Chapter 14
Equilibrium and Efficiency
McGraw-Hill/Irwin
Copyright © 2008 by The McGraw-Hill Companies, Inc. All Rights Reserved.
Main Topics – Ch 14~16
Chapters 14~16 provide an introduction
to the analysis of competitive markets.
Ch 14 – Investigate differences between
market equil. in the SR and LR. Also,
welfare properties of competitive equil.
Outcomes.
Ch 15 – Uses the tools to study the
effects of govt. policies.
Ch 16 – Look at equil. in many
competitive markets at the same time.
14-2
Main Topics
What makes a market competitive?
Market demand and market supply
Short-run and long-run competitive
equilibrium
Efficiency of perfectly competitive
markets
Measuring surplus using market demand
and supply curves
14-3
What Makes a Market
Competitive?
Buyers and sellers have absolutely no effect on
price
Three characteristics:
Absence of transaction costs
This means when different sellers produce the same product
buyers will have no difficulty identifying and purchasing from
the seller who offers it at the best terms.
Product homogeneity: products are identical in the
eyes of their purchasers
Products are differentiated when some purchasers view the
products as different.
Presence of a large number of sellers, each accounts
for a small fraction of market supply
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What Makes a Market
Competitive?
When all three factors are present…
Consumers have many options and buy from
the firm that offers the lowest price
Each firm takes the market price as given and
can focus on how much it wants to sell at that
price
Few markets are perfectly competitive
We use this this method because…
Provide useful tool for analyzing how changes in
input costs, taxes, etc. affect the price and qty sold.
Provide very good end results to both consumers
and producers so is useful as a benchmark.
14-5
Market Demand and Supply
Market demand for a product is the sum of the
demands of all individual consumers
Graphically, this is the horizontal sum of the
individual demand curves
For simplicity, assume that all demand comes from
consumers and all supply comes from firms
Market supply of a product is the sum of the
supply of all the individual sellers
Graphically this is the horizontal sum of the
individual supply curves
Very similar to the procedure for constructing market
demand curves
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Figure 14.1: Market Demand
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Figure 14.2: Market Supply
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S-R vs. L-R Market Supply
 Long-run and short-run market supply curves may differ
for two reasons:
 Firm’s short-run and long-run supply curves may differ
 Over time, set of firms able to produce in a market may change
 S-R curves are found by summing the supply curves of
all current suppliers.
 L-R supply curve is found by summing supply curves of
all potential suppliers
 Free entry in a market implies that anyone who wishes
to start a firm has access to the same technology and
entry is unrestricted
 With free entry, the number of potential firms in a market
is unlimited (or is it?)
 Long-run market supply curve is a horizontal line at ACmin
14-9
Figure 14.4: Long-Run Supply
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Figure 4.5: Market Equilibrium
At equilibrium price,
Qs=Qd
Market clears at
equilibrium price
Given demand and
supply functions, can
use algebra to find
the equilibrium
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Long-Run Competitive Equilibrium
Equilibrium price must
equal Acmin…why?
Firms must earn zero
profit
Why? Does this mean
they don’t make any
money over their input
cost?
Active firms must
produce at their
efficient scale of
production …Why?
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Responses to Changes in
Demand
 Market response is different in short-run (number of
firms is fixed) than in long-run (with free entry)
 Begin from a point of long-run equilibrium, suppose
demand curve shifts out
 In short run, new equilibrium is achieved through
movement along the short-run supply curve
 Price rises
 In long run, firms enter the market
 New equilibrium brings return to initial price but at a higher
quantity
14-13
Price ($/bench)
Figure 14.7: Response to an
Increase in Demand
S10
B
A
C
P* = ACmin
= 100
S
^
D
D
2000
4000
Garden Benches per Month
14-14
Long-Run Competitive Equilibrium
14-15
Responses to Changes in
Fixed Cost
 Start from a long-run equilibrium
 Consider the case where fixed costs decrease while
variable costs remain the same
 In short run:
 Average cost curve shifts downward, decreases minimum
average cost and minimum efficient scale
 Since marginal costs have not changed and number of firms is
fixed, equilibrium is unchanged
 Active firms make a positive profit
 In long-run:
 Firms enter market
 Market equilibrium shifts, price falls and quantity rises
14-16
Figure 14.8: Response to a
Decrease in Cost
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Responses to Changes in
Variable Cost
Start from a long-run equilibrium
If variable costs change, firm’s marginal and
average cost curves both shift
Short-run supply curve shifts
Sort-run equilibrium changes
Basic procedure in all cases:
Find new short-run equilibrium using new short-run
supply curve of initially active firms
Find new long-run equilibrium using new long-run
supply curve which reflects free entry
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Price Changes in the Long-Run
 So far we’ve assumed that the prices of firms’ inputs do
not change
 Reasonable if increases in amounts of inputs used are small
compared to overall market
 Or when supply in input markets is very elastic
 In general, though, when demand for a product
increases, prices of inputs used to make it may change
 This is a general equilibrium effect; the market we are
studying and the market for its inputs must all be in
equilibrium
 Taking the input price effect into account in the analysis
of the market response to an increase in demand
changes the result
 Price of the good rises in the long run
14-19
Price ($/bench)
Figure 14.11: Price Changes in
the Long-Run
S10
B
^
AC
min=110
ACmin=100
A
^
E
S
S
C
^
D
D
2000
4000
Garden Benches per Month
14-20
Aggregate Surplus and
Economic Efficiency
 Perfectly competitive market produces an outcome that
is economically efficient
 Net benefits indicate that consumers’ benefit from the goods
exceed the costs of producing them
 Aggregate surplus equals consumers’ total willingness
to pay for a good less firms’ total avoidable cost of
production
 Total benefits from consumption equal to willingness to
pay
 Area under consumer’s demand curve up to that quantity
 Total avoidable costs of production include all of a
firm’s costs other than sunk costs
 Area under its supply curve up to its production level
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Willingness to Pay
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Avoidable Cost of Production
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Aggregate Surplus
Total Willingness to Pay =$8+6.75=$14.75
Total Cost of Producing=$5+$3=$8
Total Aggregate Surplus = $6.75
An economic system that maximizes
aggregate surplus creates the largest
possible net social benefit to be distributed
among society’s members.
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Maximizing Aggregate Surplus
 Smith’s The Wealth of Nations (1776) commented on
the “invisible hand” of the market
 The self-interested actions of each individual lead to
economic efficiency
 “he intends only his own gain, and he is in this…led by
an invisible hand to promote an end which was no part
of his intention”
 No way to increase aggregate surplus in perfectly
competitive markets by changing:
 Who consumes the good
 Who produces the good
 How much of the good is produced and consumed
 Competitive markets maximize aggregate surplus
14-25
Effects of a Change on Who
Consumes the Good
Begin from the competitive equilibrium
Take one unit of the good from Consumer A
and give it to Consumer B
Cannot increase aggregate surplus
Value any consumer attaches to a unit of the good
they don’t buy must be less than the market price
Value any consumer attaches to a unit of the good
they do buy must be more than the market price
If we take the good from someone who
purchased it and give it to someone who didn’t,
aggregate surplus must fall
14-26
Effects of a Change in Who
Produces the Good
 Changing who produces the good can’t increase
aggregate surplus
 To achieve this, would have to reassign sales in a way that
would lower the total cost of production
 Begin from the competitive equilibrium
 Reduce sales of Producer A by one unit, increase sales
of Producer B by one unit
 Cost of producing any unit of output that a firm chooses to sell
must be less than the equilibrium price
 Cost of producing any unit of output that a firm chooses not to
sell must exceed the equilibrium price
 Any shift in production from one firm to another must
raise the total cost of production and lower aggregate
surplus
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Effects of a Change in the
Number of Goods
 Changing the total number of units of the good
produced and consumed also lowers aggregate
surplus
 Any unit of a good that is produced and consumed in a
competitive market equilibrium must be worth more
than the market price to the consumers who buy them
 Must also cost less than the market price to produce
 Those units of output must therefore make a positive
contribution to aggregate surplus
 Any units that aren’t produced and consumed should
not be; they will lower aggregate surplus
14-28
Measuring Total WTP and
Total Avoidable Cost
Market demand and supply curves can be
used to measure total willingness to pay and
total avoidable cost
Measure consumers’ total willingness to pay for
the units they consume by the area under the
market demand curve up to that quantity
When all consumers face the same market price
Measure producers’ total avoidable costs for
the units they produce by the area under the
market supply curve up to that quantity
When all producers face the same market price
14-29
Figure 14.18: Measuring Total
Willingness to Pay
If 3 cones are consumed, what is the total willingness to pay?
If the price is $2.30, how may cones would be sold?
14-30
Aggregate Surplus
Can use market supply and demand curves to
measure aggregate surplus
Consumers’ total willingness to pay is area
under market demand curve up to the quantity
consumed
Producers’ total avoidable cost is the area
under the market supply curve up to the
quantity produced
In a competitive market without any
intervention, aggregate surplus is maximized
No deadweight loss: reduction in aggregate
surplus below its maximum possible value
14-31
Consumer and Producer Surplus
Consumer surplus is the sum of consumers’
total willingness to pay less their total
expenditure
Sum of individual consumers’ surpluses
Also called aggregate consumer surplus
Producer surplus is the sum of firms’ revenues
less avoidable costs
Sum of individual firms’ producer surpluses
Also called aggregate producer surplus
Aggregate surplus = Consumer surplus + Producer Surplus
14-32
Figure 14.19: Aggregate,
Consumer, and Producer Surplus
14-33
Exercise 14.5
The market demand function for corn is
Qd=15-2P and the market supply function
is Qs=5P-6, both quantities measured in
billions of bushels per year. What are the
aggregate surplus, consumer surplus and
producer surplus at the competitive
market equilibrium?
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Exercise 14.5
The first step is to set supply and demand equal and to solve
for equilibrium price:
Qs = Qd
5P – 6 = 15 – 2P
7P = 21
P = $3.00
At a price of $3, we can see from either supply or demand that
quantity will be 9 billion bushels per year. We also need the
highest price at which quantity supplied equals zero and the
lowest price at which quantity demanded equals zero. We
find these two numbers by plugging in 0 for Qd and Qs and
solving for the prices that result.
Qd = 15 – 2P
Qs = 5P – 6
0 = 15 – 2P
0 = 5P – 6
2P = 15
6 = 5P
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P = $7.50
P = $1.20
Exercise 14.5
Now we can compute the areas of the triangles.
CS = ½(Q)($7.50 – P)
PS = ½(Q)(P – $1.20)
CS = ½(9)($7.50 – $3)
PS = ½(9)($3.00 – $1.20)
CS = $20.25
PS = $8.10
Aggregate surplus is the sum of consumer and producer
surplus:
AS = CS + PS
AS = $20.25 + $8.10
AS = $28.35
14-36