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Chapter 14
Equilibrium and Efficiency
McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All Rights Reserved.
Main Topics
What makes a market competitive?Market demand and market supplyShort-run and long-run competitive
equilibriumEfficiency of perfectly competitive
marketsMeasuring surplus using market demand
and supply curves
14-2
What Makes a Market Competitive?
Buyers and sellers have absolutely no effect on price Three characteristics:
Absence of transaction costs Product homogeneity: products are identical in the eyes of
their purchasers Presence of a large number of sellers, each accounts for a
small fraction of market supply 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
14-3
Market Demand and Supply
Market demand for a product is the sum of the demands of all individual consumersGraphically, this is the horizontal sum of the
individual demand curvesFor simplicity, assume that all demand comes from
consumers and all supply comes from firmsMarket supply of a product is the sum of the
supply of all the individual sellersGraphically this is the horizontal sum of the
individual supply curvesVery similar to the procedure for constructing
market demand curves
14-4
Figure 14.1: Market Demand
14-5
Figure 14.2: Market Supply
14-6
Short-Run vs. Long-RunMarket 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 Long-run 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
Long-run market supply curve is a horizontal line at ACmin
14-7
Figure 14.4: Long-Run Supply
14-8
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
14-9
Figure 14.6: Long-Run Competitive Equilibrium
Equilibrium price must equal ACmin
Firms must earn zero profit
Active firms must produce at their efficient scale of production
14-10
Sample Problem 1 (14.3):
The daily cost of producing pizza in New Haven is C(Q) = 4Q + (Q2/40); the marginal cost is MC = 4 + (Q/20). What is the market supply function if there are 10 firms making pizza? If 20 firms are making pizza? What is the market supply curve under free entry?
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
14-12
Figure 14.7: Response to an Increase in Demand
Garden Benches per Month
Pri
ce (
$/b
ench
)
4000
P* = ACmin
D
2000
D^
S10
C
B
A
= 100S
14-13
Responses to Changes inFixed 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
14-14
Figure 14.8: Response to a Decrease in Cost
14-15
Responses to Changes in Variable Cost
Start from a long-run equilibriumIf variable costs change, firm’s marginal and
average cost curves both shiftShort-run supply curve shiftsSort-run equilibrium changes
Basic procedure in all cases:Find new short-run equilibrium using new short-run
supply curve of initially active firmsFind new long-run equilibrium using new long-run
supply curve which reflects free entry
14-16
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
14-17
Figure 14.11: Price Changes in the Long-Run
Garden Benches per Month
Pri
ce (
$/b
ench
)
4000
ACmin=100
D
2000
D^
S10
C
B
AS
S^E
ACmin=110^
14-18
Sample Problem 2 (14.7):
Suppose the daily demand for pizza in Berkeley is Qd = 1,525 – 5P. The variable cost of making Q pizzas per day is C(q) = 3Q + 0.01Q2, there is a $100 fixed cost (which is avoidable in the long run), and the marginal cost is MC = 3 + 0.02Q. There is free entry in the long run. What is the long-run market equilibrium in this market? Suppose demand increases to Qd = 2,125 – 5P. If, in the short run, the number of firms is fixed and fixed costs are sunk, what is the new short-run market equilibrium? What is the new long-run market equilibrium if there is free entry and exit in the long run?
Aggregate Surplus andEconomic 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
14-20
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
14-21
Effects of a Change in Who Consumes the Good
Begin from the competitive equilibriumTake one unit of the good from Consumer A
and give it to Consumer BCannot 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
14-22
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
14-23
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
14-24
Measuring Total WTP andTotal 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 quantityWhen 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 quantityWhen all producers face the same market price
14-25
Figure 14.18: Measuring Total Willingness to Pay
14-26
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 maximizedNo deadweight loss: reduction in aggregate
surplus below its maximum possible value
14-27
Consumer and Producer Surplus
Consumer surplus is the sum of consumers’ total willingness to pay less their total expenditureSum of individual consumers’ surplusesAlso called aggregate consumer surplus
Producer surplus is the sum of firms’ revenues less avoidable costsSum of individual firms’ producer surplusesAlso called aggregate producer surplus
Aggregate surplus = Consumer surplus + Producer Surplus
14-28
Figure 14.19: Aggregate, Consumer, and Producer Surplus
14-29
Sample Problem 3 (14.15):
The market demand function for corn is Qd = 21 – 4P, and the market supply function is Qd = = 5P -6, both quantities are measured in billions of bushels per year. What are the aggregate surplus, consumer surplus, and producer surplus at the competitive market equilibrium?