Chapter 14 Equilibrium and Efficiency Mc Graw-Hill Irwin Copyright

Main Topics ¢What makes a market competitive? ¢Market demand market supply ¢Short-run and long-run competitive equilibrium ¢Efficiency of perfectly competitive markets ¢Measuring surplus using market demand supply curves 14 -2

What Makes a Market Competitive? ¢ Buyers and sellers have absolutely no effect on price ¢ Three characteristics: ¢ Absence of transaction costs ¢ Product homogeneity: products are identical in the eyes of their purchasers ¢ Presence of a large number of sellers, each accounts for a small fraction of market supply ¢ Consumers have many options and buy from the firm that offers the lowest price ¢ Each firm takes the market price as given and can focus on how much it wants to sell at that price ¢ Few markets are perfectly competitive 14 -3

Market Demand Supply ¢ Market demand for a product is the sum of the demands of all individual consumers ¢Graphically, this is the horizontal sum of the individual demand curves ¢For simplicity, assume that all demand comes from consumers and all supply comes from firms ¢ Market supply of a product is the sum of the supply of all the individual sellers ¢Graphically this is the horizontal sum of the individual supply curves ¢Very similar to the procedure for constructing market demand curves 14 -4

Figure 14. 1: Market Demand 14 -5

Figure 14. 2: Market Supply 14 -6

Short-Run vs. Long-Run Market Supply ¢ Long-run and short-run market supply curves may differ for two reasons: ¢ Firm’s short-run and long-run supply curves may differ ¢ Over time, set of firms able to produce in a market may change ¢ Long-run supply curve is found by summing supply curves of all potential suppliers ¢ Free entry in a market implies that anyone who wishes to start a firm has access to the same technology and entry is unrestricted ¢ With free entry, the number of potential firms in a market is unlimited ¢ Long-run market supply curve is a horizontal line at ACmin 14 -7

Figure 14. 4: Long-Run Supply 14 -8

Figure 4. 5: Market Equilibrium ¢ At equilibrium price, Qs=Qd ¢ Market clears at equilibrium price ¢ Given demand supply functions, can use algebra to find the equilibrium 14 -9

Figure 14. 6: Long-Run Competitive Equilibrium ¢ Equilibrium price must equal ACmin ¢ Firms must earn zero profit ¢ Active firms must produce at their efficient scale of production 14 -10

Sample Problem 1 (14. 3): ¢The daily cost of producing pizza in New Haven is C(Q) = 4 Q + (Q 2/40); the marginal cost is MC = 4 + (Q/20). What is the market supply function if there are 10 firms making pizza? If 20 firms are making pizza? What is the market supply curve under free entry?

Responses to Changes in Demand ¢ Market response is different in short-run (number of firms is fixed) than in long-run (with free entry) ¢ Begin from a point of long-run equilibrium, suppose demand curve shifts out ¢ In short run, new equilibrium is achieved through movement along the short-run supply curve ¢ Price rises ¢ In long run, firms enter the market ¢ New equilibrium brings return to initial price but at a higher quantity 14 -12

Price ($/bench) Figure 14. 7: Response to an Increase in Demand S 10 B P* = ACmin = 100 A C S¥ ^ D D 2000 4000 Garden Benches per Month 14 -13

Responses to Changes in Fixed Cost ¢ Start from a long-run equilibrium ¢ Consider the case where fixed costs decrease while variable costs remain the same ¢ In short run: ¢ Average cost curve shifts downward, decreases minimum average cost and minimum efficient scale ¢ Since marginal costs have not changed and number of firms is fixed, equilibrium is unchanged ¢ Active firms make a positive profit ¢ In long-run: ¢ Firms enter market ¢ Market equilibrium shifts, price falls and quantity rises 14 -14

Figure 14. 8: Response to a Decrease in Cost 14 -15

Responses to Changes in Variable Cost ¢ Start from a long-run equilibrium ¢ If variable costs change, firm’s marginal and average cost curves both shift ¢Short-run supply curve shifts ¢Sort-run equilibrium changes ¢ Basic procedure in all cases: ¢Find new short-run equilibrium using new short-run supply curve of initially active firms ¢Find new long-run equilibrium using new long-run supply curve which reflects free entry 14 -16

Price Changes in the Long-Run ¢ So far we’ve assumed that the prices of firms’ inputs do not change ¢ Reasonable if increases in amounts of inputs used are small compared to overall market ¢ Or when supply in input markets is very elastic ¢ In general, though, when demand for a product increases, prices of inputs used to make it may change ¢ This is a general equilibrium effect; the market we are studying and the market for its inputs must all be in equilibrium ¢ Taking the input price effect into account in the analysis of the market response to an increase in demand changes the result ¢ Price of the good rises in the long run 14 -17

Price ($/bench) Figure 14. 11: Price Changes in the Long-Run S 10 B ^ AC min=110 ACmin=100 A ^ E S¥ S¥ C ^ D D 2000 4000 Garden Benches per Month 14 -18

Sample Problem 2 (14. 7): ¢ Suppose the daily demand for pizza in Berkeley is Qd = 1, 525 – 5 P. The variable cost of making Q pizzas per day is C(q) = 3 Q + 0. 01 Q 2, there is a $100 fixed cost (which is avoidable in the long run), and the marginal cost is MC = 3 + 0. 02 Q. There is free entry in the long run. What is the long-run market equilibrium in this market? Suppose demand increases to Qd = 2, 125 – 5 P. If, in the short run, the number of firms is fixed and fixed costs are sunk, what is the new short-run market equilibrium? What is the new long-run market equilibrium if there is free entry and exit in the long run?

Aggregate Surplus and Economic Efficiency ¢ Perfectly competitive market produces an outcome that is economically efficient ¢ Net benefits indicate that consumers’ benefit from the goods exceed the costs of producing them ¢ Aggregate surplus equals consumers’ total willingness to pay for a good less firms’ total avoidable cost of production ¢ Total benefits from consumption equal to willingness to pay ¢ Area under consumer’s demand curve up to that quantity ¢ Total avoidable costs of production include all of a firm’s costs other than sunk costs ¢ Area under its supply curve up to its production level 14 -20

Maximizing Aggregate Surplus ¢ Smith’s The Wealth of Nations (1776) commented on the “invisible hand” of the market ¢ The self-interested actions of each individual lead to economic efficiency ¢ “he intends only his own gain, and he is in this…led by an invisible hand to promote an end which was no part of his intention” ¢ No way to increase aggregate surplus in perfectly competitive markets by changing: ¢ Who consumes the good ¢ Who produces the good ¢ How much of the good is produced and consumed ¢ Competitive markets maximize aggregate surplus 14 -21

Effects of a Change in Who Consumes the Good ¢ Begin from the competitive equilibrium ¢ Take one unit of the good from Consumer A and give it to Consumer B ¢ Cannot increase aggregate surplus ¢Value any consumer attaches to a unit of the good they don’t buy must be less than the market price ¢Value any consumer attaches to a unit of the good they do buy must be more than the market price ¢ If we take the good from someone who purchased it and give it to someone who didn’t, aggregate surplus must fall 14 -22

Effects of a Change in Who Produces the Good ¢ Changing who produces the good can’t increase aggregate surplus ¢ To achieve this, would have to reassign sales in a way that would lower the total cost of production ¢ Begin from the competitive equilibrium ¢ Reduce sales of Producer A by one unit, increase sales of Producer B by one unit ¢ Cost of producing any unit of output that a firm chooses to sell must be less than the equilibrium price ¢ Cost of producing any unit of output that a firm chooses not to sell must exceed the equilibrium price ¢ Any shift in production from one firm to another must raise the total cost of production and lower aggregate surplus 14 -23

Effects of a Change in the Number of Goods ¢ Changing the total number of units of the good produced and consumed also lowers aggregate surplus ¢ Any unit of a good that is produced and consumed in a competitive market equilibrium must be worth more than the market price to the consumers who buy them ¢ Must also cost less than the market price to produce ¢ Those units of output must therefore make a positive contribution to aggregate surplus ¢ Any units that aren’t produced and consumed should not be; they will lower aggregate surplus 14 -24

Measuring Total WTP and Total Avoidable Cost ¢ Market demand supply curves can be used to measure total willingness to pay and total avoidable cost ¢ Measure consumers’ total willingness to pay for the units they consume by the area under the market demand curve up to that quantity ¢When all consumers face the same market price ¢ Measure producers’ total avoidable costs for the units they produce by the area under the market supply curve up to that quantity ¢When all producers face the same market price 14 -25

Figure 14. 18: Measuring Total Willingness to Pay 14 -26

Aggregate Surplus ¢ Can use market supply and demand curves to measure aggregate surplus ¢ Consumers’ total willingness to pay is area under market demand curve up to the quantity consumed ¢ Producers’ total avoidable cost is the area under the market supply curve up to the quantity produced ¢ In a competitive market without any intervention, aggregate surplus is maximized ¢No deadweight loss: reduction in aggregate surplus below its maximum possible value 14 -27

Consumer and Producer Surplus ¢ Consumer surplus is the sum of consumers’ total willingness to pay less their total expenditure ¢Sum of individual consumers’ surpluses ¢Also called aggregate consumer surplus ¢ Producer surplus is the sum of firms’ revenues less avoidable costs ¢Sum of individual firms’ producer surpluses ¢Also called aggregate producer surplus Aggregate surplus = Consumer surplus + Producer Surplus 14 -28

Figure 14. 19: Aggregate, Consumer, and Producer Surplus 14 -29

Sample Problem 3 (14. 15): ¢The market demand function for corn is Qd = 21 – 4 P, and the market supply function is Qd = = 5 P -6, both quantities are measured in billions of bushels per year. What are the aggregate surplus, consumer surplus, and producer surplus at the competitive market equilibrium?