PowerPoint Presentation

1. Introduction0. Outline1. Introduction2. How markets work4. Demand elasticity5. Supply and costs3. Perfect competition model1 2. How markets work

$$ConsumersProducers

2 Consumers and demandAll 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 WTP3

Consumers and demand76982345pqD64554 Supply and firmsThe set of firms that produce and/or sell a product sum up the supplyFirms differ in technology and organization working at different Marginal Cost of Production (MC)

5 Supply (S)76982345pq65S76$$6 Market equilibriumHow consumers (demand) and producers (supply) achieve some coordination in the market?

CLEARING BY ADJUSTING PRICESBut, how prices adjust?

BY NEGOTIATION, AUCTIONING or SEARCHING 7

Market equilibriumPODq

8 Market equilibriumPODqP1P29 Market equilibriumPeqODqP1P110 WelfarePeqODqDo markets create social welfare?

Do consumers and producers gain some SURPLUS?

May a social planner organize more wisely production, consumption and transactions to create more welfare surplus for consumers and producers?

11 Consumer Surplus (CS)5ODq9412 Producer Surplus (PS)5ODq1413 Social Welfare: W=CS+PS5ODq14 3. Price-elasticity of demand

15 3. Cross-price elasticity of demand

16 4. Supply and costspOq=+++MCMCMC17 4. Cost functions Fixed Costs (FC) Variable Coste (VC) Total Costs at s/r (TCsr) Average Variable Costs at s/r (AVCsr) Average Total Costs at s/r (ATCsr) Marginal Costs at s/r (MCsr)ATCsrMCsrqAVCsr Short run with fixed factors (e.g. capital)18 4. Cost functions Total Costs at l/r (TClr) Average Costs at l/r (AClr) -> minimum efficient scale Marginal Cost at l/r (MCrl) -> profit maximazing In the long run, all factor are variableAClrMClrqqMES19 5. Equilibrium vs. optimumTwo ways of allocating resources: 1) Market equilibrium: firms compete and max profitsmax Profit = TR- TC

2) Optimum: welfare optimizationmax W = CS +PS20 Assumptions in competition equilibrium Firms take market pricing as given (large number) Homogeneous product Free entry & exit Perfect information

Firms have not market power

21 Profit maximizingIncentive compatibility constrainmax Profit = RT- TCf.o.c Profit=0 1) IMg=CMg (P=CMg) s.o.c BMRParticipation constrainFirms cover variable costs 3) TR >= VC (P>=AVC)22Market Firm Market equilibrium in the short runP*ODqAVCMCqACCompetition brings maximum welfare without costly, imperfectly informed and weak government interventionQ*23 Competitive equilibrium at long runFree entry and exit. Firms of different sizesODqCMeLPP*CMgLPqCompetiton in the long run drive inefficient firms out of the marketqEME Q*24