Chapter 8

DERIVATION OF THE MARKET SUPPLY CURVE
◦ Firm Supply Curve
◦ Market Supply Curve
-- Own-Price Elasticity of Supply
-- Producer Surplus

MARKET EQUILIBRIUM UNDER PERFECT COMPETITION

ADJUSTMENTS TO MARKET EQUILIBRIUM
◦ Market Equilibrium
◦ Total Economic Surplus
◦ Applicability to Policy Analysis
◦ Market Disequilibrium
◦ Market Surplus
◦ Cobweb Adjustment Cycle
-- Market Shortage
-- Length of Adjustment Period
Firm’s supply curve
starts at shut down
level of output
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Profit maximizing firm
will desire to produce
where MC=MR
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Economic losses will occur
beyond output OMAX, where
MC > MR
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Building the Market Supply Curve
+
=
Market supply curve can be thought of as the horizontal summation
of the supply decisions of all firms in the market. Here, at a price
of $1.50, Gary would supply 2 tons of broccoli and Ima would
supply 1 ton, giving a market supply of 3 tons.
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Point Price
A
B
C
D
1
2
3
4
Quantity
Supplied
2
3
6
8
P
D
4
C
3
B
2
A
1
0
2
3
6
8
Q
Own-Price
elasticity of
supply
=
(QSA  QSB) /(( QSA  QSB)) / 2)
( PA  PB ) /(( PA  PB ) / 2)
Calculate own-price elasticity of supply
between $2 and $3.
DQ
DP
P
X
Q
DQ = 3, DP = 1, Q = 4.5, P = 2.5
DQ
X
DP
3
P
Q
=
1
2.5
X
4.5
= 1.66
ELASTIC
1% DP gives rise to a 1.66% DQ in
quantity
Producer surplus is a fancy term
economists use for profit. We measure
producer surplus as the area above the
supply curve and below the market
equilibrium price.
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Producer surplus is a fancy term economists
use for profit. We measure producer surplus
as the area above the supply curve and
below the market equilibrium price.
Total economic surplus is therefore equal to
consumer surplus discussed in Chapter 4
plus producer surplus.
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Market Price of $4
Product price
Producer surplus at $4
is equal to area ABC
F
G
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Total revenue at $4 would be
area 0ABF while total cost
would be area 0CBF. Thus
Profit = area 0ABF-area 0CBF
Product price
C
F
G
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Total revenue at $4 would be
area 0ABF while total cost
would be area 0CBF. Thus
Profit = area 0ABF-area 0CBF
Product price
Area 0ABF can be found
by multiplying price time
quantity, or $4 times output F
C
F
G
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Suppose Price Increased to $6
Product price
Producer surplus at $6
is equal to area EDC
F
G
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Total revenue at $6 would be
area 0EDG while total cost
would be area 0CDG. Thus
profit would be area 0EDG
minus area 0CDG, or CED.
Product price
C
F
G
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The gain in producer surplus
if the price increases from $4
is equal to area AEDB
Producers are better
off economically by
responding to this
price increase by
producing output G
C
F
G
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We need to distinguish between movement
along a demand or supply curve, and shifts
in the demand or supply curve.
We need to distinguish between movement
along a demand or supply curve, and shifts
in the demand or supply curve.
Movement along a curve is referred to as a
“change in the quantity demanded or supply”.
A shift in a curve is referred to as a “change
in demand or supply”.
Increase in demand
pulls up price from
Pe to Pe*
Decrease in demand
pushes price down
from Pe to Pe*
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Increase in supply
pushed price down
from Pe to Pe*
Decrease in supply
pulls up price from
Pe to Pe*
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We can use the concepts of market demand
and supply to assess the effects of events
in the economy have upon the economic
well being of consumers and products in
a particular market.
We assess these effects using the concept of
Consumer surplus introduced in Chapter 4
with producer surplus discussed here.
ECONOMIC SURPLUS
Economic Surplus = Consumer Surplus + Producer Surplus
Consumer Surplus = area #1, Producer Surplus = area #2
An Example of Economic Welfare Analysis
Assume a drought occurs
that results in a decrease
in supply from S to S*.
Before this happened,
consumer surplus was
area 3+4+5 while producer
surplus was equal to
area 6+7.
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An Example of Economic Welfare Analysis
After the decrease in
supply, consumer surplus
is just area 3. They lose
area 4 and area 5.
Producers gain area 4 but
lose area 7.
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An Example of Economic Welfare Analysis
Consumers are therefore
worse off because of the
drought.
Producers are also worse
off if area 4 is less than
area 7.
Society loses area 5+7.
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CHANGE IN ECONOMIC SURPLUS
Δ in economic surplus = -4-5+7 = -5-7
Measuring Surplus Levels
$7
D
S
$4
Consumer surplus is
equal to (10 x (7-4))÷2,
or $15
Product price
$1
10
Measuring Surplus Levels
$7
D
S
$4
Consumer surplus is
equal to (10 x (7-4))÷2,
or $15
Product price
Producer surplus is
Equal to (10 x (4-1))÷2,
or $15
$1
10
Measuring Surplus Levels
$7
D
S
$4
Consumer surplus is
equal to (10 x (7-4))÷2,
or $15
Product price
Producer surplus is
Equal to (10 x (4-1))÷2,
or $15
$1
10
Total economic surplus
is therefore $30…
Market Surplus
If the price is PS,
producers would
supply QS while
consumers would
only want QD at
this high price.
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Market Shortage
If the price is PD,
producers would
only supply QD
while consumers
want QD at this
low price.
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Markets converge to equilibrium over time
unless other events in the economy occur.
One explanation for this adjustment which
makes sense in agriculture is the Cobweb
theory. This name stems from the spider
like trail the adjustment process makes.
Year Two Reactions
Producers use last year’s
price as their expected
price for year 2.
Consumers on the other
hand pay this year’s
price determined by Q2.
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Year Three Reactions
P3
P2
Producers now decide to
produce less at the lower
expected price. This
lower quantity pushes
price up to P3 in year 3.
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Cobweb Pattern Over Time
Market
equilibrium
The market converges to
market equilibrium where
demand intersects supply
at price PE. In some
markets, this adjustment
period may only be months
or even weeks rather than
years assumed here.
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