Market Equilibrium and Market Demand Perfect Competition Chapter

Market Equilibrium and Market Demand: Perfect Competition Chapter 8

Discussion Topics üDerivation of market supply curve üElasticity of supply and producer surplus üMarket equilibrium under perfect competition üTotal economic surplus üAdjustments to market equilibrium

Remember the firm’s supply curve? P=MR=AR Page 123

P=MR=AR Firm’s supply curve starts at shut down level of output Page 162

Profit maximizing firm will desire to produce where MC=MR P=MR=AR Page 162

Economic losses will occur beyond output OMAX, where MC > MR P=MR=AR Page 162

Building the Market Supply Curve Market supply curve can be thought of as the horizontal summation of the supply decisions of all firms in the market. Here, at a price of $1. 50, Gary would supply 2 tons of broccoli and Ima would supply 1 ton, giving a market supply of 3 tons. Page 163

Building the Market Supply Curve + Market supply curve can be thought of as the horizontal summation of the supply decisions of all firms in the market. Here, at a price of $1. 50, Gary would supply 2 tons of broccoli and Ima would supply 1 ton, giving a market supply of 3 tons. Page 163

Building the Market Supply Curve + = Market supply curve can be thought of as the horizontal summation of the supply decisions of all firms in the market. Here, at a price of $1. 50, Gary would supply 2 tons of broccoli and Ima would supply 1 ton, giving a market supply of 3 tons. Page 163

Merging Demand Supply Price D S Market clearing price PE QE Quantity

Merging Demand Supply Price D S PE Chapters 3 -5 QE Quantity

Merging Demand Supply Price D Factors that change S demand: ü Other prices ü Consumer income ü Tastes and preferences ü Real wealth effect ü Global events D* PE QE QE* Quantity

Merging Demand Supply Price D S Chapters 6 -7 PE QE Quantity

Merging Demand Supply S* Price D S PE* PE QE*QE Factors that change supply: ü Input costs ü Government policy ü Price expectations ü Weather & disease ü Global events 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. Page 165

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. Total economic surplus is therefore equal to consumer surplus discussed in Chapter 4 plus producer surplus. Page 165

Market Price of $4 A B Product price Producer surplus at $4 is equal to area ABC F G Page 165

Suppose Price Increased to $6… Product price Producer surplus at $6 is equal to area EDC F G Page 165

The gain in producer surplus if the price increases from $4 is equal to area AEDB Producers are better off economically by responding to this price increase by producing output G C F G Page 165

An Example of Economic Welfare Analysis Assume a drought occurs that results in a decrease in supply from S to S*. Before this happened, consumer surplus was area 3+4+5 while producer surplus was equal to area 6+7. Total economic equals area 3+4+5+6+7 Page 169

An Example of Economic Welfare Analysis After the decrease in supply, consumer surplus is just area 3. They lose area 4 and area 5. Producers gain area 4 but lose area 7. Page 169

An Example of Economic Welfare Analysis Consumers are therefore worse off because of the drought. Producers are also worse off if area 4 is less than area 7. Society loses area 5+7. Page 169

Measuring Surplus Levels $7 D S $4 Consumer surplus is equal to (10 x (7 -4))÷ 2, or $15 Product price $1 10 Page 168

Measuring Surplus Levels $7 D S $4 Consumer surplus is equal to (10 x (7 -4))÷ 2, or $15 Product price Producer surplus is Equal to (10 x (4 -1))÷ 2, or $15 $1 10 Page 168

Measuring Surplus Levels $7 D S $4 Consumer surplus is equal to (10 x (7 -4))÷ 2, or $15 Product price Producer surplus is Equal to (10 x (4 -1))÷ 2, or $15 $1 10 Total economic surplus is therefore $30… Page 168

Modeling Commodity Prices

Forecasting Future Commodity Price Trends $7 D S $4 D = a – b. P + c. YD + e. X Own price Disposable income Other factors $1 10 Page 168

Forecasting Future Commodity Price Trends $7 D S Own price $4 Input costs Other factors S = n + m. P – r. C + s. Z $1 10 Page 168

Projecting Commodity Price $7 D S D = 10 – 6 P +. 3 YD + 1. 2 X D=S $4 S = 2 + 4 P –. 2 C + 1. 02 Z $1 10 Substitute the demand supply equations into the equilibrium condition and solve for Page price 221

Many Applications Ø Policy decisions by Congress and the president Ø Commodity modeling by brokers and traders Ø Credit repayment capacity analysis by lenders Ø Outlook presentations by extension economists Ø Planting decisions by farmers Ø Herd size and feedlot placement decisions by livestock producers Ø Strategic planning for processors

Market Disequilibrium

Market Surplus At the price is PS, producers would supply QS. Page 170

Market Surplus At the price is PS, consumers would only want QD. Page 170

Market Surplus At the price is PS, a market surplus equal QS – QD exists Page 170

Market Shortage At the price is PD, producers would only supply QS. Page 170

Market Shortage Consumers want QD at this low price. Page 170

Market Shortage At the price is PS, Consumers awant market QD at shortage this low price. equal QD – QS exists Page 170

Adjustments to Market Equilibrium Markets converge to equilibrium over time unless other events in the economy occur. One explanation for this adjustment which makes sense in agriculture is the Cobweb theory. This names stems from the spider like trail the adjustment process makes.

Year 2 Reactions Producers use last year’s price as their expected price for year 2. Consumers on the other hand pay this year’s price determined by Q 2. Page 172

Year 3 Reactions P 3 P 2 Producers now decide to produce less at the lower expected price. This lower quantity pushes price up to P 3 in year 3. Page 172

Cobweb Pattern Over Time Market equilibrium The market converges to market equilibrium where demand intersects supply at price PE. In some markets, this adjustment period may only be months or even weeks rather than years assumed here. Page 172

Market-to-Firm Linkages

Some Important Jargon We 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 supplied”. A shift in a curve is referred to as a “change in demand or supply”.

Increase in demand pulls up price from Pe to Pe* Decrease in demand pushes price down from Pe to Pe* Page 167

Increase in supply pushed price down from Pe to Pe* Decrease in supply pulls up price from Pe to Pe* Page 167

Merging Demand Supply Price D S Chapters 6 -7 PE Chapters 3 -5 QE Quantity

Firm is a “Price Taker” Under Perfect Competition Price The Market D S The Firm Price AVC MC PE QE OMAX Quantity

If Demand Increases…… The Market Price D D 1 The Firm S Price AVC MC PE QE 10 11 Quantity

If Demand Decreases…… The Market Price D 2 D The Firm S Price AVC MC PE QE 9 10 Quantity

Firm is a “Price Taker” in the Input Market Price Labor Market D S Price The Firm MVP MIC PE QE LMAX Quantity

Firm is a “Price Taker” in the Input Market Price Labor Market D S Price The Firm MVP PE MIC QE LMAX Quantity

Effects of Increasing The Minimum Wage Price Labor Market D S Price The Firm MVP PMIN MIC LMAX QD QS Quantity

Summary ü Market equilibrium price and quantity are given by the intersection of demand supply ü Producer surplus captures the profit earned in the market by producers ü Total economic surplus is equal to producer surplus consumer surplus ü A market surplus exists when the quantity supplied exceeds the quantity demanded. ü A market shortage exists when the quantity demanded exceeds the quantity supplied.

Chapter 9 focuses on market equilibrium and product prices under conditions of imperfect competition….