How do Supply & Demand Get Together to Make Markets? Agenda: I.What is Competition? II.Birds & Bees Review A. Where do demand curves come from? B. Where do supply curves come from? III.How do demand and supply get together to make markets? A. Assumptions underlying perfect competition B. Mechanics of perfect competition short & long term IV. What’s next…Garden Gnome example…

What does “competition” mean to you?

So Where DO Demand Curves Come From? composite good quantity Price KEY: Pay attention to what is on the X and Y axes! What is the price of shelter at this budget constraint? At this price, what is the optimal quantity of shelter?

Slutsky & Elasticity Re-write the way we have written elasticities with x = Q for quantity of X Multiply both sides by P/Q, the last term by M/M and re-arrange M and Q Own price elasticity = compensated price elasticity – share of income * income elasticity Test yourself: Pick a product/service and draw the demand as a function of both the substitution and income effects.

Larger substitution & income effects Smaller substitution & income effects MARKET demand curves sum individual demand curves.

Short-run Individual firm supply curve Why not here?? Shutdown! P<AVC What if price is here? Economic loss! Supply Curves are MC curves ABOVE the minimum AVC! Test yourself: Does the supply curve have anything to do with fixed costs? Where Do Supply Curves Come From?

Price Elasticity of Supply The percent change in quantity supplied as a result of a change in market price If the cost of inputs does NOT change with quantity, then the long-run market supply curve will be horizontal and the elasticity will be zero. If the cost of inputs DOES change with quantity the long- run market supply curve will slope up, but there will still be no producer surplus.

Price Depends on Assumptions! 1. Are Products THE SAME (standardized, commodities)? 2. Are there barriers to firms entering or exiting? 3. Are there a lot of buyers and sellers? 4. Is there perfect information (no transactions costs)?

Different firms have different minimum marginal costs Allocative efficiency: no consumer will buy more, no producer will produce more at any other price. PARETO OPTIMAL Different consumers have different marginal benefits Short-run perfectly competitive equilibrium Long-run perfectly competitive equilibrium

But Wait…. Goods that are NOT Commodities, Externalities, Barriers to Entry, Regulation & Asymmetric Information

Perfect Competition MonopolyOligopolyMonopolistic Competition A Continuum of Competition…. Key questions: 1.Is there meaningful product differentiation? 2.Are there significant barriers to entry or exit?

Summary 1. IF the assumptions underlying perfect competition hold then the MARKET PRICE is all the information you need to know about both supply and demand. Price = minimum marginal benefit = maximum marginal cost 2. IF the assumptions underlying perfect competition hold then in the long run there is NO producer surplus and NO economic profit. Price = long-run marginal cost = long-run average cost 3. IF the assumptions underlying perfect competition hold then in the long run ALL firms produce the same quantity at the same cost. Price = LMC=LAC=SMC=SAC 4. IF the assumptions underlying perfect competition hold then the long-run equilibrium is PARETO OPTIMAL. But NOT SOCIALLY OPTIMAL when we consider externalities and non-commodities

Example: Garden Gnomes Market demand: P D = (1/100)Q D + 65 or Q D = P Market supply: P S = (1/1200)Q S or Q S = 1200P FIRM total cost: C(q) = q 2 /200 FRIM marginal cost: MC(q) = 2q/200 = q/ What is the equilibrium price and quantity for the MARKET? 2. What is the amount supplied by the FIRM? 3. If all firms have the same cost structure, how many firms will be in this market? 4. What is the profit (loss) for the FIRM? 5. What is the producer surplus for the FIRM? 7. Would you want to go into the Garden Gnome industry? 8. What is the lowest price you would sell your 500 Garden Gnomes for in the short run? 6. What is the consumer surplus for the MARKET? (hint: draw the graph!)