Market Equilibrium
Week 3
 At
the market equilibrium price:
◦ Quantity demanded by
consumers = quantity supplied
by firms/producers/sellers
◦ Without a change in any of the
ceterius paribus conditions, the
price will remain unchanged

Consumers
◦ Willing to buy another unit, if market price <= to
marginal (use) value of consuming it

Suppliers
◦ Willing to sell/produce another unit, if market price
>= marginal (additional) costs of producing the last
unit

Equilibrium occurs only when
◦ MVconsumer = Pmarket = MCproducer

MV < P > MC
◦ Sellers are willing to continue to supply more
goods
◦ Consumers are unwilling to buy
◦ Excess supply will lead to sellers dropping their
prices down in the future to clear inventory

MV > P < MC
◦ Sellers not willing to supply as much as
consumers will demand (excess demand)
◦ Excess demand will lead to consumers bidding
prices up to get the “shortage”



At each price, determine
whether there would be a
shortage (Qd > Qs) or a
surplus (Qs > Qd)
If there was a shortage, how
would price adjust to clear
the market?
If there is a surplus, how
would price adjust to clear
the market?
# of Pizzas
Demand
ed
Price Per
Pizza
# of Pizzas
Supplie
d
1000
$10
400
900
$12
450
800
$14
500
700
$16
550
600
$18
600
500
$20
650
Shortage or
Surplus






http://www.bized.co.uk/current/mind/2004_5/251004.
ppt
Hungarian-born economist Nicholas Kaldor (19081986)
Simple dynamic model of cyclical demand with time lags
between the response of production and a change in
price (most often seen in agricultural sectors).
Cobweb theory is the process of adjustment in markets
Traces the path of prices and outputs in different
equilibrium situations. Path resembles a cobweb with
the equilibrium point at the center of the cobweb.
Sometimes referred to as the hog-cycle (after the
phenomenon observed in American pig prices during
the 1930s).
Price
(£)
S
11
The
Assume
Farmers
the
respond
falls
initial
£5
by
equilibrium
and
planning
farmers
This
In price
acreates
‘divergent
atomassive
cobweb’
- to
price
increase
react
is
by
£7
cutting
supply,
and
the
plans
ten
quantity
months
for
turkey
9.
shortage
also termed
of 9 an
million
unstable
turkeys If
demand
later,
production.
the rises,
supply
the
months
of
shortage
turkeys
later,
is
and
cobweb
the
price
- Ten
theis
price
forced
tends
up
–to15
pushes
million.
supply
At
the
the
this
price
market
level,
upequilibrium.
to
there
will
£11be
will
per
8
and
move
soon
away
the
process
from
continues!
turkey.
be
million.
a surplus of turkeys and the
A divergent
price
drops. cobweb leads to
price instability over time.
7
5
D
8
9
15
17
D1
Quantity Bought and Sold
(millions)

Consumer surplus
◦ Difference between what you are willing-to-pay and
what you have to pay

Willingness-to-pay

What you had to pay
◦ Everything under the demand curve up to the last
unit that you bought
◦ Average price paid x number of units purchased
Demand Curve is
Also Marginal Value
and Avg Revenue
Average Price (price
per unit)
Demand Curve
$12
$10
$8
$6
$4
$2
$0
CS
Amount Paid
1
2
3
4
5
6
7
Quantity Demanded
Total WTP =
CS + Amt Paid
8
9
10

Producer Surplus
◦ The difference between what they get paid (total
revenues) and what it costs them

Total Revenues

Total Costs
◦ > = Average Price x Quantity Purchased
◦ > = Sum of Marginal Costs up to the amount
supplied (QS)
 Or = the area under the supply curve up to Qs
 Value of the market
 To Consumers = Consumer Surplus
 To Producers = Producer Surplus
 Value equals the sum of both CS and PS


Evaluating the market equilibrium
Market outcomes
1. Free markets allocate the supply of goods to the
buyers who value them most highly

Measured by their willingness to pay
2. Free markets allocate the demand for goods to
the sellers who can produce them at the least
cost
 Only produce if you are paid as much (or more) than
product costs to make (MC)
13
7
Price
Supply
A
D
Equilibrium
price
Consumer
surplus
E
Producer
surplus
B
C
Demand
0
Equilibrium
Quantity
quantity
Total surplus—the sum of consumer and producer surplus—is the area
between the supply and demand curves up to the equilibrium quantity
14

Evaluating the market equilibrium
◦ Social planner
 Cannot increase economic well-being by
 Changing the allocation of consumption among buyers
 Changing the allocation of production among sellers
 Cannot rise total economic well-being by
 Increasing or decreasing the quantity of the good
3. Free markets produce the quantity of goods that
maximizes the sum of consumer and producer
surplus
15
8
Price
Supply
Cost
to
sellers
Value
to
buyers
Demand
Value
to
buyers
Cost
to
sellers
0
Q1
Equilibrium
quantity
Value to buyers is greater
than cost to sellers
Q2
Quantity
Value to buyers is less
than cost to sellers
At quantities less than the equilibrium quantity, such as Q1, the value to buyers exceeds the cost to
sellers. At quantities greater than the equilibrium quantity, such as Q2, the cost to sellers exceeds
the value to buyers. Therefore, the market equilibrium maximizes the sum of producer and
16
consumer surplus.


Evaluating the market equilibrium
Equilibrium outcome
◦ Efficient allocation of resources
◦ Consumers:
 Goods to those who value it most (MV >= P)
◦ Suppliers
 Goods produced by those with least costs/most
efficient production (P>MC)
◦ Efficient use of resources
 Produce only goods whose value is >= cost of using
the resources
17

In the world
◦ Competition - far from perfect
 Market power
 A single buyer or seller (small group)
 Control market prices
 Markets are inefficient
 Keeps the price and quantity away from the equilibrium of
supply and demand
18

In the world
◦ Decisions of buyers and sellers
 Affect people who are not participants in the market at
all
 Externalities
 Cause welfare in a market to depend on more than just
the value to the buyers and the cost to the sellers
 Inefficient equilibrium
 From the standpoint of society as a whole
19

Market failure
◦ E.g.: market power and externalities
◦ The inability of some unregulated markets to
allocate resources efficiently
◦ Occurs only in specific market types:




Monopoly
Possibly oligopoly (small number of producers)
Externalities (pollution, fish, natural resources)
Asymmetric information (financial markets)
◦ Public policy
 Can potentially remedy the problem
 Increase economic efficiency
20