Chapter 8

 DERIVATION OF THE MARKET SUPPLY CURVE ◦ Firm Supply Curve-- Own-Price Elasticity of Supply ◦ Market Supply Curve-- Producer Surplus  MARKET EQUILIBRIUM UNDER PERFECT COMPETITION ◦ Market Equilibrium ◦ Total Economic Surplus ◦ Applicability to Policy Analysis  ADJUSTMENTS TO MARKET EQUILIBRIUM ◦ Market Disequilibrium-- Market Shortage ◦ Market Surplus-- Length of Adjustment Period ◦ Cobweb Adjustment Cycle

Page 131 Firm’s supply curve starts at shut down level of output Firm’s supply curve starts at shut down level of output

Page 131 Profit maximizing firm will desire to produce where MC=MR Profit maximizing firm will desire to produce where MC=MR

Page 131 Economic losses will occur beyond output O MAX, where MC > MR Economic losses will occur beyond output O MAX, where MC > MR

Market supply curve can be thought of as the horizontal summation of the supply decisions of all firms in the market. Here, at a price of $1.50, Gary would supply 2 tons of broccoli and Ima would supply 1 ton, giving a market supply of 3 tons. Market supply curve can be thought of as the horizontal summation of the supply decisions of all firms in the market. Here, at a price of $1.50, Gary would supply 2 tons of broccoli and Ima would supply 1 ton, giving a market supply of 3 tons. + = Page 132 Building the Market Supply Curve

Quantity Point Price Supplied A 1 2 B 2 3 C 3 6 D 4 8 A B C D P Q

Own-Price elasticity of supply =

Calculate own-price elasticity of supply between $2 and $3.  Q P  P Q X  Q = 3,  P = 1, Q = 4.5, P = 2.5

 Q P  P Q X X = 1.66= ELASTIC 1%  P gives rise to a 1.66%  Q in quantity

Producer surplus is a fancy term economists use for profit. We measure producer surplus as the area above the supply curve and below the market equilibrium price. Page 132

Producer surplus is a fancy term economists use for profit. We measure producer surplus as the area above the supply curve and below the market equilibrium price. Total economic surplus is therefore equal to consumer surplus discussed in Chapter 4 plus producer surplus. Page 132

Page 133 Producer surplus at $4 is equal to area ABC Producer surplus at $4 is equal to area ABC FG Product price Market Price of $4

Page 133 FG Total revenue at $4 would be area 0ABF while total cost would be area 0CBF. Thus Profit = area 0ABF-area 0CBF Total revenue at $4 would be area 0ABF while total cost would be area 0CBF. Thus Profit = area 0ABF-area 0CBF Product price C

Page 133 FG Total revenue at $4 would be area 0ABF while total cost would be area 0CBF. Thus Profit = area 0ABF-area 0CBF Total revenue at $4 would be area 0ABF while total cost would be area 0CBF. Thus Profit = area 0ABF-area 0CBF Product price Area 0ABF can be found by multiplying price time quantity, or $4 times output F C

Page 133 FG Producer surplus at $6 is equal to area EDC Producer surplus at $6 is equal to area EDC Product price Suppose Price Increased to $6

Page 133 FG Total revenue at $6 would be area 0EDG while total cost would be area 0CDG. Thus profit would be area 0EDG minus area 0CDG, or CED. Total revenue at $6 would be area 0EDG while total cost would be area 0CDG. Thus profit would be area 0EDG minus area 0CDG, or CED. Product price C

Page 133 The gain in producer surplus if the price increases from $4 is equal to area AEDB The gain in producer surplus if the price increases from $4 is equal to area AEDB FG Producers are better off economically by responding to this price increase by producing output G Producers are better off economically by responding to this price increase by producing output G C

We need to distinguish between movement along a demand or supply curve, and shifts in the demand or supply curve.

We need to distinguish between movement along a demand or supply curve, and shifts in the demand or supply curve. Movement along a curve is referred to as a “change in the quantity demanded or supply”. A shift in a curve is referred to as a “change in demand or supply”.

Page 135 Increase in demand pulls up price from P e to P e * Increase in demand pulls up price from P e to P e * Decrease in demand pushes price down from Pe to Pe* Decrease in demand pushes price down from Pe to Pe*

Page 135 Increase in supply pushed price down from P e to P e * Increase in supply pushed price down from P e to P e * Decrease in supply pulls up price from P e to P e * Decrease in supply pulls up price from P e to P e *

We can use the concepts of market demand and supply to assess the effects of events in the economy have upon the economic well being of consumers and products in a particular market. We assess these effects using the concept of Consumer surplus introduced in Chapter 4 with producer surplus discussed here.

ECONOMIC SURPLUS Economic Surplus = Consumer Surplus + Producer Surplus Consumer Surplus = area #1, Producer Surplus = area #2

An Example of Economic Welfare Analysis Assume a drought occurs that results in a decrease in supply from S to S*. Before this happened, consumer surplus was area while producer surplus was equal to area 6+7. Assume a drought occurs that results in a decrease in supply from S to S*. Before this happened, consumer surplus was area while producer surplus was equal to area 6+7. Page 137

An Example of Economic Welfare Analysis After the decrease in supply, consumer surplus is just area 3. They lose area 4 and area 5. Producers gain area 4 but lose area 7. After the decrease in supply, consumer surplus is just area 3. They lose area 4 and area 5. Producers gain area 4 but lose area 7. Page 137

An Example of Economic Welfare Analysis Page 137 Consumers are therefore worse off because of the drought. Producers are also worse off if area 4 is less than area 7. Society loses area 5+7. Consumers are therefore worse off because of the drought. Producers are also worse off if area 4 is less than area 7. Society loses area 5+7.

CHANGE IN ECONOMIC SURPLUS Δ in economic surplus = = -5-7

Measuring Surplus Levels Product price D S $4 10 $1 $7 Consumer surplus is equal to (10 x (7-4))÷2, or $15 Consumer surplus is equal to (10 x (7-4))÷2, or $15

Measuring Surplus Levels Product price D S $4 10 $1 $7 Consumer surplus is equal to (10 x (7-4))÷2, or $15 Consumer surplus is equal to (10 x (7-4))÷2, or $15 Producer surplus is Equal to (10 x (4-1))÷2, or $15 Producer surplus is Equal to (10 x (4-1))÷2, or $15

Product price D S $4 10 $1 $7 Consumer surplus is equal to (10 x (7-4))÷2, or $15 Consumer surplus is equal to (10 x (7-4))÷2, or $15 Producer surplus is Equal to (10 x (4-1))÷2, or $15 Producer surplus is Equal to (10 x (4-1))÷2, or $15 Total economic surplus is therefore $30… Total economic surplus is therefore $30… Measuring Surplus Levels

Market Surplus If the price is P S, producers would supply Q S while consumers would only want Q D at this high price. If the price is P S, producers would supply Q S while consumers would only want Q D at this high price. Page 138

Market Shortage If the price is P D, producers would only supply Q D while consumers want Q D at this low price. If the price is P D, producers would only supply Q D while consumers want Q D at this low price. Page 138

Markets converge to equilibrium over time unless other events in the economy occur. One explanation for this adjustment which makes sense in agriculture is the Cobweb theory. This name stems from the spider like trail the adjustment process makes.

Year Two Reactions Producers use last year’s price as their expected price for year 2. Consumers on the other hand pay this year’s price determined by Q 2. Producers use last year’s price as their expected price for year 2. Consumers on the other hand pay this year’s price determined by Q 2. Page 140

Year Three Reactions P2P2 P3P3 Producers now decide to produce less at the lower expected price. This lower quantity pushes price up to P 3 in year 3. Producers now decide to produce less at the lower expected price. This lower quantity pushes price up to P 3 in year 3. Page 140

Cobweb Pattern Over Time Market equilibrium Market equilibrium The market converges to market equilibrium where demand intersects supply at price P E. In some markets, this adjustment period may only be months or even weeks rather than years assumed here. The market converges to market equilibrium where demand intersects supply at price P E. In some markets, this adjustment period may only be months or even weeks rather than years assumed here. Page 140