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Chapter 8. Perfect Competition. © 2004 Thomson Learning/South-Western. Timing of a Supply Response. A supply response is the change in quantity of output in response to a change in demand conditions. The pattern of equilibrium prices will be different depending upon the time period
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Chapter 8 Perfect Competition © 2004 Thomson Learning/South-Western
Timing of a Supply Response • A supply response is the change in quantity of output in response to a change in demand conditions. • The pattern of equilibrium prices will be different depending upon the time period • In the very short run, quantity is fixed so there is no supply response
Timing of a Supply Response • In the short run existing firms may change the quantity they are supplying, but no firms enter or exit the market. • In the long run firms can further change the quantity supplied and new firms may enter the market.
Pricing in the Very Short Run • The market period (very short run) is a short period of time during which quantity supplied is fixed. • In this period, price acts to ration demand as it adjusts to clear the market. • This situation is illustrated in Figure 8.1 where supply is fixed at Q*.
FIGURE 8.1: Pricing in the Very Short Run Price S P1 D Quantity per week 0 Q*
Pricing in the Very Short Run • When demand is represented by the curve D, P1 is the equilibrium price. • The equilibrium price is the price at which the quantity demanded by buyers of a good is equal to the quantity supplied by sellers of the good.
Shifts in Demand: Price as a Rationing Device • If demand were to increase, as illustrated by the new demand curve D’ in Figure 8.1, P1 is no longer the equilibrium price since the quantity demanded exceeds the quantity supplied. • The new equilibrium price is now P2 where price has rationed the good to those who value it the most.
FIGURE 8.1: Pricing in the Very Short Run Price S P2 P1 D’ D Quantity per week 0 Q*
APPLICATION 8.1: Internet Auctions • Auctions on the internet have rapidly become one of the most popular ways of selling all manner of goods. • There is a sense that internet auctions resemble the theoretical situation illustrated in Figure 8.1…the goods are in fixed supply and will be sold for whatever bidders are willing to pay. • However, this view of things may be too simple because it ignores dynamic elements which may be present in suppliers’ decisions.
APPLICATION 8.1: Internet Auctions • A quick examination of internet auction sites suggests that operators employ a variety of features in their auctions. • “Reserve” prices, bidding history, and “buy it now” prices are all features offered at various sites. • Attempts to answer the many questions that surround the returns to operators usually focus on the uncertainties inherent in the auction process and how bidders respond to them.
APPLICATION 8.1: Internet Auctions • Because buyers and sellers are total strangers in internet auctions, a number of special provisions have been developed to mitigate the risks of fraud that the parties might encounter in such situations. • The primary risk facing bidders is in knowing that the goods being offered meet expected quality standards. • Previous bidders provide rankings to many of the auction sites.
APPLICATION 8.1: Internet Auctions • For sellers, the primary risk is that they will not be paid. • Various intermediaries (such as Pay Pal) have been developed to address this problem.
Applicability of the Very Short-Run Model • This model may only apply where the goods are very perishable. • It is usually assumed that a rise in price will prompt producers to bring additional quantity to the market. • This can result from greater production, or, if the goods are durable, from existing stock held by producers.
Short-Run Supply • In the short-run the number of firms is fixed as no firms are able to enter or leave the market. • However, existing firms can adjust their quantity in response to price changes. • Because of the large number of firms, each firm is treated as a price taker.
Construction of a Short-Run Supply Curve • The quantity that is supplied is the sum of the quantities supplied by each firm. • The short-run market supply curve is the relationship between market price and quantity supplied of a good in the short run. • In Figure 8.2 it is assumed that there are only two firms, A and B.
FIGURE 8.2: Short-Run Market Supply Curve Price Price Price SA P qA1 Output 0 Output 0 Quantity per week 0 (a) Firm A (b) Firm B (c) The Market
FIGURE 8.2: Short-Run Market Supply Curve Price Price Price SB SA P qA1 qB1 Output 0 Output 0 Quantity per week 0 (a) Firm A (b) Firm B (c) The Market
FIGURE 8.2: Short-Run Market Supply Curve Price Price Price SB S SA P qA1 0 qB1 0 Output Output 0 Q1 Quantity per week (a) Firm A (b) Firm B (c) The Market
Construction of a Short-Run Supply Curve • Both firm A’s and firm B’s short-run supply curves (their marginal cost curves) are shown in Figure 8.2(a) and Figure 8.2(b) respectively. • The market supply curve is the horizontal sum of the two firms are every price. • In Figure 8.2(c), Q1 equals the sum of q1A and q1B.
Short-Run Price Determination • Figure 8.3 (b) shows the market equilibrium where the market demand curve D and the short-run supply curve S intersect at a price of P1 and quantity Q1. • This equilibrium would persist since what firms supply at P1 is exactly what people want to buy at that price.
FIGURE 8.3: Interaction of Many Individuals and Firms Determine market price in the Short Run SMC Price Price S Price SAC P1 D d q1 q2 0 Q1 Q2 Quantity per week 0 q1 q2 q1 ‘ 0 Output Quantity (a) Typical Firm (b) The Market (c) Typical Person
FIGURE 8.3: Interaction of Many Individuals and Firms Determine market price in the Short Run SMC Price Price S Price SAC P2 D’ P1 d’ D d q1 q2 0 Q1 Q2 Quantity per week 0 q1 q2 q1 ‘ 0 Output Quantity (a) Typical Firm (b) The Market (c) Typical Person
Functions of the Equilibrium Price • The price serves as a signal to producers about how much should be produced. • To maximize profit, firms will produce the output level for which marginal costs equal P1. • This yields an aggregate production of Q1.
Functions of the Equilibrium Price • Given the price, utility maximizing individuals will decide how much of their limited incomes to spend • At price P1 the total quantity demanded is Q1. • No other price brings about the balance of quantity demanded and quantity supplied. • These situations are depicted in Figure 8.3 (a) and (b) for the typical firm and individual, respectively.
Effect of an Increase in Market Demand • If the typical person’s demand for the good increases from d to d’, the entire market demand curve will shift to D’ as shown in figure 8.3. • The new equilibrium is P2, Q2 where a new balance between demand and supply is established.
Effect of an Increase in Market Demand • The increase in demand resulted in a higher equilibrium price, P2 and a greater equilibrium quantity, Q2. • P2 has rationed the typical person’s demand so that only q2 is demanded rather than the q’1 that would have been demanded at P1. • P2 also signals the typical firm to increase production from q1 to q2.
Shifts in Demand Curves • Demand will increase, shift outward, because • Income increases • The price of a substitute rises • The price of a complement falls • Preferences for the good increase
Shifts in Demand Curves • Demand will decrease, shift inward, because • Income falls • The price of a substitute falls • The price of a complement rises • Preferences for the good diminish
Shifts in Supply Curves • Supply will increase, shift outward, because • Input prices fall • Technology improves • Supply will decrease, shift inward, because • Input prices rise
Short-Run Supply Elasticity • The short-run elasticity of supply is the percentage change in quantity supplied in the short run in response to a 1 percent change in price.
Short-Run Supply Elasticity • If a 1percent increase in price causes firms to increase quantity supplied by more than 1 percent, supply is elastic. • If a 1 percent increase in price causes firms to increase quantity supplied by less than 1 percent, supply is inelastic.
Shits in Supply Curves and the Importance of the Shape of the Demand Curve • The effect of a shift in supply upon equilibrium levels of P and Q depends upon the shape of the demand curve. • If demand is elastic, as in Figure 8.4 (a), a decrease in supply has a small effect on price but a relatively large effect on quantity. • If demand is inelastic, as in Figure 8.4 (b), the decrease in supply has a greater effect on price than on quantity.
FIGURE 8.4: Effect of a Shift in the Short-Run Supply Curve on the Shape of the Demand Curve Price Price S S D P P D Quantity per week Q 0 0 Q Quantity per week (a) Elastic Demand (b) Inelastic Demand
FIGURE 8.4: Effect of a Shift in the Short-Run Supply Curve on the Shape of the Demand Curve S’ Price Price S’ S S P’ P’ D P P D Q’ Quantity per week Q’ Q 0 0 Q Quantity per week (a) Elastic Demand (b) Inelastic Demand
Shifts in Demand Curves and the Importance of the Shape of the Supply Curve • The effect of a shift in demand upon equilibrium levels of P and Q depends upon the shape of the supply curve. • If supply is inelastic, as in Figure 8.5 (a), the effect on price is much greater than on quantity. • If the supply curve is elastic, as in Figure 8.5 (b), the effect on price is relatively smaller than the effect on quantity.
Figure 8.5: Effect of A shift in the Demand Curve Depends on the Shape of the Short-Run Supply Curve S Price Price S P’ P P D D Quantity per week 0 Q 0 Q Quantity per week (a) Inelastic Supply (b) Elastic Supply
Figure 8.5: Effect of A shift in the Demand Curve Depends on the Shape of the Short-Run Supply Curve S Price Price S P’ P’ P P D’ D’ D D Quantity per week 0 Q Q’ 0 Q Q’ Quantity per week (a) Inelastic Supply (b) Elastic Supply
APPLICATION 8.2: Ethanol Subsidies in the United States and Brazil • Ethanol has potentially desirable properties as a fuel for automobiles or additive to gasoline that may reduce air pollution. • Several governments have adopted subsides to producers of ethanol. • One way to show the effect of a subsidy is to treat it as a shift in the short-run supply curve as shown in Figure 1.
APPLICATION 8.2: Figure 1: Ethanol Subsidies Shift the Supply Curve Price Price ($/gallon) S1 P1 D Q1 0 Quantity (million gallons)
APPLICATION 8.2: Figure 1: Ethanol Subsidies Shift the Supply Curve Price Price ($/gallon) S1 S2 P1 P2 Subsidy D Q2 Q1 0 Quantity (million gallons)
APPLICATION 8.2: Ethanol Subsidies in the United States and Brazil • The subsidy shifts out the supply curve (by about 54 cents-a-gallon in the U.S.) which results in a quantity demanded increase from Q1 to Q2. • The total cost of the subsidy depends upon the per-gallon amount and on the amount of the increase in quantity demanded.
APPLICATION 8.2: Ethanol Subsidies in the United States and Brazil • In the U.S. it is made from corn, and the subsidy is primarily found in Iowa where many major corn producers are located. • In Brazil it is made from sugar cane and was heavily subsidized until Economic liberalization in the 1990s. • Due to political pressure from producers, the subsidy is again being proposed.
A Numerical Illustration • Suppose the quantity of cassette tapes demanded per week (Q) depends on the price of the tapes (P) per equation 8.2, • Suppose short-run supply is given by equation 8.3.
A Numerical Illustration • Figure 8.6 shows the graph for these equations. • Since the supply curve intersects the vertical axis at P = 2, this is the shutdown price. • The equilibrium price is $6 with people demanding 4 tapes which equals the amount supplied by the firms.
FIGURE 8.6: Demand and Supply Curves for Cassette Tapes Price S 10 6 2 D 0 4 10 Tapes per week
A Numerical Illustration • If the demand increased as reflected in equation 8.4, the former equilibrium price and quantity would no longer hold. • As shown in Figure 8.6, the new equilibrium price is $7 where the quantity demanded and supplied of tapes is 5.
FIGURE 8.6: Demand and Supply Curves for Cassette Tapes Price $12 S 10 7 6 5 2 D’ D 0 3 4 5 6 10 12 Tapes per week
A Numerical Illustration • Table 8.2 shows the two cases. • After the increase in demand, there is an excess demand for tapes at the old equilibrium price of $6. • The increase in price from $6 to $7 restores equilibrium in the market.
TABLE 8.2: Supply and Demand Equilibrium in the Market for Cassette Tapes New equilibrium Initial equilibrium