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Market Equilibrium and Market Demand: Perfect Competition

Market Equilibrium and Market Demand: Perfect Competition. Chapter 8. Discussion Topics. Derivation of market supply curve Elasticity of supply and producer surplus Market equilibrium under perfect competition Total economic surplus Adjustments to market equilibrium. 2.

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Market Equilibrium and Market Demand: Perfect Competition

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  1. MarketEquilibrium and Market Demand:Perfect Competition Chapter 8

  2. Discussion Topics • Derivation of market supply curve • Elasticity of supply and producer surplus • Market equilibrium under perfect competition • Total economic surplus • Adjustments to market equilibrium 2

  3. Remember the firm’s supply curve? P=MR=AR 3 Page 131

  4. Profit maximizing firm will desire to produce where MC=MR P3=MR3=AR3 P2=MR2=AR2 P1=MR1=AR1 • Firm’s supply curve starts at shut down output level • Where MR < AVC Economic losses occur where MC > MR Page 131 4 4 4 4 4 4 4 4 4 4

  5. Building the Industry Supply Curve • Market supply curve: The horizontal summation of the supply decisions of all firms in the market • At a price of $1.50, Gary would supply 2 tons of broccoli 5 Page 132

  6. Building the Industry Supply Curve • Market supply curve: The horizontal summation of the supply decisions of all firms in the market • At a price of $1.50, Ima would supply 1 ton of broccoli 6 Page 132

  7. Building the Industry Supply Curve • Market supply curve: The horizontal summation of the supply decisions of all firms in the market • At a price of $1.50 market supply would be 3 tons Page 132 7

  8. Determining Market Equilibrium • With the above we have identified the Market Supply Curve • Previously we derived the Market Demand Curve • Horizontal summation of individual demand curves • We can combine these concepts to identify what is referred to as the Market Equilibrium 8

  9. Determining Market Equilibrium Market Supply Curve = Horizontal summation of individual firm supply curves D S Price PE Market clearing price Quantity QE Market Demand Curve = Horizontal summation of individual consumer demand curves 9

  10. Determining Market Equilibrium Price D S PE Chapters 3 - 5 Quantity QE 10

  11. Determining Market Equilibrium • Factors that change (shift) demand: • Prices of other goods • Consumer income • Tastes and preferences • Real wealth effect • Global events Price D* D S PE* PE Quantity QE QE* 11

  12. Determining Market Equilibrium Price D S Chapters 6 - 7 PE Quantity QE 12

  13. Determining Market Equilibrium • Factors that change (shift) supply: • Input costs • Government policy • Price expectations • Weather & disease • Global events S* Price D S PE* PE Quantity QE* QE 13

  14. Concept of Producer Surplus • Producer Surplus(PS) is a term economists use foraggregatereturns over total variable costs • PS measured as the area above the supply curve and below market equilibrium price • Remember the supply curve is determined by individual MC curves 14 Page 133

  15. Concept of Producer Surplus Market Price of $4 Price Market Supply Total Revenue = 0ABD A B $4 Product Price Total Variable Cost = 0CBD C Output 0 D 15 Page 133

  16. Concept of Producer Surplus Market Price of $4 Price Market Supply A B $4 Product Price PS at $4 = area ABC C Output D 16 Page 133

  17. Concept of Producer Surplus Suppose Price Increased to $6… Price Market Supply F E $6 A B $4 PS at $6 = area EFC C Output G D 17 Page 133

  18. Concept of Producer Surplus The gain in PS if the price increases from $4 to $6 is equal to area AEFB Price Market Supply F E $6 Producers are better off by increasing output from D to G A $4 B C Output G D 18 Page 133

  19. Assessing Economic Welfare • We can use the concepts of market demand and supply to • Assess the effects of events in the economy on the economic well being of consumers and producers • For a particular market • During a specific time period • We do this using the concept of total economic surplus (TES) defined as: TES=CS+ PS Producer Surplus Total Surplus Consumer Surplus 19

  20. Assessing Economic Welfare $ E An Example of Economic Welfare Analysis S • Assume we have a market • PS = area BCE • CS = area BCA • TES = area BCA + area BCE = area AEC • Then a drought occurs • How can we examine whether consumers or producers are impacted B C A D Q 20 Page 136-137

  21. Assessing Economic Welfare $ An Example of Economic Welfare Analysis E S* S • Assume the drought causes supply curve to shift up • After the drought • PS = area HFI • Gain BFIC + Lose AHGC • CS = area FEI • Lose BFIG + Lose GIC • TES= area HEI • Lose AHGC + Lose GIC I F B C G H A D Q 21 Page 136-137

  22. Assessing Economic Welfare $ An Example of Economic Welfare Analysis E S* S • Drought causes • Consumers to be worse off as no gain area • Producers are worse off if area BFIG (gain) is less than AHGC (loss) • Area BFIG is transferred from consumers to producers • Society is on net worse off as no gain area (area AHIC) I F B C G H A D Q 22 Page 136-137

  23. Assessing Economic Welfare Measuring Surplus Levels $ ABCD = ? FADE = ? Supply B C $6 CS = (10 x (6-4))÷2 = $10 D A $4 Product price PS =(10 x (4-1))÷2 = $15 Demand $1 E F Q 10 →Total economic surplus = CS + PS = $10 + $15 = $25 23 Page 136-137

  24. Modeling CommodityPrices 24

  25. Modeling Commodity Prices Forecasting Future Commodity Price Trends $ D = α – βP + γYD + δX S $6 Own price Disposable income Other factors $4 Own price Input costs Other factors D $1 Q 10 S = θ + πP – τC + χZ 25 Page 136-137

  26. Modeling Commodity Prices $ S QD = 10 – 6P + .3YD + 1.2X Equilibrium Condition Q* =QD= QS P* QD = QS D QS = 2 + 4P – .2C + 1.02Z Q Q* How can we determine the values of P* and Q*? Page 221 26

  27. Modeling Commodity Prices $ S QD = 10 – 6P + .3YD + 1.2X Equilibrium Condition Q* =QD= QS QD = QS P* D QS = 2 + 4P – .2C + 1.02Z Q Q* • The above shows relationship between P and either QS and/or QD • Lets undertake a ceteris paribus analysisand assume values for YD, X C and Z Page 221 27

  28. Modeling Commodity Prices $ S QD = 50 – 6P Equilibrium Condition Q* =QD= QS P* QD = QS D QS = 42 + 4P Q Q* • How can we determine the value of Q* • Substitute demand and supply equations into equilibrium condition • Solve for equilibrium price (P*) • Substitute this price into either supply or demand equation for Q* Page 221 28

  29. Modeling Commodity Prices • How can we determine the value of Q* and P* • Substitute demand and supply equations into equilibrium condition • Solve for equilibrium price (P*) • 50 – 6P = 42 + 4P → 8 + 10P = 0 • →P* = 8/10 = 0.80 • Substitute this price into either supply or demand equation for Q* • Demand Equation • QD* = 50 – 6P* = 50 – 6(0.8) = 50 – 4.8 = 45.2 • Supply Equation • QS*= 42 + 4P* = 42 + 4(0.8) = 42 + 3.2 = 45.2 Q* =QD= QS→ (50 – 6P) = (42 + 4P) Page 221 29

  30. Many Applications • Policy decisions by Congress and the President • Commodity modeling by brokers/traders • Lender credit repayment capacity analysis • Outlook presentations by extension eco. • Farm planting decisions • Livestock producers herd size and feedlot placement decisions • Strategic planning for processors 30

  31. Market Disequilibrium 31

  32. Market Disequilibrium At PS→Market Surplus exists as QS – QD > 0 Surplus S PS At price PS, consumerswould demand QD At price PS, producerswould supply QS P* PD D QS QD Q* 32 Page 138

  33. Market Disequilibrium At PD→Market Shortage exists as QS – QD < 0 S PS At price PD, producerswould supply QD At price PD, consumerswould demand QS P* PD D QS QD Q* Page 138 Shortage 33

  34. Market Disequilibrium • Markets converge to equilibrium over time unless other events in the economy occur • One explanation for this adjustment which makes sense for agriculture is the Cobweb theory • This names comes from the spider web-like trail the adjustment process makes 34

  35. Market Disequilibrium • Lets use the example of a grain producer • Producers tend to use last year’s price (P1) as their expected price for this year (year 2) • In contrast, consumer’s pay this years price (P2) determined by market equilibrium Q2 35

  36. Market Disequilibrium Year Two Reactions 36 Page 140

  37. Market Disequilibrium Year Three Reactions P3 P2 Page 140 37

  38. Market Disequilibrium Year Four Reactions Producer decision based on Year 3 Price P3 P4 Consumer decision based on Year 4 Price Q4 38 Page 140

  39. Market Disequilibrium • From the above results we have the following: • (P1 – P2) > (P3 – P2) > (P3 – P4) • (Q2 – Q1) > (Q2 – Q3) > (Q4 – Q3) • Eventually wil converge to P*, Q* the equilibrium price and quantity Price changes are getting smaller Quantity changes are getting smaller Page 140 39

  40. Market Disequilibrium • The market converges to an equilibrium price and quantity • QD = QS at PE • In some markets, adjustment period may months, weeks or years • Depends on production time required Cobweb Pattern Over Time Market equilibrium 40 Page 140

  41. Market-to-Firm Linkages 41

  42. Some Important Jargon • As we noted before we distinguish between • Movement along a particular demand or supply curve • Referred to as a change in quantity demanded or supplied • Shifts in the demand or supply curve • Referred to as a change in demand or supply 42

  43. Decrease in demand decreases price from Pe to Pe* Increase in demand increases price from Pe to Pe* Page 135 43

  44. Decrease in supply increases price from Pe to Pe* Increase in supply decreases price from Pe to Pe* Page 135 44

  45. Merging Demand and Supply Price D S Chapters 6-7 PE Chapters 3-5 Quantity QE 45

  46. Firm is a Price Taker Under Perfect Competition The Firm The Market Price Price D S PE= MR = MC AVC MC PE QE QF Quantity 46

  47. Impact of an Increase in Demand The Market The Firm Price D1 Price D S MC AVC PE QE Q*E 10 11 Quantity 47

  48. Impact of a Decrease in Demand The Market The Firm Price Price D S D2 AVC MC PE Q*E QE 9 10 Quantity 48

  49. Firm is a Price Takerin the Input Market Wage Rate Labor Market Wage Rate The Firm SL DL MVP MIC PL QL LF Labor 49

  50. Firm is a Price Taker in the Input Market Labor Market Wage Rate The Firm Wage Rate DL* SL DL MVP PL MIC QL LF L*F Labor 50

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