1. Equilibrium and Efficiency
Chapter 14
Equilibrium and Efficiency
McGraw-Hill/Irwin
Copyright © 2008 by The McGraw-Hill Companies, Inc. All Rights Reserved.

2. Main Topics What makes a market competitive?
Market demand and market supply
Short-run and long-run competitive equilibrium
Efficiency of perfectly competitive markets
Measuring surplus using market demand and supply curves
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3. What Makes a Market Competitive?
Buyers and sellers have absolutely no effect on price
Three characteristics:
Absence of transaction costs
Product homogeneity: products are identical in the eyes of their purchasers
Presence of a large number of sellers, each accounts for a small fraction of market supply
Consumers have many options and buy from the firm that offers the lowest price
Each firm takes the market price as given and can focus on how much it wants to sell at that price
Few markets are perfectly competitive
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4. Market Demand and Supply
Market demand for a product is the sum of the demands of all individual consumers
Graphically, this is the horizontal sum of the individual demand curves
For simplicity, assume that all demand comes from consumers and all supply comes from firms
Market supply of a product is the sum of the supply of all the individual sellers
Graphically this is the horizontal sum of the individual supply curves
Very similar to the procedure for constructing market demand curves
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5. Figure 14.1: Market Demand
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6. Figure 14.2: Market Supply
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7. Short-Run vs. Long-Run Market Supply
Long-run and short-run market supply curves may differ for two reasons:
Firm’s short-run and long-run supply curves may differ
Over time, set of firms able to produce in a market may change
Long-run supply curve is found by summing supply curves of all potential suppliers
Free entry in a market implies that anyone who wishes to start a firm has access to the same technology and entry is unrestricted
With free entry, the number of potential firms in a market is unlimited
Long-run market supply curve is a horizontal line at ACmin
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8. Figure 14.4: Long-Run Supply
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9. Figure 4.5: Market Equilibrium
At equilibrium price, Qs=Qd
Market clears at equilibrium price
Given demand and supply functions, can use algebra to find the equilibrium
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10. Figure 14.6: Long-Run Competitive Equilibrium
Equilibrium price must equal ACmin
Firms must earn zero profit
Active firms must produce at their efficient scale of production
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11. Sample Problem 1 (14.3):
The daily cost of producing pizza in New Haven is C(Q) = 4Q + (Q2/40); the marginal cost is MC = 4 + (Q/20). What is the market supply function if there are 10 firms making pizza? If 20 firms are making pizza? What is the market supply curve under free entry?

12. Responses to Changes in Demand
Market response is different in short-run (number of firms is fixed) than in long-run (with free entry)
Begin from a point of long-run equilibrium, suppose demand curve shifts out
In short run, new equilibrium is achieved through movement along the short-run supply curve
Price rises
In long run, firms enter the market
New equilibrium brings return to initial price but at a higher quantity
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13. Figure 14.7: Response to an Increase in Demand
Price ($/bench) B A C S¥
P* = ACmin
= 100 D ^ D
2000
4000
Garden Benches per Month
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14. Responses to Changes in Fixed Cost
Start from a long-run equilibrium
Consider the case where fixed costs decrease while variable costs remain the same
In short run:
Average cost curve shifts downward, decreases minimum average cost and minimum efficient scale
Since marginal costs have not changed and number of firms is fixed, equilibrium is unchanged
Active firms make a positive profit
In long-run:
Firms enter market
Market equilibrium shifts, price falls and quantity rises
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15. Figure 14.8: Response to a Decrease in Cost
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16. Responses to Changes in Variable Cost
Start from a long-run equilibrium
If variable costs change, firm’s marginal and average cost curves both shift
Short-run supply curve shifts
Sort-run equilibrium changes
Basic procedure in all cases:
Find new short-run equilibrium using new short-run supply curve of initially active firms
Find new long-run equilibrium using new long-run supply curve which reflects free entry
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17. Price Changes in the Long-Run
So far we’ve assumed that the prices of firms’ inputs do not change
Reasonable if increases in amounts of inputs used are small compared to overall market
Or when supply in input markets is very elastic
In general, though, when demand for a product increases, prices of inputs used to make it may change
This is a general equilibrium effect; the market we are studying and the market for its inputs must all be in equilibrium
Taking the input price effect into account in the analysis of the market response to an increase in demand changes the result
Price of the good rises in the long run
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18. Figure 14.11: Price Changes in the Long-Run
Price ($/bench) B ^ E S¥ ^
ACmin=110 S¥
ACmin=100 A C D ^ D
2000
4000
Garden Benches per Month
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19. Sample Problem 2 (14.7):
Suppose the daily demand for pizza in Berkeley is Qd = 1,525 – 5P. The variable cost of making Q pizzas per day is C(q) = 3Q Q2, there is a $100 fixed cost (which is avoidable in the long run), and the marginal cost is MC = Q. There is free entry in the long run. What is the long-run market equilibrium in this market? Suppose demand increases to Qd = 2,125 – 5P. If, in the short run, the number of firms is fixed and fixed costs are sunk, what is the new short-run market equilibrium? What is the new long-run market equilibrium if there is free entry and exit in the long run?

20. Aggregate Surplus and Economic Efficiency
Perfectly competitive market produces an outcome that is economically efficient
Net benefits indicate that consumers’ benefit from the goods exceed the costs of producing them
Aggregate surplus equals consumers’ total willingness to pay for a good less firms’ total avoidable cost of production
Total benefits from consumption equal to willingness to pay
Area under consumer’s demand curve up to that quantity
Total avoidable costs of production include all of a firm’s costs other than sunk costs
Area under its supply curve up to its production level
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21. Maximizing Aggregate Surplus
Smith’s The Wealth of Nations (1776) commented on the “invisible hand” of the market
The self-interested actions of each individual lead to economic efficiency
“he intends only his own gain, and he is in this…led by an invisible hand to promote an end which was no part of his intention”
No way to increase aggregate surplus in perfectly competitive markets by changing:
Who consumes the good
Who produces the good
How much of the good is produced and consumed
Competitive markets maximize aggregate surplus
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22. Effects of a Change in Who Consumes the Good
Begin from the competitive equilibrium
Take one unit of the good from Consumer A and give it to Consumer B
Cannot increase aggregate surplus
Value any consumer attaches to a unit of the good they don’t buy must be less than the market price
Value any consumer attaches to a unit of the good they do buy must be more than the market price
If we take the good from someone who purchased it and give it to someone who didn’t, aggregate surplus must fall
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23. Effects of a Change in Who Produces the Good
Changing who produces the good can’t increase aggregate surplus
To achieve this, would have to reassign sales in a way that would lower the total cost of production
Begin from the competitive equilibrium
Reduce sales of Producer A by one unit, increase sales of Producer B by one unit
Cost of producing any unit of output that a firm chooses to sell must be less than the equilibrium price
Cost of producing any unit of output that a firm chooses not to sell must exceed the equilibrium price
Any shift in production from one firm to another must raise the total cost of production and lower aggregate surplus
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24. Effects of a Change in the Number of Goods
Changing the total number of units of the good produced and consumed also lowers aggregate surplus
Any unit of a good that is produced and consumed in a competitive market equilibrium must be worth more than the market price to the consumers who buy them
Must also cost less than the market price to produce
Those units of output must therefore make a positive contribution to aggregate surplus
Any units that aren’t produced and consumed should not be; they will lower aggregate surplus
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25. Measuring Total WTP and Total Avoidable Cost
Market demand and supply curves can be used to measure total willingness to pay and total avoidable cost
Measure consumers’ total willingness to pay for the units they consume by the area under the market demand curve up to that quantity
When all consumers face the same market price
Measure producers’ total avoidable costs for the units they produce by the area under the market supply curve up to that quantity
When all producers face the same market price
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26. Figure 14.18: Measuring Total Willingness to Pay
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27. Aggregate Surplus
Can use market supply and demand curves to measure aggregate surplus
Consumers’ total willingness to pay is area under market demand curve up to the quantity consumed
Producers’ total avoidable cost is the area under the market supply curve up to the quantity produced
In a competitive market without any intervention, aggregate surplus is maximized
No deadweight loss: reduction in aggregate surplus below its maximum possible value
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28. Consumer and Producer Surplus
Consumer surplus is the sum of consumers’ total willingness to pay less their total expenditure
Sum of individual consumers’ surpluses
Also called aggregate consumer surplus
Producer surplus is the sum of firms’ revenues less avoidable costs
Sum of individual firms’ producer surpluses
Also called aggregate producer surplus
Aggregate surplus = Consumer surplus + Producer Surplus
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29. Figure 14.19: Aggregate, Consumer, and Producer Surplus
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30. Sample Problem 3 (14.15):
The market demand function for corn is Qd = 21 – 4P, and the market supply function is Qd = = 5P -6, both quantities are measured in billions of bushels per year. What are the aggregate surplus, consumer surplus, and producer surplus at the competitive market equilibrium?