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Market Equilibrium and Market Demand:
Perfect Competition
Chapter 8
DERIVATION OF THE MARKET SUPPLY CURVE◦ Firm Supply Curve -- Own-Price Elasticity of Supply◦ Market Supply Curve -- Producer Surplus
MARKET EQUILIBRIUM UNDER PERFECT COMPETITION◦ Market Equilibrium◦ Total Economic Surplus◦ Applicability to Policy Analysis
ADJUSTMENTS TO MARKET EQUILIBRIUM◦ Market Disequilibrium -- Market Shortage◦ Market Surplus -- Length of Adjustment Period◦ Cobweb Adjustment Cycle
Chapter 8 - Topics of Discussion
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Firm’s supply curvestarts at shut downlevel of output
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Profit maximizing firm will desire to producewhere MC=MR
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Economic losses will occurbeyond output OMAX, whereMC > MR
Market supply curve can be thought of as the horizontal summationof the supply decisions of all firms in the market. Here, at a priceof $1.50, Gary would supply 2 tons of broccoli and Ima would supply 1 ton, giving a market supply of 3 tons.
+ =
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Building the Market Supply Curve
MARKET SUPPLY SCHEDULE
0
1
2
3
4
2 3 6 8
QuantityPoint Price Supplied A 1 2 B 2 3 C 3 6 D 4 8 A
B
C
DP
Q
Own-Price elasticity of
supply
)2/)/(()()2/))/(()(
BABA
SBSASBSA
PPPPQQQQ
=
Calculate own-price elasticity of supply between $2 and $3.
DQ P
DP QX
DQ = 3, DP = 1, Q = 4.5, P = 2.5
DQ P
DP QX3 2.5
1 4.5X = 1.66 =
ELASTIC
1% DP gives rise to a 1.66% DQ in 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.
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Concept of Producer Surplus
Producer surplus is a fancy term economists use for profit. We measure producer surplusas the area above the supply curve andbelow the market equilibrium price.
Total economic surplus is therefore equal toconsumer surplus discussed in Chapter 4plus producer surplus.
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Producer surplus at $4is equal to area ABC
F G
Product price
Market Price of $4
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F G
Total revenue at $4 would bearea 0ABF while total costwould be area 0CBF. ThusProfit = area 0ABF-area 0CBF
Product price
C
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F G
Total revenue at $4 would bearea 0ABF while total costwould be area 0CBF. ThusProfit = area 0ABF-area 0CBF
Product price
Area 0ABF can be foundby multiplying price timequantity, or $4 times output FC
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F G
Producer surplus at $6is equal to area EDC
Product price
Suppose Price Increased to $6
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F G
Total revenue at $6 would bearea 0EDG while total costwould be area 0CDG. Thusprofit would be area 0EDG minus area 0CDG, or CED.
Product price
C
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The gain in producer surplus if the price increases from $4is equal to area AEDB
F G
Producers are betteroff economically byresponding to thisprice increase byproducing output G
C
Some Important JargonWe 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 supply”. A shift in a curve is referred to as a “changein demand or supply”.
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Increase in demandpulls up price from Pe to Pe*
Decrease in demandpushes price downfrom Pe to Pe*
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Increase in supplypushed price down from Pe to Pe*
Decrease in supplypulls up price from Pe to Pe*
Economic Welfare Concepts
We can use the concepts of market demandand supply to assess the effects of eventsin the economy have upon the economicwell being of consumers and products ina particular market.
We assess these effects using the concept of Consumer surplus introduced in Chapter 4 with producer surplus discussed here.
ECONOMIC SURPLUS
Economic Surplus = Consumer Surplus + Producer Surplus
Consumer Surplus = area #1, Producer Surplus = area #2
An Example of Economic Welfare Analysis
Assume a drought occursthat results in a decreasein supply from S to S*.
Before this happened,consumer surplus wasarea 3+4+5 while producersurplus was equal toarea 6+7.
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An Example of Economic Welfare Analysis
After the decrease insupply, consumer surplusis just area 3. They lose area 4 and area 5.
Producers gain area 4 butlose area 7.
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An Example of Economic Welfare Analysis
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Consumers are thereforeworse off because of thedrought.
Producers are also worse off if area 4 is less than area 7.
Society loses area 5+7.
CHANGE IN ECONOMIC SURPLUS
Δ in economic surplus = -4-5+7 = -5-7
Measuring Surplus Levels
Product price
DS
$4
10
$1
$7 Consumer surplus isequal to (10 x (7-4))÷2,or $15
Measuring Surplus Levels
Product price
DS
$4
10
$1
$7 Consumer surplus isequal to (10 x (7-4))÷2,or $15
Producer surplus isEqual to (10 x (4-1))÷2,or $15
Product price
DS
$4
10
$1
$7 Consumer surplus isequal to (10 x (7-4))÷2,or $15
Producer surplus isEqual to (10 x (4-1))÷2,or $15
Total economic surplusis therefore $30…
Measuring Surplus Levels
Market Disequilibrium
Market Surplus
If the price is PS, producers wouldsupply QS whileconsumers wouldonly want QD atthis high price.
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Market Shortage
If the price is PD, producers wouldonly supply QD while consumers want QD at thislow price.
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Adjustments to Market Equilibrium
Markets converge to equilibrium over time unless other events in the economy occur.
One explanation for this adjustment whichmakes sense in agriculture is the Cobwebtheory. This name stems from the spiderlike trail the adjustment process makes.
Year Two Reactions
Producers use last year’sprice as their expectedprice for year 2.
Consumers on the otherhand pay this year’s price determined by Q2.
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Year Three Reactions
P2
P3
Producers now decide toproduce less at the lowerexpected price. Thislower quantity pushesprice up to P3 in year 3.
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Cobweb Pattern Over Time
Marketequilibrium
The market converges tomarket equilibrium wheredemand intersects supplyat price PE. In some markets, this adjustmentperiod may only be monthsor even weeks rather thanyears assumed here.
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