AAEC 2305
Fundamentals of Ag Economics
THEORY OF MARKETS
Objectives:
 How Supply & Demand curves interact to determine
the prices & quantities of goods & services produced
& consumed
 About markets in time, space, & form
 Characteristics of a competitive market
 Determination of Output in a competitive market
Economic Profit
Economic
Profit
Total
Revenue
Accounting
Profit
Explicit
Costs
“Normal”
Profit
Explicit
Costs
“Normal” Profit is the opportunity cost of resources supplied by
owner of the firm; Economic profit (excess profits) are profits
above opportunity costs and explicit costs
Graph
 Economic profit
Pudge the Corn Farmer
Stay in Farming
Manage Retail Store
 TR = $22,000
 TR = $11,000
 Explicit Costs = $10,000
 Explicit Costs = $0
 Implicit Costs = $11,000
 Implicit Costs = $11,000
 Accounting Profit = $12,000
 Accounting Profit = $11,000
 Economic Profit = $1,000
 Economic Profit = $0
 Excess profits attract new
Competition
Suppose that economic
(excess) profits were
that high for corn
farming, would Pudge
be the only person
wanting to farm corn?
entrants into the business with
similar opportunity costs as
Pudge.



For those with OC less than Pudge,
farming is very attractive
For those with OC equal to Pudge, they
are indifferent about farming
For those with OC greater than Pudge,
farming is not attractive
Markets
 A Market is an institution or an arrangement that
brings buyers and sellers together.
 Market Price - is the mutually agreeable price at
which willing buyers and willing sellers exchange a
good.
Market Equilibrium
 Market equilibrium occurs when the quantity of a
good offered by a sellers at a given price equals the
quantity buyers are willing and able to purchase at
that same price.

Like the two blades of scissors—which one cuts the paper?
Graph
 Market Equilibrium
Numerical Example
Qd  10,000 5,000p
Qs  5,000p
In equilibrium, demand and supply
must equal one another:
Qd  Qs
10,000 5,000p  5,000p
10,000  10,000p
p 1
The equilibrium price is $1. To get quantity, simply substitute $1
into either supply or demand: Q = 5,000p = 5,000 sandwiches.
Shifts in Supply and Demand
 Graph of increase in input cost
 Graph of increase in demand
Numerical Example—Input Cost Increase
 Increase in minimum wage shifts supply function
Qs  4,000p
Qd  Qs
10,000 5,000p  4,000p
10,000  9,000p
p  1.11
The increase in the minimum wage increased the
equilibrium price of chicken sandwiches by $0.11
Numerical Example—Demand Increase
 News of healthy chicken increases demand
Qd  12,000 5,000p
Qd  Qs
12,000 5,000p  5,000p
10,000p  12,000
p  1.20
The health news increased demand, increasing price by
$0.20.
Functions of Price
 Rationing—distribute scarce goods among potential
claimants insuring that those that get them are the
ones that value them the most
 Allocative—direct productive resources to different
sectors of the economy
Graphs
 Firm profit
 Equilibrium
 Excess Profits and New Entry
 Short-run vs. Long run effects of demand and supply
changes
No-Cash-On-The-Table
 If the price is “too low,” consumers will buy more to
capture their “excess profits” by consuming products
at a price less than they were willing to pay
 If the price is “too high,” producers will produce
more to capture their “excess profits” by producing
products at a price more than they willing to accept
No-Cash-On-The-Table
 Why are all lanes on a crowded, multi-lane freeway
moving at about the same speed?
 Why do grocery check-out lines all tend to be about
the same length?
Perfect Competition
 Large number of buyers and sellers
 At least a relatively large number of comparably sized firms
 Relatively homogeneous products
 Basic commodities
 Low barriers to entry
 Relatively easy to get in and out of the market
 Economic conditions
 Small portion of consumer’s budget and relatively large
production
Graph
 Hairstylists and Aerobic Instructors
Economic Rent vs. Economic Profit
 Profit is earnings above explicit and implicit costs;
these are driven toward zero by competition
 Rent is payment for a factor of production in excess
of the reservation price

Influenced by the “uniqueness” of the input
Efficiency (Pareto Efficiency)
 Efficiency—if price and quantity take anything other
than their equilibrium values, a transaction that will
make someone better off without making anyone else
worse off can always be found
 A perfectly competitive market is the most
efficient market form. It results in the highest
possible total welfare of everyone in the market.
Surplus
 Surplus is simply the economic benefits less the costs
 In equilibrium, surplus is the total economic benefits
accumulated from consuming/producing a good
across all units at the equilibrium price.


Consumer surplus is the area under the demand curve and
above the equilibrium price
Producer surplus is the area above the supply function and
below the equilibrium price (also called profit)
Calculation
 Consumer surplus is given by:


1
CS  Pd  P* Q*  0
2
 Producer surplus is given by:


1 *
PS  P  0 Q *  0
2


Numerical Example
 Back to our chicken sandwich example:
First find Pd :
Qd  10,000 5,000p
Set demand = 0 to get yintercept:
0  10,000 5,000p
5,000p  10,000
p2
Find surplus:
1
CS  2  15,000 0 
2
1
CS  5,000
2
CS  $2,500/ day
1
1  05,000 0
2
1
PS  5,000
2
PS  $2,500/ day
PS 
Changes in Consumer Surplus
 Graph of Change in Demand and Change in
Consumer Surplus
Numerical Example
Solving for y-intercept
Qd  12,000 5,000p
0  12,000 5,000p
5,000p  12,000
p  $2.40
Calculating new CS:
CS 
1
2.4  1.26,000 0  $3,600
2
Change in consumer surplus:
CS  $3,600 $2,500  $1,100