Download lecture 3

session three
the perfectly competitive market
demand and supply curves revisited ………….1
market mechanism and equilibrium ………….2
market dynamics: shifting curves ………….3
market dynamics: long-run ………….5
market dynamics: key points ………….8
consumer surplus ………….9
producer surplus ………11
market efficiency analysis ……….13
price floor analysis ………14
price ceiling analysis ……….15
consumer tax analysis ……….16
tax incidence analysis ………17
key points ……….18
spring
2016
microeconomi
the analytics of
cs
constrained optimal
microeconomics
lecture 3
the perfectly competitive market & government intervention
the analytics of constrained optimal
decisions
demand and supply curves revisited
► Demand and supply curves revisited
► How does the market adjust to an equilibrium?
demand curve
The demand curve associates to each possible price level the
utility maximizing consumption level. In particular, the optimal
consumption satisfies the condition:
MU(Q*) = P
 The demand curve is identical with the marginal utility curve. For a given quantity consumed the
marginal utility shows by how much the satisfaction increases for the last unit is consumed. That
unit is actually bought only if the price paid is no more than the marginal utility obtained.
 The height of the demand curve for a given quantity shows the maximum price the consumer is
willing to pay for that quantity.
Figure 1. Demand curve
30
25
MU = 25 – 2Q
20
15
10
5
0
0
2.5
5
7.5
10
12.5
10
12.5
quantity
supply curve
The supply curve associates to each possible price level the
profit maximizing output. In particular:
30
 for P  Pshut-down, Q* satisfies P = MC(Q*) or Q* = Qmax
25
 for P < Pshut-down, Q* satisfies Q* = 0
20
 The supply curve is identical with the marginal cost curve. For a given quantity produced the
marginal cost shows by how much the cost increases if the last unit is produced. That unit is
actually produced only if the price obtained is no less than the marginal cost incurred (for that unit).
 The height of the supply curve for a given quantity shows the minimum price the producer is
willing to accept for that quantity.
 2016 Kellogg School of Management
Figure 2. Supply curve
lecture 3
MC = 3Q
15
10
5
0
0
2.5
5
7.5
quantity
page | 1
microeconomics
lecture 3
the perfectly competitive market & government intervention
the analytics of constrained optimal
decisions
demand and supply curves revisited
► Demand and supply curves revisited
► How does the market adjust to an equilibrium?
the market mechanism
A market mechanism is a set of rules through which agents (consumers, producers,
government, market makers, etc.) organize the trade of goods by determining a price level at
which the quantity demanded equals the quantity supplied: market equilibrium.
Figure 3. The market maker mechanism
Figure 4. The web adjustment mechanism
30
30
P = 25 – 2Q
25
P = 3Q
20
(0)
20
(M)
15
P = 25 – 2Q
25
(M)
(1)
P = 3Q
15
10
10
5
5
0
(2)
(3)
0
0
2.5
5
7.5
10
12.5
 The market maker mechanism assumes that a benevolent
individual (the market maker) receives from consumers and
producers their demand and supply schedules (for each
possible price what is the quantity demanded and supplied
respectively). The market maker would simply match the two
curves by finding the price at which the quantity demanded
equals the quantity supplied at point (M) the market equilibrium
 2016 Kellogg School of Management
0
2.5
5
7.5
10
12.5
 The web adjustment mechanism assumes the market will
reach its equilibrium by successive adjustments of quantity
supplied and demanded. Starting from point (0) at a price of
$20 producers are willing to produce about 6.67 units at point
(1). But for this output a maximum price of $11.33 at point (2)
is paid by consumers which in turn prompts producers to
reduce their output to 3.78 units at point (3) and so on unit
point (M) – the market equilibrium – is reached.
lecture 3
page | 2
microeconomics
lecture 3
the perfectly competitive market & government intervention
the analytics of constrained optimal
decisions
market dynamics: shifting curves
► Demand and supply curves shifts
► Long run dynamics
Figure 5. Shift in demand curve
D1
Figure 6. Shift in supply curve
D2
D1
S
S1
S2
(M2)
P2
(M1)
P1
(M1)
P1
(M2)
P2
Q1
Q2
Q1
 A shift in demand curve from D1 to D2
moves the equilibrium from (M1) to (M2). The
change in equilibrium is a movement along
the supply curve in this case. The equilibrium
price increases from P1 to P2 while the
equilibrium quantity increases from Q1 to Q2.
 2016 Kellogg School of Management
Q2
 A shift in supply curve from S1 to S2 moves
the equilibrium from (M1) to (M2). The change
in equilibrium is a movement along the
demand curve in this case. The equilibrium
price decreases from P1 to P2 while the
equilibrium quantity increases from Q1 to Q2.
lecture 3
page | 3
microeconomics
lecture 3
the perfectly competitive market & government intervention
the analytics of constrained optimal
decisions
market dynamics: shifting curves
► Demand and supply curves shifts
► Long run dynamics
 Consider a firm serving two markets
characterized by demand curves D1 and D2. They
intersecting at point (M0) which is the initial
equilibrium in both markets (the initial supply curve
is Sinitial for both markets thus the same price P0
and quantity Q0 are initially seen in both markets).
Figure 7. Demand elasticity and shift in supply curve
D1
 The firm manages to decrease its marginal cost
which result in a rotation downward in the supply
curve to Snew for each market.
 In market one the new equilibrium is at point (M1)
with price P1 and quantity Q1. In market two the
new equilibrium is at point (M2) with price P2 and
quantity Q2.
Sinitial
D2
Snew
(M0)
P0
P2
P1
(M2)
(M1)
 What explains the different reaction in the two
markets (notice that P1 > P2 and Q1 < Q2)? Which
demand is more elastic at the initial point (M0)?
Q0
Q1
Q2
 A change in price will result in a higher change in
quantity for a more elastic demand. In this case D2
is more elastic than D1 at the initial point (M0).
 2016 Kellogg School of Management
lecture 3
page | 4
microeconomics
lecture 3
the perfectly competitive market & government intervention
the analytics of constrained optimal
decisions
market dynamics: the long-run
► Demand and supply curves shifts
► Long run dynamics
Figure 9. Shut-down and entry price: several firms
Figure 8. Shut-down and entry price: one firm
MC = S(1)
MC = S(1)
FRATC
Pentry
ATC
S(N)
Pentry
Pshut-down
Pshut-down
 Start with one firm that has a simple marginal cost function, i.e. MC(Q) = cQ. We already know that the shut-down
price is the minATC and the entry price is minFRATC. The interpretation of these two thresholds is simple:
- if the market price is expected to be forever below Pshut-down then the firm is better off to close
- if the market price is expected to be forever above Pentry then the investor should incur the investment
costs and setup an operational firm
 When several identical firms enter the market the shut-down and entry price thresholds have the same meaning.
 2016 Kellogg School of Management
lecture 3
page | 5
microeconomics
lecture 3
the perfectly competitive market & government intervention
the analytics of constrained optimal
decisions
market dynamics: the long-run
► Demand and supply curves shifts
► Long run dynamics
 The market starts at point (M0). The
market price P0 is below the shut-down
price Pshut-down.
Figure 10. Market exit
Snew
 If the demand curve (D) is expected
to remain the same forever then some
firms will have to exit the market…
 What is the market dynamics?
D
Sinitial
Pentry
 As firms et the market the supply
curve starts to rotate to the left with the
market price increasing as a result.
Pshut-down
 The market intermediate equilibrium
P0
points are all aligned along the demand
curve.
 The exit process ends when enough
firms exit the market to bring the
market price just equal to Pshut-down.
 At point (M1) the market settles in the
new equilibrium with an obvious
contraction of the total output offered
and at a higher price.
 2016 Kellogg School of Management
(M1)
(M0)
Q1 Q0
 Market output decreases
as a result of firms exiting
the market.
lecture 3
page | 6
microeconomics
lecture 3
the perfectly competitive market & government intervention
the analytics of constrained optimal
decisions
market dynamics: the long-run
► Demand and supply curves shifts
► Long run dynamics
 The market starts at point (M1) with
initial demand curve (D1). The market
price is exactly Pshut-down.
 Say market demand expands to a
new curve (D2) and is expected to
remain at this new schedule forever…
 What is the market dynamics?
Figure 11. Market entry
(M2)
P2
Snew
D1
Pentry
 Obviously the new equilibrium is at
point (M2) where the market price P2 is
above the entry price... we expect Pshut-down
some entry to occur…
 In the interim the existing firms will
expand their output resulting in an
increase in market output increase
from Q1 to Q2.
 The entry process begins with new
firms entering the market which rotate
the supply curve to the right…
 The entry process ends when
enough firms enter the market to bring
the market price just equal to Pentry.
 2016 Kellogg School of Management
Sinitial
D2
(M3)
(M1)
Q1
Q2
 In the first phase market output
increases as a result of existing
firms increasing their output.
lecture 3
Q3
 The market output continues to
increase as new firms enter the
market.
page | 7
microeconomics
lecture 3
the perfectly competitive market & government intervention
the analytics of constrained optimal
decisions
market dynamics: key points
► Demand and supply curves shifts
► Long run dynamics
► The market equilibrium will be found at the intersection of demand and supply curves…
► We can distinguish the short-run dynamics and the long-run dynamics:
- the short-run refers to the adjustment from a current equilibrium to the new equilibrium through an adjustment of
output for existing firms
- the long-run refers to the adjustment from a current equilibrium to the new equilibrium through an adjustment in the
number of firms operating in the market (exit or entry)
► The critical point in understanding the long-run adjustment is always to consider the shut-down and entry threshold prices in
relation to a “hypothetical” forever price level…
 2016 Kellogg School of Management
lecture 3
page | 8
microeconomics
lecture 3
the perfectly competitive market & government intervention
the analytics of constrained optimal
decisions
government intervention and market efficiency
► Consumer surplus, producer surplus and market efficiency
► Government intervention
► Consider a consumer who has to decide how much he values
each additional unit he might consume. Arguably each additional unit
brings a lower satisfaction.
Figure 12. Consumer surplus (I)
12
11
► On the vertical axis we record the (hypothetical) amount the
consumer is willing to give up for each unit…
value for
1st unit
► Suppose that actually he can buy any number of units at the
same price $4 per unit. How many units is he going to buy?
value for
2nd unit
9
value for
3rd unit
► Given the conditions in the diagram he will buy 4 units
value for
4th unit
his valuation ($10) – price ($4) = surplus ($6)
This is the area of the first vertical rectangle…
► For the second unit he gets a surplus of $4 as:
consumer
surplus
8
7
► As long as his valuation of a certain unit is at least as high as the
price he has to pay for it he will buy that unit
► For the first unit he gets a surplus of $6 as:
10
6
5
(price) P = $4
4
3
value for
5th unit
value for
6th unit
2
1
0
1
2
3
4
5
6
7
8
9
10 Q
his valuation ($8) – price ($4) = surplus ($4)
This is the area of the second vertical rectangle…
consumer surplus
 2016 Kellogg School of Management
The total consumer surplus is the sum of all the
per unit surpluses ( = own valuation – price) for
each unit demanded.
lecture 3
units
demanded
page | 9
microeconomics
lecture 3
the perfectly competitive market & government intervention
the analytics of constrained optimal
decisions
government intervention and market efficiency
► Consumer surplus, producer surplus and market efficiency
► Government intervention
Figure 13. Consumer surplus (II)
price ($)
► If we consider now that the good can be divided in very small
units we get a “smooth” demand curve for the good.
► Moreover aggregating demand over all consumers in the market
we can talk about the market demand for the good and consumers’
surplus defined as
► The total consumer surplus is the area under the demand
curve and above the price charged.
12
11
value for
1st unit
9
value for
2nd unit
value for
4th unit
Area = ½ ∙ (8) ∙ (4) = 16
consumer
surplus
8
7
value for
3rd unit
► For the case shown in the diagram we get:
10
6
5
(price) P = $4
4
3
value for
5th unit
value for
6th unit
market
demand
2
1
0
1
2
3
4
5
6
7
8
9
10 Q
units
demanded
 2016 Kellogg School of Management
lecture 3
page | 10
microeconomics
the analytics of constrained optimal
decisions
► Consumer surplus, producer surplus and market efficiency
► Government intervention
lecture 3
the perfectly competitive market & government intervention
government intervention and market efficiency
Figure 14. Producer surplus (I)
price ($)
► Consider a producer who has to decide how much it costs her
each additional unit he might produce. Arguably (under increasing
marginal cost) each additional unit brings a higher cost.
12
► On the vertical axis we record the cost – the amount the
producer is willing to give up for each unit produced…
10
► Suppose that actually she can sell any number of units at the
same price $4 per unit. How many units is she going to sell?
8
11
9
7
► As long as her cost of a unit is at most as high as the price
she receives for it she will produce and sell that unit
cost of 6th unit
6
cost of 5th unit
5
► Given the conditions in the diagram she will sell 4 units
cost of 4th unit
4
► For the first unit she gets a surplus of $3 as:
cost of 3rd unit
3
cost of 2nd unit
2
cost of 1st unit
1
price ($4) – her cost ($1) = surplus ($3)
This is the area of the first vertical rectangle…
► For the second unit she gets a surplus of $2 as:
0
(price) P = $4
producer
surplus
1
2
3
4
5
6
7
8
9
10 Q
price ($4) – her cost ($2) = surplus ($2)
This is the area of the second vertical rectangle…
producer surplus
 2016 Kellogg School of Management
The total producer surplus is the sum of all the
per unit surpluses ( = price – cost for unit) for each
unit sold.
lecture 3
units
produced
page | 11
microeconomics
the analytics of constrained optimal
decisions
► Consumer surplus, producer surplus and market efficiency
► Government intervention
lecture 3
the perfectly competitive market & government intervention
government intervention and market efficiency
Figure 15. Producer surplus (II)
price ($)
► If we consider now that the good can be divided in very small
units we get a “smooth” supply curve for the good.
12
► Moreover aggregating supply over all producers in the market
we can talk about the market supply for the good and producers’
surplus defined as
11
► The total producer surplus is the area above the supply
curve and below the price received.
8
► For the case shown in the diagram we get:
Area = ½ ∙ (4) ∙ (4) = 8
market
supply
10
9
7
cost of 6th unit
6
cost of 5th unit
5
cost of 4th unit
4
cost of 3rd unit
3
cost of 2nd unit
2
cost of 1st unit
1
0
(price) P = $4
producer
surplus
1
2
3
4
5
6
7
8
9
10 Q
units
produced
 2016 Kellogg School of Management
lecture 3
page | 12
microeconomics
the analytics of constrained optimal
decisions
lecture 3
the perfectly competitive market & government intervention
government intervention and market efficiency
Figure 16. Market equilibrium and total surplus
price ($)
12
► The quantity traded and trading price in a free-of-constraints market is
obtained at the intersection of demand and supply curves.
demand
11
10
supply
9
8
7
6
► The total surplus is the sum of the consumers’ and producers’
surpluses.
(CS)
5
(price) P = $4
4
3
(PS)
2
consumers’ surplus
(CS) light gray area
producers’ surplus
(PS) dark grey area
total surplus
1
0
► In this case (left diagram) the equilibrium price is P = $4 and 4 units
are traded. Consumers’ surplus is the area below the demand curve and
above the price paid. Producers’ surplus is the are above the supply curve
and below the price received.
1
2
3
4
5
6
7
8
9
10 Q
(CS) + (PS)
► For the case shown in the diagram we get:
Total surplus = 16 + 8 = 24
equilibrium
Defines the market outcome in terms of price and quantity.
efficiency
Related to the possibility to obtain a total surplus at least as high (through a different pair of price and
quantity) as the total surplus obtained through the market outcome.
 2016 Kellogg School of Management
lecture 3
page | 13
microeconomics
lecture 3
the perfectly competitive market & government intervention
the analytics of constrained optimal
decisions
government intervention: price floor
Figure 17. Price floor analysis
non-binding floor
price ($)
12
12
demand
11
supply
A
9
B
6
C
5
4
2
A
E
3
floor PF = $2
1
2
3
4
5
6
7
B
C
4
D
8
9
10 Q
2
floor PF = $8
market
outcome
5
market
outcome
1
0
oversupply 6 units
7
7
3
supply
8
8
6
demand
11
10
10
9
binding floor
price ($)
D
1
2
3
4
5
6
7
8
9
left diagram
right diagram
change
consumers’ surplus
A+B+C
A
–B–C
producers’ surplus
D+E
B+D
+B–E
total surplus
A+B+C+D+E
A+B+D
–E–C
 2016 Kellogg School of Management
► For a binding case the
floor has effect on the
market: the floor becomes
the transaction price.
► Whenever the price floor
is binding the producers
would like to produce more
than what the consumers
demand (oversupply).
E
1
0
► Price floor: a minimum
price imposed in the market
(the price in the market
cannot be less than the price
floor).
lecture 3
10 Q
deadweight loss
page | 14
microeconomics
lecture 3
the perfectly competitive market & government intervention
the analytics of constrained optimal
decisions
government intervention: price ceiling
Figure 18. Price ceiling analysis
non-binding ceiling
price ($)
12
12
demand
11
supply
A
9
ceiling PC = $8
8
B
6
4
1
0
A
4
3
2
F
1
1
2
3
4
5
6
7
C
5
market
outcome
E
D
B
8
9
10 Q
0
market
outcome
E
D
ceiling PC = $2
F
shortage 3 units
1
2
3
4
5
6
7
8
9
left diagram
right diagram
change
consumers’ surplus
A+B+C
A+B+D
+D–C
producers’ surplus
D+E+F
F
– D–E
total surplus
A+B+C+D+E+F
A+B+D+F
–E–C
 2016 Kellogg School of Management
► Price ceiling: a maximum
price imposed in the market
(the price in the market
cannot be more than the
price ceiling).
► For a binding case the
ceiling has effect on the
market: the ceiling becomes
the transaction price.
8
6
C
5
2
supply
7
7
3
demand
11
10
10
9
binding ceiling
price ($)
lecture 3
10 Q
► Whenever the price
ceiling is binding the
consumers would like to buy
more than what the
producers offer (demand
surplus).
deadweight loss
page | 15
microeconomics
lecture 3
the perfectly competitive market & government intervention
the analytics of constrained optimal
decisions
government intervention: taxes
Figure 19. Consumer tax analysis
no taxes
price ($)
12
12
demand
11
A
price paid by
consumer
7
B
6
C
5
4
market
outcome
E
D
tax paid by
consumer
0
A
PC 8
7
6
B
C
5
4
E
D
market
outcome
price received by
PD 2
producer
1 F
F
1
9
3
2
1
supply
10
8
3
demand
11
supply
10
9
consumer tax of $6 per unit
price ($)
2
3
4
5
6
7
8
9
0
10 Q
1
left diagram
right diagram
change
consumers’ surplus
A+B+C
A
–B–C
producers’ surplus
D+E+F
F
–D–E
B+D
+B+D
A+B+D+F
–E–C
government revenue
total surplus
 2016 Kellogg School of Management
A+B+C+D+E
lecture 3
2
3
4
5
6
7
8
9
10 Q
deadweight loss
page | 16
microeconomics
the analytics of constrained optimal
decisions
► Tax on consumers
lecture 3
the perfectly competitive market & government intervention
government intervention and market efficiency
consumer tax of $6 per unit
price ($)
12
demand
11
supply
10
9
price paid by
P 8
consumer C
tax paid by
consumer
7
tax burden on
consumer
tax burden on
producer
A
6
B
C
5
equilibrium price,
P* 4
no taxes
3
market
outcome
E
D
price received by 2
PD
producer
1 F
0
1
2
3
4
5
6
7
8
9
10 Q
 For the consumer tax case the difference between the price paid by consumer (PC) and the price received by the producer (PD) is
exactly the tax (t):
PC – PD = t
 Using the equilibrium price for “no taxes case” (P*), the above difference can be written as (PC – P*) + (P* – PD) = t
 The “tax burdens” (TB) for consumer and producer respectively are then:
 2016 Kellogg School of Management
lecture 3
P P *
TBconsumer  C
t
TBproducer 
P * PD
t
page | 17
microeconomics
lecture 3
the perfectly competitive market & government intervention
the analytics of constrained optimal
decisions
► DEMAND:
demand
key points
- shows the willingness to pay for each unit
► CONSUMER
consumer
surplus SURPLUS: - the difference between the willingness to pay and the actual payment for all units that the
buyers ends buying
- critical issues: clearly identify the price paid for each unit and the number of units that the
consumer buys; the surplus is calculated only for the units actually bought
supply
► SUPPLY:
- shows the minimum price accepted by the producer for each unit to be produced
► PRODUCER
producer
surplus SURPLUS: - the difference between the price received for each unit sold and the cost of producing those
units
- critical issues: clearly identify the price received for each unit and the number of units that the
producer sells; the surplus is calculated only for the units actually sold
total
surplus
► APPLICATIONS:
- represent the sum of consumer and producer surpluses (and other agents in economy)
► DEADWEIGHT
deadweight
loss LOSS:
- the surplus that is lost as a result of a certain change in market conditions
- it is important to remember that the deadweight loss is a relative measure: calculate the total
surplus under scenario 1 and scenario 2 – the change in total surplus (if negative) gives you the
deadweight loss – if the change is positive you obtained a surplus gain
 2016 Kellogg School of Management
lecture 3
page | 18