Market Equilibrium and Market Demand: Perfect Competition Chapter 8

Chapter 8 - Topics of Discussion DERIVATION OF THE MARKET SUPPLY CURVE Firm Supply Curve -- Own-Price Elasticity of Supply Market Supply Curve -- Producer Surplus MARKET EQUILIBRIUM UNDER PERFECT COMPETITION Market Equilibrium Total Economic Surplus Applicability to Policy Analysis ADJUSTMENTS TO MARKET EQUILIBRIUM Market Disequilibrium -- Market Shortage Market Surplus -- Length of Adjustment Period Cobweb Adjustment Cycle

Firm’s supply curve starts at shut down level of output Page 131

Profit maximizing firm will desire to produce where MC=MR Page 131

Page 131 Economic losses will occur beyond output OMAX, where MC > MR Page 131

Building the Market Supply Curve + = Market supply curve can be thought of as the horizontal summation of the supply decisions of all firms in the market. Here, at a price of $1.50, Gary would supply 2 tons of broccoli and Ima would supply 1 ton, giving a market supply of 3 tons. Page 132

MARKET SUPPLY SCHEDULE Quantity Point Price Supplied A 1 2 B 2 3 C 3 6 D 4 8 D C B A Q

Own-Price elasticity of supply =

Calculate own-price elasticity of supply between $2 and $3. DQ P DP Q X DQ = 3, DP = 1, Q = 4.5, P = 2.5

DQ P DP Q X 3 2.5 1 4.5 X = 1.66 = ELASTIC 1% DP gives rise to a 1.66% DQ in quantity

Concept of Producer Surplus Producer surplus is a fancy term economists use for profit. We measure producer surplus as the area above the supply curve and below the market equilibrium price. Page 132

Concept of Producer Surplus Producer surplus is a fancy term economists use for profit. We measure producer surplus as the area above the supply curve and below the market equilibrium price. Total economic surplus is therefore equal to consumer surplus discussed in Chapter 4 plus producer surplus. Page 132

Market Price of $4 Page 133 Producer surplus at $4 Product price Producer surplus at $4 is equal to area ABC F G Page 133

Page 133 Total revenue at $4 would be area 0ABF while total cost would be area 0CBF. Thus Profit = area 0ABF-area 0CBF Product price C F G Page 133

by multiplying price time quantity, or $4 times output F Total revenue at $4 would be area 0ABF while total cost would be area 0CBF. Thus Profit = area 0ABF-area 0CBF Product price Area 0ABF can be found by multiplying price time quantity, or $4 times output F C F G Page 133

Suppose Price Increased to $6 Product price Producer surplus at $6 is equal to area EDC F G Page 133

Page 133 Total revenue at $6 would be area 0EDG while total cost would be area 0CDG. Thus profit would be area 0EDG minus area 0CDG, or CED. Product price C F G Page 133

The gain in producer surplus if the price increases from $4 is equal to area AEDB Producers are better off economically by responding to this price increase by producing output G C F G Page 133

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

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 supply”. A shift in a curve is referred to as a “change in demand or supply”.

Page 135 Increase in demand pulls up price from Pe to Pe* Decrease in demand pushes price down from Pe to Pe* Page 135

Page 135 Decrease in supply Increase in supply pulls up price from pushed price down from Pe to Pe* Decrease in supply pulls up price from Pe to Pe* Page 135

Economic Welfare Concepts We can use the concepts of market demand and supply to assess the effects of events in the economy have upon the economic well being of consumers and products in a particular market. We assess these effects using the concept of Consumer surplus introduced in Chapter 4 with producer surplus discussed here.

ECONOMIC SURPLUS Economic Surplus = Consumer Surplus + Producer Surplus Consumer Surplus = area #1, Producer Surplus = area #2

An Example of Economic Welfare Analysis Assume a drought occurs that results in a decrease in supply from S to S*. Before this happened, consumer surplus was area 3+4+5 while producer surplus was equal to area 6+7. Page 137

An Example of Economic Welfare Analysis After the decrease in supply, consumer surplus is just area 3. They lose area 4 and area 5. Producers gain area 4 but lose area 7. Page 137

An Example of Economic Welfare Analysis Consumers are therefore worse off because of the drought. Producers are also worse off if area 4 is less than area 7. Society loses area 5+7. Page 137

CHANGE IN ECONOMIC SURPLUS

Measuring Surplus Levels $7 D Consumer surplus is equal to (10 x (7-4))÷2, or $15 S $4 Product price $1 10

Measuring Surplus Levels $7 D Consumer surplus is equal to (10 x (7-4))÷2, or $15 S $4 Product price Producer surplus is Equal to (10 x (4-1))÷2, or $15 $1 10

Measuring Surplus Levels $7 D Consumer surplus is equal to (10 x (7-4))÷2, or $15 S $4 Product price Producer surplus is Equal to (10 x (4-1))÷2, or $15 $1 10 Total economic surplus is therefore $30…

Market Disequilibrium

Market Surplus Page 138 If the price is PS, producers would supply QS while consumers would only want QD at this high price. Page 138

Market Shortage Page 138 If the price is PD, producers would only supply QD while consumers want QD at this low price. Page 138

Adjustments to Market Equilibrium Markets converge to equilibrium over time unless other events in the economy occur. One explanation for this adjustment which makes sense in agriculture is the Cobweb theory. This name stems from the spider like trail the adjustment process makes.

Year Two Reactions Page 140 Producers use last year’s price as their expected price for year 2. Consumers on the other hand pay this year’s price determined by Q2. Page 140

Year Three Reactions Page 140 Producers now decide to produce less at the lower expected price. This lower quantity pushes price up to P3 in year 3. Page 140

Cobweb Pattern Over Time Market equilibrium The market converges to market equilibrium where demand intersects supply at price PE. In some markets, this adjustment period may only be months or even weeks rather than years assumed here. Page 140