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Perfectly Competitive Markets Economics 110 Introduction to Economic Theory Professor Tanya Rosenblat 1 Experiment (Session 1). Widget Market (48 participants) Type of Agent Number of Agents Cost Value Low-Cost Supplier 16 10 High-Cost Supplier 8 30 High-Value Demander 8 40 Low-Value Demander 16 20 2 Supply Schedule Price Range P<10 Amount Supplied 0 10<P<30 16 P>30 24 3 Demand Schedule Price Range Amount Demanded P>40 0 20<P<40 8 P<20 24 4 Session 1: Supply and Demand for Widgets P 40 R I 30 C E 20 10 8 16 24 5 Number of Bushels Experimental Data • Round 1 – Average Price 18.3 (19.5) Round 1 Prices 40 Price 30 20 10 0 0 10 20 30 Transactions 6 Experimental Data • Round 2 – Average Price 17.4 (17.3) Price Round 2 Prices 35 30 25 20 15 10 5 0 0 5 10 15 20 Transactions 7 A Demand Curve Can Be Thought of as a Schedule of Buyers’ Maximum Willingnesses to Pay $5.75 $2.25 $ per unit Highest price Potential at which individual is willing to buy Buyer #1 $ 6.00 #2 $ 5.50 #3 $ 5.00 #4 $ 4.50 #5 $ 4.00 #6 $ 3.50 #7 $ 3.00 #8 $ 2.50 #9 $ 2.00 #10 $ 1.50 #11 $ 1.00 #12 $ 0.50 • Only one buyer has a maximum willingness to pay greater than $5.75 • Thus: at a price of $5.75, only one potential buyer (#1) would buy. • Quantity demanded at $5.75 = 1 $6.50 $6.00 $5.50 $5.00 $4.50 $4.00 $3.50 $3.00 $2.50 • At a price of $2.25, eight potential buyers would buy (#1 - #8). • Quantity demanded at $2.25 = 8. $2.00 $1.50 $1.00 Demand Curve $0.50 Quantity $- 0 1 2 3 4 5 6 7 8 9 10 11 12 Notice that the demand curve also describes the maximum willingness to pay of all potential buyers in the market! 8 A Supply Curve Can Be Thought of as a Schedule of Seller’s Minimum Willingnesses to Sell $5.75 $ per unit • $6.50 • Supply Curve The price of $5.75 is greater than the minimum willingness to sell for 11 potential sellers Thus: quantity supplied at $5.75 = 11 $6.00 Lowest price Potential at which seller is willing to sell* Seller #1 $ 0.50 #2 $ 1.00 #3 $ 1.50 #4 $ 2.00 #5 $ 2.50 #6 $ 3.00 #7 $ 3.50 #8 $ 4.00 #9 $ 4.50 #10 $ 5.00 #11 $ 5.50 #12 $ 6.00 $5.50 $5.00 $4.50 $4.00 $3.50 $3.00 $2.25 $2.50 $2.00 $1.50 $1.00 $0.50 Quantity $- 0 1 2 3 4 5 6 7 8 9 10 11 12 9 Is There An Equilibrium in Our Market? Yes! Supply Curve $ per unit • $6.50 $6.00 • $5.50 $5.00 $4.50 • $4.00 $3.50 equilibrium price “band” At any price above $3.00 but below $3.50, exactly 6 potential buyers are willing to buy At a price above $3.00 but below $3.50, exactly 6 potential sellers are willing to sell. For any price in this band, quantity supplied equals quantity demanded at this price. $3.00 $2.50 $2.00 $1.50 $1.00 Demand Curve $0.50 Quantity $- 0 1 2 3 4 5 6 7 8 9 10 11 12 10 How Much Do Buyers Gain at the Market Equilibrium? Buyer #1: winning to pay as much as: $6.00 actually pays: $3.25 net gain (consumer surplus): $2.75 (area A) $ per unit $6.50 Buyer #2: winning to pay as much as: $5.50 actually pays: $3.25 net gain (consumer surplus): $2.25 (area B) $6.00 $5.50 $5.00 Buyer #6: winning to pay as much as: $3.50 actually pays: $3.25 net gain (consumer surplus): $0.25 (area F) A $4.50 B $4.00 $3.50 F $3.25 $3.00 Highest price Potential at which individual is willing to buy Buyer #1 $ 6.00 #2 $ 5.50 #3 $ 5.00 #4 $ 4.50 #5 $ 4.00 #6 $ 3.50 #7 $ 3.00 #8 $ 2.50 #9 $ 2.00 #10 $ 1.50 #11 $ 1.00 #12 $ 0.50 $2.50 $2.00 $1.50 $1.00 These buyers do not buy Their consumer surplus is zero! $0.50 Demand Curve Quantity $- 0 1 2 3 4 5 6 7 8 9 10 11 12 11 Consumer Surplus • Consumer surplus: the aggregate net gain to $ per unit consumers from purchasing at a given market price. • Equal to: the area underneath the demand curve above the market price • In our picture: consumer surplus at a market price of $3.25 equals area A+B+C+D+E+F. • This number, which equals $9.00, is the aggregate difference between what consumers are willing to pay and what they actually pay. $6.50 $6.00 $5.50 $5.00 A $4.50 B C $4.00 D E $3.50 F $3.25 $3.00 $2.50 $2.00 Consumer Surplus: Willingness to pay - Actual payment $1.50 $1.00 Demand Curve $0.50 Quantity $- 0 1 2 3 4 5 6 7 8 9 10 11 12 12 The Concept of Consumer Surplus Also Applies to “Smooth” Demand Curves P ($ per liter) • Consumers demand 4000 liters at $6 per unit. • Consumers surplus = difference between total willingness to pay and actual amount paid = area A = $8,000. $10 $6 A MARKET DEMAND CURVE Q (liters per year) 4000 13 How Much Do Sellers Gain at the Market Equilibrium? Supply Curve $ per unit Seller #1: actually receives: $3.25 must receive at least: $0.50 net gain (producer surplus): $2.75 (area A) $6.50 $6.00 $5.50 Lowest price Potential at which seller is willing to sell* Seller #1 $ 0.50 #2 $ 1.00 #3 $ 1.50 #4 $ 2.00 #5 $ 2.50 #6 $ 3.00 #7 $ 3.50 #8 $ 4.00 #9 $ 4.50 #10 $ 5.00 #11 $ 5.50 #12 $ 6.00 Seller #2: actually receives: $3.25 must receive at least: $1.00 net gain (producer surplus): $2.25 (area B) $5.00 $4.50 $4.00 $3.50 $3.25 F $3.00 $2.50 B $2.00 Seller #6: actually receives: $3.25 must receive at least: $3.00 net gain (producer surplus): $0.25 (area F) A $1.50 $1.00 $0.50 Quantity $- 0 1 2 3 4 5 6 7 8 9 10 11 12 14 Producer Surplus Supply Curve $ per unit Producer Surplus: Actual payment - required payment $6.50 $6.00 $5.50 $5.00 $4.50 $4.00 • Producer surplus: the aggregate net gain to sellers from selling at a given market price. • Equal to: the area underneath the market price above the supply curve. • In our picture: producer surplus at a market price of $3.25 equals area A+B+C+D+E+F. • This number, which equals $9.00, is the aggregate difference between what sellers actually receive and the smallest amount they need to receive. $3.50 $3.25 $3.00 F E D $2.50 C B $2.00 A $1.50 $1.00 $0.50 Quantity $- 0 1 2 3 4 5 6 7 8 9 10 11 12 15 Producer Surplus Also Applies to “Smooth” Supply Curves P ($ per liter) Market Supply Curve $6 A • Firms supply 4000 liters at $6 per liter. • Producer surplus is area A in the diagram = $8,000. $2 Q (liters per year) 4000 16 Total Economic Value Created in a Market = Consumer Surplus + Producer Surplus Supply Curve $ per unit $6.50 $6.00 $5.50 $5.00 $4.50 • Total economic value created when market price is $3.25 = Consumer surplus at $ 3.25 + Producer surplus at $3.25 = $9.00 + 9.00 = $18.00 $4.00 $3.50 $3.25 $3.00 $2.50 $2.00 $1.50 $1.00 Demand Curve $0.50 Quantity $- 0 1 2 3 4 5 6 7 8 9 10 11 12 17 If The Market is Prevented From Reaching Equilibrium, Economic Surplus is Not Realized Supply Curve $ per unit $6.50 $6.00 $5.50 $5.00 • If, for some reason, potential buyers #3,4,5 and potential sellers #3,4,5 were prevented from participating in the market, consumer and producer surplus would be lost. • Gains from exchange would not be realized! • We say there is a deadweight loss: unrealized economic benefits. • How could this happen? Government interventions! $4.50 $4.00 $3.50 $3.00 $2.50 $2.00 $1.50 $1.00 Demand Curve $0.50 Quantity $- 0 1 2 3 4 5 6 7 8 9 10 11 12 18 The Economics of Price Controls Price ($ per unit) Free market (no price control) Price controls Difference due to price controls Producer surplus F + C+ E F - C-E Consumer surplus A+B+D A+B+C C–D Total surplus A+B+C +D+E+F A+B+C +F -E-D A B S D $2,000 E C $1,400 F D QS Q* QD Quantity (units per period) E + D = Deadweight loss 19 Elasticity • Where is the Demand Curve coming from? How do we measure its slope? • The Demand Curve tells us how much consumers will buy for different prices of the good • From Consumer Behavior, we know how to deduce from tastes how much an individual consumer will buy at a given price. Summing over consumers, we get the Demand Curve • The Demand Curve is (assumed to be) decreasing (The “Law of Demand”): The higher the price, the lower the consumption 20 How to measure elasticity? • It is important to measure how sensitive Demand is to changes in Prices • Preferably, this measure should not depend on units: are we counting in dollars, cents, or euros? Pounds, Kilograms or Tons? • The price elasticity of demand provides such a measure: Q / Q Ep P / P D D In words, it is the % change in quantity for (or divided by) a given % change in prices (sometimes, the elasticity is defined as the opposite number: the precise convention does not matter, as long as one realizes that the law of demand applies) 21 The Importance of Elasticity • The Concept of Elasticity is used for other concepts: - Income elasticity of Demand: Q D / Q D EI I / I - Price Elasticity of Supply: Q S / Q S ES P / P • What affects the Slope? When is it steep? It is steep when 22 there is no good substitute Using Calculus % change in quantity demanded dQ / Q P dQ x % change in price dP / P Q dP % change in quantity demanded dQ / Q I dQ % change in income dI / I Q dI 23 Examples • Linear Demand • Q = a – bP • Elasticity = dQ / Q P dQ P bP (b) dP / P Q dP Q bP a 24 Elasticity • Elastic – responsive to price changes • Inelastic – not responsive to price changes Examples: - An unconscious bleeding man is brought to the hospital emergency room. - Among hospital patients whose insurance will pay all charges, what would the demand be like for nurse-administered propoxyphene (Darvon), a pain-killer? - Now suppose that the patients are in managed care plans that pressure physicians to use lower-price drugs. What might demand for the Darvon be? - A patient is given a presciption for a drug to control high blood pressure. The patient's insurance doesn't cover drugs, so the 25 patient must pay out of pocket. Elasticity • Demand is more elastic if the decision-maker has an incentive to save money and if there is an adequate substitute for the product or service. 26 What Shifts Demand Curves? • • • • • • • • Change in income Change in a price of a substitute Change in a price of a complement Change in composition of population Change in tastes Change in information Change in availability of credit Change in expectations 27 What Shifts Supply Curve? • • • • • Change in price of inputs Change in technology Change in natural environment Change in availability of credit Change in expectations 28