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Demand, Supply, and Equilibrium in a Perfectly Competitive Market

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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

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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

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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

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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

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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

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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

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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

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A Note on Demand Semantics

• Changes in price result in “changes in the quantity demanded”

• “Changes in demand” imply shifts of the demand curve

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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 + (-)

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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)

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A Firm’s MC of Producing Good X

Quantity of X MC

1 $2

2 $3

3 $4

4 $5

5 $6

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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

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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

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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

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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

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A Note on Supply Semantics

• Changes in price result in “changes in the quantity supplied”

• “Changes in supply” imply shifts of the supply curve

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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 + (-)

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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*

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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*

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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