Chapter 14

Equilibrium and Efficiency

McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All

Rights Reserved.
 Main Topics

What makes a market competitive?

Market demand and market supply
Short-run and long-run competitive
equilibrium
Efficiency of perfectly competitive
markets
Measuring surplus using market demand
and supply curves

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 What Makes a Market
Competitive?
 Buyers and sellers have absolutely no effect on price
 Three characteristics:
 Absence of transaction costs
 Product homogeneity: products are identical in the eyes of
their purchasers
 Presence of a large number of sellers, each accounts for a
small fraction of market supply
 Consumers have many options and buy from the firm
that offers the lowest price
 Each firm takes the market price as given and can
focus on how much it wants to sell at that price
 Few markets are perfectly competitive

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 Market Demand and Supply
 Market demand for a product is the sum of the
demands of all individual consumers
 Graphically, this is the horizontal sum of the
individual demand curves
 For simplicity, assume that all demand comes from
consumers and all supply comes from firms
 Market supply of a product is the sum of the
supply of all the individual sellers
 Graphically this is the horizontal sum of the
individual supply curves
 Very similar to the procedure for constructing
market demand curves

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Figure 14.1: Market Demand

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Figure 14.2: Market Supply

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 Short-Run vs. Long-Run
Market Supply
 Long-run and short-run market supply curves may differ
for two reasons:
 Firm’s short-run and long-run supply curves may differ
 Over time, set of firms able to produce in a market may change
 Long-run supply curve is found by summing supply
curves of all potential suppliers
 Free entry in a market implies that anyone who wishes
to start a firm has access to the same technology and
entry is unrestricted
 With free entry, the number of potential firms in a
market is unlimited
 Long-run market supply curve is a horizontal line at
ACmin

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Figure 14.4: Long-Run Supply

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 Figure 4.5: Market Equilibrium

 At equilibrium price,
Qs=Qd
 Market clears at
equilibrium price
 Given demand and
supply functions, can
use algebra to find
the equilibrium

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 Figure 14.6: Long-Run
Competitive Equilibrium
 Equilibrium price
must equal ACmin
 Firms must earn zero
profit
 Active firms must
produce at their
efficient scale of
production

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 Sample Problem 1 (14.3):
The daily cost of producing pizza in New
Haven is C(Q) = 4Q + (Q2/40); the
marginal cost is MC = 4 + (Q/20). What is
the market supply function if there are 10
firms making pizza? If 20 firms are making
pizza? What is the market supply curve
under free entry?
 Responses to Changes in
Demand
 Market response is different in short-run (number of
firms is fixed) than in long-run (with free entry)
 Begin from a point of long-run equilibrium, suppose
demand curve shifts out
 In short run, new equilibrium is achieved through
movement along the short-run supply curve
 Price rises
 In long run, firms enter the market
 New equilibrium brings return to initial price but at a higher
quantity

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Figure 14.7: Response to an
Increase in Demand
Price ($/bench)

S10

B
A C
P* = ACmin S
∞
= 100
^
D
D

2000 4000

Garden Benches per Month

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 Responses to Changes in
Fixed Cost
 Start from a long-run equilibrium
 Consider the case where fixed costs decrease while
variable costs remain the same
 In short run:
 Average cost curve shifts downward, decreases minimum
average cost and minimum efficient scale
 Since marginal costs have not changed and number of firms is
fixed, equilibrium is unchanged
 Active firms make a positive profit
 In long-run:
 Firms enter market
 Market equilibrium shifts, price falls and quantity rises

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Figure 14.8: Response to a
Decrease in Cost

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 Responses to Changes in
Variable Cost
 Start from a long-run equilibrium
 If variable costs change, firm’s marginal and
average cost curves both shift
 Short-run supply curve shifts
 Sort-run equilibrium changes
 Basic procedure in all cases:
 Find new short-run equilibrium using new short-run
supply curve of initially active firms
 Find new long-run equilibrium using new long-run
supply curve which reflects free entry

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 Price Changes in the Long-Run

 So far we’ve assumed that the prices of firms’ inputs do

not change
 Reasonable if increases in amounts of inputs used are small
compared to overall market
 Or when supply in input markets is very elastic
 In general, though, when demand for a product
increases, prices of inputs used to make it may change
 This is a general equilibrium effect; the market we are
studying and the market for its inputs must all be in
equilibrium
 Taking the input price effect into account in the
analysis of the market response to an increase in
demand changes the result
 Price of the good rises in the long run
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Figure 14.11: Price Changes in
the Long-Run
Price ($/bench)

S10

B
^ E ^
AC min=110 S∞
ACmin =100 S
A C ∞
^
D
D

2000 4000

Garden Benches per Month

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 Sample Problem 2 (14.7):
 Suppose the daily demand for pizza in Berkeley is
Qd = 1,525 – 5P. The variable cost of making Q
pizzas per day is C(q) = 3Q + 0.01Q2, there is a
$100 fixed cost (which is avoidable in the long
run), and the marginal cost is MC = 3 + 0.02Q.
There is free entry in the long run. What is the
long-run market equilibrium in this market?
Suppose demand increases to Qd = 2,125 – 5P. If,
in the short run, the number of firms is fixed and
fixed costs are sunk, what is the new short-run
market equilibrium? What is the new long-run
market equilibrium if there is free entry and exit in
the long run?
 Aggregate Surplus and
Economic Efficiency
 Perfectly competitive market produces an outcome that is
economically efficient
 Net benefits indicate that consumers’ benefit from the goods
exceed the costs of producing them
 Aggregate surplus equals consumers’ total willingness to
pay for a good less firms’ total avoidable cost of production
 Total benefits from consumption equal to willingness to
pay
 Area under consumer’s demand curve up to that quantity
 Total avoidable costs of production include all of a firm’s
costs other than sunk costs
 Area under its supply curve up to its production level

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 Maximizing Aggregate Surplus
 Smith’s The Wealth of Nations (1776) commented on
the “invisible hand” of the market
 The self-interested actions of each individual lead to
economic efficiency
 “he intends only his own gain, and he is in this…led by
an invisible hand to promote an end which was no part
of his intention”
 No way to increase aggregate surplus in perfectly
competitive markets by changing:
 Who consumes the good
 Who produces the good
 How much of the good is produced and consumed
 Competitive markets maximize aggregate surplus

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 Effects of a Change in Who
Consumes the Good
 Begin from the competitive equilibrium
 Take one unit of the good from Consumer A
and give it to Consumer B
 Cannot increase aggregate surplus
 Value any consumer attaches to a unit of the good
they don’t buy must be less than the market price
 Value any consumer attaches to a unit of the good
they do buy must be more than the market price
 If we take the good from someone who
purchased it and give it to someone who didn’t,
aggregate surplus must fall

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 Effects of a Change in Who
Produces the Good
 Changing who produces the good can’t increase
aggregate surplus
 To achieve this, would have to reassign sales in a way that would
lower the total cost of production
 Begin from the competitive equilibrium
 Reduce sales of Producer A by one unit, increase sales of
Producer B by one unit
 Cost of producing any unit of output that a firm chooses to sell
must be less than the equilibrium price
 Cost of producing any unit of output that a firm chooses not to sell
must exceed the equilibrium price
 Any shift in production from one firm to another must raise
the total cost of production and lower aggregate surplus

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 Effects of a Change in the
Number of Goods
 Changing the total number of units of the good
produced and consumed also lowers aggregate
surplus
 Any unit of a good that is produced and consumed in a
competitive market equilibrium must be worth more
than the market price to the consumers who buy them
 Must also cost less than the market price to produce
 Those units of output must therefore make a positive
contribution to aggregate surplus
 Any units that aren’t produced and consumed should
not be; they will lower aggregate surplus

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 Measuring Total WTP and
Total Avoidable Cost
 Market demand and supply curves can be used to
measure total willingness to pay and total
avoidable cost
 Measure consumers’ total willingness to pay for
the units they consume by the area under the
market demand curve up to that quantity
 When all consumers face the same market price
 Measure producers’ total avoidable costs for the
units they produce by the area under the market
supply curve up to that quantity
 When all producers face the same market price

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Figure 14.18: Measuring Total
Willingness to Pay

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 Aggregate Surplus
 Can use market supply and demand curves to
measure aggregate surplus
 Consumers’ total willingness to pay is area
under market demand curve up to the quantity
consumed
 Producers’ total avoidable cost is the area
under the market supply curve up to the
quantity produced
 In a competitive market without any
intervention, aggregate surplus is maximized
 No deadweight loss: reduction in aggregate
surplus below its maximum possible value
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 Consumer and Producer Surplus
 Consumer surplus is the sum of consumers’ total
willingness to pay less their total expenditure
 Sum of individual consumers’ surpluses
 Also called aggregate consumer surplus
 Producer surplus is the sum of firms’ revenues less
avoidable costs
 Sum of individual firms’ producer surpluses
 Also called aggregate producer surplus

Aggregate surplus = Consumer surplus + Producer Surplus

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 Figure 14.19: Aggregate,
Consumer, and Producer Surplus

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 Sample Problem 3 (14.15):

The market demand function for corn is Qd

= 21 – 4P, and the market supply function is
Qd = = 5P -6, both quantities are measured
in billions of bushels per year. What are the
aggregate surplus, consumer surplus, and
producer surplus at the competitive market
equilibrium?