Transcript Document

Chapter 2
Modeling the Market Process:
A Review of the Basics
© 2004 Thomson Learning/South-Western
Market Models: The Fundamentals
 Defining the Relevant Market
 Market – the interaction between consumers and
producers to exchange a well-defined commodity
 Defining the market context is one of the more critical
steps in economic analysis
 Specifying the Market Model
 Form of the model varies with the objective of the
prospective study and its level of complexity
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The Model of Supply and Demand:
An Overview
 Decisions of sellers are modeled through a supply
function
 Decisions of consumers are modeled through a
demand function
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The Model of Supply and Demand:
An Overview
 The Purpose of the Model
 The primary objective of the supply and demand model
is to facilitate and analysis of market conditions and any
observed change in price
 Conventional supply and demand model must be
modified to account for conditions that weaken the
operation of market forces
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The Model of Supply and Demand:
An Overview
 Building a Basic Model: Competitive
Markets for Private Goods
Assumptions
Large number of buyers and sellers with no
control over price
Homogenous or standardized product
Absence of entry barriers
Perfect information
Private good – a commodity that has two
characteristics, rivalry in consumption and
excludability
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Market Demand
 Demand – the quantities of a good the consumer
is willing and able to purchase at a set of prices
during some discrete time period
 Demand price is considered a measure of the
marginal benefit (MB) associated with consuming
another unit of the good
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Market Demand
 The Law of Demand – There is an inverse
relationship between price and quantity
demanded of a good
 Modeling Individual Demand
 Deriving Market Demand from Individual Demand Data
 Market demand for a private good – the decisions of all
consumers willing and able to purchase a good, derived
by horizontally summing the individual demands
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Market Demand
Figure 2.1 One Consumer’s Demand (d) for Bottled
Water
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Market Demand
Figure 2.2 Market Demand (D) for Bottled Water
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Market Supply
 Supply – the quantities of a good the producer
is willing and able to bring to market at a given
set of prices during some discrete time period
 Variables that potentially affect the pricequantity response of a firm:
 Production technology
 Input prices
 Taxes and subsidies
 Price expectations
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Market Supply
 The Law of Supply – there is a direct
relationship between price and quantity
supplied of a good
 Modeling Individual Supply
 Deriving Market Supply from Individual Supply Data
 Market supply of a private good – the combined decisions
of all producers in a given industry derived by horizontally
summing the individual supplies
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Market Supply
Figure 2.3 One Producer’s Supply (s) of Bottled Water
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Market Supply
Figure 2.4 Market Supply (S) of Bottled Water
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Market Equilibrium
 Supply and demand must be considered
simultaneously to generate a model of price
determination
 The formal theory that price is simultaneously
determined by supply and demand is one of the
most significant in all of economic analysis
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Market Equilibrium
 Equilibrium Price and Quantity
 Equilibrium price – the point at which the market system
has no tendency to change
 Equilibrium quantity – the “market-clearing” price
associated with the equilibrium quantity
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Market Equilibrium
 Market Adjustment to Disequilibrium
 Disequilibrium – if the prevailing market price is at some
level other than the equilibrium level, the market is said
to be in disequilibrium
 Shortage – excess demand of a commodity equal to (QD
– QS), that arises if price is below its equilibrium level
 Surplus – excess supply of a commodity equal to
(QS – QD), that arises if price is above its equilibrium
level
 Price movements serve as a signal that a
shortage or surplus exists, whereas stability or
price suggest equilibrium
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Market Equilibrium
Figure 2.5 Equilibrium in the Market for Bottled Water:
Market Supply and Market Demand
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Economic Criteria of Efficiency
 Allocative efficiency – requires that resources be
appropriated such that the additional benefits to
society are equal to the additional costs incurred
 Evaluating Resource Allocation at the Market Level
 The value society places on the good is equivalent to
the value of the resources given up to produce it
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Economic Criteria of Efficiency
 Evaluating Resource Allocation at the Firm Level
 Assumed motivation governing firm decision making is
profit maximization
 Total profit – total profit is equal to total revenue minus
total costs
 Decision making process relies on changes, the relevant
marginal variables are:
• Marginal Revenue
• Marginal Cost
• Marginal Profit
 Profit maximization – achieved at the output level where
marginal revenue equals marginal cost or where M∏ = 0
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Economic Criteria of Efficiency
Figure 2.6 Competitive Firm’s Profit-Maximizing Equilibrium
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Economic Criteria of Efficiency
 Technical Efficiency – production decisions that generate
maximum output given some stock of resources
 Market forces can achieve technical efficiency so long as
competitive conditions prevail
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Welfare Measures: Consumer
Surplus and Producer Surplus
 Consumer surplus – the net benefit to buyers
estimated by the excess of the marginal benefit
(MB) of consumption over market price (P),
aggregated over all units purchased
 Consumer surplus depends on two distinct notions of
price – one that measures a willingness to pay and on
that measures what is actually paid
 Any disturbance to market equilibrium will change the
size of consumer surplus
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Welfare Measures: Consumer
Surplus and Producer Surplus
Figure 2.7 Consumer Surplus in the Competitive Market for
Bottled Water
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Welfare Measures: Consumer
Surplus and Producer Surplus
 Producer surplus – the net gain to sellers of a good
estimated by the excess of the market price (P) over
marginal cost (MC), aggregated by units sold
 Any market disturbance will change its value and
provide a way to assess any associated welfare gain or
loss to firms
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Welfare Measures: Consumer
Surplus and Producer Surplus
Figure 2.8 Producer Surplus in the Competitive Market for
Bottled Water
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Welfare Measures: Consumer
Surplus and Producer Surplus
 The Welfare of a Society: Sum of Consumer and
Producer Surplus
 Society’s welfare – the sum of consumer surplus and
producer surplus
 Measuring Welfare Changes
 Deadweight loss to society – the net loss of consumer
and producer surplus due to an allocatively inefficient
market event
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Welfare Measures: Consumer
Surplus and Producer Surplus
Figure 2.9 Deadweight Loss to Society Under a Pricing
Regulation in the Bottled Water Market
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