Chap 4,7: Competitive markets how they work, properties

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• Chap 4,7 Competitive markets- how they work,
  properties
• characteristics of competitive markets
• demand
• supply
• market equilibrium and how to compute it
• welfare properties of competitive equilibrium

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Main lessons

• Aggregate demand for and supply of a good
  together determine its observed market price
• Aggregate demand is determined by preferences,
  income, availability of substitutes, complements
  etc.
• Aggregate supply is determined by technology,
  costs of inputs etc.
• Competitive market equilibrium is socially
  efficient maximizes the sum of consumers and
  producers welfare
• No other price-quantity combination achieves this

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• Chap 4 Competitive markets- how they work
• 1. Characteristics of a Perfectly Competitive
  market
• A1. many buyers and sellers
• A2. homogeneity of goods, no brand names
• A3. free entry and exit of firms, no entry
  barriers
• A4. perfect flow of information
• 2. A1- A4 implies, firms and consumers are price
  takers
• Price taking behavior individual buyers or
  sellers do not think that their actions influence
  market demand and supply and hence market price.

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Individual demand function demand for a good is
inversely related to its price
positively related to income if goods are
normal, negatively related if goods are
inferior examples of normal goods examples of
inferior goods positively related to price of
substitute goods, negatively related to price of
complementary goods examples of substitute
goods examples of complementary goods other
factors which affect demand for a good taste,
expectations, number of buyers (size of market)
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Law of Demand relationship between own price and
quantity demanded of a good, everything else
remaining constant. The graph of this
relationship is called the demand curve/demand
schedule and is a negatively sloped line. At each
Q on the demand curve the p represents the buyers
willingness to pay per unit of that item As p
rises Q diminishes this is described as a
decrease in quantity demanded because of a price
rise. Geometrically, we move from one point on
the curve to another. As income, price of a
substitute item or price of a complementary item
changes the entire curve shifts either to the
right or to the left depending on how the
quantity demanded of the item is related to
these. This is described as a decrease or
increase in demand. Be careful not to use the two
phrases synonymously! decrease (increase) in
demand decrease (increase) in the quantity
demanded for any price
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An individual demand curve
Price of the good

• Do the axes labels look strange?

An increase in demand
a decrease in quantity demanded
a
b
a decrease in demand
Quantity of the good
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Individual and market demand curves
Price of the good

• Individual demand curves are added horizontally,
  to get the market demand curves

total or market demand
As demand
Bs demand
Quantity of the good
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The individual and market Supply curves Quantity
supplied by individual firm - is positively
related to the price of the good. Why? -
related to prices of inputs, technology How? -
market expectations, number of sellers etc. Law
of supply relationship between the price of a
good and its quantity supplied, everything else
constant when p increases Q increases movement
described as an increase in quantity supplied
geometrically supply curve is a positively sloped
line when price of inputs or other factors
change, the supply curve shifts right or
left For a given Q on the supply curve, the
corresponding supply price p reflects the
producers opportunity cost of producing the item
at that level Market supply horizontal sum of
individual supply
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Market Equilibrium
p
surplus
p1
a
b
p
c
d
p2
shortage
demand
Q
Q
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How to find equilibrium p and Q, given a demand
and a supply curve? Q 2619 0.5p, demand
curve Q 10p, supply curve 2619 0.5p
10p Solve for p, solution is p Plug p into
either the demand curve or the supply curve, to
get Q p 2619/10.5 249.4 approx. Q 10 x
249.4 2494
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• How do Q and p change because of changes in
  various parameters?
• Figure out which curve or curves shift. Draw the
  picture and conclude about the new equilibrium.
• As average y (or ps) goes up, the demand curve
  shifts rightwards. Supply doesnt change.
  Equilibrium p and Q go up.
• A rise in any input price increases the cost of
  production and reduces profits. Hence the supply
  curve shifts to the left Supply goes down.
  Demand is not affected. Equilibrium p goes up,
  equilibrium Q goes down.
• Improvement in technology will increase supply,
  lower p and increase Q.

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Efficiency property of a competitive market
equilibrium (material from Chap 7) Consumers
surplus Buyers willingness to pay maximum
price he is willing to pay A point on a demand
curve reflects the willingness to pay of some
buyers. Demand curve is downward sloping because
as you are lowering the market price, more people
whose willingness to pay is lower, enters the
market. Consumers surplus willingness to pay
actual price buyer pays in a market, measures the
benefits to buyers of participating in a market.
Consumer surplus is measured as the area below
the demand curve above the market price.
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Market Demand Curve, Price and Consumer Surplus
If quantity demanded is perfectly divisible we
have this smooth linear demand curve.
Price
Initial consumer surplus
Demand
Quantity
0
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Observation Lower price raises consumer
surplus. Consumers surplus measures the benefit
from the good to the buyer, as the buyers
themselves perceive it. Producers surplus A
point on a supply curve reflects the opportunity
cost of some producers supplying the
good. producers surplus market price costs
of production, surplus of the sellers whose costs
are lower. Producers surplus measures the
benefit to sellers of participating in the
market. Producers surplus area below the
market price and above the supply curve.
Observation Lower price reduces producers
surplus.
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Market Supply Curve, Price and Producer Surplus
Price
Supply
Initial Producer surplus
Quantity
0
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Market efficiency Observation A lower market
price increases consumer surplus but decreases
producer surplus. A higher market price increases
producers surplus but decreases consumer
surplus. Conflict of interest between buyers and
sellers. Total social surplus consumers
surplus producers surplus. Is there a price
which can maximize the sum of the two? Yes! At
the price at which quantity demanded quantity
supplied, the total social surplus is
maximized. The competitive market equilibrium is
therefore described as socially efficient.
Further, there is no other price-quantity
combination which maximizes total social surplus.
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Evaluating the Market Equilibrium
Consumers surplus
Price
A
D
Supply
G
F
H
p
E
K
L
Producers surplus
Demand
B
C
0
Quantity
J
Q
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If the price is raised up to the red line, the
consumers surplus is reduced by the area
FGEp. At this price, producers will be able to
sell only OJ which is less than Q. So producers
surplus total profits total revenue
total costs OFGJ OCLJ trapezium
CFGL. Producers surplus consumers surplus
AFG CFGL CAGL This is less than the area CAE.
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Another way of looking
Price
Supply
Surplus for each unit value to buyers cost
to sellers
Cost to sellers
Value to buyers
Value to buyers
Cost to sellers
Demand
0
Quantity
Equilibrium quantity
Value to buyers is greater than cost to sellers.
Value to buyers is less than cost to sellers.
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• Alternative way of looking at social efficiency
• Free markets allocate the supply Q to the
  buyers who value them most. Buyers whose
  willingness to pay is more or equal to p will
  get the good.
• Free markets allocate the demand for goods Q
  among the sellers who produce them at least cost,
  whose costs are lower or equal to p.
• Market failures free market outcome is socially
  inefficient if
• some agents buyers or sellers have market power
  (monopoly).
• there are externalities. People other than
  buyers or sellers are affected by market outcome.
• we are discussing public goods or common
  resources
• there are informational problems leading to
  missing markets.