ECONOMICS 103. Topic 3: Supply, Demand & Equilibrium

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1 ECONOMICS 103 Topic 3: Supply, Demand & Equilibrium Assumptions of the competitive market model: all agents are price takers, homogeneous products. Demand & supply: determinants of demand & supply, demand & supply curves, consumer and producer surplus, divisibility, the laws of demand and supply, movements along versus shifts of demand and supply curves,, normal & inferior goods, complements & substitutes, individual demand and supply v market demand and supply. Equilibrium prices and quantities, price as a mechanism for equilibration. 1

2 INTRO TO DEMAND Recall: Topic 2 ex, Person 1 and 2 exchanged 10M and 6F. - Price per M was 6/10 of a F. - Price per F was 10/6 of an M. These prices made both better off than before trade. Contrast this with trade in real economies: - Goods are exchanged money, not other goods. Prices are measured in $s, not fish. - Typically, there is more than one buyer and seller, and prices are determined by the interaction of all buyers and sellers. Topic 3: analyses interactions of buyers and sellers in a particular type of market, the competitive market. 2

3 THE COMPETITIVE MARKET MODEL Competitive market model assumes: - A market in which goods are homogenous: Every seller offers an identical version of the product. - Many potential buyers of the good in question. - Each buyer small relative to overall mkt size; can t influence price. Can buy as much or as little of the good as he/she wants, without affecting the price. - Many potential sellers of the good in question. - Each seller small relative to overall mkt, can t influence price. Can sell as much or as little without affecting the price. Unrealistic assumptions to make for many markets; BUT this will provide a useful baseline case for comparison. 3

4 THE COMPETITIVE MARKET MODEL Potential buyers in a market are known as the demand side. Potential sellers in a market are known as the supply side. In comp. mkts., the demand and supply side jointly determine: - The quantity of goods that are produced & consumed; and - The price at which goods sells for. Other key points to understand in Topic 3: Buyers & sellers both better off as a result of mkt trades. - Measures of buyer & seller welfare will allow us to see this. Competitive markets will - under certain circumstances - maximize consumer and producer well-being. - This is the sense in which we say comp. mkts. are efficient. 4

5 DEMAND SIDE We begin with the demand side of the market. What determines how much of a given good a potential buyer is willing to buy? - What are the determinants of demand? There are many determinants of demand; price of the good in question is the most obvious one. To think about how price and other things matter, return to beer example from Topic 1. - Recall we were looking at how much I was willing to pay for beer at the U Club on a Friday evening. 5

6 DEMAND MB of beer on Friday evening: - MB1: $20 - MB2: $12 - MB3: $6 - MB4: $2 Turns out this is my demand schedule for (Fri evening) beer. - This table contains the information needed to determine how many beers I will buy at a given price. We will see this representing this information graphically. - We will be drawing my demand curve for beer. 6

7 DEMAND Demand (D) curve plots the quantities I am willing to buy at different prices for the good (holding everything else constant). - Ignore the everything else held constant for now; more on this shortly. The quantity I am willing to buy at a certain price is called the quantity demanded. - The terminology very important here; we ll see why shortly. - On a test (etc.) if you mean Q demanded, say so. - Don t, for instance, say demand when you mean Q demanded. 7

8 DEMAND Recall: we want to see that the graphical representation of my MB schedule is actually my D curve. Note: By convention, we put Q on the horizontal axis. $/pint 20 Plot each point from the MB schedule Q (Pints) 8

9 DEMAND Recall: we want to see that MB schedule is the D schedule. (By convention, we put Q on the horizontal axis.) $/pint 20 Plot each point from the MB schedule, then join up points with stair-step line. - That line is the MB curve MB curve Q (Pints) 9

10 DEMAND Recall: in Topic 1, we used this info to see how many beers I would buy at a price of $5/pint. - Compare MB of each beer to MC, and buy if MB MC. $/pint 20 If P = $5, I buy 3 beers P = $5 = MC of beer Q (Pints) 10

11 DEMAND Same info could be used to see what I do at different price. Now suppose P = $10. MB MC only for first 2 beers, so if P = $10, Q = 2. $/pint MB curve can be used to tell us what Q we would buy at any possible P......which is just what a demand curve tells us. P = $10 my MB curve is my D curve! Q (Pints) D curve 11

12 DEMAND We can used D curve diagrams to measure consumer well-being. - That is, we can measure a consumer s net benefit (NB) from a given purchase choice. We called this things like happiness we didn t have to pay for, in Topic 1. Here we will use its formal name: consumer surplus. Definition: Recall consumer surplus (CS) is the difference between what a consumer was willing to pay for a given Q of a good, and what the consumer had to pay for that Q. - Total benefits of consumption minus total costs of consumption. 12

13 CONSUMER SURPLUS Recall that I am willing to pay $20 for 1st B. On D curve diagram, that willingness to pay can be represented by the area under the D curve, as Q goes from 0 to 1. $/pint 20 First beer gives me $20 of happiness Q (Pints) 13

14 CONSUMER SURPLUS Recall that I am willing to pay $12 for 2nd B. On D curve diagram, that willingness to pay can be represented by the area under the D curve, as Q goes from 1 to 2. $/pint Second beer gives me $12 of happiness Q (Pints) 14

15 CONSUMER SURPLUS Recall that I am willing to pay $6 for 3rd B. On D curve diagram, that willingness to pay can be represented by the area under the D curve, as Q goes from 2 to 3. $/pint 20 Third beer gives me $6 of happiness Fourth beer gives me $2 of happiness Q (Pints) 15

16 CONSUMER SURPLUS When P = $5 and I buy 3, total happiness from beer = $38. - $20 + $12 + $6. - $38 = the maximum amount of money I would have been willing to spend to get those three beers. $/pint 20 But I didn t have to spend $ I had to spend $15 = P Q P = $5 = MC of beer Q (Pints) 16

17 CONSUMER SURPLUS Willingness to pay minus actual cost = $38 - $15 = $23. - My $15 bought me $38 of happiness. - Consumer surplus (CS) = $23. $/pint Diagrammatically, CS is the area: - Below the demand curve; and - Above the price line, up to the Q bought. P = $5 Q (Pints) 17

18 CONSUMER SURPLUS CS can be used to analyze changes in consumer well-being as market conditions change. Now suppose P from $5 to $10. $/pint 20 At P = $5, CS = $ P = $5 Q (Pints) 18

19 CONSUMER SURPLUS CS can be used to analyze changes in consumer well-being as market conditions change. Suppose P from $5 to $10. $/pint 20 At P = $10, CS = $ P = $10 6 P = $5 = MC of beer Q (Pints) 19

20 CONSUMER SURPLUS CS can be used to analyze changes in consumer well-being as market conditions change. Suppose P from $5 to $10. $/pint P = $10 CS decreases by $11. 6 P = $5 = MC of beer Q (Pints) 20

21 CONSUMER SURPLUS It can be useful to decompose the in CS into two parts: - 1st part = P New Q = $ I used to buy those 2 beers for $5 each, now they are $10 each; I spend $10 more on them than before the P. $/pint P = $10-2nd part = lost CS due to in Q. I used to buy a third beer, which gave me CS = $1; that is now gone. 6 P = $ Q (Pints) 21

22 CONSUMER SURPLUS It can be useful to decompose the in CS into two parts: - 1st part = P New Q = $ I used to buy those 2 beers for $5 each, now they are $10 each; I spend $10 more on them than before the P. $/pint P = $10-2nd part = lost CS due to in Q. I used to buy a third beer, which gave me CS = $1; that is now gone. 6 P = $5 Lost CS totals $ Q (Pints) 22

23 DEMAND Contrast our stair step demand curve to the smooth demand curves in Chapter 3 of text. - Difference is due to assumptions about what we call the divisibility of goods. To see this, let s define our units of beer differently. Suppose now we don t buy beer in pints, we buy in half pints. Now think about willingness to pay for half pints of beer, but we will still be using whole pints as our Q-axis measure. - Price will still be $x per whole pint, but now I can buy in halves. 23

24 DEMAND Recall MB of beer on Friday evening: - MB1: $20 - MB2: $12 - MB3: $6 - MB4: $2 How might these marginal benefits of whole pints be split up into valuations of half pints? Lots of possibilities, but these valuations of half pints should be consistent with the above valuations of whole pints. - For instance, if we add my valuation of the 1st half pint to my valuation of the 2nd half pint, it should sum to $20. Also continue to assume MB declining, so that the value of the 2nd half pint < value of the 2nd half pint, etc. 24

25 DEMAND Suppose the following willingness to pay (WTP) for half pints - 1st half pint, WTP: $11 } MB 1 = $20-2nd half pint: $9-3rd half pint: $7 } MB2 = $12-4th half pint: $5-5th half pint: $4 } MB3 = $6-6th half pint: $2-7th half pint: $1.50 } MB4 = $2-8th half pint: $

26 DEMAND We want to plot these points, but on a diagram that is directly comparable to our earlier D curve. Means we will use the same units as previous diagram; namely pints of beer, even though now we are measuring in halves. $/pint Follows that $s also measure price and value, per pint of beer. Actually not as confusing as it sounds Q (Pints) 26

27 DEMAND Recall I am WTP $11 for 1st half pint. Note: same as saying I am WTP $22 per pint for the 1st half pint. Means that MB (measured in pints) of the 1st half pint = $22. $/pint I m not actually WTP $22 for a whole pint. But I am WTP $22 per pint as long as I only consume between 0 and 1/2 pint. Similarly, I am WTP $18 per pint for 2nd half pint (i.e., WTP $9 for that half). 1/2 1 Q (Pints) 27

28 DEMAND Can plot all the other points in a similar way. I am WTP $7 for 3rd half pint, which means I am WTP $14 per pint for that half pint. WTP $5 for 4th half pint WTP $10 per pint for 4th half. $/pint Etc. etc Q (Pints) 28

29 DEMAND Once again, join up the dots to get D curve. We still have a stair step D curve, but with more, smaller steps. We have smoothed it out, relative to the case where we had to buy beer in whole pints. $/pint Transition from stair step D curves to the smooth D curves in text all about making beer even more divisible Q (Pints) 29

30 DEMAND We could allow beer to be sold in quarter pints. - Even more stairs. All the way to very small fractions of a millilitre. $/pint Q (Pints) 30

31 DEMAND We could allow beer to be sold in quarter pints. - Even more stairs. All the way to very small fractions of a millilitre. $/pint In the limit, we will have so many tiny tiny stairs that effectively the D curve becomes perfectly smooth. D curve Q (Pints) 31

32 DEMAND Throughout the rest of the term we will generally assume that goods are infinitely divisible. - i.e., assume D curves can be drawn as perfectly smooth $/pint D curve Q (Pints) 32

33 DEMAND Often, we will also assume that D curves are linear. - Not because we think they are, just because it makes a lot of stuff easier. $/pint D curve Q (Pints) 33

34 DEMAND Everything we learned about stair-step D curves hold true when they are smooth (and linear). - We can still calculate CS & changes in CS as before. $/pint At price P1, Q demanded is Q1. - Consumer was WTP (A + B + C) for Q1 units. - Consumer only had to pay (B + C) for Q1 units. A P1 B C D Q1 Q (Pints) 34

35 DEMAND Everything we learned about stair-step D curves hold true when they are smooth (and linear). - We can still calculate CS & changes in CS as before. $/pint P1 A At price P1, Q demanded is Q1. - Consumer was WTP (A + B + C) for Q1 units. - Consumer only had to pay (B + C) for Q1 units. CS = area A D Q1 Q (Pints) 35

36 DEMAND If price falls to P2, Q demanded increases to Q2. - Consumer was WTP (A + B + C + E + F) for Q2 units. - Consumer only had to pay (C + F) for Q1 units.. New CS = area (A + B + E): i.e., in CS = (B + E). $/pint D - Part of the gain is area B: P1 P2 A B C E F Q1 units bought at P1 now cost P2 each. - Rest of the gain is area E: At P, Q ; those extra units yield CS. Q1 Q2 Q (Pints) 36

37 DEMAND D curves slope if MB as consumption : - Known as the law of demand. Does not have to be true, however (a law not a Law). - Later on, we ll see cases of vertical and horizontal D curves. $/pint Terminology reminder: D - If P and Q, we say this is an in quantity demanded, NOT an in demand. Q demanded s in Q demanded are movements along a D curve. Q (Pints) 37

38 DEMAND Recall from early in Topic 3 that we are interested in all the determinants of demand. So far, we have only talked explicitly about one: the price of the good in question. - This is often called own price (the good s own price). Other things affect how much of a good I am prepared to buy at each and every possible price of the good in question. Other determinants of my D include: my income, prices of related goods, my tastes or preferences, and my expectations about the future. - We want to see that changes in these things are represented by shifts of the entire D curve. 38

39 DEMAND Income. Suppose my income increases. - Holding constant the price of beer, would I buy more or less? Depends on whether the beer is normal or inferior for me. Definitions: - If income, I buy more of a good if it is normal. or less if income. - If income, I buy less of a good if it is inferior. or more if income. Changes in income will shift my D curve right or left - Right shifts are called an increase in D ; Left shifts are called a decrease in D. 39

40 DEMAND Income. Income and beer is normal for me. - At original income I am willing to buy Q1 units at price P1. - At new income I am willing to buy Q2 units at price P1. $/pint D1 in D Willing to buy more than before at any possible price: - The entire D curve has shifted right. P1 D2 An increase in demand. Q1 Q2 Q (Pints) 40

41 DEMAND Prices of related goods. Relationship between my D for beer and other prices depends on relationship between beer and other goods. - Depends on whether other goods are substitutes for or complements to my consumption of beer. A substitute is a good I could consume instead of beer. A complement is a good I like to consume with beer. - Wine might be a substitute, pizza might be a complement. Changes in the price of related goods will also shift my demand curve left or right. - Right shifts are an increase in D; left shifts are a decrease. 41

42 DEMAND Other prices. Wine is a substitute, and its price (PW ). - At original PW I am willing to buy Q1 beers at beer price P1. - At lower PW I am willing to buy just Q2 beers (i.e., fewer beers) at price P1. $/pint D2 in D Willing to buy less than before at any possible own price: - The entire D curve has shifted left. P1 D1 A decrease in demand. Q2 Q1 Q (Pints) 42

43 DEMAND Tastes/preferences Obviously how much beer I am willing to buy depends also on how I feel about beer. - Do I like it or not? If so, how much do I like it? If my tastes change, my D curve will shift accordingly. - Note that tastes can depend on place as well as time. Expectations If I think beer is going to be more (or less) expensive tomorrow, I might buy more (or less) today. - Again, represented by a shift of the D curve. 43

44 DEMAND One final point about demand before we move to supply. So far we have been looking at one individual s D curve. - Obviously there are many potential buyers of most goods. - We need to be able to derive market demand curves from individual demand curves. Fairly straightforward process of adding up Q demanded at each and every price 44

45 DEMAND Suppose we have 2 consumers - A & B - with D curves below. - Q demanded by B at any P is greater than Q demanded by A. - (Think about why that might be true.) $ DB P1 DA Q A 1 Q B 1 Q 45

46 DEMAND At price P1, A would buy Q A 1 units and B would buy Q B 1 units. Market Q demanded is thus Q M 1 Q A 1 + Q B 1 units. Gives us one point on the market D curve. $ $ DB P1 P1 DA Q A 1 Q B 1 Q Q M 1 Q 46

47 DEMAND At higher price P2, Q demanded by each would be lower. Market Q demanded is now Q M 2 Q A 2 + Q B 2 units. Gives us another point on the market D curve. $ $ DB P2 P2 P1 P1 DA Q A 2 Q B 2 Q Q M 2 Q M 1 Q 47

48 DEMAND Do this for every price, and we have the entire market D curve. - If linear D, two points are sufficient, right? Final determinant of (market) D: number of potential buyers. - If more potential buyers, D (shifts right), and vice versa. $ $ DB P2 P2 Market D P1 P1 DA Q A 2 Q B 2 Q Q M 2 Q M 1 Q 48

49 INTRO TO SUPPLY Demand side all about behaviour of potential buyers of a good. Supply side all about behaviour of sellers of a good. To start thinking about the supply side, recall mushroom and fish example from Topic 2. For 1st 10M, MC = 1/10F. For 2nd 10M, MC = 3/10F. For 3rd 10M, MC = 5/10F. For 4rd 10M, MC = 6/10F. Output per day Mushrooms Fish

50 SUPPLY We can derive a supply curve from info about MC. - Analogous to derivation of D curve from MB. Reminder: we are in the competitive market model. - Each potential seller is small relative to the overall market, and cannot influence price. Must take price as given and make decisions accordingly. Because we are assuming competitive markets, we will have to assume other producers, and lots of buyers. Also helpful to assume that money is the medium of exchange (so mushrooms etc. trade for $$s, not fish). - Means we can convert MC info into dollars. 50

51 SUPPLY Assume technology of mushroom/fish producer is as earlier, and also assume that the current market price of fish is $10/ fish. - MC of 1st 10 M = 1/10 F = $1. - MC of 2nd 10 M = 3/10 F = $3. - MC of 3rd 10 M = 5/10 F = $5. - MC of 4th 10 M = 6/10 F = $6. We can use this MC info to figure out how many M will be produced and sold at different mushroom prices. So MC info tells us all we need to know about supply decisions. - Analogous to fact that MB info told us about D. 51

52 SUPPLY We want to see that the graphical representation of MC schedule is producers S curve. Again, by convention, we put Q on the horizontal axis. $ Plot each point from the MC schedule. Recall we have translated MC into $$S Q (Mushrooms) 52

53 SUPPLY We want to see that the graphical representation of MC schedule is producers S curve. Again, by convention, we put Q on the horizontal axis. 6 5 $ Join up points with stair-step line. - That line is the MC curve. 3 MC curve Q (Mushrooms) 53

54 SUPPLY We can use marginal analysis to examine S decisions, just as we used marginal analysis to examine D decisions. Compare MB and MC of each little step, where here the steps are increases in output. $ MC Just need info about MB. Seller s MB (in comp. mkt.) is price at which it can sell its output, PM. Suppose PM = $ Q (Mushrooms) 54

55 SUPPLY If PM = $4, MB > MC for Q up to 20. Tells us that at PM = $4, 20 mushrooms will be supplied. $ Can do this for any potential PM. 6 5 So MC curve is supply curve 4 MB = PM 3 1 Supply curve Q (Mushrooms) 55

56 SUPPLY We can used S curve diagrams to measure producer well-being. - That is, we can measure a producer s net benefit (NB) from a given sales choice. This is called producer surplus. Definition: producer surplus (PS) is the difference between the minimum payment a producer had to receive in order to be willing to sell a given Q, and the actual payment it received for that Q. - We will relate PS to more familiar idea of profit, later in term. Simply need to note that, at minimum, producer needs to receive enough $$ to cover MC, in order to be willing to sell a given unit. 56

57 PRODUCER SURPLUS To calculate minimum payment required for the 20 M sold, add up all the MCs MC of 1st 10 = $10. - MC of 2nd 10 = $30 $ 4 PM S Producer needs at least $40 to be willing to sell 20M. - Note: this is the area under S curve up to Q = 20. Producer actually receives revenue = PM Q = $80. PS is the difference between the two Q (Mushrooms) 57

58 PRODUCER SURPLUS To calculate minimum payment required for the 20 M sold, add up all the MCs MC of 1st 10 = $10. - MC of 2nd 10 = $30 $ 4 PM S Producer needs at least $40 to be willing to sell 20M. - Note: this is the area under S curve up to Q = 20. Producer actually receives revenue = PM Q = $80. PS = $ Q (Mushrooms) 58

59 PRODUCER SURPLUS PS can be used to analyze changes in producer well-being as market conditions change. Suppose PM from $4 to $ $ S PM Q sold from 20 to PM 3 PS will also increase. 1 Q sold Q (Mushrooms) 59

60 PRODUCER SURPLUS Minimum payment needed to sell 30 M = $90 - Area under S curve up to Q = 30. Revenue now = $ = $165. $ New PS = $75, an of $35. S PM 3 Q sold 1 PM Again, useful to decompose PS into 2 component parts. - Just like we did for in CS Q (Mushrooms) 60

61 PRODUCER SURPLUS First part: producer used to sell 20 units at PM = $4; now sells those 20 M at PM = $5.50; a gain of $30. But producer now sells extra 10M, because these extra units have PS > 0 at new PM; a gain of $5. $ S PM 4 PM Overall in PS is sum of these component parts Q (Mushrooms) 61

62 SUPPLY Supply curve in our example is stair step function. - Implicitly, we are assuming that mushrooms can only be sold in 10 unit increments. Can easily allow for a greater degree of divisibility, in the same way we did on the D side in beer example. - More divisibility more stairs in S curve; a smoothing out - In the limit, if the good is infinitely divisible, we will have perfectly smooth S curves. We will do this from now on. We will also often assume linear S curves, again for easy of exposition. 62

63 SUPPLY S curves slope if MC as production : - Known as the law of supply. Does not have to be true, however (a law not a Law). - You ve seen cases of constant MC in Topic 2 Exercises. $ Important terminology analogous to D side: S - If P and Q, this is a in Q supplied, NOT a in supply. Q supplied s in Q supplied are movements along an S curve. Q 63

64 SUPPLY Recall from early in Topic 3 that we are interested in all the determinants of supply. So far, we have only talked explicitly about one: own price. Other things affect how much of a good a producer is prepared to sell at each and every possible price of the good in question. All these other things (the other determinants of supply) will cause the S curve to shift. - Again analogous to the D side. To begin thinking about some other determinants of supply, we will stick with mushroom and fish example. But to think about all determinants of supply it will be useful to think more generally about production. 64

65 SUPPLY Continuing with the mushroom and fish example. Recall that we built the MC/S curve assuming PF = $10. If PF, MC of M production would also. - Would still have to give up same number of F for a given increase in M, but those F are now more valuable. - in MC results in leftward shift in S curve: a in S. At any given PM, producer willing to supply less M, since F production is more attractive. 65

66 SUPPLY Generalizing from this. In some sense, fish are are input into the production of M. - Specifically, foregone F are an input. - In order to M production we must F foregone. So in PF is an in cost of an input to the production of M. More generally, if there is an in price of any input to the production of a good, this will MC and so S. - Inputs to the production of goods in modern markets include wages, raw material costs, etc. Input prices are another determinant of supply. 66

67 SUPPLY What else might shift the mushroom S curve? Suppose something happens that changes the underlying PPF. - Specifically, suppose this change affects the slope of the PPF. - For instance, a mushroom harvesting machine is invented that makes M collection easier. Easier = can get extra M at cost in terms of F foregone. This will the MC of M production and so result in an in S. Technology is another determinant of supply. - Note: to shift S for mushrooms, nature of tech. progress must make resources relatively more productive in M production. 67

68 SUPPLY Two final determinants of supply. Changes in expectations: if a producer believes that PM will be in future (relative PF), current S decisions may change. - That is, we would expect to see an in S. Note that this assumes mushrooms can be stored... This will the MC of M production and so result in an in S. Number of producers. So far, just one producer of M. Competitive markets characterized by many potential sellers. To get market S curve we just aggregate individual S curves, like we did with individual D curves. If more suppliers enter an industry, market S will. 68

69 RECAP: TOPIC 3 SO FAR We now know all about the factors that determine the: - Q that consumers are prepared to buy; and - Q that producers are prepared to sell. Reminder: all of this is in the context of competitive markets: - Producers and consumers all take price as given. Each observes market P and makes decisions accordingly. So where does this market P come from? Key point to understand: - Even though individually none of the buyers and sellers can influence P, collectively, their actions determine P. - Market price is determined by the interaction of S and D. 69

70 EQUILIBRIUM But first, a little more terminology. Dictionary definition of the word equilibrium: - A state of rest or balance due to the equal action of opposing forces; or - Equal balance between any powers, influences, etc.; equality of effect. Forces, powers, & influences in comp. mkts are S & D. Equilibrium in a comp. mkt. is an outcome in which S & D are, in some sense, in equal balance. - This will be where Q demanded = Q supplied. - i.e., where the D curve and S curve cross. 70

71 EQUILIBRIUM Point where S & D cross is the equilibrium point. Quantity Q E is only Q such that Q D = Q S. Q E is called the equilibrium quantity. - Note that we don t have to specify Q supplied or Q demanded, because they are the same in equilibrium. $ S Equilibrium D Identifying Q E is all well and good, but how do we get there? What is the mechanism that allows the market to achieve this state of balance? Q E Q 71

72 EQUILIBRIUM In competitive markets, that mechanism is price. We want to see how price works to ensure that Q D = Q S. Note: there is only one P consistent with Q D = Q S = Q E. - Price labeled P E is the equilibrium price. P E $ E S To see how price plays an equilibrating role, imagine what would happen in P P E. D Q E Q 72

73 EQUILIBRIUM In particular, consider P H > P E. At P H, Q S > Q D : mkt is not in balance; not in equilibrium. Gap between Q S & Q D is called a surplus or excess supply. - Presence of XS means something has to give in the market. $ Excess S (XS) S What gives is price. P H P E Too many sellers & too few buyers downward pressure on P. D Market forces cause P to, relative to P H. Q D Q E Q S Q 73

74 EQUILIBRIUM Market forces cause P to, relative to P H. As P, two things occur: - in Q D (the law of D); a movement along the D curve. - in Q S (the law of S); a movement along the S curve. P H P E $ S Gap between Q S & Q D is closed as both sides of mkt adjust to P. Note: pressure for P to remains as long as there is XS > 0. Q D Q E Q S D Q Tells us P will fall to P E. Only at P = P E is there no further tendency for change in the mkt. 74

75 EQUILIBRIUM We can perform a similar analysis for any P < P E. In that case we would have Q D > Q S. - Gap = (Q D - Q S ) is called a shortage or excess demand. P E P L $ S D Now there will be upward pressure on P. Again, gap will close from both sides of the mkt as P. Only at P = P E is there no further tendency for change in the mkt. Q S Q E Q D Q 75

76 EQUILIBRIUM Once a market is in equilibrium, it will - by definition - stay there until changes occur in market condition. i.e., until something causes S or D conditions to change. Ex: suppose consumers incomes in mkt for a normal good. $ D1 D2 Before in income, equ P & Q are P E 1 & Q E 1. in Demand S in income in demand: D shifts from D1 to D2. P E 1 Magnitude of in D = Q D - Q E 1. Q E 1 Q D Q At P E 1, Q S Q D. 76

77 EQUILIBRIUM At P E 1, Q S = Q E 1 < Q D : there is excess demand (XD) in mkt. Excess D upward pressure on P. As P, quantity demanded decreases, partially offsetting the original increase in demand. in mkt for a normal good. $ D1 D2 Movement along the new D curve, D2. S Also as P, quantity supplied increases; a movement along S curve. P E 2 P E 1 XD eliminated by change on both sides of the market. Q E 1 Q E 2 Q D Q P until XD eliminated, at new equ. price P E 2. 77

78 EQUILIBRIUM Both P E & Q E are higher at new equ than at old equ. in equ Q is less than the original in D When P (doing its work to restore equ.) some of original D is offset by in Q D. $ D2 Sometimes confusion around all this: P E 2 P E 1 D1 S If D but then Q D, how can we tell whether equilibrium Q goes or, overall? Q E 1 Q E 2 Q D Q 78

79 EQUILIBRIUM Key is to look carefully at (and think about!) diagram. Equ Q cannot go down: that is, cannot be below Q E 1. Why not? Because in new equ, we (obviously) need Q D = Q S. P E 2 $ D1 D2 And the only way for Q S to be less than Q E 1 is if new P is lower than P E 1. S But we know that price didn t decrease, it increased. P E 1 Q E 1 Q E 2 Q D Q So impossible for Q D to more than offset original in D. 79

80 COMPARATIVE STATICS The exercise we just did - analyzing the effects of an increase in demand - is an example of what we call comparative statics. - Introducing a perturbation in a mkt. - Explaining the transition from old equ to new equ. - Comparing the new equ and the old equ. You will be asked to do comparative statics exercises in exams. You need to be able to take a story about a change, and translate this story into shifts of curves. Make sure you can do this for ANY possible shift of the supply curve or the demand curve. Make sure you can do it for multiple simultaneous shifts also. 80

81 COMPARATIVE STATICS We have only worked through one example out of MANY possible examples. We haven t spent a lot of lecture time on comparative statics. Don t take that as an indicator of the topic s importance. Thinking about changes in market conditions brings together everything we have covered in the class so far. This material will feature heavily in exams (midterms and/or the final exam). You should make up examples of things that shift S and D curves and work through the comparative statics. Make sure you are comfortable drawing relevant diagrams, and doing so relatively quickly (and legibly!) 81

82 CONSUMER & PRODUCER SURPLUS Recall: CS & PS measures consumer & producer well-being. In the market below, CS = area X and PS = area Y. CS + PS is a measure of the net benefits accruing to all participants in a market. $ X S We call CS + PS market surplus. P E Y D Q E Q 82

83 MARKET SURPLUS We ve seen that we can calculate market surplus by finding CS (X below) and PS (Y below), and adding them together (X + Y). We can also calculate market surplus directly, without thinking about it s distribution between consumers and producers. $ P E X S We do this by focussing just on the quantity traded in a market. Y D Q E Q 83

84 MARKET SURPLUS Recall that the: - D curve can also be interpreted as the MB curve; and - S curve can also be interpreted as the MC curve. $ Area under D curve can be used to calculate total benefits to consumers. MC S - Equivalent to total WTP F G MB D Total benefits of Q E units = areas F + G. Q E Q 84

85 MARKET SURPLUS Recall that the: - D curve can also be interpreted as the MB curve; and - S curve can also be interpreted as the MC curve. $ MC Area under S curve can be used to calculate cost of supplying a given quantity. - Adding up the MCs of each unit. G MB Cost of supplying Q E units = area G. Q E Q 85

86 MARKET SURPLUS Taking total benefits and subtracting cost of supply leaves area F. Area F = market surplus, given Q E units. Note that we are not thinking at all about its distribution between between consumers and producer. $ MC Of course, we know that in the mkt equ, X goes to consumers and Y goes to producers (from slide 82). F G MB But we don t need to think about that if all we are interested in is the overall amount of market surplus. Q E Q 86

87 MARKET SURPLUS Market surplus lets us think about efficiency in comp mkts. Recall: - If we are in position such that we cannot make one person better off without making someone else worse off, then this position is efficient. Inference: - If we are in position such that we can make at least one person better off without making someone else worse off, then this position is inefficient. Basic message: it can t be efficient to leave win-wins on the table. In the rest of this topic (and in next 2 topics), we ll relate our definition of efficiency relates to the concept of market surplus. 87

88 MARKET SURPLUS C Key point to understand at this point in the class: at the competitive market equilibrium, market surplus is maximized. - That is, overall net benefits cannot be higher at any Q Q E. To prove this, consider quantities such that Q Q E, and demonstrate that market surplus is lower. $ A B Q L Q E MC MB Consider Q L < Q E : - Consumer benefits = areas A + B. - Cost of supplying = area B. Market surplus = A. Market surplus is C lower at Q L than it was at Q E. Q 88

89 MARKET SURPLUS Now consider Q H > Q E : - Consumer benefits = areas H + J + K. - Cost of supplying = areas J + K + L. Market surplus = H - L. $ MC Market surplus is L lower at Q H than it was at Q E. H J K L MB Market surplus is lower at any Q Q E ; market surplus is maximized at Q E. Q E Q H Q 89

90 ROUND-UP: TOPIC 3 Demand curve is derived from MB; determinants of demand: 1. Own price (i.e., the price of the good in question). Changes in own price are represented graphically by a movement along a given demand curve. We describe movements along a D curve as increases or decreases in quantity demanded. 2. Income: effect depends on whether the good is normal or inferior. 3. Prices of related goods: effect depends on whether the goods are complements or substitutes. 4. Preferences/tastes. 5. Expectations of future market conditions. Changes in determinants 2-5 shift entire demand curve. We describe shifts of a D curve as an increase or 90

91 ROUND-UP: TOPIC 3 Supply curve is derived from MC; determinants of supply: 1. Own price (i.e., the price of the good in question). Changes in own price are represented graphically by a movement along a given supply curve. We describe movements along a S curve as increases or decreases in quantity supplied. 2. Cost of production: increases in inputs prices increase MC, and decreases in input prices decrease MC. 3. Technology: improved technology can reduce MC. 4. Expectations of future market conditions. Changes in determinants 2-4 shift entire supply curve. We describe shifts of S curve as an increase or decrease in supply. 91

92 ROUND-UP: TOPIC 3 Competitive market equilibrium is the price quantity pair such that quantity supplied equals quantity demanded. Price is the mechanism that ensures that markets reach equilibrium. Once a market is in equilibrium it will stay there until either D, S, or both shift. Make sure you can translate a story into the relevant curve shift. Which of the determinants of demand or supply is affected? Remember - it will be one of the determinants of S or D that is NOT own price. After a curve shift, once again, price is the mechanism that ensures the market reaches a new equilibrium. 92

93 ROUND-UP: TOPIC 3 Consumer surplus = amount of money a consumer is willing to pay for a given Q minus amount of money that he/she must pay. CS = Total benefit to consumers - total cost of purchase. CS = Area below the demand curve and above the price line. Producer surplus = amount of money a seller receives for a given Q sold minus minimum amount he/she needed to be paid. CS = Total benefit to sells - cost of supply. CS = Area above the supply curve and below the price line. Market surplus = consumer surplus + producer surplus. Mkt Surplus = Total benefits to consumers - cost of supply. Mkt Surplus = Area between supply and demand curves, up to the quantity in question. 93