Market Equilibrium and Market Demand: Perfect Competition

MarketEquilibrium and Market Demand:

Perfect CompetitionChapter 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?

P=MR=AR

3

Page 131

P3=MR3=AR3

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

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

5

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

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

curvesWe can combine these concepts to identify

what is referred to as the Market Equilibrium

8

Price

Quantity

D S

PE

QE


Market clearing price

9

Market Demand Curve =Horizontal summation ofindividual consumer demand curves

Market Supply Curve =Horizontal summation ofindividual firm supply curves

Price

Quantity

D S

PE

QE


Chapters 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 - 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 SurplusProducer Surplus (PS) is a term

economists use for aggregate returns over total variable costs

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

determined by individual MC curves

Page 13314

Page 133

D

Product Price

Market Price of $4

A B

Concept of Producer Surplus

Market Supply

$4

C

Output

Price

15

0

Total Revenue = 0ABD

Total Variable Cost = 0CBD

Page 133

D

Product Price

Market Price of $4

A B

PS at $4 = area ABC


Market Supply

$4

C

Output

Price

16

Page 133

D

PS at $6 = area EFC


Market Supply

$4

C

$6

Suppose Price Increased to $6…

E F

G

A

Output

Price

17

B

Page 133

D

B


Market Supply

$4

C

$6 E F

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

A

Producers are better off by increasing output from D to G

G

Price

Output

18

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 + PSTotal Surplus Consumer Surplus Producer Surplus

19

An Example of Economic Welfare Analysis

Page 136-137

Assessing Economic Welfare

Assume we have a market PS = area BCE CS = area BCA TES = area BCA + area BCE

= area AECThen a drought occurs

How can we examine whether consumers or producers are impactedA

B C

E

Q

$

20

D

S

Page 136-137


A

B C

E

IF

G

H

Assume the drought causes supply curve to shift up

After the droughtPS = area HFI

Gain BFIC + Lose AHGCCS = area FEI

Lose BFIG + Lose GIC TES = area HEI

Lose AHGC + Lose GIC

Q

$

21


D

SS*

Page 136-137


A

B C

E

IF

G

H

Q

$

22


D

SS*

Drought causes Consumers to be worse off

as no gain area Producers are worse off if

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

Area BFIG is transferred from consumers to producers

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

Measuring Surplus Levels

Product priceD

Supply

10

CS = (10 x (6-4))÷2 = $10

Page 136-137


PS =(10 x (4-1))÷2 = $15

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

A

B C

EF

ABCD = ?FADE = ?

23

$4

$1

$6

Demand

$

Q

Modeling Commodity

Prices

24

Page 136-137

S

$4

10

$1

$6Otherfactors

D

D = α – βP + γYD + δX

Inputcosts

Otherfactors

S = θ + πP – τC + χZ

Ownprice

Ownprice Disposable

income

Forecasting Future Commodity Price Trends

Modeling Commodity Prices

25

$

Q

Page 221

S

P*

D

QD = 10 – 6P + .3YD + 1.2X

26


Q*

QS = 2 + 4P – .2C + 1.02Z

How can we determine the values of P* and Q*?

$

Q

QD = QSQ* =QD = QSEquilibriumCondition

Page 221

S

P*

D

QD = 10 – 6P + .3YD + 1.2X

27


Q*

QS = 2 + 4P – .2C + 1.02Z

$

Q

The above shows relationship between P and either QS and/or QD

Lets undertake a ceteris paribus analysis and assume values for YD, X C and Z

QD = QSQ* =QD = QSEquilibriumCondition

Page 221

QD = QS

S

P*

D

QD = 50 – 6P

How can we determine the value of Q*(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*28


Q*

QS = 42 + 4P

$

Q

Q* =QD = QSEquilibriumCondition

How can we determine the value of Q* and P*1) Substitute demand and supply equations

into equilibrium condition

2) Solve for equilibrium price (P*)50 – 6P = 42 + 4P → 8 + 10P = 0

→P* = 8/10 = 0.803) Substitute this price into either supply or

demand equation for Q*Demand EquationQD

* = 50 – 6P* = 50 – 6(0.8) = 50 – 4.8 = 45.2Supply EquationQS

* = 42 + 4P* = 42 + 4(0.8) = 42 + 3.2 = 45.2Page 22129


Q* =QD = QS→ (50 – 6P) = (42 + 4P)

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

30

Market Disequilibrium

31

At PS→ Market Surplus exists as QS – QD > 0

Page 138

At price PS, producers would supply QS

At price PS, consumers would demand QD

32


QD QS

PS

PD

P*

Q*

D

SSurplus

At PD→ Market Shortage exists as QS – QD < 0

Page 138

At price PD, consumers would demand QS

At price PD, producers would supply QD

33


QD QS

PS

PD

P*

Q*D

S

Shortage

Market DisequilibriumMarkets 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

34

Market DisequilibriumLets use the example of a grain producer

Producers tend to use last year’s price (P1) as their expected price for this year (year 2)

In contrast, consumer’s pay this years price (P2) determined by market equilibrium Q2

35

Year Two Reactions

Page 140


36

Year Three Reactions

P2

P3

Page 140


37

Year Four Reactions

P4

P3

Page 140


Producer decisionbased on Year 3 Price

Consumer decisionbased on Year 4 Price

Q4

38

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 quantity39

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

Cobweb Pattern Over Time


40

Market-to-Firm Linkages

41

Some Important JargonAs we noted before we 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

42

Page 135

Increase in demand increases price from Pe to Pe*

Decrease in demanddecreases price from Pe to Pe*

43

Page 135

Increase in supplydecreases price from Pe to Pe*

Decrease in supplyincreases price from Pe to Pe*

44

Merging Demand and SupplyPrice

Quantity

D S

PE

QE

Chapters 6-7

Chapters 3-5

45

Firm is a Price Taker Under Perfect Competition

Price

Quantity

D S

PE

QE

Price

QF

AVC MC

The Market The Firm

PE= MR = MC

46

Impact of an Increase in Demand

Price

Quantity

D S

PE

QE

Price

AVCMC

The Market The Firm

10 11

D1

Q*E

47

Price

Quantity

D S

PE

QE

Price

AVC MC

The Market The Firm

9 10

D2

Impact of a Decrease in Demand

Q*E

48

Firm is a Price Taker in the Input Market

DL SL

PL

QL LF

MVP

MIC

Labor Market The Firm

Labor

WageRate

WageRate

49

WageRate

Labor

DL

SL

PL

QL LF

MVP

MIC


L*F

WageRate

Firm is a Price Taker in the Input Market

50

DL*

Effects of Increasing The Minimum Wage

D S

PMIN

QD LMAX

MVP

MIC


QS

WageRate Wage

Rate

Labor51

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