THEORY OF MARKETS

AAEC 2305Fundamentals of Ag

Economics

Objectives:

How Supply & Demand curves interact to determine the prices & quantities of goods & services produced & consumed

About markets in time, space, & formCharacteristics of a competitive marketDetermination of Output in a competitive

market

Economic Profit

Total Revenue

Explicit Costs

Accounting Profit

Explicit Costs

Economic Profit

“Normal” Profit

“Normal” Profit is the opportunity cost of resources supplied by owner of the firm; Economic profit (excess profits) are profits above opportunity costs and explicit costs

Graph

Economic profit

Stay in Farming Manage Retail Store

TR = $22,000 Explicit Costs = $10,000 Implicit Costs = $11,000 Accounting Profit = $12,000 Economic Profit = $1,000

TR = $11,000 Explicit Costs = $0 Implicit Costs = $11,000 Accounting Profit = $11,000 Economic Profit = $0

Pudge the Corn Farmer

Competition

Suppose that economic (excess) profits were that high for corn farming, would Pudge be the only person wanting to farm corn?

Excess profits attract new entrants into the business with similar opportunity costs as Pudge. For those with OC less than

Pudge, farming is very attractive For those with OC equal to Pudge,

they are indifferent about farming For those with OC greater than

Pudge, farming is not attractive

Markets

A Market is an institution or an arrangement that brings buyers and sellers together.

Market Price - is the mutually agreeable price at which willing buyers and willing sellers exchange a good.

Market Equilibrium

Market equilibrium occurs when the quantity of a good offered by a sellers at a given price equals the quantity buyers are willing and able to purchase at that same price. Like the two blades of scissors—which one cuts the

paper?

Graph

Market Equilibrium

Numerical Example

1

000,10000,10

000,5000,5000,10

000,5

000,5000,10

p

p

pp

QQ

pQ

pQ

sd

s

d

In equilibrium, demand and supply must equal one another:

The equilibrium price is $1. To get quantity, simply substitute $1 into either supply or demand: Q = 5,000p = 5,000 sandwiches.

Shifts in Supply and Demand

Graph of increase in input costGraph of increase in demand

Numerical Example—Input Cost Increase

Increase in minimum wage shifts supply function

11.1

000,9000,10

000,4000,5000,10

000,4

p

p

pp

QQ

pQ

sd

s

The increase in the minimum wage increased the equilibrium price of chicken sandwiches by $0.11

Numerical Example—Demand Increase

News of healthy chicken increases demand

20.1

000,12000,10

000,5000,5000,12

000,5000,12

p

p

pp

QQ

pQ

sd

d

The health news increased demand, increasing price by $0.20.

Functions of Price

Rationing—distribute scarce goods among potential claimants insuring that those that get them are the ones that value them the most

Allocative—direct productive resources to different sectors of the economy

Graphs

Firm profitEquilibriumExcess Profits and New EntryShort-run vs. Long run effects of demand and

supply changes

No-Cash-On-The-Table

If the price is “too low,” consumers will buy more to capture their “excess profits” by consuming products at a price less than they were willing to pay

If the price is “too high,” producers will produce more to capture their “excess profits” by producing products at a price more than they willing to accept

No-Cash-On-The-Table

Why are all lanes on a crowded, multi-lane freeway moving at about the same speed?

Why do grocery check-out lines all tend to be about the same length?

Perfect Competition

Large number of buyers and sellers At least a relatively large number of comparably sized

firmsRelatively homogeneous products

Basic commoditiesLow barriers to entry

Relatively easy to get in and out of the marketEconomic conditions

Small portion of consumer’s budget and relatively large production

Graph

Hairstylists and Aerobic Instructors

Economic Rent vs. Economic Profit

Profit is earnings above explicit and implicit costs; these are driven toward zero by competition

Rent is payment for a factor of production in excess of the reservation price Influenced by the “uniqueness” of the input

Efficiency (Pareto Efficiency)

Efficiency—if price and quantity take anything other than their equilibrium values, a transaction that will make someone better off without making anyone else worse off can always be found

A perfectly competitive market is the most efficient market form. It results in the highest possible total welfare of everyone in the market.

Surplus

Surplus is simply the economic benefits less the costs

In equilibrium, surplus is the total economic benefits accumulated from consuming/producing a good across all units at the equilibrium price. Consumer surplus is the area under the demand curve

and above the equilibrium price Producer surplus is the area above the supply function

and below the equilibrium price (also called profit)

Calculation

Consumer surplus is given by:

Producer surplus is given by:

02

1 ** QPPCS d

002

1 ** QPPS

Numerical Example

Back to our chicken sandwich example:

2

000,10000,5

000,5000,100

000,5000,10

p

p

p

pQd

First find Pd :

Set demand = 0 to get y-intercept:

dayCS

CS

CS

/500,2$

000,52

1

0000,5122

1

Find surplus:

dayPS

PS

PS

/500,2$

000,52

1

0000,5012

1

Changes in Consumer Surplus

Graph of Change in Demand and Change in Consumer Surplus

Numerical Example

40.2$

000,12000,5

000,5000,120

000,5000,12

p

p

p

pQd

Solving for y-intercept

600,3$0000,62.14.22

1CS

Calculating new CS:

100,1$500,2$600,3$ CSChange in consumer surplus: