Chapter 2

Modeling the Market Process: A Review of the Basics

2004 Thomson Learning/South-Western

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

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

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

The Model of Supply and Demand: An Overview

Building a Basic Model: Competitive Markets for Private Goods
Assumptions Large number of buyers and sellers with no control over price Homogenous or standardized product Absence of entry barriers Perfect 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

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

Market Demand
Figure 2.1 One Consumers Demand (d) for Bottled Water

Market Demand
Figure 2.2 Market Demand (D) for Bottled Water

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 pricequantity 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 Producers 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 Firms 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 Surplus

Figure 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 Surplus

Figure 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
Societys 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 Surplus

Figure 2.9 Deadweight Loss to Society Under a Pricing Regulation in the Bottled Water Market

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