THEORY OF MARKETS AAEC 2305 Fundamentals of Ag Economics

Objectives: How Supply & Demand curves interact to determine the prices & quantities of goods & services produced & consumed About markets in time, space, & form Characteristics of a competitive market Determination of Output in a competitive market

Economic Profit Total Revenue Explicit Costs Accounting Profit Explicit Costs Economic Profit “Normal” Profit “Normal” Profit is the opportunity cost of resources supplied by owner of the firm; Economic profit (excess profits) are profits above opportunity costs and explicit costs

Graph Economic profit

Stay in Farming Manage Retail Store TR = $22,000 Explicit Costs = $10,000 Implicit Costs = $11,000 Accounting Profit = $12,000 Economic Profit = $1,000 TR = $11,000 Explicit Costs = $0 Implicit Costs = $11,000 Accounting Profit = $11,000 Economic Profit = $0 Pudge the Corn Farmer

Competition Suppose that economic (excess) profits were that high for corn farming, would Pudge be the only person wanting to farm corn? Excess profits attract new entrants into the business with similar opportunity costs as Pudge.  For those with OC less than Pudge, farming is very attractive  For those with OC equal to Pudge, they are indifferent about farming  For those with OC greater than Pudge, farming is not attractive

Markets A Market is an institution or an arrangement that brings buyers and sellers together. Market Price - is the mutually agreeable price at which willing buyers and willing sellers exchange a good.

Market Equilibrium Market equilibrium occurs when the quantity of a good offered by a sellers at a given price equals the quantity buyers are willing and able to purchase at that same price.  Like the two blades of scissors—which one cuts the paper?

Graph Market Equilibrium

Numerical Example In equilibrium, demand and supply must equal one another: The equilibrium price is $1. To get quantity, simply substitute $1 into either supply or demand: Q = 5,000p = 5,000 sandwiches.

Shifts in Supply and Demand Graph of increase in input cost Graph of increase in demand

Numerical Example—Input Cost Increase Increase in minimum wage shifts supply function The increase in the minimum wage increased the equilibrium price of chicken sandwiches by $0.11

Numerical Example—Demand Increase News of healthy chicken increases demand The health news increased demand, increasing price by $0.20.

Functions of Price Rationing—distribute scarce goods among potential claimants insuring that those that get them are the ones that value them the most Allocative—direct productive resources to different sectors of the economy

Graphs Firm profit Equilibrium Excess Profits and New Entry Short-run vs. Long run effects of demand and supply changes

No-Cash-On-The-Table If the price is “too low,” consumers will buy more to capture their “excess profits” by consuming products at a price less than they were willing to pay If the price is “too high,” producers will produce more to capture their “excess profits” by producing products at a price more than they willing to accept

No-Cash-On-The-Table Why are all lanes on a crowded, multi-lane freeway moving at about the same speed? Why do grocery check-out lines all tend to be about the same length?

Perfect Competition Large number of buyers and sellers  At least a relatively large number of comparably sized firms Relatively homogeneous products  Basic commodities Low barriers to entry  Relatively easy to get in and out of the market Economic conditions  Small portion of consumer’s budget and relatively large production

Graph Hairstylists and Aerobic Instructors

Economic Rent vs. Economic Profit Profit is earnings above explicit and implicit costs; these are driven toward zero by competition Rent is payment for a factor of production in excess of the reservation price  Influenced by the “uniqueness” of the input

Efficiency (Pareto Efficiency) Efficiency—if price and quantity take anything other than their equilibrium values, a transaction that will make someone better off without making anyone else worse off can always be found A perfectly competitive market is the most efficient market form. It results in the highest possible total welfare of everyone in the market.

Surplus Surplus is simply the economic benefits less the costs In equilibrium, surplus is the total economic benefits accumulated from consuming/producing a good across all units at the equilibrium price.  Consumer surplus is the area under the demand curve and above the equilibrium price  Producer surplus is the area above the supply function and below the equilibrium price (also called profit)

Calculation Consumer surplus is given by: Producer surplus is given by:

Numerical Example Back to our chicken sandwich example: First find P d : Set demand = 0 to get y- intercept: Find surplus:

Changes in Consumer Surplus Graph of Change in Demand and Change in Consumer Surplus

Numerical Example Solving for y-intercept Calculating new CS: Change in consumer surplus: