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Demand, Supply, and Equilibrium in a Perfectly Competitive Market 1 The Context: “Perfectly Competitive Markets” • A group of buyers and sellers of a particular good or service – can be defined narrowly or broadly (e.g., rice vs. food) – at a given point in time (e.g., day, month, year) • Enough buyers and sellers so that no one has an impact on the price – typical with many buyers and sellers 2 Willingness to Pay • Willingness to pay (WTP): the maximum amount that a buyer will pay for a good • Further distinctions are helpful… • Marginal willingness to pay (MWTP): WTP for one more unit of a good • Total willingness to pay (TWTP): WTP for any number of units of a good 3 An Individual’s WTP for good X Quantity of X Marginal WTP (MWTP) Total WTP (TWTP) 1 $4 $4 2 $3 $7 3 $2 $9 4 $1 $10 5 $0 $10 5 4 An Individual’s Demand Curve • A graph of an individual’s MWTP curve is her demand curve • Demand curve: gives the relationship between the price of a good and the quantity demanded • Law of demand: downward sloping curve reflects diminishing MWTP 5 An Individual’s Demand Schedule • A table that gives the relationship between the price and quantity demanded Price of X Quantity Demanded $5 0 • Based on the individual’s MWTP $4 1 $3 2 $2 3 $1 4 $0 5 6 Consider a Market with Two Individuals Price of X Individuals 1’s Quantity Demanded Individual 2’s Quantity Demanded Total Quantity Demanded $5 0 0 0 $4 1 2 3 $3 2 4 6 $2 3 6 9 $1 4 8 12 $0 5 10 15 7 The Market (Aggregate) Demand Curve • A horizontal summation of individual demand curves • Tells the market quantity demanded at any given price • Also tells the MWTP in the market—the most someone is WTP for each additional unit of the good 8 A Note on Demand Semantics • Changes in price result in “changes in the quantity demanded” • “Changes in demand” imply shifts of the demand curve 9 Shifters of the Demand Curve 1. Changes in income, + (-) • Normal goods, + (-) • Inferior goods, - (+) 2. Changes in the price of related goods, + (-) • Substitutes, + (-) • Complements, - (+) 3. Tastes and preferences 4. Expectations 5. Number of buyers in the market, + (-) implies + (-) 10 A Firm’s Marginal Cost (MC) of Production • Marginal cost (MC): tells a firm’s incremental cost of producing an additional unit of a good • We assume it is increasing (for now) • We ignore the total costs of production (for now) 11 A Firm’s MC of Producing Good X Quantity of X MC 1 $2 2 $3 3 $4 4 $5 5 $6 12 An Firm’s Supply Curve • A graph of a firm’s MC curve is its supply curve • Supply curve: gives the relationship between the price of a good and the quantity supplied • Law of supply: upward sloping curve reflects increasing MC 13 A Firm’s Supply Schedule • A table that gives the relationship between the price and quantity supplied • Based on the firm’s MC Price of X Quantity Supplied $1 0 $2 1 $3 2 $4 3 $5 4 14 Consider a Market with Two Firms Price of X Firm 1’s Quantity Supplied Firm 2’s Quantity Supplied Total Quantity Supplied $1 0 0 0 $2 1 2 3 $3 2 4 6 $4 3 6 9 $5 4 8 12 15 The Market (Aggregate) Supply Curve • A horizontal summation of the individual firm supply curves • Tells the market quantity supplied at any given price • Also tells the MC in the market—the lowest cost of producing each additional unit of the good 16 A Note on Supply Semantics • Changes in price result in “changes in the quantity supplied” • “Changes in supply” imply shifts of the supply curve 17 Shifters of the Supply Curve 1. Changes in input prices, + (-) implies - (+) 2. Changes in the technology of production, such that better (worse) implies + (-) 3. Expectations 4. Number of sellers in the market, + (-) implies + (-) 18 Equilibrium: Supply “meets” Demand • The intersection of the supply and demand curves determines the equilibrium price and quantity • Market clearing condition: when the quantity supplied equals the quantity demanded • Given the equations for the supply and demand curves, you can solve algebraically for P* and Q* 19 Equilibrium Proof by Contradiction • If P > P*, then there would be excess supply (a surplus) – Firms would lower prices • If P < P*, then there would be excess demand (a shortage) – Consumers would pay more • Must be true that P = P* and that QS = QD = Q* 20 Comparative Static Analysis Ceteris paribus : other things being equal • An increase (decrease) in demand results in more (less) exchange at a higher (lower) price • An increase (decrease) in supply results in more (less) exchange at a lower (higher) price • Simultaneous shifts in supply and demand can generate ambiguous effects 21