CurveMarket Demand Curve

9

Price

Quantity

D S

PE

QE


Chapters 3 - 5Chapters 3 - 5

10

Price

Quantity

D S

PE

QE

Factors that change (shift) demand:Prices of other goodsConsumer income Tastes and preferencesReal wealth effectGlobal events

D*

QE*

PE*


11

Price

Quantity

D S

PE

QE


Chapters 6 - 7Chapters 6 - 7

12

Price

Quantity

D S

PE

QE

Factors that change (shift) supply:Input costsGovernment policyPrice expectationsWeather & diseaseGlobal events

QE*

PE*

S*


13

Concept of Producer Surplus

Producer Surplus (PS) is a term economists use for profit

PS measured as the area above the supply curve and below market equilibrium price

→Total Economic Surplus (TES) = Consumer Surplus (CS, Chapter 4) + PS

Page 13314

Page 133

F

Product Price

Market Price of $4Market Price of $4

A B

PS at $4 = area ABC

PS at $4 = area ABC


Market Supply

$4

C

Output

Price

15

Page 133

F

B

PS at $6 = area EDC

PS at $6 = area EDC


Market Supply

$4

C

$6

Suppose Price Increased to $6…Suppose Price Increased to $6…

E D

G

A

Output

Price

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F

B


Market Supply

$4

C

$6 E D

The gain in PS if the price increases from $4 to $6 is equal to area AEDB

The gain in PS if the price increases from $4 to $6 is equal to area AEDB

A

Producers are better off by increasing output from F to G

Producers are better off by increasing output from F to G

G

Price

Output

17

Assessing Economic WelfareWe can use the concepts of market

demand and supply to Assess the effects of events in the

economy on the economic well being of consumers and producers For a particular market During a specific time period

We do this using the concept of total economic surplus (TES) defined as:

TES = CS + PS

Total Consumers Producers18

An Example of Economic Welfare AnalysisAn Example of Economic Welfare Analysis

Page 136-137

Assessing Economic Welfare

Assume a drought occursBefore this happened

PS = area BCACS = area BCDTES = area BCA + area

BCD = area ADC

A

B C

D

Q

$

19


Page 136-137


A

B C

D

EF

G

H

Assume the drought causes supply curve to shift up

After the droughtPS = area FEH

Gain BFEG + Loss AHGCCS = area FDE

Loss of BFEG + GECTES = area HDE

Loss of AHGC + GEC

Q

$

20


Page 136-137


A

B C

D

EF

G

H

Drought causes Consumers to be worse off as

no gain area Producers are worse off if

area BFEG (gain) is less than AHGC (loss)

Area BFEG is transferred from consumers to producers

Society is on net worse off as no gain area (area AHEC)

Q

$

21

Measuring Surplus LevelsMeasuring Surplus Levels

Product priceD

Supply

10

CS = (10 x (6-4))÷2 = $10CS = (10 x (6-4))÷2 = $10

Page 136-137


PS =(10 x (4-1))÷2 = $15PS =(10 x (4-1))÷2 = $15

→Total economic surplus = CS + PS= $10 + $15 = $25

→Total economic surplus = CS + PS= $10 + $15 = $25

A

B C

EF

ABCD = ?FADE = ?

22

$4

$1

$6

Demand

$

Q

Modeling Commodity

Prices

23

Page 136-137

S

$4

10

$1

$6

Otherfactors

Otherfactors

D

D = α – βP + γYD + δXD = α – βP + γYD + δX

Inputcosts

Inputcosts

Otherfactors

Otherfactors

S = θ + πP – τC + χZ

Ownprice

Ownprice

Ownprice

Ownprice Disposable

income

Disposableincome

Forecasting Future Commodity Price TrendsForecasting Future Commodity Price Trends

Modeling Commodity Prices

24

$

Q

Page 221

QD = QSQD = QS

S

P*

D

QD = 10 – 6P + .3YD + 1.2XQD = 10 – 6P + .3YD + 1.2X

(1) Substitute demand and supply equations into equilibrium condition

(2) Solve for equilibrium price (P*)(3) Substitute this price into either supply

or demand equation for Q*25

Modeling Commodity Prices

Q*

QS = 2 + 4P – .2C + 1.02ZQS = 2 + 4P – .2C + 1.02Z

Determining P* and Q*

$

Q

Assume you knowYD, X, C and Z

Many ApplicationsPolicy decisions by Congress and the

PresidentCommodity modeling by brokers/tradersLender credit repayment capacity

analysisOutlook presentations by extension eco.Farm planting decisionsLivestock producers herd size and feedlot

placement decisionsStrategic planning for processors

26

Market Disequilibrium

27

At PS→ Market Surplus exists = QS - QDAt PS→ Market Surplus exists = QS - QD

Page 138

At price PS, producers would supply QS

At price PS, producers would supply QS

At price PS, consumers would demand QD

At price PS, consumers would demand QD

28


QD QS

PS

PD

P*

Q*

D

SSurplus

At PD→ Market Shortage exists = QS - QDAt PD→ Market Shortage exists = QS - QD

Page 138

At price PD, consumers would demand QS

At price PD, consumers would demand QS

At price PD, producers would supply QD

At price PD, producers would supply QD

29


QD QS

PS

PD

P*

Q*

D

S

Shortage


Markets converge to equilibrium over time unless other events in the economy occur One explanation for this adjustment which

makes sense for agriculture is the Cobweb theory

This names comes from the spider web-like trail the adjustment process makes

30

Market DisequilibriumLets use the example of a grain producer

Producers tend to use last years price (year 1) as their expected price for this year (year 2)

Alternatively, consumer’s pay this years price determined by market equilibrium Q2

31

Year Two ReactionsYear Two Reactions

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Year Three ReactionsYear Three Reactions

P2

P3

Page 140


33

Year Four ReactionsYear Four Reactions

P4

P3

Page 140


Producer decisionbased on Year 3 Price

Consumer decisionbased on Year 4 Price

Q4

34

Page 140


From the above results we have the following:(P1 – P2) > (P3 – P2) > (P3 – P4)

(Q2 – Q1) > (Q2 – Q3) > (Q4 – Q3)

Eventually wil converge to P*, Q* the equilibrium price and quantity35

Price changes are getting smaller

Quantity changes are getting smaller

Page 140

The market converges to an equilibrium price and quantityQD = QS at PE

In some markets, adjustment period may months, weeks or yearsDepends on production

time requiredMarket

equilibrium

Marketequilibrium

Cobweb Pattern Over TimeCobweb Pattern Over Time


36

Market-to-Firm Linkages

37

Some Important Jargon

We need to distinguish between Movement along a particular demand or

supply curve Referred to as a change in quantity

demanded or supplied Shifts in the demand or supply curve

Referred to as a change in demand or supply

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Increase in demand increases price from Pe to Pe*

Increase in demand increases price from Pe to Pe*

Decrease in demanddecreases price from Pe to Pe*

Decrease in demanddecreases price from Pe to Pe*

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Increase in supplydecreases price from Pe to Pe*

Increase in supplydecreases price from Pe to Pe*

Decrease in supplyincreases price from Pe to Pe*

Decrease in supplyincreases price from Pe to Pe*

40

Merging Demand and Supply

Price

Quantity

D S

PE

QE

Chapters 6-7Chapters 6-7

Chapters 3-5Chapters 3-5

41

Firm is a Price Taker Under Perfect Competition

Price

Quantity

D S

PE

QE

Price

QF

AVC MC

The MarketThe Market The FirmThe Firm

PE= MR = MC

42

Impact of an Increase in Demand

Price

Quantity

D S

PE

QE

Price

AVCMC


10 11

D1

Q*E

43

Price

Quantity

D S

PE

QE

Price

AVC MC


9 10

D2

Impact of a Decrease in Demand

Q*E

44

Firm is a Price Taker in the Input Market

DLSL

PL

QL LF

MVP

MIC

Labor MarketLabor Market The FirmThe Firm

Labor

WageRate

WageRate

45

WageRate

Labor

DL

SL

PL

QL LF

MVP

MIC


L*F

WageRate

Firm is a Price Taker in the Input Market

46

DL*

Effects of Increasing The Minimum Wage

D S

PMIN

QD LMAX

MVP

MIC


QS

WageRate Wage

Rate

Labor

47

SummaryMarket equilibrium price and quantity are

given by the intersection of demand and supplyProducer surplus captures the profit earned in

the market by producers Total economic surplus is equal to producer

surplus plus consumer surplusA 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….

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Market Equilibrium and Market Demand: Perfect Competition