0.

Outline

1. Introduction
1. Introduction

2. How markets work

3. Perfect competition model
4. Demand elasticity
5. Supply and costs

2. How markets work

$$

Consumers

Producers

Consumers and demand

- All individuals that purchase or would like to purchase a
good or service sum up the demand.
- What characterize each consumer is her willingness to pay
(WTP)
- Consumers are heterogeneous with respect to their WTP

Consumers and demand

p

9
8
7

6
5

5
4
D

2
4

Supply and firms

- The set of firms that produce and/or sell a product sum up
the supply

- Firms differ in technology and organization working at different

Marginal Cost of Production (MC)

Supply (S)
p

S
8

6
5
4
3
2
5

Market equilibrium
How consumers (demand) and producers (supply) achieve some
coordination in the market?

CLEARING BY ADJUSTING PRICES

But, how prices adjust?

BY NEGOTIATION, AUCTIONING or
SEARCHING

Market equilibrium
O

Market equilibrium
O
P2

P1
D

Market equilibrium
O
P1

Peq

P1
D

Welfare
Do markets create social welfare?
O

Do consumers and producers gain

some SURPLUS?
Peq

May a social planner organize more

wisely production, consumption and
transactions to create more welfare
surplus for consumers and
producers?

Consumer Surplus (CS)

4
9

Producer Surplus (PS)

O

5
4

D
1

Social Welfare: W=CS+PS

O

3. Price-elasticity of demand

Q P
Ep

P Q

3. Cross-price elasticity of demand

4. Supply and costs

p

=
q

MC

MC

MC

4. Cost functions
Shortrunwithfixed
factors(e.g.capital)

MCsr
AVCsr
ATCsr

FixedCosts(FC)
VariableCoste(VC)
TotalCostsats/r(TCsr)
AverageVariableCostsats/r(AVCsr)
AverageTotalCostsats/r(ATCsr)
MarginalCostsats/r(MCsr)

4. Cost functions
Inthelongrun,all
factorarevariable

MClr

AClr

TotalCostsatl/r(TClr)

qMES

AverageCostsatl/r(AClr)>minimumefficientscale
MarginalCostatl/r(MCrl)>profitmaximazing

5. Equilibrium vs. optimum

Two ways of allocating resources:
1) Market equilibrium: firms compete and max profits
max Profit = TR- TC
2) Optimum: welfare optimization
max W = CS +PS

Assumptions in competition equilibrium

Firms take market pricing as given (large number)
Homogeneous product
Free entry & exit
Perfect information
Firms have not market power

Profit maximizing
Incentive compatibility constrain
max Profit = RT- TC
f.o.c Profit=0 1) IMg=CMg (P=CMg)
s.o.c B<0 2) MC>MR
Participation constrain
Firms cover variable costs 3) TR >= VC
(P>=AVC)

Market equilibrium in the short run

Market Firm
MC

AC
AVC
P*

D
Q*

Competition brings maximum welfare without costly, imperfectly

informed and weak government intervention

Competitive equilibrium at long run

Free entry and exit. Firms of different sizes
CMgLP

CMeLP
P*

D
Q*

qEME

Competiton in the long run drive inefficient firms out of the market