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Demand, Supply, and Equilibrium

in a Perfectly Competitive Market

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The Context: Perfectly Competitive Markets
Market: A group of buyers and sellers of a particular good or service
can be defined narrowly or broadly (e.g., rice vs. food)
at a given point in time (e.g., day, month, year)

Perfect Competition:
Enough buyers and sellers so that no one has an impact on the price
typically with many buyers and sellers
Perfect information about products
No externalities
Only buyer and seller are affected by a transaction
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Willingness to Pay
Willingness to pay (WTP): the maximum amount that a buyer will pay for
a good

Further distinctions are helpful

Marginal willingness to pay (MWTP): WTP for one more unit of a good

Total willingness to pay (TWTP): WTP for any number of units of a good
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An Individuals WTP for good X




Quantity of X Marginal WTP
(MWTP)
1 $4
2 $3
3 $2
4 $1
5 $0
5

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An Individuals Demand Curve
A graph of an individuals MWTP curve is her demand curve

Demand curve: gives the relationship between the price of a good and the
quantity demanded

Law of demand: downward sloping curve reflects diminishing MWTP

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An Individuals Demand Schedule
A table that gives the relationship
between the price and quantity
demanded

Based on the individuals MWTP



Price of X Quantity
Demanded
$5 0
$4 1
$3 2
$2 3
$1 4
$0 5
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Consider a Market with Two Individuals
Price of X
Individuals 1s
Quantity Demanded
Individual 2s
Quantity Demanded
Total
Quantity Demanded
$5 0 0 0
$4 1 2 3
$3 2 4 6
$2 3 6 9
$1 4 8 12
$0 5 10 15
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The Market (Aggregate) Demand Curve
A horizontal summation of individual demand curves

Tells the market quantity demanded at any given price

Also tells the MWTP in the marketthe most someone is WTP for each
additional unit of the good
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A Note on Demand Semantics
Changes in price result in changes in the quantity demanded

Changes in demand imply shifts of the demand curve
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Shifters of the Demand Curve
1. Changes in income, + (-)
Normal goods, + (-)
Inferior goods, - (+)
2. Changes in the price of related goods, + (-)
Substitutes, + (-)
Complements, - (+)
3. Tastes and preferences
4. Number of buyers in the market, + (-) implies + (-)
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A Firms Marginal Cost (MC) of Production
Marginal cost (MC): tells a firms incremental cost of producing an
additional unit of a good

We assume it is increasing (for now)

We ignore the total costs of production (for now)
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A Firms MC of Producing Good X
Quantity of X MC
1 $2
2 $3
3 $4
4 $5
5 $6
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An Firms Supply Curve
A graph of a firms MC curve is its supply curve

Supply curve: gives the relationship between the price of a good and the
quantity supplied

Law of supply: upward sloping curve reflects increasing MC
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A Firms Supply Schedule
A table that gives the relationship
between the price and quantity
supplied

Based on the firms MC
Price of X Quantity
Supplied
$1 0
$2 1
$3 2
$4 3
$5 4
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Consider a Market with Two Firms
Price of X
Firm 1s
Quantity Supplied
Firm 2s
Quantity Supplied
Total
Quantity Supplied
$1 0 0 0
$2 1 2 3
$3 2 4 6
$4 3 6 9
$5 4 8 12
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The Market (Aggregate) Supply Curve
A horizontal summation of the individual firm supply curves

Tells the market quantity supplied at any given price

Also tells the MC in the marketthe lowest cost of producing each
additional unit of the good
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A Note on Supply Semantics
Changes in price result in changes in the quantity supplied

Changes in supply imply shifts of the supply curve
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Shifters of the Supply Curve
1. Changes in input prices, + (-) implies - (+)
2. Changes in the technology of production, such that better
(worse) implies + (-)
3. Number of sellers in the market, + (-) implies + (-)
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Equilibrium: Supply meets Demand
The intersection of the supply and demand curves determines the
equilibrium price and quantity

Market clearing condition: when the quantity supplied equals the quantity
demanded

Given the equations for the supply and demand curves, you can solve
algebraically for P* and Q*
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Equilibrium Proof by Contradiction
If P > P*, then there would be excess supply (a surplus)
Firms would lower prices

If P < P*, then there would be excess demand (a shortage)
Consumers would pay more

Must be true that P = P* and that Q
S
= Q
D
= Q*

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Comparative Static Analysis
Ceteris paribus : other things being equal

An increase (decrease) in demand results in more (less) exchange at a
higher (lower) price

An increase (decrease) in supply results in more (less) exchange at a
lower (higher) price

Simultaneous shifts in supply and demand can generate ambiguous
effects