3. Competitive markets.pdf

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Competitive product markets and rmdecisions

Competition, if not prevented, tends to bring about a state of affairs in which: rst,everything will be produced which somebody knows how to produce and which hecan sell protably at a price at which buyers will prefer it to the available alternatives;second, everything that is produced is produced by persons who can do so at least as

cheaply as anybody else who in fact is not producing it; and third, that everything willbe sold at prices lower than, or at least as low as, those at which it could be sold byanybody who in fact does not do so.

Friedrich A. Hayek

In the heart of New York City, Fred Lieberman’s small grocery is dwarfed by thetall buildings that surround it. Yet it is remarkable for what it accomplishes.

Lieberman’s carries thousands of items, most of which are not produced locally, and

some of which come from other parts of this country or the world, thousands of miles away. A man of modest means, with little knowledge of production processes,Fred Lieberman has nevertheless been able to stock his store with many if not mostof the foods and toiletries his customers need and want. Occasionally Lieberman’sruns out of certain items, but most of the time the stock is ample. Its supply is sodependable that customers tend to take it for granted, forgetting that Lieberman’s isone small strand in an extremely complex economic network.



How does Fred Lieberman get the goods he sells, and how does he know which onesto sell and at what price? The simplest answer is that the goods he offers and theprices at which they sell are determined through the market process – the interactionof many buyers and sellers trading what they have (their labor or other resources)

for what they want. Lieberman stocks his store by appealing to the private interestsof suppliers – by paying them competitive prices. His customers pay him extra for the convenience of purchasing goods in their neighborhood grocery – appealing tohis private interests in the process. To determine what he should buy, FredLieberman considers his suppliers’ prices. To determine what and how much they should buy, his customers consider the prices he charges. The economist FriedrichHayek (1945) has suggested that the market process is manageable for people suchas Fred Lieberman, his suppliers, and his customers, precisely because prices con-dense a great deal of information into a useful form, signaling quickly what peoplewant, what goods cost, and what resources are readily available. Prices guide and

coordinate the sellers’ production decisions and consumers’ purchases.How are prices determined? That is an important question for people in business,simply because an understanding of how prices are determined can help business-people understand the forces that will cause prices to change in the future and,therefore, the forces that affect their businesses’ bottom lines. There’s money to bemade in being able to understand the dynamics of prices. Our most general answer to the question of how prices are determined is deceptively simple: in competitivemarkets, the forces of supply and demand establish prices. However, there is much tobe learned through the concepts of supply and demand. Indeed, we suspect that mostMBA students will nd supply and demand the most useful business concepts and

tools of analysis developed in this book (and perhaps their entire MBA program). Tounderstand supply and demand, you must rst understand that the market process isinherently competitive.

Part A Theory and public policy applications

The competitive market process

So far, our discussion of markets and their consequences has been rather casual. Inthis section, we shall dene precisely such terms as “market” and “competition.” Inlater sections, we shall examine the way competitive markets work and learn why,in a limited sense, markets can be considered efcient systems for determining whatand how much to produce. Markets, along with the prices that emerge in them, makethe problem of scarcity less pressing than it otherwise would be.

Competitive product markets and rm decisions 81



The market settingMost people tend to think of a market as a geographical location – a shoppingcenter, an auction hall, a business district. From an economic perspective, however,it is more useful to think of a market as a process. You may recall from chapter 1 that

a market is dened as the process by which buyers and sellers determine what they are willing to buy and sell and on what terms. That is, a market is the process by which buyers and sellers decide the prices and quantities of goods to be bought andsold. The market process can work within the connes of a building, but alsothrough the Internet that extends to all points on the globe.

In this process, individual market participants search for information relevant totheir own interests. Buyers ask about the models, sizes, colors, and quantitiesavailable and the prices they must pay for them. Sellers inquire about the types of goods and services buyers want and the prices they are willing to pay.

This market process is self-correcting . Buyers and sellers routinely revise their

plans on the basis of experience. As economist Israel Kirzner has written:The overly ambitious plans of one period will be replaced by more realistic ones; marketopportunities overlooked in one period will be exploited in the next. In other words, evenwithout changes in the basic data of the market, the decision made in one period one timegenerates systematic alterations in corresponding decisions for the succeeding period. (Kirzner 1973, 10)

But then overly ambitious plans do affect the “basic data” people receive throughresulting changes in prices, which affect the quantities and qualities of goodsproduced.

The market consists of people – consumers and entrepreneurs – attemptingto buy and sell on the best terms possible. Through the groping process of giveand take, they move from relative ignorance about others’ wants and needs toa reasonably accurate understanding of how much can be bought and sold andat what price. The market functions as an ongoing information and exchange system .

Competition among buyers and among sellersPart and parcel of the market process is the concept

of competition . Competition does not occur betweenbuyer and seller, but among buyers or among sellers.Buyers compete with other buyers for the limitednumber of goods on the market. To compete, they must discover what other buyers are bidding andoffer the seller better terms – a higher price or the

Competition is the process by which marketparticipants, in pursuing their own interests,attempt to outdo, outprice, outproduce, andoutmaneuver each other. By extension,competition is also the process by whichmarket participants attempt to avoid beingoutdone, outpriced, outproduced, oroutmaneuvered by others.

82 Microeconomics for MBAsA



same price for a lower-quality product. Sellers compete with other sellersfor the consumer’s dollar. They must learn what their rivals are doing andattempt to do it better or differently – to lower the price or enhance the product’sappeal.

This kind of competition stimulates the exchange of information, forcing com-petitors to reveal their plans to prospective buyers or sellers. The exchange of information can be seen clearly at auctions. Before the bidding begins, buyerslook over the merchandise and the other buyers, attempting to determine howhigh others might be willing to bid for a particular piece. During the auction, thisspecic information is revealed as buyers call out their bids and others try to topthem. Information exchange is less apparent in department stores, where competi-tion is not as transparent. Even there, however, comparison-shopping by buyersacross stores will often reveal some sellers who are offering lower prices in anattempt to attract consumers.

In competing with each other, sellers reveal information that is ultimately of use to buyers.Buyers likewise inform sellers. From the consumer’s point of view, the function of competi-tion is precisely to teach us who will serve us well: which grocer or travel agent, whichdepartment store or hotel, which doctor or solicitor, we can expect to provide the mostsatisfactory solution for whatever particular personal problem we may have to face. (Hayek 1948, 97)

From the seller’s point of view – say, the auctioneer’s – competition among buyersbrings the highest prices possible.

Competition among sellers takes many forms, including the price, quality, weight, volume, color, texture, durability, and smell of products, as well as the credit termsoffered to buyers. Sellers also compete for consumers’ attention by appealing totheir hunger and sex drives or their fear of death,pain, and loud noises. All these forms of competi-tion can be divided into two basic categories – price and nonprice competition. Price competition is of particular interest to economists, who see it as animportant source of information for market partic-ipants and a coordinating force that brings thequantity produced into line with the quantity con-sumers are willing and able to buy. In the followingsections, we shall construct a model of the compet-itive market and use it to explore the process of price competition under intense competitive market con-ditions called perfect competition . Nonprice compe-tition will be covered in a later section.

Perfect competition (in extreme form) is amarket composed of numerous independentsellers and buyers of an identical product,such that no one individual seller or buyer hasthe ability to affect the market price bychanging the production level. Entry into andexit from a perfectly competitive market isunrestricted. Producers can start up or shutdown production at will. Anyone can enterthe market, duplicate the good, and competefor consumers’ dollars. Since each competitorproduces only a small share of the totaloutput, the individual competitor cannotsignicantly inuence the degree ofcompetition or the market price by enteringor leaving the market.




Supply and demand: a market model A fully competitive market is made up of many buyers and sellers searching for opportunities or ready to enter the market when opportunities arise. To be describedas “competitive,” therefore, a market must include a signicant number of actual or potential competitors. A fully competitive market offers freedom of entry: there areno legal or articial barriers to producing and selling goods in the market.

Our market model assumes perfect competition – an idealized situation that isseldom, if ever, achieved in real life but that will simplify our calculations. This kindof market is well suited to graphic analysis and helps us clarify the pricing forcesafoot in all competitive markets. Our discussion concentrates on how buyers andsellers interact to determine the price of tomatoes, a product Fred Lieberman almostalways carries. It will employ two curves. The rst represents buyers’ behavior,which is called their demand for the product.

The elements of demandTo the general public, demand is simply what peoplewant, but to economists, demand has much moretechnical meaning. The concept of demand is impor-tant because it is so widely applicable to humanbehavior, not just in business, but in everyday life.

Demand as a relationshipThe relationship between price and quantity is normally assumed to be inverse . Thatis, when the price of a good rises, the quantity sold, ceteris paribus (Latin for “everything else held constant”), will go down. Conversely, when the price of agood falls, the quantity sold goes up. Demand is not a quantity but a relationship. A given quantity sold at a particular price is properly called the quantity demanded .

Both tables and graphs can be used to describe the assumed inverse relationshipbetween price and quantity.

Demand as a table or a graphDemand may be thought of as a schedule of the various quantities of a particular

good consumers will buy at various prices. As the price goes down, the quantity purchased goes up and vice versa. Table 3.1 contains a hypothetical schedule of thedemand for tomatoes in the New York area during a typical week. Column (2) showsprices that might be charged. Column (3) shows the number of bushels consumerswill buy at those prices. Note that as the price rises from zero to $11 a bushel, thenumber of bushels purchased drops from 110,000 to zero.

Demand is the assumed inverse relationshipbetween the price of a good orservice and thequantity consumers are willing and able tobuy during a given period, all other thingsheld constant.




Demand may also be thought of as a curve . If price is scaled on a graph’s verticalaxis and quantity on the horizontal axis, the demand curve has a negative slope(downward and to the right), reecting the assumed inverse relationship betweenprice and quantity. The shape of the market demand curve is shown in gure 3.1,which is based on the data from table 3.1. Points a through l on the graph correspondto the price–quantity combinations A through L in the table. Note that as the price

Table 3.1 Market demand for tomatoes

Price–quantitycombinations (1) Price per bushel ($) (2) No. (000) of bushels (3)

A 0 110B 1 100C 2 90D 3 80E 4 70F 5 60G 6 50H 7 40I 8 30J 9 20K 10 10

L 11 0

a

b c

d

e

f

g

h

i

j

k

l

P 1

Q 1 Q 2

P 2

P r i c e p e r

b u s h e

l o

f t o m a

t o e s

( $ )

Bushels of tomatoes per week (000)

2

200 40 60 80 100

Demand

120

4

6

8

10

12 Figure 3.1 Market demand fortomatoesDemand, the assumed inverserelationship between price andquantity purchased, can berepresented by a curve thatslopes down toward the right.Here, as the price falls from $11to zero, the number of bushels oftomatoes purchased per weekrises from zero to 110,000.




falls from P 2 ($8) to P 1 ($5), consumers move down their demand curve from aquantity of Q1 (30,000) to the larger quantity Q2 (60,000).

[See online Video Module 3.1 Demand]

The slope and determinants of demandPrice and quantity are assumed to be inversely related, for two elemental reasons.(See chapter 6 for more detailed explanations of the downward sloping demandcurve.) First, as the price of a good decreases (and the prices of all other goodsremain the same), the good becomes relatively cheaper, and consumers will sub-stitute that good for others. This response is called the “substitution effect.” Thesubstitution can come from within product categories, say, “fruit.” If the price of oranges falls (the price of apples remains constant), people can be expected to buy more oranges and fewer apples. But then a price reduction for oranges can causesome people to move from “nonconsumption” of fruit to the consumption of

oranges. That is, consumers can move from consuming cookies to oranges to satisfy their desire for something with sugar content.In addition, as the price of a good decreases (and the prices of all other goods stay

the same – remember ceteris paribus ), the purchasing power of consumer incomesrises. That is, their real incomes increase. More consumers are able to buy the good,and many will buy more of most (but not all) goods. This response is called the“income effect.”

In sum, when the price of tomatoes (or razor blades, or any other good) falls, moretomatoes will be purchased because more people will be buying them for morepurposes. Moreover, embedded in the downward sloping demand curves for many

goods can be large and small behavioral changes among consumers. When the priceof gasoline goes up, drivers can be expected to economize on their uses of gasolinein a variety of ways. For example, drivers can be expected to reduce the number of times they stomp down on the cars’ accelerators when leaving stoplights and, if they have more than one car, to use their more fuel-efcient cars more frequently,behavioral changes that can enable them to buy fewer gallons of gasoline.

Although price is an important part of the denition of demand, it is not the only determinant of how much of a good people will want. It may not even be the mostimportant. The major factors that affect market demand are called the determinantsof demand . They are:

* consumer tastes or preferences* the prices of other goods* consumer incomes* the number of consumers* expectations concerning future prices and incomes.




A host of other factors, such as weather, may also inuence the demand for particular goods – ice cream, for instance. A change in any of these determinantsof demand will cause either an increase or a decrease in demand:

* An increase in demand is an increase in the quantity demanded at each and every price. It is represented graphically by a rightward, or outward, shift in the demandcurve.

* A decrease in demand is a decrease in the quantity demanded at each and every price. It is represented graphically by a leftward, or inward, shift of the demandcurve.

Figure 3.2 illustrates the shifts in the demand curve that result from a change in oneof the determinants of demand. The outward shift from D1 to D2 indicates anincrease in demand: consumers now want more of a good at each and every price.For example, they want Q3 instead of Q2 tomatoes at price P 2 . Consumers are alsonow willing to pay a higher price for any quantity. For example, they will pay P 3instead of P 2 for Q2 tomatoes. The inward shift from D1 to D3 indicates a decrease in

demand: consumers want less of a good at each and every price – Q1 instead of Q2

tomatoes at price P 2 . And they are willing to pay less than before for any quantity –P 1 instead of P 2 for Q2 tomatoes.

A change in a determinant of demand may be translated into an increase or decrease in current market demand in numerous ways. An increase in marketdemand can be caused by:

P 1

Q 1 Q 2 Q 3

D 2

D 1

D 3

P 2

P 3

P r i c e p e r

b u s h e

l o

f t o m a

t o e s

( $ )


2

200 40 60 80 100 120

Decreasein demandIncreasein demand

4

6

8

10

12 Figure 3.2 Shifts in thedemand curveAn increase in demand isrepresented by a rightward, oroutward, shift in thedemandcurve,from D 1 to D 2 . A decrease in

demand is represented by aleftward, or inward, shift in thedemand curve, from D 1 to D 3 .




* An increase in consumers’ desire or taste for the good . If people truly want thegood more, they will buy more of the good at any given price or pay a higher pricefor any given quantity.

* An increase in the number of buyers . If, because more people consume the good,more of the good will be purchased at any given price, then the price will behigher at any given quantity.

* An increase in the price of substitute goods (which can be used in place of the goodin question). If the price of oranges increases, the demand for grapefruit willincrease.

* A decrease in the price of complementary goods (which are used in conjunctionwith the good in question). If the price of MP3 players falls, the demand for downloadable songs will rise. If the price of gasoline falls, the overall demand for automobiles can increase. (But the demand for various models can rise or fall,depending on their gas consumption: the demand for SUVs can fall while the

demand for hybrids can rise.)* Generally speaking (but not always), an increase in consumer incomes . An

increase in people’s incomes may increase the demand for luxury goods, suchas new cars. It may also decrease demand for low-quality goods (such as ham-burger) because people can now afford better-quality products (such as steak).

* An expected increase in the future price of the good in question . If people expectthe price of cars to rise faster than the prices of other goods, then (depending onexactly when they expect the increase) they may buy more cars now, thusavoiding the expected additional cost in the future.

* An expected increase in future incomes of buyers . College seniors’ demand for cars

tends to increase as graduation approaches and they anticipate a rise in income.The determinants of a decrease in market demand are just the opposite:

* a decrease in consumers’ desire or taste for the good* a decrease in the number of buyers* a decrease in the price of substitute goods* an increase in the price of complementary goods* generally speaking (but not always), a decrease in consumer incomes* an expected decrease in the future price of the good in question* an expected decrease in the future incomes of buyers.

As will be noticeable throughout this book, much attention will be placed on howchanges in price affect the quantity demanded, while little attention will be given tohow changes in “tastes” affect the quantity demanded. The differential treatment of price and tastes does not presume that price is more important than tastes indetermining the consumption level of any good. Rather, economists concentrate




on price because they seek a theory of price determination (not a theory of tastedetermination, which is a major interest of psychology). In addition, the effect of price changes on quantity demanded is viewed as being highly predictable, givenextensive consumer theory and empirical observation. The inverse relationship

between price and quantity consumed is viewed as a “law,” or the “law of demand.”“Tastes,” on the other hand, are an amorphous, subjective concept. Hence, predict-ing the impact of changes in “tastes” on quantity demanded is, for economists (butperhaps not for psychologists), problematic.

Similarly, as will be discussed in chapter 6, the impact of a change in buyer’sreal income on quantity bought has an element of uncertainty. Granted, for most normal goods, the relationship between income and quantity of a goodbought can be positive, as indicated above, in which case the substitution andincome effects have the same direction impact on quantity consumed. However,the relationship can be inverse for some goods (so-called “inferior goods”).

When low-income people experience an increase in real income, they may switchbetween low-quality sources of, say, protein – beans – to high-quality sources –meat. In this case, the negative effect of an increase in real income works againstthe substitution effect on the quantity demanded of beans. However, economistshave found that for most goods the substitution and income effects compoundone another or the positive substitution effect dominates any negative incomeeffect, which means demand curves of most – if not almost all – goods slopedownward.

The elements of supplyOn the other side of the market are the producers of goods. The average personthinks of supply as the quantity of a good producers are willing to sell. To econo-mists, however, supply means something quite different. As with demand, supply isnot a “given quantity” – that is called the “quantity supplied.” Supply is a relationship between price and quantity . As the price of a good rises, producersare generally willing to offer a larger quantity. Thereverse is equally true: as price decreases, so doesquantity supplied. Like demand, supply can bedescribed in a table or a graph.

Supply as a table or a graphSupply may be described as a schedule of the quantity that producers will offer at various prices during a given period of time. Table 3.2 shows such a supply schedule. As the price of tomatoes goes up from zero to $11 a bushel, the quantity offered rises

Supply is the assumed relationship betweenthe quantity of a good producers are willingto offer during a given period and the price,everything else held constant. Generally,because additional costs tend to rise withexpanded production, this relationship ispresumed to be positive (a point that isdeveloped with care in chapters 7 and 8).




from zero to 110,000, reecting the assumed positive relationship between priceand quantity.

Supply may also be thought of as a curve . If the quantity producers will offer isscaled on the horizontal axis of a graph and the price of the good is scaled on the vertical axis, the supply curve will slope upward to the right, reecting the assumedpositive relationship between price and quantity. In gure 3.3, which was plottedfrom the data in table 3.2, points a through l represent the price–quantity combi-nations A through L. Note how a change in the price causes a movement along thesupply curve.

[See online Video Module 3.2 Supply]

The slope and determinants of supplyThe quantity producers will offer on the market depends on their production costs .Obviously the total cost of production will rise when more is produced because more

resources will be required to expand output. Theadditional or marginal cost of each additional bushelproduced also tends to rise as total output expands

(beyond some point, which will be explained inchapter 7). In other words, when it costs more to produce the second bushel of tomatoes than the rst, and more to produce the third than the second, rms will notexpand their output unless they can cover their progressively higher marginal costswith a progressively higher price. This is the reason the supply curve is thought toslope upward.

Table 3.2 Market supply of tomatoes

Price–quantity combinations(1) Price per bushel ($) (2) No. (000) of bushels (3)

A 0 0B 1 10C 2 20D 3 30E 4 40F 5 50G 6 60H 7 70I 8 80J 9 90K 10 100L 11 110

Marginal cost is the additional cost ofproducing an additional unit of output.




Anything that affects production costs will inuence supply and the positionof the supply curve. Such factors, which are called determinants of supply ,include:

* change in productivity due to a change in technology * change in the protability of producing other goods* change in the scarcity (and prices) of various productive resources.

Many other factors, such as the weather, can also affect production costs andtherefore supply. A change in any of these determinants of supply can either increase or decrease supply:

* An increase in supply is an increase in the quantity producers are willing and ableto offer at each and every price. It is represented graphically by a rightward, or outward, shift in the supply curve.

* A decrease in supply is a decrease in the quantity producers are willing and able to

offer at each and every price. It is represented graphically by a leftward, or inward, shift in the supply curve.

In gure 3.4, an increase in supply is represented by the shift from S 1 to S 2 .Producers are willing to produce a larger quantity at each price – Q3 instead of Q2

at price P 2 , for example. They will also accept a lower price for each quantity – P 1

a

c

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Supply

10

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2

200 40 60 80 100 120

P r i c e p e r

b u s

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t o e

s ( $ )


Figure 3.3 Supply of tomatoesSupply, the assumedrelationship between price andquantity produced, can berepresented by a curve that

slopes up toward the right.Here, as the price rises fromzero to $11, the number ofbushels of tomatoes offeredfor sale during the course of aweek rises from zero to110,000.




instead of P 2 for quantity Q2 . Conversely, the decrease in supply represented by theshift from S 1 to S 3 means that producers will offer less at each price – Q1 instead of Q2 at price P 2 . They must also have a higher price for each quantity– P 3 instead of P 2for quantity Q2 .

A few examples will illustrate the impact of changes in the determinants of supply. If rms learn how to produce more goods with the same or fewer resources,the cost of producing any given quantity will fall. Because of the technologicalimprovement, rms will be able to offer a larger quantity at any given price or thesame quantity at a lower price. The supply will increase, shifting the supply curveoutward to the right.

Similarly, if the protabilityof producing oranges increases relative to grapefruit,grapefruit producers will shift their resources to oranges. The supply of oranges willincrease, shifting the supply curve to the right. Finally, if lumber (or labor or equipment) becomes scarcer, its price will rise, increasing the cost of new housingand reducing the supply of new houses coming onto the market. The supply curve of new houses will shift inward to the left.

Market equilibriumSupply and demand represent the two sides of the market – sellers and buyers. By plotting the supply and demand curves together, as in gure 3.5, we can explore theconditions under which the decisions of buyers and sellers will be inconsistent with

Decreasein supply

Increasein supply

P 1

P 2

S 2

S 1

S 3

P 3

Q 10 Q 2 Q 3

P r i c e p e r

b u s

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l o

f t o m a

t o e s

( $ )


Figure 3.4 Shifts in the supply curveA rightward, or outward, shift in thesupplycurve, from S 1 to S 2 , representsan increase in supply. A leftward, orinward, shift in thesupply curve, from

S 1 to S 3 , represents a decrease insupply.




each other, and why a market surplus or shortage of tomatoes will result. We canalso illuminate the competitive market forces at work to push the market pricetoward the market-clearing price – or the price atwhich the market is said to be in equilibrium , atwhich the forces of supply and demand balanceone another with no net pressure for the price andoutput to move up or down.

Market surplusesSuppose that the price of a bushel of tomatoes is $9, or P 2 in gure 3.5. At thisprice, the quantity demanded by consumers is 20,000 bushels, much less than thequantity offered by producers – 90,000. There is amarket surplus , or excess supply, of 70,000 bushels.Graphically, an excess quantity supplied occurs atany price above the intersection of the supply anddemand curves.

What will happen in this situation? Producers who cannot sell their tomatoes willhave to compete by offering to sell at a lower price, forcing otherproducers to followsuit. All producers might agree that holding the price above equilibrium can be intheir “common interest,” since an above-equilibrium price can generate extraprots for all (even though sales might be undercut). However, in competitivemarkets producers are in a large-group setting in which their individual curbs on

Market equilibrium occurs when the forces ofsupply and demand are in balance with no netpressure for the price and output level tochange.

A market surplus is the amount by which thequantity supplied exceeds the quantitydemanded at any given price.

P 1

P 2

Q 1 Q 2 Q 3

P r i c e p e r

b u s h e

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( $ )


2

200 40 60 80 100 120

4

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10 SurplusS

D

12 Figure 3.5 Market surplusIf a price is higher than theintersection of the supply anddemand curves, a market surplus – agreater quantity supplied, Q 3 , than

demanded, Q 1 – results. Competitivepressure will push the price down tothe equilibrium price, P 1 , the price atwhich the quantity supplied equalsthe quantity demanded, Q 2 .




production to pursue their common interest will have an inconsequential impact ontotal market supply. They each can reason that they can possibly gain market shareby individually lowering their price, if all others hold to the higher price. And eachcan reason that all others are thinking the same way, which means they can expect

other producers to lower their prices. The logic leads the producers to do what is notin their common interest and to act competitively, which is cut their prices. As the competitive process forces the price down, the quantity that consumers are

willing to buy will expand, while the quantity that producers are willing to sell willdecrease. The result will be a contraction of the surplus, until it is nally eliminatedat a price of $5.50 or P 1 (at the intersection of the two curves). At that price,producers will be selling all they want; they will see no reason to lower pricesfurther. Similarly, consumers will see no reason to pay more; they will be buying allthey want. This point at which the wants of buyers and sellers intersect is called theequilibrium , with the price and quantity at that point called equilibrium price and

equilibrium quantity :* The equilibrium price is the price toward which a competitive market will move,

and at which it will remain once there, everything else held constant. It is the priceat which the market “clears” – that is, at which the quantity demanded by consumers is matched exactly by the quantity offered by producers. At theequilibrium price, the quantity sellers are willing to supply and the quantity buyers want to consume are equal. This is the equilibrium quantity.

* The equilibrium quantity is the output (or sales) level toward which the marketwill move, and at which it will remain once there, everything else held constant.

In sum, a surplus emerges when the price asked is above the equilibrium price. It willbe eliminated, through competition among sellers, when the price drops to theequilibrium price.

Market shortagesSuppose that the price asked is below the equilibrium price, as in gure 3.6. At therelatively low price of$1, or P 1 , buyers want topurchase 100,000 bushels – substantially

more than the 10,000 bushels producers are willing tooffer. The result is a market shortage . Graphically, a

market shortage is the shortfall that occurs at any price below the intersection of the supply and demandcurves.

As with a market surplus, competition will correct the discrepancy betweenbuyers’ and sellers’ plans. Buyers who want tomatoes but are unable to get themat a price of $1 will bid higher prices, as at an auction. Many buyers might have a

A market shortage is the amount by which thequantity demanded exceeds the quantitysupplied at any given price.




“common interest” to hold the price below the equilibrium price (even with fewer units of the good they can buy). However, as with producers when there was amarket surplus, buyers are in a large-group setting, with each individual buyer reasoning that not offering a higher price will not affect the market outcomes,because other buyers will offer a higher price. Each buyer can reason that they mightas well offer a higher price just to get the units they want.

As the price rises, a larger quantity will be supplied because suppliers will bebetter able to cover their increasing production costs. Simultaneously, the quantity

demanded will contract as buyers seek substitutes that are now relatively lessexpensive compared with tomatoes. At the equilibrium price of $5.50, or P 2 , themarket shortage will be eliminated. Buyers will have no reason to bid prices upfurther; they will be getting all the tomatoes they want at that price. Sellers will haveno reason to expand production further; they will be selling all they want at thatprice. The equilibrium price will remain the same until some force shifts the positionof either the supply or the demand curve. If such a shift occurs, the price will movetoward a new equilibrium at the new intersection of the supply and demand curves.

In our graphical treatment of supply and demand, movement toward equilibriumcan be thought of as instantaneous. Real-world movements in price will necessarily

take some time, which means that the equilibrium price and quantity toward whichthe market will ultimately settle can shift with changes in supply and demand.

The effect of changes in demand and supplyFigure 3.7 shows the effects of shifts in demand and supply on the equilibrium priceand quantity. In gure 3.7(a), an increase in demand from D1 to D2 raises the

P 1

P 2

Q 1 Q 2 Q 3

P r i c e p e r

b u s h e

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t o e s

( $ )


2

200 40 60 80 100 120

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Shortage

S

D

12 Figure 3.6 Market shortagesA price that is below theintersection of the supply anddemand curves will create ashortage – a greater quantity

demanded, Q 3 , than supplied, Q 1 .Competitive pressure will push theprice up to the equilibrium price P 2 ,the price at which the quantitysupplied equals the quantitydemanded ( Q 2 ).




equilibrium price from P 1 to P 2 and quantity from Q1 to Q2 . The equilibrium pricerises because at the moment the demand curve shifts out to the right, a market

shortage develops at the initial price P 1 . The quantity demanded at that initial priceis Q3 ; the quantity supplied is less, Q1 . Those buyers who want the good but areunable to get it will bid the price up. As the price goes up, producers can justify incurring the higher marginal costs of producing more, but some buyers will retreaton their purchases. The market will clear – or quantity supplied and demand will beequal – at the higher price of P 2 .

P 1

D 2

S 1

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D 1

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Q 10 Q 2 Q 3

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Bushels of tomatoes per week

(a) (b)

(c) (d)

S

P 1

D

P 2

Q 10 Q 2 Q 3

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S 1

S 2

P 1

D

P 2

Q 10 Q 2 Q 3

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P 1

D 2

D 1

P 2

Q 10 Q 2 Q 3

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Figure 3.7 The effects of changes in supply and demandAn increase in demand – panel (a) – raises both the equilibrium price and the equilibriumquantity. A decrease in demand – panel (b) – has the opposite effect: a decrease in theequilibrium price and quantity. An increase in supply – panel (c) – causes the equilibriumquantity to rise but the equilibrium price to fall. A decrease in supply – panel (d) – has theopposite effect: a rise in the equilibrium price and a fall in the equilibrium quantity.




Figure 3.7(b) shows the reverse effects of a decrease in demand. When the demandinitially falls, a market surplus develops at price P 2 . At P 2 , the quantity demanded is Q1

while the quantity supplied is Q3 . Producers who want to sell their output will putdownward pressure on the price. As the price falls, buyers increase theirpurchases while

producers curb theiroutput.Equilibrium is reestablishedat a price of P 1

andquantity Q2

. An increase in supply from S 1 to S 2 – gure 3.7(c) – has a different effect. Theequilibrium quantity rises from Q1 to Q2 , but the equilibrium price falls from P 2 toP 1 . When supply initially expands, a market surplus emerges at price P 2 . Thequantity demanded is Q1 while the quantity supplied is Q3 , which makes for amarket surplus. As producers try to sell what they produce, they put downwardpressure on the price. As the price falls toward P 1 , the quantity produced contractsfrom Q3 to Q2 . The quantity demanded rises from Q1 to Q2 .

A decrease in supply from S 1 to S 2 – gure 3.7(d) – causes the opposite effect: theequilibrium quantity falls from Q3 to Q2 , and the equilibrium price rises from P 1 to P 2 .

At the time supply decreases, a shortage develops, with the quantity supplied at Q1

and the quantity demanded at Q3 . Buyers who want more units of the good than areavailable at P 1 will bid the price up. As the price rises from P 1 toward P 2 , the quantity demanded decreases from Q3 to Q2 ; the quantity supplied rises from Q1 to Q2 .

[See online Video Modules 3.3 Changes in supply and demand and 3.4 Applications of supply and demand]

The efciency of the competitive market modelEarly in this chapter we asked how Fred Lieberman knows what prices to charge for

thegoods hesells. The answeris now apparent: he adjustshis prices until hiscustomersbuy the quantities that he wants to sell. If he cannot sell all the fruits and vegetableshe has, he lowers his price to attract customers and cuts back on his orders for thosegoods. If he runs short,he knows thathe can raisehis prices andincrease hisorders. Hiscustomers then adjust their purchases accordingly. Similar actions by other producersand customers all over the city move the market for produce toward equilibrium.The information provided by the orders, reorders, and cancellations from storessuch as Lieberman’s eventually reaches the suppliers of goods and then the suppliersof resources. Similarly, wholesale prices give Fred Lieberman information onsuppliers’ costs of production and the relative scarcity and productivity of resources.

The use of the competitive market system to determine what and how much toproduce has two advantages. First, it coordinates the decisions of consumers andproducers very effectively. Most of the time the amount produced in a competitivemarket system is very close to the amount consumers want at the prevailing price –no more, no less. Second, the market system maximizes the amount of output that isacceptable to both buyer and seller. In gure 3.8(a), note that all the price–quantity


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3. Competitive markets.pdf