Consumption, Production, Welfare B: Competitive markets (partial eq) Univ. Prof. dr. Maarten Janssen University of Vienna Winter semester 2013

Must individual supply curve always be upward sloping? Supply curve denoted by s(p;w) – Individual suppliers take input and output price as given if they are small relative to the respective markets Profit maximization implies that 2nd order condition is fulfilled: mc are increasing. Thus, situation here is quite different from situation whether demand should be downward sloping. – What is the difference?

Aggregate supply Aggregate supply is, in principle, the sum of the individual supply curves. – Aggregation is done horizontally – But only if the assumption of given input prices holds also at the market level (this industry is only one of many using that input) – When input prices are not given at the market level, situation on right will happen – Effective supply curves may be downward sloping if input prices increase sufficiently price y

Aggregate demand

Market equilibrium Market equilibrium is a price at which all consumers and suppliers can realize their optimal choice. Does it always exist? p y D(p) S(p) p y D(p) S(p) p y D(p) S(p)

Existence

Stability of equilibrium Nice to know that equilibrium exists (under some conditions), but may we expect it to happen in the real world? – Or at least a tendency in that direction. – Problem is that in the theory no one is supposed to have an influence on price, so question is how do prices emerge? – What type of information is required to reach a market equilibrium? Two processes: tatonnement, expectation driven dynamics

Tatonnement p z(p)

Cobweb (expectation) process p y D(p) S(p)

Information requirements If these processes work, then the great thing is that individual agents only need to know the prices, and the market system then performs the rest – Information decentralisation – Still remains somewhat of a mystery In planned economies, to determine the prices, one planning organisation needs to know all cost curves and people‘s preferences to calculate the best prices – Impossible task

Long-run equilibrium So far, we studied „short-run“ equilibrium where the number of firms is fixed. In short- run, firms can make profits. In long-run, when there is profits, new firms enter the market. – Note this is based on notion of opportunity cost – Note this is a different notion of „long-run“ than when talking about cost. We may call this „ultra long-run“

Short-run vs Long-run dynamics P y ATC MC p Q Individual firm Market level S(p) D(p)

Long-run equilibrium Long-run supply curve is horizontal at level of minimum of average total cost curve. – If price would be higher, there will be entry in the industry – If price is lower, there will be exit S(p) D(p) p Q

What about welfare? Consumer surplus: Willingness to pay – what has to be paid (blue area) Producer surplus: revenue – cost (green area) Total Surplus: sum of the two (when there is no government) p y D(p) S(p) Partial equilibrium outcome is Pareto- efficicient as there does not exist another possible outcome such that no decision maker is worse off and at least one is strictly better off.

Other possible arrangements Price floor above competitive price (red line) Why to introduce it? – Protect suppliers? (think of minimum wage and potential employees) What happens to total surplus? Are suppliers better off? p y D(p) S(p) Similar analysis for price ceilings (for example, appartment rent ceilings). Who benefits? Interventions usually create their own interest groups and then later difficult to change

When is Consumer Surplus appropriate measure? Consumer surplus is area under walrasian demand Earlier we said appropriate measure is area under Hicksian demand (EV or CV, depending on which price is taken as reference point). CS in between, but exactly right if there is no income effect – U(x) + m X h(p,u’) p p’ h(p,u) x(p,w)

Non-equilibrium price and Pareto efficiency At equilibrium quantity marginal cost of producing extra unit, equal to marginal willingness to pay. At larger quantity, marginal cost of producing extra unit larger than marginal willingness to pay – Better not to produce that extra unit At larger quantity, marginal cost of producing extra unit smaller than marginal willingness to pay – Better to produce that extra unit