Modeling the Market Process: A Review of the Basics Chapter 2 © 2004 Thomson Learning/South-Western.

Modeling the Market Process: A Review of the Basics

Chapter 2

© 2004 Thomson Learning/South-Western

2

Market Models: The Fundamentals

Defining the Relevant Market Market – the interaction between consumers and

producers to exchange a well-defined commodity Defining the market context is one of the more critical

steps in economic analysis Specifying the Market Model

Form of the model varies with the objective of the prospective study and its level of complexity

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The Model of Supply and Demand: An Overview Decisions of sellers are modeled through a supply

function Decisions of consumers are modeled through a

demand function

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The Model of Supply and Demand: An Overview The Purpose of the Model

The primary objective of the supply and demand model is to facilitate and analysis of market conditions and any observed change in price

Conventional supply and demand model must be modified to account for conditions that weaken the operation of market forces

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The Model of Supply and Demand: An OverviewBuilding a Basic Model: Competitive

Markets for Private Goods Assumptions

Large number of buyers and sellers with no control over price

Homogenous or standardized productAbsence of entry barriersPerfect information

Private good – a commodity that has two characteristics, rivalry in consumption and excludability

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Market Demand

Demand – the quantities of a good the consumer is willing and able to purchase at a set of prices during some discrete time period

Demand price is considered a measure of the marginal benefit (MB) associated with consuming another unit of the good

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Market Demand

The Law of Demand – There is an inverse relationship between price and quantity demanded of a good Modeling Individual Demand Deriving Market Demand from Individual Demand Data

Market demand for a private good – the decisions of all consumers willing and able to purchase a good, derived by horizontally summing the individual demands

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Market Demand

Figure 2.1 One Consumer’s Demand (d) for Bottled Water

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Market Demand

Figure 2.2 Market Demand (D) for Bottled Water

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Market Supply

Supply – the quantities of a good the producer is willing and able to bring to market at a given set of prices during some discrete time period

Variables that potentially affect the price-quantity response of a firm: Production technology Input prices Taxes and subsidies Price expectations

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Market Supply

The Law of Supply – there is a direct relationship between price and quantity supplied of a good Modeling Individual Supply Deriving Market Supply from Individual Supply Data

Market supply of a private good – the combined decisions of all producers in a given industry derived by horizontally summing the individual supplies

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Market Supply

Figure 2.3 One Producer’s Supply (s) of Bottled Water

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Market Supply

Figure 2.4 Market Supply (S) of Bottled Water

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Market Equilibrium

Supply and demand must be considered simultaneously to generate a model of price determination

The formal theory that price is simultaneously determined by supply and demand is one of the most significant in all of economic analysis

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Market Equilibrium

Equilibrium Price and Quantity Equilibrium price – the point at which the market system

has no tendency to change Equilibrium quantity – the “market-clearing” price

associated with the equilibrium quantity

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Market Equilibrium

Market Adjustment to Disequilibrium Disequilibrium – if the prevailing market price is at some

level other than the equilibrium level, the market is said to be in disequilibrium

Shortage – excess demand of a commodity equal to (QD – QS), that arises if price is below its equilibrium level

Surplus – excess supply of a commodity equal to (QS – QD), that arises if price is above its equilibrium level

Price movements serve as a signal that a shortage or surplus exists, whereas stability or price suggest equilibrium

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Market Equilibrium

Figure 2.5 Equilibrium in the Market for Bottled Water: Market Supply and Market Demand

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Economic Criteria of Efficiency

Allocative efficiency – requires that resources be appropriated such that the additional benefits to society are equal to the additional costs incurred Evaluating Resource Allocation at the Market Level

The value society places on the good is equivalent to the value of the resources given up to produce it

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Economic Criteria of Efficiency

Evaluating Resource Allocation at the Firm Level Assumed motivation governing firm decision making is

profit maximization Total profit – total profit is equal to total revenue minus

total costs Decision making process relies on changes, the relevant

marginal variables are:• Marginal Revenue

• Marginal Cost

• Marginal Profit Profit maximization – achieved at the output level where

marginal revenue equals marginal cost or where M∏ = 0

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Economic Criteria of Efficiency

Figure 2.6 Competitive Firm’s Profit-Maximizing Equilibrium

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Economic Criteria of Efficiency

Technical Efficiency – production decisions that generate maximum output given some stock of resources

Market forces can achieve technical efficiency so long as competitive conditions prevail

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Welfare Measures: Consumer Surplus and Producer Surplus Consumer surplus – the net benefit to buyers

estimated by the excess of the marginal benefit (MB) of consumption over market price (P), aggregated over all units purchased Consumer surplus depends on two distinct notions of

price – one that measures a willingness to pay and on that measures what is actually paid

Any disturbance to market equilibrium will change the size of consumer surplus

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Welfare Measures: Consumer Surplus and Producer SurplusFigure 2.7 Consumer Surplus in the Competitive Market for

Bottled Water

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Welfare Measures: Consumer Surplus and Producer Surplus Producer surplus – the net gain to sellers of a good

estimated by the excess of the market price (P) over marginal cost (MC), aggregated by units sold Any market disturbance will change its value and

provide a way to assess any associated welfare gain or loss to firms

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Welfare Measures: Consumer Surplus and Producer SurplusFigure 2.8 Producer Surplus in the Competitive Market for

Bottled Water

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Welfare Measures: Consumer Surplus and Producer Surplus The Welfare of a Society: Sum of Consumer and

Producer Surplus Society’s welfare – the sum of consumer surplus and

producer surplus Measuring Welfare Changes

Deadweight loss to society – the net loss of consumer and producer surplus due to an allocatively inefficient market event

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Welfare Measures: Consumer Surplus and Producer SurplusFigure 2.9 Deadweight Loss to Society Under a Pricing

Regulation in the Bottled Water Market