1 Demand, Supply, and Equilibrium in a Perfectly Competitive Market

2 The Context: “Perfectly Competitive Markets” A group of buyers and sellers of a particular good or service –can be defined narrowly or broadly (e.g., rice vs. food) –at a given point in time (e.g., day, month, year) Enough buyers and sellers so that no one has an impact on the price –typical with many buyers and sellers

3 Willingness to Pay Willingness to pay (WTP): the maximum amount that a buyer will pay for a good Further distinctions are helpful… Marginal willingness to pay (MWTP): WTP for one more unit of a good Total willingness to pay (TWTP): WTP for any number of units of a good

4 An Individual’s WTP for good X

5 An Individual’s Demand Curve A graph of an individual’s MWTP curve is her demand curve Demand curve: gives the relationship between the price of a good and the quantity demanded Law of demand: downward sloping curve reflects diminishing MWTP

6 An Individual’s Demand Schedule A table that gives the relationship between the price and quantity demanded Based on the individual’s MWTP Price of XQuantity Demanded $50 $41 $32 $23 $14 $05

7 Consider a Market with Two Individuals Price of X Individuals 1’s Quantity Demanded Individual 2’s Quantity Demanded Total Quantity Demanded $5000 $4123 $3246 $2369 $14812 $051015

8 The Market (Aggregate) Demand Curve A horizontal summation of individual demand curves Tells the market quantity demanded at any given price Also tells the MWTP in the market—the most someone is WTP for each additional unit of the good

9 A Note on Demand Semantics Changes in price result in “changes in the quantity demanded” “Changes in demand” imply shifts of the demand curve

10 Shifters of the Demand Curve 1.Changes in income, + (-) Normal goods, + (-) Inferior goods, - (+) 2.Changes in the price of related goods, + (-) Substitutes, + (-) Complements, - (+) 3.Tastes and preferences 4.Expectations 5.Number of buyers in the market, + (-) implies + (-)

11 A Firm’s Marginal Cost (MC) of Production Marginal cost (MC): tells a firm’s incremental cost of producing an additional unit of a good We assume it is increasing (for now) We ignore the total costs of production (for now)

12 A Firm’s MC of Producing Good X Quantity of XMC 1$2 2$3 3$4 4$5 5$6

13 An Firm’s Supply Curve A graph of a firm’s MC curve is its supply curve Supply curve: gives the relationship between the price of a good and the quantity supplied Law of supply: upward sloping curve reflects increasing MC

14 A Firm’s Supply Schedule A table that gives the relationship between the price and quantity supplied Based on the firm’s MC Price of XQuantity Supplied $10 $21 $32 $43 $54

15 Consider a Market with Two Firms Price of X Firm 1’s Quantity Supplied Firm 2’s Quantity Supplied Total Quantity Supplied $1000 $2123 $3246 $4369 $54812

16 The Market (Aggregate) Supply Curve A horizontal summation of the individual firm supply curves Tells the market quantity supplied at any given price Also tells the MC in the market—the lowest cost of producing each additional unit of the good

17 A Note on Supply Semantics Changes in price result in “changes in the quantity supplied” “Changes in supply” imply shifts of the supply curve

18 Shifters of the Supply Curve 1.Changes in input prices, + (-) implies - (+) 2.Changes in the technology of production, such that better (worse) implies + (-) 3.Expectations 4.Number of sellers in the market, + (-) implies + (-)

19 Equilibrium: Supply “meets” Demand The intersection of the supply and demand curves determines the equilibrium price and quantity Market clearing condition: when the quantity supplied equals the quantity demanded Given the equations for the supply and demand curves, you can solve algebraically for P* and Q*

20 Equilibrium Proof by Contradiction If P > P*, then there would be excess supply (a surplus) –Firms would lower prices If P < P*, then there would be excess demand (a shortage) –Consumers would pay more Must be true that P = P* and that Q S = Q D = Q*

21 Comparative Static Analysis Ceteris paribus : other things being equal An increase (decrease) in demand results in more (less) exchange at a higher (lower) price An increase (decrease) in supply results in more (less) exchange at a lower (higher) price Simultaneous shifts in supply and demand can generate ambiguous effects