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1
Demand, Supply, and Equilibrium in a Perfectly Competitive Market
2
The Context: “Perfectly Competitive Markets”
• A group of buyers and sellers of a particular good or service– can be defined narrowly or broadly (e.g., rice vs. food)– at a given point in time (e.g., day, month, year)
• Enough buyers and sellers so that no one has an impact on the price– typical with many buyers and sellers
3
Willingness to Pay
• Willingness to pay (WTP): the maximum amount that a buyer will pay for a good
• Further distinctions are helpful…
• Marginal willingness to pay (MWTP): WTP for one more unit of a good
• Total willingness to pay (TWTP): WTP for any number of units of a good
4
An Individual’s WTP for good X
Quantity of X Marginal WTP (MWTP)
Total WTP (TWTP)
1 $4 $4
2 $3 $7
3 $2 $9
4 $1 $10
5 $0 $10
5
5
An Individual’s Demand Curve
• A graph of an individual’s MWTP curve is her demand curve
• Demand curve: gives the relationship between the price of a good and the quantity demanded
• Law of demand: downward sloping curve reflects diminishing MWTP
6
An Individual’s Demand Schedule
• A table that gives the relationship between the price and quantity demanded
• Based on the individual’s MWTP
Price of X Quantity Demanded
$5 0
$4 1
$3 2
$2 3
$1 4
$0 5
7
Consider a Market with Two Individuals
Price of X Individuals 1’sQuantity
Demanded
Individual 2’sQuantity
Demanded
TotalQuantity
Demanded
$5 0 0 0
$4 1 2 3
$3 2 4 6
$2 3 6 9
$1 4 8 12
$0 5 10 15
8
The Market (Aggregate) Demand Curve
• A horizontal summation of individual demand curves
• Tells the market quantity demanded at any given price
• Also tells the MWTP in the market—the most someone is WTP for each additional unit of the good
9
A Note on Demand Semantics
• Changes in price result in “changes in the quantity demanded”
• “Changes in demand” imply shifts of the demand curve
10
Shifters of the Demand Curve
1. Changes in income, + (-) • Normal goods, + (-)• Inferior goods, - (+)
2. Changes in the price of related goods, + (-)• Substitutes, + (-)• Complements, - (+)
3. Tastes and preferences
4. Expectations
5. Number of buyers in the market, + (-) implies + (-)
11
A Firm’s Marginal Cost (MC) of Production
• Marginal cost (MC): tells a firm’s incremental cost of producing an additional unit of a good
• We assume it is increasing (for now)
• We ignore the total costs of production (for now)
12
A Firm’s MC of Producing Good X
Quantity of X MC
1 $2
2 $3
3 $4
4 $5
5 $6
13
An Firm’s Supply Curve
• A graph of a firm’s MC curve is its supply curve
• Supply curve: gives the relationship between the price of a good and the quantity supplied
• Law of supply: upward sloping curve reflects increasing MC
14
A Firm’s Supply Schedule
• A table that gives the relationship between the price and quantity supplied
• Based on the firm’s MC
Price of X Quantity Supplied
$1 0
$2 1
$3 2
$4 3
$5 4
15
Consider a Market with Two Firms
Price of X Firm 1’sQuantity Supplied
Firm 2’sQuantity Supplied
TotalQuantity Supplied
$1 0 0 0
$2 1 2 3
$3 2 4 6
$4 3 6 9
$5 4 8 12
16
The Market (Aggregate) Supply Curve
• A horizontal summation of the individual firm supply curves
• Tells the market quantity supplied at any given price
• Also tells the MC in the market—the lowest cost of producing each additional unit of the good
17
A Note on Supply Semantics
• Changes in price result in “changes in the quantity supplied”
• “Changes in supply” imply shifts of the supply curve
18
Shifters of the Supply Curve
1. Changes in input prices, + (-) implies - (+)
2. Changes in the technology of production, such that better (worse) implies + (-)
3. Expectations
4. Number of sellers in the market, + (-) implies + (-)
19
Equilibrium: Supply “meets” Demand
• The intersection of the supply and demand curves determines the equilibrium price and quantity
• Market clearing condition: when the quantity supplied equals the quantity demanded
• Given the equations for the supply and demand curves, you can solve algebraically for P* and Q*
20
Equilibrium Proof by Contradiction
• If P > P*, then there would be excess supply (a surplus)– Firms would lower prices
• If P < P*, then there would be excess demand (a shortage)– Consumers would pay more
• Must be true that P = P* and that QS = QD = Q*
21
Comparative Static Analysis
Ceteris paribus : other things being equal
• An increase (decrease) in demand results in more (less) exchange at a higher (lower) price
• An increase (decrease) in supply results in more (less) exchange at a lower (higher) price
• Simultaneous shifts in supply and demand can generate ambiguous effects