AAEC 3315 Agricultural Price Theory Chapter 10 Theory of Markets Under Perfect Competition

Objectives  To learn: How Market Supply & Demand curves interact to determine the prices & quantities of goods & services produced & consumed under a perfectly competitive market structure. We begin with perfect competition because it is basic to understanding of the economic system and a benchmark against which other market forms may be compared.

Characteristics of Perfectly Competitive Markets  Many Buyers & Sellers  Homogenous Product  Freedom of Entry & Exit (i.e. there are no barriers to entry)  Perfect Information

Market Demand  Remember that the aggregate or market demand is obtained by the horizontal summation of all individual consumer’s demand curves.  Market Demand - a schedule showing the amounts of a good consumers are willing and able to purchase in the market at different price levels during a specified period of time.  Mathematically, a demand function can be expressed as: Q D = f (P).  A hypothetical Demand function would be 3Q D = 120 – 6P Q P $2 $ D1 D Market Demand

Market Supply  Remember that the supply curve for a good in the market is the horizontal sum of all individual firm’s supply curves.  Market Supply - is the various amounts of a good that producers are willing & able to produce and supply at different price levels during a specified period of time.  Mathematically, a supply function can be expressed as: Q S = f (P).  A hypothetical Demand function would be 5Q S = 10P S1 S2 Market Supply Q P P1P1 P2P2 Q 11 Q 12 Q 1M Q 21 Q 22 Q 2M

Markets  A Market is an institution or an arrangement that brings buyers and sellers together.  Market Price - is the mutually agreeable price at which willing buyers and willing sellers exchange a good.

Market Equilibrium  Thus, we need to simultaneously consider both the market demand and supply to understand the concept of market equilibrium.  Market equilibrium occurs when the quantity of a good offered by a sellers at a given price equals the quantity buyers are willing and able to purchase at that same price.  Thus, Market equilibrium occurs at price equals P * and quantity equals Q *. Q P D S Q*Q* P*P*

Market Equilibrium A Mathematical Application  Suppose that the demand and supply function are given by 3Q D = 120 – 6P 5Q S = 10P  Market equilibrium occurs when the quantity of a good offered by a sellers at a given price (Q S ) equals the quantity buyers are willing and able to purchase at that same price (Q D ).  Thus, Market equilibrium occurs when Q S = Q D.  To set Q S = Q D, first we have to express the demand and supply functions in terms of Q. 3Q D = 120 – 6P or Q D = 40 – 2P 5Q S = 10P or Q S = 2P  Now, setting Q S = Q D, we have 40 – 2P = 2P or 4P = 40 or P = 10 (equilibrium price)  Market equilibrium quantity can now be calculated by plugging the equilibrium price back to either the demand function or the supply function 3Q D = 120 – 6(10) or 3Q D = 60 or Q D = 20 = Q S (equilibrium quantity)

Effects on price of Shift in the Demand Curve Q P D S Q*Q* P*P* D1D1 Q1*Q1* P1*P1* An increase in demand, or a shift of the Demand curve to the right, results in an increase in equilibrium price and quantity. A decrease in demand, or a shift of the Demand curve to the left, results in a decrease in equilibrium price & quantity. D2D2 P2*P2* Q2*Q2*

Effects on price of Shift in the Supply Curve Q P D Q*Q* P*P* S  An increase in supply, or a shift of the supply curve to the right, results in a decrease in equilibrium price and an increase in quantity.  A decrease in supply, or a shift of the supply curve to the left, results in an increase in equilibrium price and a decrease in quantity. S1S1 P1*P1* Q1*Q1* S2S2 P2*P2* Q2*Q2*

Disequilibrium Prices Shortages and Surpluses  Markets that are not in equilibrium have either shortages or surpluses.  If the market price is higher than the equilibrium price then: Quantity supplied is Q S Quantity demanded is Q D  Thus there is surplus in the market. Q P D S Q*Q* P*P* P1P1 QSQS QDQD Surplus

Disequilibrium Prices Shortages and Surpluses  If the market price is lower than the equilibrium price there then: Quantity supplied is Q S Quantity demanded is Q D  Thus there is shortage in the market. Q P D S Q*Q* P*P* QDQD QSQS P2P2 Shortage

Market Forces at Play  If the market price is either higher or lower than the equilibrium price, economic forces come into play to move the price toward the equilibrium price.  The tendency of markets to move toward equilibrium is a phenomenon that is sometimes called the INVISIBLE HAND. Q P D S P*P* P1P1 P2P2 Q*Q*

LET’S PUT THINGS TOGETHER

Q P D S Q*Q* P*P* Y P D1 D2 Market Demand (D) V Y Z IC 2 W IC 3 S IC 1 Y1Y1 Y2Y2 Y3Y3 Z3Z3 Z2Z2 Z1Z1 Y Price of Y Y1Y1 Y2Y2 Y3Y3 P1P1 P2P2 P3P3 S1 S2 Market Supply (S) Y P AR=MR I X Y TPP X Y APP MPP 0 III II D1