Modeling the Market Process: A Review of the Basics Chapter 2 © 2004 Thomson Learning/South-Western

2 Market Models: The Fundamentals Defining the Relevant Market  Market – the interaction between consumers and producers to exchange a well-defined commodity  Defining the market context is one of the more critical steps in economic analysis Specifying the Market Model  Form of the model varies with the objective of the prospective study and its level of complexity

3 The Model of Supply and Demand: An Overview Decisions of sellers are modeled through a supply function Decisions of consumers are modeled through a demand function

4 The Model of Supply and Demand: An Overview The Purpose of the Model  The primary objective of the supply and demand model is to facilitate and analysis of market conditions and any observed change in price  Conventional supply and demand model must be modified to account for conditions that weaken the operation of market forces

5 The Model of Supply and Demand: An Overview Building a Basic Model: Competitive Markets for Private Goods  Assumptions Large number of buyers and sellers with no control over price Homogenous or standardized product Absence of entry barriers Perfect information  Private good – a commodity that has two characteristics, rivalry in consumption and excludability

6 Market Demand Demand – the quantities of a good the consumer is willing and able to purchase at a set of prices during some discrete time period Demand price is considered a measure of the marginal benefit (MB) associated with consuming another unit of the good

7 Market Demand The Law of Demand – There is an inverse relationship between price and quantity demanded of a good  Modeling Individual Demand  Deriving Market Demand from Individual Demand Data Market demand for a private good – the decisions of all consumers willing and able to purchase a good, derived by horizontally summing the individual demands

8 Market Demand Figure 2.1 One Consumer’s Demand (d) for Bottled Water

9 Market Demand Figure 2.2 Market Demand (D) for Bottled Water

10 Market Supply Supply – the quantities of a good the producer is willing and able to bring to market at a given set of prices during some discrete time period Variables that potentially affect the price- quantity response of a firm:  Production technology  Input prices  Taxes and subsidies  Price expectations

11 Market Supply The Law of Supply – there is a direct relationship between price and quantity supplied of a good  Modeling Individual Supply  Deriving Market Supply from Individual Supply Data Market supply of a private good – the combined decisions of all producers in a given industry derived by horizontally summing the individual supplies

12 Market Supply Figure 2.3 One Producer’s Supply (s) of Bottled Water

13 Market Supply Figure 2.4 Market Supply (S) of Bottled Water

14 Market Equilibrium Supply and demand must be considered simultaneously to generate a model of price determination The formal theory that price is simultaneously determined by supply and demand is one of the most significant in all of economic analysis

15 Market Equilibrium Equilibrium Price and Quantity  Equilibrium price – the point at which the market system has no tendency to change  Equilibrium quantity – the “market-clearing” price associated with the equilibrium quantity

16 Market Equilibrium Market Adjustment to Disequilibrium  Disequilibrium – if the prevailing market price is at some level other than the equilibrium level, the market is said to be in disequilibrium  Shortage – excess demand of a commodity equal to (Q D – Q S ), that arises if price is below its equilibrium level  Surplus – excess supply of a commodity equal to (Q S – Q D ), that arises if price is above its equilibrium level Price movements serve as a signal that a shortage or surplus exists, whereas stability or price suggest equilibrium

17 Market Equilibrium Figure 2.5 Equilibrium in the Market for Bottled Water: Market Supply and Market Demand

18 Economic Criteria of Efficiency Allocative efficiency – requires that resources be appropriated such that the additional benefits to society are equal to the additional costs incurred  Evaluating Resource Allocation at the Market Level The value society places on the good is equivalent to the value of the resources given up to produce it

19 Economic Criteria of Efficiency  Evaluating Resource Allocation at the Firm Level Assumed motivation governing firm decision making is profit maximization Total profit – total profit is equal to total revenue minus total costs Decision making process relies on changes, the relevant marginal variables are: Marginal Revenue Marginal Cost Marginal Profit Profit maximization – achieved at the output level where marginal revenue equals marginal cost or where M ∏ = 0

20 Economic Criteria of Efficiency Figure 2.6 Competitive Firm’s Profit-Maximizing Equilibrium

21 Economic Criteria of Efficiency  Technical Efficiency – production decisions that generate maximum output given some stock of resources Market forces can achieve technical efficiency so long as competitive conditions prevail

22 Welfare Measures: Consumer Surplus and Producer Surplus Consumer surplus – the net benefit to buyers estimated by the excess of the marginal benefit (MB) of consumption over market price (P), aggregated over all units purchased  Consumer surplus depends on two distinct notions of price – one that measures a willingness to pay and on that measures what is actually paid  Any disturbance to market equilibrium will change the size of consumer surplus

23 Welfare Measures: Consumer Surplus and Producer Surplus Figure 2.7 Consumer Surplus in the Competitive Market for Bottled Water

24 Welfare Measures: Consumer Surplus and Producer Surplus Producer surplus – the net gain to sellers of a good estimated by the excess of the market price (P) over marginal cost (MC), aggregated by units sold  Any market disturbance will change its value and provide a way to assess any associated welfare gain or loss to firms

25 Welfare Measures: Consumer Surplus and Producer Surplus Figure 2.8 Producer Surplus in the Competitive Market for Bottled Water

26 Welfare Measures: Consumer Surplus and Producer Surplus The Welfare of a Society: Sum of Consumer and Producer Surplus  Society’s welfare – the sum of consumer surplus and producer surplus Measuring Welfare Changes  Deadweight loss to society – the net loss of consumer and producer surplus due to an allocatively inefficient market event

27 Welfare Measures: Consumer Surplus and Producer Surplus Figure 2.9 Deadweight Loss to Society Under a Pricing Regulation in the Bottled Water Market