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Chapter 8

Chapter 8. Perfect Competition. © 2004 Thomson Learning/South-Western. Timing of a Supply Response. A supply response is the change in quantity of output in response to a change in demand conditions. The pattern of equilibrium prices will be different depending upon the time period

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Chapter 8

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  1. Chapter 8 Perfect Competition © 2004 Thomson Learning/South-Western

  2. Timing of a Supply Response • A supply response is the change in quantity of output in response to a change in demand conditions. • The pattern of equilibrium prices will be different depending upon the time period • In the very short run, quantity is fixed so there is no supply response

  3. Timing of a Supply Response • In the short run existing firms may change the quantity they are supplying, but no firms enter or exit the market. • In the long run firms can further change the quantity supplied and new firms may enter the market.

  4. Pricing in the Very Short Run • The market period (very short run) is a short period of time during which quantity supplied is fixed. • In this period, price acts to ration demand as it adjusts to clear the market. • This situation is illustrated in Figure 8.1 where supply is fixed at Q*.

  5. FIGURE 8.1: Pricing in the Very Short Run Price S P1 D Quantity per week 0 Q*

  6. Pricing in the Very Short Run • When demand is represented by the curve D, P1 is the equilibrium price. • The equilibrium price is the price at which the quantity demanded by buyers of a good is equal to the quantity supplied by sellers of the good.

  7. Shifts in Demand: Price as a Rationing Device • If demand were to increase, as illustrated by the new demand curve D’ in Figure 8.1, P1 is no longer the equilibrium price since the quantity demanded exceeds the quantity supplied. • The new equilibrium price is now P2 where price has rationed the good to those who value it the most.

  8. FIGURE 8.1: Pricing in the Very Short Run Price S P2 P1 D’ D Quantity per week 0 Q*

  9. APPLICATION 8.1: Internet Auctions • Auctions on the internet have rapidly become one of the most popular ways of selling all manner of goods. • There is a sense that internet auctions resemble the theoretical situation illustrated in Figure 8.1…the goods are in fixed supply and will be sold for whatever bidders are willing to pay. • However, this view of things may be too simple because it ignores dynamic elements which may be present in suppliers’ decisions.

  10. APPLICATION 8.1: Internet Auctions • A quick examination of internet auction sites suggests that operators employ a variety of features in their auctions. • “Reserve” prices, bidding history, and “buy it now” prices are all features offered at various sites. • Attempts to answer the many questions that surround the returns to operators usually focus on the uncertainties inherent in the auction process and how bidders respond to them.

  11. APPLICATION 8.1: Internet Auctions • Because buyers and sellers are total strangers in internet auctions, a number of special provisions have been developed to mitigate the risks of fraud that the parties might encounter in such situations. • The primary risk facing bidders is in knowing that the goods being offered meet expected quality standards. • Previous bidders provide rankings to many of the auction sites.

  12. APPLICATION 8.1: Internet Auctions • For sellers, the primary risk is that they will not be paid. • Various intermediaries (such as Pay Pal) have been developed to address this problem.

  13. Applicability of the Very Short-Run Model • This model may only apply where the goods are very perishable. • It is usually assumed that a rise in price will prompt producers to bring additional quantity to the market. • This can result from greater production, or, if the goods are durable, from existing stock held by producers.

  14. Short-Run Supply • In the short-run the number of firms is fixed as no firms are able to enter or leave the market. • However, existing firms can adjust their quantity in response to price changes. • Because of the large number of firms, each firm is treated as a price taker.

  15. Construction of a Short-Run Supply Curve • The quantity that is supplied is the sum of the quantities supplied by each firm. • The short-run market supply curve is the relationship between market price and quantity supplied of a good in the short run. • In Figure 8.2 it is assumed that there are only two firms, A and B.

  16. FIGURE 8.2: Short-Run Market Supply Curve Price Price Price SA P qA1 Output 0 Output 0 Quantity per week 0 (a) Firm A (b) Firm B (c) The Market

  17. FIGURE 8.2: Short-Run Market Supply Curve Price Price Price SB SA P qA1 qB1 Output 0 Output 0 Quantity per week 0 (a) Firm A (b) Firm B (c) The Market

  18. FIGURE 8.2: Short-Run Market Supply Curve Price Price Price SB S SA P qA1 0 qB1 0 Output Output 0 Q1 Quantity per week (a) Firm A (b) Firm B (c) The Market

  19. Construction of a Short-Run Supply Curve • Both firm A’s and firm B’s short-run supply curves (their marginal cost curves) are shown in Figure 8.2(a) and Figure 8.2(b) respectively. • The market supply curve is the horizontal sum of the two firms are every price. • In Figure 8.2(c), Q1 equals the sum of q1A and q1B.

  20. Short-Run Price Determination • Figure 8.3 (b) shows the market equilibrium where the market demand curve D and the short-run supply curve S intersect at a price of P1 and quantity Q1. • This equilibrium would persist since what firms supply at P1 is exactly what people want to buy at that price.

  21. FIGURE 8.3: Interaction of Many Individuals and Firms Determine market price in the Short Run SMC Price Price S Price SAC P1 D d q1 q2 0 Q1 Q2 Quantity per week 0 q1 q2 q1 ‘ 0 Output Quantity (a) Typical Firm (b) The Market (c) Typical Person

  22. FIGURE 8.3: Interaction of Many Individuals and Firms Determine market price in the Short Run SMC Price Price S Price SAC P2 D’ P1 d’ D d q1 q2 0 Q1 Q2 Quantity per week 0 q1 q2 q1 ‘ 0 Output Quantity (a) Typical Firm (b) The Market (c) Typical Person

  23. Functions of the Equilibrium Price • The price serves as a signal to producers about how much should be produced. • To maximize profit, firms will produce the output level for which marginal costs equal P1. • This yields an aggregate production of Q1.

  24. Functions of the Equilibrium Price • Given the price, utility maximizing individuals will decide how much of their limited incomes to spend • At price P1 the total quantity demanded is Q1. • No other price brings about the balance of quantity demanded and quantity supplied. • These situations are depicted in Figure 8.3 (a) and (b) for the typical firm and individual, respectively.

  25. Effect of an Increase in Market Demand • If the typical person’s demand for the good increases from d to d’, the entire market demand curve will shift to D’ as shown in figure 8.3. • The new equilibrium is P2, Q2 where a new balance between demand and supply is established.

  26. Effect of an Increase in Market Demand • The increase in demand resulted in a higher equilibrium price, P2 and a greater equilibrium quantity, Q2. • P2 has rationed the typical person’s demand so that only q2 is demanded rather than the q’1 that would have been demanded at P1. • P2 also signals the typical firm to increase production from q1 to q2.

  27. Shifts in Demand Curves • Demand will increase, shift outward, because • Income increases • The price of a substitute rises • The price of a complement falls • Preferences for the good increase

  28. Shifts in Demand Curves • Demand will decrease, shift inward, because • Income falls • The price of a substitute falls • The price of a complement rises • Preferences for the good diminish

  29. Shifts in Supply Curves • Supply will increase, shift outward, because • Input prices fall • Technology improves • Supply will decrease, shift inward, because • Input prices rise

  30. Table 8.1: Reasons for a Shift in a Demand or Supply Curve

  31. Short-Run Supply Elasticity • The short-run elasticity of supply is the percentage change in quantity supplied in the short run in response to a 1 percent change in price.

  32. Short-Run Supply Elasticity • If a 1percent increase in price causes firms to increase quantity supplied by more than 1 percent, supply is elastic. • If a 1 percent increase in price causes firms to increase quantity supplied by less than 1 percent, supply is inelastic.

  33. Shits in Supply Curves and the Importance of the Shape of the Demand Curve • The effect of a shift in supply upon equilibrium levels of P and Q depends upon the shape of the demand curve. • If demand is elastic, as in Figure 8.4 (a), a decrease in supply has a small effect on price but a relatively large effect on quantity. • If demand is inelastic, as in Figure 8.4 (b), the decrease in supply has a greater effect on price than on quantity.

  34. FIGURE 8.4: Effect of a Shift in the Short-Run Supply Curve on the Shape of the Demand Curve Price Price S S D P P D Quantity per week Q 0 0 Q Quantity per week (a) Elastic Demand (b) Inelastic Demand

  35. FIGURE 8.4: Effect of a Shift in the Short-Run Supply Curve on the Shape of the Demand Curve S’ Price Price S’ S S P’ P’ D P P D Q’ Quantity per week Q’ Q 0 0 Q Quantity per week (a) Elastic Demand (b) Inelastic Demand

  36. Shifts in Demand Curves and the Importance of the Shape of the Supply Curve • The effect of a shift in demand upon equilibrium levels of P and Q depends upon the shape of the supply curve. • If supply is inelastic, as in Figure 8.5 (a), the effect on price is much greater than on quantity. • If the supply curve is elastic, as in Figure 8.5 (b), the effect on price is relatively smaller than the effect on quantity.

  37. Figure 8.5: Effect of A shift in the Demand Curve Depends on the Shape of the Short-Run Supply Curve S Price Price S P’ P P D D Quantity per week 0 Q 0 Q Quantity per week (a) Inelastic Supply (b) Elastic Supply

  38. Figure 8.5: Effect of A shift in the Demand Curve Depends on the Shape of the Short-Run Supply Curve S Price Price S P’ P’ P P D’ D’ D D Quantity per week 0 Q Q’ 0 Q Q’ Quantity per week (a) Inelastic Supply (b) Elastic Supply

  39. APPLICATION 8.2: Ethanol Subsidies in the United States and Brazil • Ethanol has potentially desirable properties as a fuel for automobiles or additive to gasoline that may reduce air pollution. • Several governments have adopted subsides to producers of ethanol. • One way to show the effect of a subsidy is to treat it as a shift in the short-run supply curve as shown in Figure 1.

  40. APPLICATION 8.2: Figure 1: Ethanol Subsidies Shift the Supply Curve Price Price ($/gallon) S1 P1 D Q1 0 Quantity (million gallons)

  41. APPLICATION 8.2: Figure 1: Ethanol Subsidies Shift the Supply Curve Price Price ($/gallon) S1 S2 P1 P2 Subsidy D Q2 Q1 0 Quantity (million gallons)

  42. APPLICATION 8.2: Ethanol Subsidies in the United States and Brazil • The subsidy shifts out the supply curve (by about 54 cents-a-gallon in the U.S.) which results in a quantity demanded increase from Q1 to Q2. • The total cost of the subsidy depends upon the per-gallon amount and on the amount of the increase in quantity demanded.

  43. APPLICATION 8.2: Ethanol Subsidies in the United States and Brazil • In the U.S. it is made from corn, and the subsidy is primarily found in Iowa where many major corn producers are located. • In Brazil it is made from sugar cane and was heavily subsidized until Economic liberalization in the 1990s. • Due to political pressure from producers, the subsidy is again being proposed.

  44. A Numerical Illustration • Suppose the quantity of cassette tapes demanded per week (Q) depends on the price of the tapes (P) per equation 8.2, • Suppose short-run supply is given by equation 8.3.

  45. A Numerical Illustration • Figure 8.6 shows the graph for these equations. • Since the supply curve intersects the vertical axis at P = 2, this is the shutdown price. • The equilibrium price is $6 with people demanding 4 tapes which equals the amount supplied by the firms.

  46. FIGURE 8.6: Demand and Supply Curves for Cassette Tapes Price S 10 6 2 D 0 4 10 Tapes per week

  47. A Numerical Illustration • If the demand increased as reflected in equation 8.4, the former equilibrium price and quantity would no longer hold. • As shown in Figure 8.6, the new equilibrium price is $7 where the quantity demanded and supplied of tapes is 5.

  48. FIGURE 8.6: Demand and Supply Curves for Cassette Tapes Price $12 S 10 7 6 5 2 D’ D 0 3 4 5 6 10 12 Tapes per week

  49. A Numerical Illustration • Table 8.2 shows the two cases. • After the increase in demand, there is an excess demand for tapes at the old equilibrium price of $6. • The increase in price from $6 to $7 restores equilibrium in the market.

  50. TABLE 8.2: Supply and Demand Equilibrium in the Market for Cassette Tapes New equilibrium Initial equilibrium

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