Intermediate Microeconomics Module 10 Market Equilibrium – Supply and Demand

MARKET EQUILIBRIUM 207 CHAPTER 10 Market Equilibrium Supply and Demand Supply and Demand I I I , Chinatown Scene on is licensed under BY THE POLICY QUESTION SHOULD THE GOVERNMENT PROVIDE PUBLIC MARKETPLACES ?

In the Capitol Hill neighborhood of Washington , the Eastern Market is a large building and grounds owned and operated by the city government . Farmers , bakers , cheese makers , and other merchants of food , arts , and crafts assemble there to sell their wares . Marketplaces like it were once a common ture of cities in the United States and Europe but are now a relative rarity . Many have disappeared due to citizens questioning whether the government should be supporting these marketplaces . So why does the government play a role in providing some markets ?

The answer is found in the way markets create benefits for the citizens they serve . In this chapter , we explore how prices and quantities 207 208 PATRICK EMERSON are set in market equilibrium , how changes in supply and demand factors cause market equilibrium to adjust , and how we measure the benefit of markets to society . Markets are often private in the sense that the government is not involved in their creation or ence instead , they are generated by the desire of private individuals to engage in an exchange for a particular good . Sometimes , however , the government plays an active role in establishing and managing markets . At the end of the chapter , we will study why this occurs , using the Eastern Market as an ple . EXPLORING THE POLICY QUESTION Is public investment in and if so why ?

LEARNING OBJECTIVES What is a Market ?

Learning the characteristics of a market . Market Equilibrium The Supply and Demand Curves Together Learning Objective Determine the equilibrium price and quantity for a market , both graphically and mathematically . Excess Supply and Demand Learning Objective Calculate and graph excess supply and excess demand . Measuring Welfare and Efficiency Learning Objective Calculate consumer surplus , producer surplus , and deadweight loss for a market . Policy Example Should the Government Provide Public Marketplaces ?

Learning Objective Apply the concept of economic welfare to the policy of publicly supported marketplaces . WHAT IS A MARKET ?

Learning Objective Identify the characteristics ofa market . In chapter , we found out that the market supply curve comes from the cost structure of individual firms , which in turn comes from their technology , as we discovered in chapter . In chapter , we found out where the demand curve comes individual utility maximization problems of individual consumers . In both cases , we assumed the demand for and supply of a specific good or service . In other words , we were describing a particular market . A market is characterized as a particular location where a specific good or service is being sold at a defined time . So , for example , we might talk about

MARKET EQUILIBRIUM 209 the market for eggs in Nashville , Tennessee , in April 2016 the market for rolled aluminum in the United States in 2015 or the market for radiological diagnostic services worldwide in the last decade . In addition , for whatever item , time , and place we describe , there must be both buyers and sellers in order for a market to exist . A market is where buyers and sellers exchange or where there is both demand and supply . We tend to talk about markets somewhat loosely when studying economics . For example , we might discuss the market for orange juice and leave the time and place undefined in order to keep things ple . Or we mightjust say that we are looking at the market for denim jeans in the United States . The difficulty with these is that we can lose sight of the basic assumptions about markets that are necessary for our analysis of them . The six necessary assumptions for markets are the following I . A market is for a single good or service . All goods or services bought and sold in a market are identical . The good or service sells for a single price . All consumers know everything about the product , including how much they value it . There are many buyers and sellers , and they are known to each other and can interact . All the costs and benefits ofa transaction accrue only to the buyers and sellers who engage in them . These assumptions are actually pretty easy to understand . They guarantee that the buyers who value the good more than it costs sellers to produce it will find a seller willing to sell to them . In other words , there are no transactions that do happen because the buyer does know how much they like the product or because a buyer ca find a seller , or vice versa . Of course , the assumptions describe an ideal market . In reality , many markets are not exactly like this , and later , in chapters 20 , 21 , and 22 , we will examine what happens when these assumptions fail to hold . MARKET EQUILIBRIUM THE SUPPLY AND DEMAND CURVES TOGETHER Learning Objective Determine the equilibrium price and quantity for a market , both graphically and mathematically . Market equilibrium is the point where the quantity supplied by producers and the quantity demanded by consumers are equal . When we put the demand and supply curves together , we can mine the equilibrium price the price at which the quantity demanded equals the quantity supplied . In figure , the equilibrium price is shown as , and it is precisely where the demand curve and supply curve cross . This makes demand curve gives the quantity demanded at every price and the supply curve gives the quantity supplied at every price so there is one price that they have in common , which is at the intersection of the two curves .

210 PATRICK EMERSON Price Quantity Figure The supply and demand curves and market equilibrium Graphing the supply and demand curves to locate their intersection is one way to find the equilibrium price . We can also find this quantity mathematically . Consider a demand curve for stereo headphones that is described by the following function , 800 2013 Note that in general , we draw graphs of functions with the independent variable on the horizontal axis and the dependent variable on the vertical axis . In the case of supply and demand curves , however , we draw them with quantity on the horizontal axis and price on the vertical . Because ofthis , it is sometimes easier to express the demand relationship as an inverse demand curve the demand curve expressed as price as a function of quantity . In our example , this would be 90 This is just the original demand curve solved for instead of . in the inverse demand curve , the vertical intercept is easy to see from the equation demand for headphones stops at the price of 90 . No consumer is willing to pay 90 or more for headphones . Similarly , the supply curve can be represented as a mathematical function . For example , consider a supply curve described by the following function Similar to the demand curve , we can express this as an inverse supply curve the supply curve expressed as price as a function of quantity . In this case , the inverse supply curve would be 20 .

MARKET 211 Here the vertical intercept , 20 , gives us the minimum price to get a seller to sell headphones . At prices of 20 or less , there will be no supply . 50 we know that the equilibrium price should be between 20 and 90 . Solving for the equilibrium price and quantity is simply a matter of setting and solving for the price that makes this equality happen . In our example , setting yields , 800 , 000 or , 800 or 40 At 40 , the quantity demanded and supplied can be found from the demand and supply curves 20 ( 40 ) 50 ( 40 ) That these two quantities match is no accident this was the condition we set at the supplied equals quantity demanded . So we know that a price of 40 per unit is the equilibrium price . These supply and demand curves for headphones are in figure below , and their section confirms the equilibrium price we calculated mathematically . Price 1000 40 20 Figure supply and demand curves for headphones Note that we have also identified the equilibrium quantity , quantity at which supply equals demand . At 40 per unit , one thousand headphones are demanded , and exactly one thousand phones are supplied . The equilibrium quantity has nothing to do with any kind of coordination or among the buyers and sellers it has only to do with the price in the market . Seeing a unit

212 PATRICK EMERSON price of 40 , consumers demand one thousand units . Independently , sellers who see that price will choose to supply exactly one thousand units . 103 EXCESS SUPPLY AND DEMAND Learning Objective Calculate and graph excess supply and excess demand . It makes sense that the equilibrium price is the one that equates quantity demanded with quantity supplied , but how does the market get to this equilibrium ?

is this just an accident ?

No . The market price will automatically adjust to a point where supply matches demand . Excess supply or demand in a market will trigger such an adjustment . To understand this feature of the market price , let return to our headphones example . Suppose the price is 50 instead of 40 . At this price , we know from the supply curve that fifteen hundred units will be supplied to the market . Also , from the demand curve , we know that eight hundred units will be demanded . Thus there will be an excess supply of seven hundred units , as shown in figure . Excess supply occurs when , at a given price , firms supply more of a good than what consumers demand . These are goods that have been produced by the firms that supply the market and have not found any willing buyers . Firms will want to sell these goods and know that by lowering the price , more buyers will appear . So this excess supply of goods will lead to a price decrease . The price will continue to fall as long as the excess supply conditions exist . In other words , price will continue to fall until it reaches 40 . Price 90 Excess Supply 700 1000 50 20 800 1500 1800 Quantity Figure Excess supply at a price 50 The same logic applies to situations where the price is below the intersection of supply and demand . Suppose the price of headphones is 30 . We know from the demand curve that at this price , consumers will demand twelve hundred units . We also know from the supply curve that at this price , suppliers will

MARKET EQUILIBRIUM 213 supply five hundred units . So at 30 , there will be excess demand of seven hundred units , as shown in figure . Excess demand occurs when , at a given price , consumers demand more ofa good than firms supply . Consumers who are not able to find goods to purchase will offer more money in an effort to entice pliers to supply more . Suppliers who are offered more money will increase supply , and this will continue to happen as long as the price is below 40 and there is excess demand . Price 90 SOP 30 20 ) 1800 Quantity Figure Excess headphones at a price of Only at a price of 40 is the pressure for prices to rise or fall relieved and will the price remain constant . MEASURING WELFARE AND EFFICIENCY Learning Objective Calculate consumer surplus , producer surplus , and deadweight loss for a ket . From our study of markets so far , it is clear that they can contribute to the economic of both buyers and sellers . The term welfare , as it is used in economics , refers to the economic of society as a whole , including producers and consumers . We can measure welfare for particular market situations . To understand the economic concept of how to quantify is useful to think about the weekly farmers market in , New York . The market is a place where local growers can sell their produce directly to consumers throughout the summer . It is very successful , and many local residents go to the market to buy produce . Now consider the specific example of tomatoes . What is this market worth to the tomato sellers and buyers that transact in the market ?

Suppose a farmer has a minimum price of for an heirloom tomato . This price could be based on the farmer cost of production or the value she places on consuming the tomato self . Suppose also that there is a consumer who really wants an heirloom tomato to add to his salad that

214 PATRICK EMERSON evening and is willing to pay up to for one . If these two people meet each other at the market and agree on a price of , how much benefit do they each get ?

The seller receives , and it cost her to provide the tomato , so she is better off , the difference between what she received and what she would have accepted for the tomato . Likewise , the buyer pays but receives in benefit from the tomato , since that was his willingness to pay his net benefit is the difference , or . The seller and buyer are both better off because they had the opportunity to meet and transact . Without this opportunity , the seller would have stayed at home with the tomato and been no better or worse off , and the buyer would not have a tomato for his salad but would be no better or worse off . The difference between the price received and the price is called the producer surplus ( The difference between the price and the price paid is called the surplus ( The sum of these two surpluses is called total surplus ( So the producer surplus in the tomato example is , the consumer surplus is , and the total surplus is . This is the surplus generated by one transaction ifwe add up all such transactions in the market , we get a measure ofthe consumer and producer surplus from the market . surplus for an entire market is easy to do with a graph . Let return to our previous ple of headphones and find the consumer and producer surplus . Figure shows that the consumer surplus is the area above the equilibrium price and below the demand green triangle in the figure . Similarly , the producer surplus is the area below the equilibrium price and above the supply red triangle in the figure . The area of each surplus triangle is easy to calculate using the formula for the area of a triangle , where I is base and is height . Price 90 Consumer Surplus 1000 40 20 Producer Surplus 1200 1800 Quantity Figure Consumer surplus and producer surplus in the headphones

MARKET 215 In the case of consumer surplus , the triangle has a base of one thousand , the distance from the origin to , and a height of 50 , the difference between 90 , the vertical intercept , and , which is 40 . Consumer surplus ( 50 ) 25 , 000 Similarly , Producer surplus ( 20 ) 10 , Total surplus created by this market is the sum ofthe two , or . This is the measure of how much value the market creates through its enabling of these transactions . Without the ability to come together in this market , the buyers and sellers would miss out on the opportunity to capture this surplus . We say that a market is efficient when the entire potential surplus has been created . Such a market is an example of allocation of goods and services in which no redistribution can occur without making someone worse off . Think about the distribution of goods in the headphones example . All the buyers and sellers that transact are made better off by the transaction because they gain some surplus from it . If they did , they would not voluntarily trade . None of the trades that happen do . For example , if there were more than one thousand units exchanged , it would mean sellers were selling to buyers who valued the good less than the sellers cost of production , where the supply curve is above the demand curve , and one or both of the parties would be worse off because of the exchange . Another way to see that the market equilibrium outcome is efficient is if we arbitrarily limit the number of goods exchanged to nine hundred . Let call this maximum quantity restriction where the bar above the indicates that it is fixed at that quantity . There are one hundred that do occur this can not be an efficient outcome because the entire potential surplus has not been created . The lost potential surplus has a name , deadweight ( the loss of total surplus that occurs when there is an inefficient allocation of resources . The blue triangle in figure this deadweight loss .

216 PATRICK EMERSON Price 90 Consumer Surplus 1000 40 Deadweight 20 Loss ) Producer Surplus 900 1800 Quantity Figure from a quantity constraint We can calculate the value of the deadweight loss precisely , again using the formula for the area of a triangle . Since the demand function is 800 2013 , the point on the demand curve that results in a demand of nine hundred is a price of 45 . Similarly , if the supply function is given as ( 17 000 , the point on the supply curve that results in a quantity supplied of nine is a price of 38 . Thus the base of the triangle is 45 38 , or , and the height is the difference between the one thousand units that are sold in the absence of a restriction and the restricted quantity , or one hundred . So ( 100 ) 350 . POLICY EXAMPLE SHOULD THE GOVERNMENT PROVIDE PUBLIC MARKETPLACES ?

Learning Objective Apply the concept of economic welfare to the policy of publicly supported . The first question in determining whether a case can be made for the public provision of marketplaces , such as the Eastern Market in Washington , is what would occur in the absence of such a market . If the buyers and sellers in these markets could easily access other markets , then it would be hard to argue that the marketplace is providing a net benefit . Similarly , if the commercial activity that takes place in this market is simply a diversion of similar activity that would have taken place elsewhere , then it is likely that there is little to no net benefit . So for the sake of this exercise , we will assume that the marketplace is providing an opportunity to these buyers and sellers that they would not otherwise have . So given this assumption , are these marketplaces valuable ?

The simple answer , as long as transactions are occurring , is yes . We can see this from a simple diagram of a market for an individual good , let say fresh apples , that exists within the Eastern Market ( figure ) MARKET 217 Price of Apples Consumer Surplus Producer Surplus Quantity of Apples Figure The apples in the Eastern Market There is clearly a surplus being created by the apple transactions that take place within the market . This in itself is the primary argument for the marketplace . Buyers and sellers are able to transact and become better offfor it . The value to those individuals is measured by surplus . But a complete answer must compare the value to society of the markets to the cost to society of the marketplace itself . Does the total surplus created by the the cost ?

Let return now to the key a market for fresh apples would not exist without support . Is this a reasonable assumption ?

In the nineteenth and early twentieth centuries , when many public markets were founded , tion was difficult , and bringing fresh food to support urban population centers was something local commonly did . Today , transportation is not nearly as difficult or costly . But although many areas are well served by grocery stores , where it is reasonable to expect customers will find fresh fruits and vegetables , other locations are characterized by food deserts . Food deserts are defined as urban neighborhoods and rural towns without ready access to fresh , healthy , and affordable food . Instead of supermarkets and grocery stores , these communities may have no food access or are served only by restaurants and convenience stores that offer few healthy , affordable food options . The lack of access contributes to a poor diet and can lead to higher levels of obesity and other diseases , such as diabetes and heart disease ( US Department of Agriculture ) The estimates that million people in the United States live in food deserts . Although the Capitol Hill neighborhood experienced some hard times in the past , today it is ous and well served by grocery stores . So the need for government support of the Eastern Market there

218 PATRICK EMERSON is less clear . In chapter 21 , we will explore public goods and in detail and become better equipped to fully explore this issue . EXPLORING THE POLICY QUESTION what other kinds of marketplaces can you think of that the government aids by providing infrastructure ?

Airports allow the market for airline travel to exist in a functional way . Most airports in the United States are run by local governments . Using the topics explored in this chapter , give a for government expenditures on airports . Should the District of Columbia government spend money on a market that primarily serves one neighborhood ?

Give reasons for and against . REVIEW TOPICS AND LEARNING OBJECTIVES What is a Market ?

Learning Objective Identify the characteristics of a market . Market Equilibrium The Supply and Demand Curves Together Learning Objective Determine the equilibrium price and quantity for a market , both graphically and mathematically . Excess Supply and Demand Learning Objective Calculate and graph excess supply and excess demand . Measuring Welfare and Efficiency Learning Objective Calculate consumer surplus , producer surplus , and deadweight loss for a market . Policy Example Should the Government Provide Public Marketplaces ?

Learning Objective Apply the concept of economic welfare to the policy of publicly supported marketplaces . LEARN KEY TOPICS Terms Market equilibrium The point where the quantity supplied by producers and the quantity demanded by consumers are equal .

MARKET 219 Inverse demand curve The demand curve expressed as price as a function of quantity 90 Inverse supply curve The supply curve expressed as price as a function of quantity 20 Equilibrium price The price at which the quantity demanded equals the quantity supplied . Equilibrium quantity quantity at which supply equals demand . Excess demand When , at a given price , consumers demand more of a good than supply , ie , the latest video game consoles . Excess supply When , at a given price , supply more of a good than what consumers demand , ie , the sales of holiday merchandise once it has passed . Welfare In economics , refers to the economic of society as a whole , including producers and consumers . Producer surplus The difference between the price received and the price . Consumer surplus The difference between the price and the price paid . Total surplus The sum of the consumer surplus and the producer surplus . an allocation of goods and services in which no redistribution can occur without making someone worse off , ie , both seller and buyer are gain ing from the are selling an amount that is equal to the demand curve and buyers are paying prices that indicate close to price . Deadweight loss The loss of total surplus that occurs when there is an allocation of resources , a firm produces exactly 900 limited edition phones worth 200 each . The demand tests out at 1000 . There are 100 transactions that don should have been allocated to make the 1000 . Graphs The supply and demand curves and market equilibrium

220 PATRICK EMERSON Price Quantity Figure The supply and demand ( and marker Explicit supply and demand curves Price 509 1000 40 20 1000 1800 Quantity Figure and demand headphones Excess supply at a price of 50 MARKET 221 Price 90 Excess Supply 700 SOP 1000 50 20 800 1500 1800 Quantity Figure 703 Excess supply at a price 50 Excess demand at a price of 30 Price 90 SOP 1000 20 1300 Quantity Figure 704 Excess at ( of 30 Consumer surplus and producer surplus 222 PATRICK EMERSON Price 90 Consumer Surplus SOP 1000 20 Producer Surplus 1200 1800 Quantity Figure surplus the headphones Deadweight loss from a quantity constraint Price 90 Consumer Surplus Deadweight Loss ) Producer Surplus 900 1800 Quantity Figure from a ( A typical goods market in the eastern market

MARKET Price of Apples Consumer Surplus Producer Surplus Quantity of Apples Figure 707 The or apples in the Eastern Market Equations Quantity supplied 1000 Determining and ( The above equation utilizes the relationship between quantity and price to determine a starting algorithm for drafting a supply curve . Review this relationship in chapter . Inverse supply curve 20 Quantity demanded Derived from max production and minimum price to cover costs with profit . 800 Inverse demand curve 90 The original equation set to solve for In this inverse curve , the vertical intercept is very clear demand for this product stops at 90 . No one is willing to pay more than 90 for the product . Solving for equilibrium price ( and equilibrium quantity Solving for the equilibrium price and quantity is simply a matter of setting

224 PATRICK EMERSON and solving for the price that makes this equality happen . In our example , setting yields , 800 Ol Ol At the quantity demanded and supplied can be found from the demand and supply curves 20 ( 40 ) 50 ( 40 ) If the proper and have been found , the two equations should be equal . Issues of excess and deadweight loss surplus is easy to do with a graph , see in via link or below Price 90 Consumer Surplus SOP I 40 20 Producer Surplus 1200 1800 Figure 705 Consumer surplus and ( er surplus ih the the consumer surplus is the area above the equilibrium price and below the demand green triangle in the figure . Similarly , the surplus is the area below the equilibrium price and above the supply red triangle in the figure . The area of each surplus triangle is easy to calculate using the formula for the area of a triangle , where bis base and is height Utilizing figures from the graph , the following formulas can be derived Consumer surplus Consumer surplus ( 50 )

MARKET 225 Consumer surplus where the area equals the total dollar amount of producer surplus , the base is the distance from the origin to , and the height is the difference between the maximum willing to pay price or the , and . This can also be written thusly ( where is the origin of the supply curve and is the vertical intercept of the , and also the maximum price that anyone is willing to pay for the product . Producer surplus Producer surplus ( 20 ) area where the area equals the total dollar amount of producer surplus , the base is the distance from the origin to , and the height is minimum price . This can also be written thusly Producer surplus ( area where is the origin of the supply curve and is the minimum price . Total surplus The sum of Deadweight loss The loss of total surplus that occurs when there is an inefficient allocation of resources . Where is the price determined by the curves to be viable at the current output , See Figure for or see below . Figure illustrates utilizing a graph to develop a equation

PATRICK EMERSON Price 90 Consumer Surplus sop . 1000 40 Deadweight 20 Loss ) 900 1800 Figure 706 a quantity i If a produces 900 headphones , but the that 1000 is the optimum output , the lost surplus price would then equate to the between the price for 900 units in ca , or 38 , and the , or 45 . Thus the denominator would be 100 ( and the numerator ( 38 ) The equation would look thus ( 100 ) 350