Market Equilibrium and Market Demand: Perfect Competition Chapter 8

Discussion Topics Derivation of market supply curve Elasticity of supply and producer surplus Market equilibrium under perfect competition Total economic surplus Adjustments to market equilibrium

Remember the firm’s supply curve? P=MR=AR Page 123

Page 162 Firm’s supply curve starts at shut down level of output P=MR=AR Firm’s supply curve starts at shut down level of output Page 162

Page 162 Profit maximizing firm will desire to produce where MC=MR P=MR=AR Page 162

Page 162 Economic losses will occur beyond output OMAX, where MC > MR P=MR=AR Page 162

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 163

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 163

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 163

Merging Demand and Supply Price D S PE Market clearing price QE Quantity

Merging Demand and Supply Price D S PE Chapters 3-5 QE Quantity

Merging Demand and Supply Factors that change demand: Other prices Consumer income Tastes and preferences Real wealth effect Global events Price D* D S PE* PE QE QE* Quantity

Merging Demand and Supply Price D S Chapters 6-7 PE QE Quantity

Merging Demand and Supply Factors that change supply: Input costs Government policy Price expectations Weather & disease Global events Price D S PE* PE QE* QE 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 165

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 165

Market Price of $4 Page 165 Producer surplus at $4 B Product price Producer surplus at $4 is equal to area ABC F G Page 165

Suppose Price Increased to $6… Product price Producer surplus at $6 is equal to area EDC F G Page 165

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 165

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 during a specific period. We do this using the total economic surplus which is given by: Total economic Consumer Producer surplus surplus surplus = +

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. Total economic equals area 3+4+5+6+7 Page 169

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 169

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 169

Measuring Surplus Levels $7 D Consumer surplus is equal to (10 x (7-4))÷2, or $15 S $4 Product price $1 10 Page 168

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 Page 168

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… Page 168

Modeling Commodity Prices

Forecasting Future Commodity Price Trends $7 D S D = a – bP + cYD + eX $4 Own price Disposable income Other factors $1 10 Page 168

Forecasting Future Commodity Price Trends $7 D S Own price Input costs Other factors $4 S = n + mP – rC + sZ $1 10 Page 168

Projecting Commodity Price $7 D S D = 10 – 6P + .3YD + 1.2X $4 D = S S = 2 + 4P – .2C + 1.02Z $1 10 Substitute the demand and supply equations into the the equilibrium condition and solve for price Page 221

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

Market Disequilibrium

Market Surplus At the price is PS, producers would supply QS. Page 170

At the price is PS, consumers would only want QD. Market Surplus Page 170

At the price is PS, a market surplus equal QS – QD exists Page 170

At the price is PD, producers would only supply QS. Market Shortage Page 170

Market Shortage Consumers want QD at this low price. Page 170

At the price is PS, a market shortage equal QD – QS exists Consumers want QD at this low price. Page 170

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 names stems from the spider like trail the adjustment process makes.

Year 2 Reactions Page 172 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 172

Year 3 Reactions Page 172 Producers now decide to produce less at the lower expected price. This lower quantity pushes price up to P3 in year 3. Page 172

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 172

Market-to-Firm Linkages

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

Increase in demand pulls up price from Pe to Pe* Decrease in demand pushes price down from Pe to Pe* Page 167

Increase in supply pushed price down from Pe to Pe* Decrease in supply pulls up price from Pe to Pe* Page 167

Merging Demand and Supply Price D S Chapters 6-7 PE Chapters 3-5 QE Quantity

Firm is a “Price Taker” Under Perfect Competition The Market The Firm Price Price D S AVC MC PE QE OMAX Quantity

If Demand Increases…… The Market The Firm Price Price S AVC MC PE QE 10 11 Quantity

If Demand Decreases…… The Market The Firm Price Price D S D2 AVC MC PE QE 9 10 Quantity

Firm is a “Price Taker” in the Input Market Labor Market The Firm Price Price D S MVP MIC PE QE LMAX Quantity

Firm is a “Price Taker” in the Input Market Labor Market The Firm Price Price D S MVP PE MIC QE LMAX Quantity

Effects of Increasing The Minimum Wage Labor Market The Firm Price Price D S MVP PMIN MIC QD QS LMAX Quantity

Summary Market equilibrium price and quantity are given by the intersection of demand and supply Producer surplus captures the profit earned in the market by producers Total economic surplus is equal to producer surplus plus consumer surplus A market surplus exists when the quantity supplied exceeds the quantity demanded. A market shortage exists when the quantity demanded exceeds the quantity supplied.

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