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MarketEquilibrium and Market Demand:

Perfect Competition

Chapter 8

Introduction to Agricultural Economics, 5th edPenson, Capps, Rosson, and Woodward

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Discussion Topics

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

competitionTotal economic surplusAdjustments to market equilibrium

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Page 131

P=MR=AR

Remember the firm’ssupply curve?

Remember the firm’ssupply curve?

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Page 131

Firm’s supply curvestarts at shut downlevel of output

Firm’s supply curvestarts at shut downlevel of output

P=MR=AR

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Page 131

Profit maximizing firm will desire to producewhere MC=MR

Profit maximizing firm will desire to producewhere MC=MR

P=MR=AR

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Page 131

Economic losses will occurbeyond output OMAX, whereMC > MR

Economic losses will occurbeyond output OMAX, whereMC > MR

P=MR=AR

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Market supply curve can be thought of as the horizontal summationof the supply decisions of all firms in the market. Here, at a priceof $1.50, Gary would supply 2 tons of broccoli and Ima would supply 1 ton, giving a market supply of 3 tons.

Market supply curve can be thought of as the horizontal summationof the supply decisions of all firms in the market. Here, at a priceof $1.50, Gary would supply 2 tons of broccoli and Ima would supply 1 ton, giving a market supply of 3 tons.

Page 132

Building the Market Supply CurveBuilding the Market Supply Curve

Introduction to Agricultural Economics, 5th edPenson, Capps, Rosson, and Woodward

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Market supply curve can be thought of as the horizontal summationof the supply decisions of all firms in the market. Here, at a priceof $1.50, Gary would supply 2 tons of broccoli and Ima would supply 1 ton, giving a market supply of 3 tons.

Market supply curve can be thought of as the horizontal summationof the supply decisions of all firms in the market. Here, at a priceof $1.50, Gary would supply 2 tons of broccoli and Ima would supply 1 ton, giving a market supply of 3 tons.

+

Page 132

Building the Market Supply CurveBuilding the Market Supply Curve

Introduction to Agricultural Economics, 5th edPenson, Capps, Rosson, and Woodward

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Market supply curve can be thought of as the horizontal summationof the supply decisions of all firms in the market. Here, at a priceof $1.50, Gary would supply 2 tons of broccoli and Ima would supply 1 ton, giving a market supply of 3 tons.

Market supply curve can be thought of as the horizontal summationof the supply decisions of all firms in the market. Here, at a priceof $1.50, Gary would supply 2 tons of broccoli and Ima would supply 1 ton, giving a market supply of 3 tons.

+ =

Page 132

Building the Market Supply CurveBuilding the Market Supply Curve

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Merging Demand and Supply

Price

Quantity

D S

PE

QE

Market clearing priceMarket clearing price

Introduction to Agricultural Economics, 5th edPenson, Capps, Rosson, and Woodward

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Merging Demand and Supply

Price

Quantity

D S

PE

QE

Chapters 3-5Chapters 3-5

Introduction to Agricultural Economics, 5th edPenson, Capps, Rosson, and Woodward

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Merging Demand and Supply

Price

Quantity

D S

PE

QE

Factors that changedemand: Other prices Consumer income Tastes and preferences Real wealth effect Global events

Factors that changedemand: Other prices Consumer income Tastes and preferences Real wealth effect Global events

D*

QE*

PE*

Introduction to Agricultural Economics, 5th edPenson, Capps, Rosson, and Woodward

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Merging Demand and Supply

Price

Quantity

D S

PE

QE

Chapters 6-7Chapters 6-7

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Merging Demand and Supply

Price

Quantity

D S

PE

QE

Factors that changesupply: Input costs Government policy Price expectations Weather & disease Global events

Factors that changesupply: Input costs Government policy Price expectations Weather & disease Global events

QE*

PE*

S*

Introduction to Agricultural Economics, 5th edPenson, Capps, Rosson, and Woodward

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Concept of Producer Surplus

Producer surplus is a fancy term economists use for profit. We measure producer surplusas the area above the supply curve andbelow the market equilibrium price.

Page 133

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Concept of Producer Surplus

Producer surplus is a fancy term economists use for profit. We measure producer surplusas the area above the supply curve andbelow the market equilibrium price.

Total economic surplus is therefore equal toconsumer surplus discussed in Chapter 4 plus producer surplus.

Page 133

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Page 133

F G

Product price

Market Price of $4Market Price of $4

A B

Producer surplus at $4is equal to area ABC

Producer surplus at $4is equal to area ABC

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Page 133

F G

Producer surplus at $6is equal to area EDC

Producer surplus at $6is equal to area EDC

Product price

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

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Page 133

The gain in producer surplus if the price increases from $4is equal to area AEDB

The gain in producer surplus if the price increases from $4is equal to area AEDB

F G

Producers are betteroff economically byresponding to thisprice increase byproducing output G

Producers are betteroff economically byresponding to thisprice increase byproducing output GC

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Economic Welfare Concepts

We can use the concepts of market demandand supply to assess the effects of eventsin the economy have upon the economicwell being of consumers and products ina particular market during a specific period.

We do this using the total economic surplus which is given by:

Total economic Consumer Producer surplus surplus surplus= +

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An Example of Economic Welfare AnalysisAn Example of Economic Welfare Analysis

Page 136-137

Assume a drought occursthat results in a decreasein supply from S to S*.

Before this happened,consumer surplus wasarea 3+4+5 while producersurplus was equal toarea 6+7. Total economicequals area 3+4+5+6+7

Assume a drought occursthat results in a decreasein supply from S to S*.

Before this happened,consumer surplus wasarea 3+4+5 while producersurplus was equal toarea 6+7. Total economicequals area 3+4+5+6+7

Introduction to Agricultural Economics, 5th edPenson, Capps, Rosson, and Woodward

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An Example of Economic Welfare AnalysisAn Example of Economic Welfare Analysis

After the decrease insupply, consumer surplusis just area 3. They lose area 4 and area 5.

Producers gain area 4 butlose area 7.

After the decrease insupply, consumer surplusis just area 3. They lose area 4 and area 5.

Producers gain area 4 butlose area 7.

Page 136-137

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An Example of Economic Welfare AnalysisAn Example of Economic Welfare Analysis

Consumers are thereforeworse off because of thedrought.

Producers are also worse off if area 4 is less than area 7.

Society loses area 5+7.

Consumers are thereforeworse off because of thedrought.

Producers are also worse off if area 4 is less than area 7.

Society loses area 5+7.

Page 136-137

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Measuring Surplus LevelsMeasuring Surplus Levels

Product price

DS

$4

10

$1

$7Consumer surplus isequal to (10 x (7-4))÷2,or $15

Consumer surplus isequal to (10 x (7-4))÷2,or $15

Page 136-137

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Measuring Surplus LevelsMeasuring Surplus Levels

Product price

DS

$4

10

$1

$7Consumer surplus isequal to (10 x (7-4))÷2,or $15

Consumer surplus isequal to (10 x (7-4))÷2,or $15

Producer surplus isEqual to (10 x (4-1))÷2,or $15

Producer surplus isEqual to (10 x (4-1))÷2,or $15

Page 136-137

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Measuring Surplus LevelsMeasuring Surplus Levels

Product price

DS

$4

10

$1

$7Consumer surplus isequal to (10 x (7-4))÷2,or $15

Consumer surplus isequal to (10 x (7-4))÷2,or $15

Producer surplus isEqual to (10 x (4-1))÷2,or $15

Producer surplus isEqual to (10 x (4-1))÷2,or $15

Total economic surplusis therefore $30…

Total economic surplusis therefore $30…

Page 136-137

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Modeling Commodity

Prices

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Forecasting Future Commodity Price TrendsForecasting Future Commodity Price Trends

DS

$4

10

$1

$7

D = a – bP + cYD + eXD = a – bP + cYD + eX

Ownprice

Ownprice

Disposableincome

Disposableincome

Otherfactors

Otherfactors

Page 136-137

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DS

$4

10

$1

$7

S = n + mP – rC + sZS = n + mP – rC + sZ

Ownprice

Ownprice

Inputcosts

Inputcosts

Forecasting Future Commodity Price TrendsForecasting Future Commodity Price Trends

Otherfactors

Otherfactors

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Projecting Commodity PriceProjecting Commodity Price

Page 221

D = SD = S

DS

$4

10

$1

$7

D = 10 – 6P + .3YD + 1.2XD = 10 – 6P + .3YD + 1.2X

S = 2 + 4P – .2C + 1.02ZS = 2 + 4P – .2C + 1.02Z

Substitute the demand and supplyequations into the the equilibriumcondition and solve for price

Substitute the demand and supplyequations into the the equilibriumcondition and solve for price

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Many Applications Policy decisions by Congress and the president Commodity modeling by brokers and traders Credit repayment capacity analysis by lenders Outlook presentations by extension economists Planting decisions by farmers Herd size and feedlot placement decisions by

livestock producers Strategic planning for processors

Introduction to Agricultural Economics, 5th edPenson, Capps, Rosson, and Woodward

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Market Disequilibrium

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Market SurplusMarket Surplus

At the price is PS, producers wouldsupply QS.

At the price is PS, producers wouldsupply QS.

Page 138

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Market SurplusMarket Surplus

At the price is PS, consumers wouldonly want QD.

At the price is PS, consumers wouldonly want QD.

Page 138

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Market SurplusMarket Surplus

At the price is PS, a market surplus equal QS – QD exists

At the price is PS, a market surplus equal QS – QD exists

Page 138

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Market ShortageMarket Shortage

At the price is PD, producers wouldonly supply QS.

At the price is PD, producers wouldonly supply QS.

Page 138

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Market ShortageMarket Shortage

Consumers want QD at thislow price.

Consumers want QD at thislow price.

Page 138

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Market ShortageMarket Shortage

Consumers want QD at thislow price.

Consumers want QD at thislow price.

Page 138

At the price is PS, a market shortage equal QD – QS exists

At the price is PS, a market shortage equal QD – QS exists

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Adjustments to Market Equilibrium

Markets converge to equilibrium over time unless other events in the economy occur.

One explanation for this adjustment whichmakes sense in agriculture is the Cobwebtheory. This names stems from the spiderlike trail the adjustment process makes.

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Year Two ReactionsYear Two Reactions

Producers use last year’sprice as their expectedprice for year 2.

Consumers on the otherhand pay this year’s price determined by Q2.

Producers use last year’sprice as their expectedprice for year 2.

Consumers on the otherhand pay this year’s price determined by Q2.

Page 140

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Year Three ReactionsYear Three Reactions

P2

P3

Producers now decide toproduce less at the lowerexpected price. Thislower quantity pushesprice up to P3 in year 3.

Producers now decide toproduce less at the lowerexpected price. Thislower quantity pushesprice up to P3 in year 3.

Page 140

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Cobweb Pattern Over TimeCobweb Pattern Over Time

Marketequilibrium

Marketequilibrium

The market converges tomarket equilibrium wheredemand intersects supplyat price PE. In some markets, this adjustmentperiod may only be monthsor even weeks rather thanyears assumed here.

The market converges tomarket equilibrium wheredemand intersects supplyat price PE. In some markets, this adjustmentperiod may only be monthsor even weeks rather thanyears assumed here.

Page 140

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Market-to-Firm Linkages

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Some Important Jargon

We need to distinguish between movement along a demand or supply curve, and shifts in the demand or supply curve.

Introduction to Agricultural Economics, 5th edPenson, Capps, Rosson, and Woodward

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Some Important Jargon

We need to distinguish between movement along a demand or supply curve, and shifts in the demand or supply curve.

Movement along a curve is referred to as a“change in the quantity demanded or supplied”. A shift in a curve is referred to as a “changein demand or supply”.

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Page 135

Increase in demandpulls up price from Pe to Pe*

Increase in demandpulls up price from Pe to Pe*

Decrease in demandpushes price downfrom Pe to Pe*

Decrease in demandpushes price downfrom Pe to Pe*

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Page 135

Increase in supplypushed price down from Pe to Pe*

Increase in supplypushed price down from Pe to Pe*

Decrease in supplypulls up price from Pe to Pe*

Decrease in supplypulls up price from Pe to Pe*

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Merging Demand and Supply

Price

Quantity

D S

PE

QE

Chapters 6-7Chapters 6-7

Chapters 3-5Chapters 3-5

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Firm is a “Price Taker” Under Perfect Competition

Price

Quantity

D S

PE

QE

Price

OMAX

AVC MC

The MarketThe Market The FirmThe Firm

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If Demand Increases……

Price

Quantity

D S

PE

QE

Price

AVC MC

The MarketThe Market The FirmThe Firm

10 11

D1

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If Demand Decreases……

Price

Quantity

D S

PE

QE

Price

AVC MC

The MarketThe Market The FirmThe Firm

9 10

D2

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Firm is a “Price Taker” in the Input Market

Price

Quantity

D S

PE

QE

Price

LMAX

MVP

MIC

Labor MarketLabor Market The FirmThe Firm

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Firm is a “Price Taker” in the Input Market

Price

Quantity

D S

PE

QE

Price

LMAX

MVP

MIC

Labor MarketLabor Market The FirmThe Firm

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Effects of Increasing The Minimum Wage

Price

Quantity

D S

PMIN

QD

Price

LMAX

MVP

MIC

Labor MarketLabor Market The FirmThe Firm

QS

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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.

Introduction to Agricultural Economics, 5th edPenson, Capps, Rosson, and Woodward

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Chapter 9 focuses on market equilibrium and product prices under conditions of imperfect competition….