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
Remember the firm’s
supply curve?
P=MR=AR
3
Page 131
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
4
Economic losses occur
where MC > MR
Page 131
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
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
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
7
Page 132
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
Determining Market Equilibrium
Price
D
S
PE
Market clearing price
QE
9
Market Supply Curve =
Horizontal summation of
individual firm supply
curves
Quantity
Market Demand Curve =
Horizontal summation of
individual consumer
demand curves
Determining Market Equilibrium
Price
D
S
PE
Chapters 3 - 5
QE
10
Quantity
Determining Market Equilibrium
Factors that change
(shift) demand:
Price
D*
D
S
PE*
PE
QE QE*
11
Prices of other goods
Consumer income
Tastes and preferences
Real wealth effect
Global events
Quantity
Determining Market Equilibrium
Price
D
S
Chapters 6 - 7
PE
QE
12
Quantity
Determining Market Equilibrium
Factors that change
S*
Price
D
S
PE*
PE
QE*QE
13
(shift) supply:
Input costs
Government policy
Price expectations
Weather & disease
Global events
Quantity
Concept of Producer Surplus
Producer Surplus (PS) is a term
economists use for aggregate returns
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
Concept of Producer Surplus
Market Price of $4
Price
Market Supply
Total Revenue = 0ABD
$4
A
B
Product Price
Total Variable Cost = 0CBD
C
0
15
D
Output
Page 133
Concept of Producer Surplus
Market Price of $4
Price
Market Supply
$4 A
B
PS at $4 =
area ABC
C
D
16
Product Price
Output
Page 133
Concept of Producer Surplus
Suppose Price Increased to $6…
Price
F
$6 E
$4
A
B
PS at $6 =
area EFC
C
D
17
Market Supply
G
Output
Page 133
Concept of Producer Surplus
Price
The gain in PS if the price increases
from $4 to $6 is equal to area AEFB
F
$6 E
$4
Market Supply
Producers are
better off by
increasing output
from D to G
A
B
C
D
18
G
Output
Page 133
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
Total Surplus
19
Consumer Surplus
Producer Surplus
$
E
Assessing Economic Welfare
An Example of Economic Welfare Analysis
S
Assume we have a market
B
C
 PS = area BCE
 CS = area BCA
 TES = area BCA + area BCE
= area AEC
Then a drought occurs
A
 How can we examine whether
consumers or producers are
impacted
D
20
Q
Page 136-137
$
Assessing Economic Welfare
An Example of Economic Welfare Analysis
E
S*
S
I
F
B
H
A
G
C
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
D
21
Q
Page 136-137
$
Assessing Economic Welfare
An Example of Economic Welfare Analysis
E
S*
S
Drought causes
I
F
B
H
A
22
G
C
 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
D no gain area (area AHIC)
Q
Page 136-137
Assessing Economic Welfare
Measuring Surplus Levels
$
$6
B
C
ABCD = ?
FADE = ?
Supply
CS = (10 x (6-4))÷2 = $10
$4
A
D
Product price
PS =(10 x (4-1))÷2 = $15
$1
Demand
E
F
10
Q
→Total economic surplus = CS + PS
= $10 + $15 = $25
23
Page 136-137
Modeling
Commodity
Prices
24
Modeling Commodity Prices
Forecasting Future Commodity Price Trends
D = α – βP + γYD + δX
$
S
$6
Own
price
Disposable
income
Other
factors
$4
Own
price
Other
factors
D
$1
10
25
Input
costs
Q
S = θ + πP – τC + χZ
Page 136-137
$
Modeling Commodity Prices
S
P*
QD = 10 – 6P + .3YD + 1.2X
QD = QS= Q
Q* =Q
D
S
D
Equilibrium
Condition
QS = 2 + 4P – .2C + 1.02Z
Q
Q*
How can we determine the values of P* and Q*?
26
Page 221
$
Modeling Commodity Prices
S
QD = 10 – 6P + .3YD + 1.2X
QD = QS= Q
Q* =Q
D
S
P*
D
Q*
Equilibrium
Condition
QS = 2 + 4P – .2C + 1.02Z
Q
 The above shows relationship between P and
either QS and/or QD
 Lets undertake a ceteris paribus analysis
and assume values for YD, X C and Z
27
Page 221
Modeling Commodity Prices
$
S
P*
QD = 50 – 6P
QD = QS= Q
Q* =Q
D
S
D
Equilibrium
Condition
QS = 42 + 4P
Q
Q*
 How can we determine the value of Q*
28
(1) Substitute demand and supply equations into
equilibrium condition
(2) Solve for equilibrium price (P*)
(3) Substitute this price into either supply or
demand equation for Q*
Page 221
Modeling Commodity Prices
 How can we determine the value of Q* and P*
1) Substitute demand and supply equations
into equilibrium condition
Q* =QD = QS→ (50 – 6P) = (42 + 4P)
2) Solve for equilibrium price (P*)
50 – 6P = 42 + 4P → 8 + 10P = 0
→P* = 8/10 = 0.80
3) 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
29
Page 221
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
Market Disequilibrium
31
Market Disequilibrium
At PS→ Market Surplus exists as QS – QD > 0
Surplus
S
PS
At price PS,
consumers would
demand QD
At price PS,
producers would
supply QS
P*
PD
D
QD
32
Q*
QS
Page 138
Market Disequilibrium
At PD→ Market Shortage exists as QS – QD < 0
S
PS
At price PD,
producers would
supply QD
At price PD,
consumers would
demand QS
P*
PD
D
QD
33
Q*
Shortage
QS
Page 138
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 weblike trail the adjustment process makes
34
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
Market Disequilibrium
Year Two Reactions
36
Page 140
Market Disequilibrium
Year Three Reactions
P3
P2
37
Page 140
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
Market Disequilibrium
From the above results we have the
following:
(P1 – P2) > (P3 – P2) > (P3 – P4)
Price changes are getting smaller
(Q2 – Q1) > (Q2 – Q3) > (Q4 – Q3)
Quantity changes are getting smaller
39
Eventually wil converge to P*, Q* the
Page 140
equilibrium price and quantity
Market Disequilibrium
Cobweb Pattern Over Time
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
Market
equilibrium
40
Page 140
Market-to-Firm Linkages
41
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
Increase in demand
increases price from Pe
to Pe*
Decrease in demand
decreases price from Pe
to Pe*
Page 135
43
Increase in supply
decreases price from
Pe to Pe*
Decrease in supply
increases price from
Pe to Pe*
Page 135
44
Merging Demand and Supply
Price
D
S
Chapters 6-7
PE
Chapters 3-5
QE
45
Quantity
Firm is a Price Taker Under
Perfect Competition
Price
The Firm
The Market
D
S
Price
PE= MR = MC
AVC
MC
PE
QE
QF
Quantity
46
Impact of an Increase in Demand
The Market
Price
D
D1
S
The Firm
Price
MC
AVC
PE
QE Q* E
47
Quantity
10 11
Impact of a Decrease in Demand
The Market
Price
D2
D
The Firm
S
Price
AVC
MC
PE
Q* E Q E
9 10
Quantity
48
Firm is a Price Taker in the
Input Market
Wage
Rate
Labor Market
SL
DL
Wage
Rate
The Firm
MVP
MIC
PL
QL
LF
Labor
49
Firm is a Price Taker in the
Input Market
Labor Market
Wage
Rate
DL*
SL
DL
Wage
Rate
The Firm
MVP
PL
MIC
QL
50
Labor
L*F
LF
Effects of Increasing The
Minimum Wage
Wage
Rate
Labor Market
D
S
Wage
Rate
The Firm
MVP
PMIN
MIC
LMAX
QD QS
Labor
51
Summary
Market equilibrium price and quantity are
given by the intersection of demand and supply
Producer surplus captures the profit earned in
the market by producers
Total economic surplus is equal to producer
surplus plus consumer surplus
A market surplus exists when the quantity
supplied exceeds the quantity demanded.
A market shortage exists when the quantity
demanded exceeds the quantity supplied.
52
Chapter 9 focuses on market
equilibrium and product prices
under conditions of imperfect
competition….
53