Review of Economic Principles: Supply, Demand, Perfect Competition and Monopoly

 

 

 

Demand:

 

Demand schedule relates a good’s price to the amount that people are willing to buy

 

Key Determinants: income, tastes, price of substitutes, price of complements

 

Typically downward sloping (“Law of Demand”):

 

 

Change in Demand

 

Change in Demand = Shift in the demand curve, caused by changes in the underlying determinants.

 

Note than any change that affects buying behavior, apart from a change in the price of the good, will cause a shift in the demand curve. A change in the price of the good will result in a movement along the demand curve.

 

Example: demand for books.

 

Price elasticity of demand =  Ed = % change in quantity demanded/% change in price = - (ΔQ/Q)/(ΔP/P)

 

 

Supply:

 

Schedule relating a good’s price to the amount that firms are willing to offer

 

Key Determinants: technology, input prices (capital, labor, inputs)

 

Typically upward sloping (“Law of Supply”)

 

 

Change in Supply

 

Change in Supply = shift in the supply curve, caused by changes in the underlying determinants.

 

Example: supply of ice-cream.

 

Price Elasticity of Supply: % change in quantity supplied/% change in price = Es= (ΔQ/Q)/(ΔP/P)

 

 

Competitive Market: idealized market situation where there are many demanders and many suppliers. As each (buyer and) supplier makes up a small fraction of the market, they believe any actions taken will have no effect on market transactions

 

Assume:

a)      free entry and exit

b)      (nearly) identical firms

c)      product homogeneity: e.g. agricultural products

d)      price-taking behavior: treat the market price as given

e)      perfect information

 

 

Competitive Market Equilibrium:

 

The equilibrium is a price, quantity pair (P*, Q*) where both buyers and sellers are satisfied.

 

 

If P < P*, D(P) > S(P) = shortage

 

If P > P*, D(P) < S(P) = surplus

 

 

Change in Demand and Supply

 

Consider the ice cream market. Using the demand and supply curves, suppose that one summer the weather is very hot. How does the affect the market? Now suppose that an earthquake destroys 10 ice-cream factories. How does this affect the market?

 

 

Surplus and Deadweight Loss: Welfare?

 

Consumer Surplus: area below demand curve and above the price.

 

Producer Surplus: area above the supply curve and below the price.

 

Consumer surplus and producer surplus are the two basic tools that economists use to study the welfare of buyers and sellers in a market.

 

Total surplus = (value to buyers – amount paid by buyers) + (amount received by sellers – cost to sellers) = value to buyers – cost to sellers.

 

Deadweight Loss: comes from two sources

a)      willingness to pay exceeds cost, but the good is not produced

b)      willingness to pay is less than cost, but the good is produced

 

 

Monopoly: only one producer in the market, who faces the entire market demand, and sells a product with no close substitutes.

 

Profit Maximization: monopolist will choose to produce that output where MR=MC, p>MC.

 

 

Profitability: since perfectly competitive firms earn no competitive profits in the long run, a monopolist earns higher profits. Should we care?

 

Resource Allocation: of more importance is that monopolists distort the allocation of resources because they intentionally restrict production in order to raise prices.

 

 

 

Summary:

·        Free (perfectly competitive) markets allocate the supply of goods to the buyers who value them most highly, as measured by WTP

 

·        Free markets allocate the demand for goods to the sellers who can produce them at least cost

 

·        Free markets produce the quantity of goods that maximizes the sum of consumer and producer surplus.

 

·        Many markets are not perfectly competitive: market failure exists