Download REVIEW OF THE ECONOMIC FUNDAMENTALS OF MARKETS

Exhibit PEPCO ____ (JSG-1)
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REVIEW OF THE ECONOMIC FUNDAMENTALS OF MARKETS
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Competitive markets are characterized by decentralized decision making conducted by
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independent economic actors.
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independently, is free to select, respectively, how much they will purchase (consumers) or how
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much they will sell (producers). These independent actors each make these decisions based
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solely on their own self-interest. Fortunately, the result of these independent, self-interested
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decisions is not chaos, but rather economic efficiency. The market will clear at a price that will
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maximize the profit of all sellers and net consumption value for all consumers. Moreover, this
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market clearing price will then determine the amount purchased by each consumer and the
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amount sold by each producer. No market participant could be made better off by selling or
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buying less or more. The optimality and order of this aggregate solution based on the self-
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interested, actions of many buyers and sellers is what Adam Smith referred to as the “invisible
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hand.” This exhibit reviews the fundamental concepts that explain the rationale underlying this
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economics of markets.
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We begin this discussion by assuming the existence of market demand and supply curves to
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focus on the aggregate market clearing price and quantity determination. Subsequently, we focus
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on individual buyers and sellers to show how the demand curve and supply curve are developed.
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Finally, we return to the aggregate market focus to address how the market clearing price
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determines the actions of each buyer and seller.
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MARKET CLEARING PRICE DETERMINATION
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Assume that we have already developed the market demand and supply curves. 1 Let us now
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examine them. A hypothetical, sample demand curve is shown in Figure 1.
Each consumer and each producer, individually and
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The derivation of these curves from the marginal consumption values of consumers and the marginal
production costs of producers, respectively, is addressed in the next section of this exhibit.
Price ($)
Exhibit PEPCO ____ (JSG-1)
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Demand
Curve
Quantity
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Figure 1. Hypothetical Demand Curve
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The demand curve shows the total amount that all buyers will purchase as a function of the
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market price. Some consumers will still buy a substantial amount even at high prices, but others
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will not. At low prices consumers will all want some and demand will be the highest. Generally,
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high prices coincide with low demand and, conversely, low prices coincide with high demand.
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Accordingly, the demand curve typically slopes downward when moving from low to high levels of
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consumption.
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A hypothetical, sample supply curve is shown in Figure 2.
Marginal Cost ($)
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Supply
Curve (MC)
Quantity
10
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Figure 2. Hypothetical Supply Curve
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This supply curve represents the amount of supply that will be brought to the market at any level
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of price. It is based directly on the marginal cost of production for each unit of output. Typically,
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this curve increases with increasing output. The lowest marginal cost sources of supply are used
Exhibit PEPCO ____ (JSG-1)
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first. Then, and only then, are higher marginal cost sources used. Sources with relatively high
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marginal costs of production are used only when output is high.
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The market clears at the point where the demand curve and the supply curve intersect.2 This is
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shown graphically in Figure 3.
Supply
$
P*
MarketClearing
Price
Demand
Q*
Market-Clearing Quantity
Q
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Figure 3. Market Clearing Price and Quantity
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The intersection defines both the market clearing price P* and the market clearing quantity Q*.
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The market must clear at this level. Consider what happens if price is below or above P*.
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Suppose that the price were less than P*. At that price, more will be demanded than will be
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supplied and price will rise until the quantity demanded declines to equal the amount that
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producers are willing to supply. Conversely, assume that the price is above P*. In this case,
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more of the product will be available, willingly supplied, than purchasers will want to buy.
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Accordingly, some suppliers will reduce price in order to reach higher sales. This reduced price
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Note that here we are talking about the aggregate supply and demand curves for the entire market. In
contrast, in the next section, we will discuss the supply curves and the demand curves of individual market
participants.
Exhibit PEPCO ____ (JSG-1)
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will stimulate demand and the solution will be pushed back to the equilibrium market clearing
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values of P* and Q*.
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BUILDING SUPPLY AND DEMAND CURVES
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Next, it is instructive to review how the market supply and demand curves are developed. They
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represent simply the aggregation, respectively, of the supply and demand curves of individual
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producers and individual consumers.
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individual economic actors will operate to best serve their own self-interest.
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To demonstrate this, consider a hypothetical, sample market with three consumers (A, B and C)
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and two producers (1 and 2). Let us focus on the demand curve of Consumer A. An example is
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Each of these individual curves traces out how these
shown graphically in Figure 4.
P
Consumer A
p=7
da
p=5
p=2
qa=2
qa=6
qa=10
qa
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Figure 4. Demand Curve for Consumer A
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The demand curve for each individual consumer is based directly on that consumer’s marginal
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value of consumption as a function of the level of consumption. Consumer A is no exception. As
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can be seen from the diagram, the marginal value of consumption of the first two units is 7 for
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Consumer A. Similarly, the marginal value of the next four units of consumption (from 3 through
Exhibit PEPCO ____ (JSG-1)
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6) is 5. Finally, the marginal value of the next four units of consumption (from 7 through 10) is 2.
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Once Consumer A is consuming 10 units, no additional units will increase Consumer A’s
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consumption value. Accordingly, Consumer A can be expected to behave as follows. If the price
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is above 7, Consumer A will buy no units. If the price is 7 or less but not as low as 5, Consumer A
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will buy two units. If the price is 5 or lower but not as low as 2, Consumer A will buy six units.
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Finally, if the price is 2 or below, Consumer A will buy 10 units. Thus, we have completely
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characterized how Consumer A will act in the market to serve Consumer A’s own self-interest.
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This behavior depends only upon the price available to Consumer A and the behavior is
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completely characterized by Consumer A’s demand curve as shown in the figure. The same
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approach would be followed to trace out the demand curves of the other two individual consumers
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(B and C).
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Note that Consumer A will not deviate from the behavior defined by its demand curve. If it were to
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do so it would be harming its own self interest. Suppose for example that at a price of 3,
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Consumer A were to buy more than the 6 units indicated. The result would be spending an
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additional 3 but only receiving an increase of 2 in its consumption value for a net loss of 1.
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Similarly, if it were to purchase only 5 instead of six, it would reduce its consumption value by 5
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yet only save 3 in purchase costs and, thus, be worse off by 2. Consumer A best serves its self-
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interest by buying 6 units when the price is 3.
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On the other side of the market, the individual supply curves of each supplier can similarly be
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developed as follows. For purposes of this example, let us focus on the supply curve of Producer
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1 as shown in Figure 5.
Exhibit PEPCO ____ (JSG-1)
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P
p=10
p=8
S1 = MC1
p=5
p=3
q1=2
q1=6
q1
q1=12 q1=15
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Figure 5. Supply Curve for Producer 1
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Recall that the supply curve is based directly on the marginal cost of the supplier. Referring to the
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figure, we see that Producer 1 can produce its first two units at a marginal production cost of 3 per
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unit. The next four units (units 3 through 6) can be produced at a marginal production cost of 5
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per unit. The subsequent group of six units (units 7 through 12) can be produced at a marginal
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cost of 8 per unit. Finally, the last block of three units (units 13 through 15) have a marginal
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production cost of 10 per unit. Accordingly, we can expect Producer 1 to act as follows. If the
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price is below 3, Producer 1 will not produce any units for sale. If the price is at or above 3 but not
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as high as 5, Producer 1 will sell two units into the market. If the price is at or above 5 but not as
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high as 8, Producer 1 will sell six units. If the price is at least 8 but not as high as 10, Producer 1
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will sell 12 units. Finally, if the price is 10 or higher, Producer 1 will sell 15 units. Again, just as
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the demand curve did for Consumer A, this supply curve traces out specifically all of the actions
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that Producer 1 would take in the market and those actions depend only on the price that
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Producer 1 is able to receive.
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Producer 1 will not deviate from this specified course of action. To do so would be to adversely
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affect its own self-interest. For example, assume that the price available to Producer 1 is 7. At
Exhibit PEPCO ____ (JSG-1)
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this price, Producer 1’s supply curve indicates that it will sell six units. Suppose it were to sell only
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five units, what would be the effect? Compared to selling six units, Producer 1 would be missing
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out on receiving 7 on the sixth unit while incurring a marginal production cost to sell the sixth unit
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of only 5. Thus, a profit of 2 would be forgone. Suppose alternatively that with the same $7 price
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available, Producer 1 were to produce and sell not six but rather seven units, what would be the
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consequence? Making and selling the seventh unit would yield an additional 7 in revenue, but
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cost an additional 8 because the marginal cost of production for the seventh unit would be 8.
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Accordingly, selling the extra unit would result in a net loss of 1 to Producer 1. Just as the supply
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curve indicates, Producer 1’s self-interest is best served by making and selling six units when the
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price is 7.
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AGGREGATING INDIVIDUAL CURVES TO GET THE MARKET CURVES
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Having discussed the development of individual consumer demand curves and individual
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producer supply curves, we now return our focus to the aggregate market. The market demand
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and supply curves that we spoke of in the first section are derived simply by aggregating the
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individual consumer’s demand curves to develop the market demand curve and integrating the
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individual producer’s supply curves to develop the market supply curve. This process is illustrated
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graphically in Figure 6. The figure encompasses the detailed demand curve for Consumer A
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discussed in the last section and similar hypothetical curves for Consumer B and Consumer C.
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Similarly, on the other side of the market, it encompasses the detailed supply curve for Producer 1
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discussed in the previous section and a similar curve for Supplier 2. In the middle of the figure,
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the individual demand curves and supply curves are aggregated to develop the market supply and
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demand curves.
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1
6
da
qa
P
5
qb
db
P
Consumer A Consumer B
P*=5
P
4
dc
qc
P
Consumer C
Consumers' Demands
Q
Aggregate
Market
Q * = 15
15
P
D = da+ db+ dc
S = S 1 + S2
Market Clearing
q1
Producer 1
6
s1
P
q2
Producer 2
9
s2
Producers' Supplies
Exhibit PEPCO ____ (JSG-1)
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Exhibit PEPCO ____ (JSG-1)
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As shown in the figure, this hypothetical market clears at a price of 5 and a market-clearing
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quantity of 15. Because we now recognize that these market supply and demand curves are
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simply the aggregation of the individual supply and demand curves, we can track backwards from
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this market-clearing solution to see what the implied levels of purchase and sale are for each of
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the consumers and producers, respectively. Again, as shown in the diagram, Consumer A buys
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six units, Consumer B buys five units and Consumer C buys four units. This consumption equals
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the total market-clearing quantity of 15. On the other side of the market, Producer 1 sells six units
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and Producer 2 sells nine units, thus, equaling the market clearing quantity of 15 between them.
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Thus, we see that by building up the market demand curve from the individual demand curves of
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buyers and building up the market supply curve from the individual supply curves of sellers allows
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us to identify not only the market-clearing price and quantity, but also the amounts bought by each
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buyer and sold by each seller in the market.
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