Lecture 3

3.1.1. Partial equilibrium3.1. Market equilibrium - Introduction• The free market system allocates factors of production and goods and services using the invisible hand rather than by central planning• There is is no command-and-control mechanism that works out how much individuals value different goods to determine how much to produce• Instead, for every product or service there is an individual market where interactions between buyers and sellers determine how much is produced, i.e. what resources society devotes to it• Can the decentralised market system achieve efficiency, i.e. allocate productive resources to best meet society’s needs and wants?• We work this out by looking at the gains from trade, the net benefit or “total surplus” consumers and firms realise by interacting in the market• Will the total surplus be maximised in the market?We analyse the model of the market in two steps: first to find equilibrium and then to examine whether the equilibrium is an efficient allocation of resources. At first we assume ceteris paribus, prices in related markets (substitutes, complements and FOPs) are constant.Q0 P DSpqd qs pq d qs Surplusshortagemarket clearingp* q* At first we examine partial equilibrium in a market, i.e. ceteris paribus , prices in related markets (substitutes, complements and FOPs) are constant.Equilibrium: a situation where demand and supplyhave been brought into balance.P Qd Qs Difference14 0 12 12 12 1 10 910 2 8 6 8 3 6 3 6 4 4 0 4 5 2 -3 2 6 0-67In the competitive market, the equilibrium occurs at the price where Qd = Qs . This price clears the market such that no shortage nor surplus exists.2 4 6 8 10 121416 0 1 2 3 4 5 6 7 8 9 10 11 12 13P r i c e (P )Quantity (Q)The coffee market Demand SupplyThe equilibrium price balances the quantity supplied and the quantity demanded.The equilibrium quantity is the quantitysupplied and the quantity demanded at theequilibrium price.The equilibrium price and quantity depend on the position of the supply and demand curves. When some event shifts one of these curves, the equilibrium in the market changes, resulting in a new price and a new quantity exchanged between buyers and sellers.QPDp1 q1 The analysis of such a change is called comparative statics because it involves comparing an old equilibrium and a new equilibrium.This analysis is done in three steps:1. Decide whether the event shifts the supply or demand curve (or perhaps both);2. Decide in which direction the curve shifts;3. Use the supply and demand diagram to see how the shift changes the equilibrium price and quantity.SQPDSp1 q 1 We examine the effect of a change in the prevailing conditions on the (initial) equilibrium in the market. We find the new equilibrium and compare it to the previous one.D’p 2 q2 S’ p3 q 3 Commodities - The Wall Street Journal, March 17, 2013India's Taste for Coffee to Affect Bean PricesNeena Rai in London and Debi Nayak in Mumbai“The size of the Indian economy and the rate of growth of the cafe sector, combined with rising spending power and shift in consumer preferences present a tremendous opportunity for us” says Avani Saglani Davda, chief executive of Tata Starbucks Ltd.Barron’s -Leslie Josephs, Nov. 21, 2014 - Arabica-coffee prices have surged 72% so far this year, after Brazil’s worst drought in decades crimped output, down 8% from last year. Many parts of Brazil’s main arabica-growing areas have received half the normal amount of rainfall.SoySugarMilkTeaCottonCorn Wheat BaristasConstructionRetail Tourism TelecomRubberCoffee Bean pickers ChemicalsMachinesPlastics WineVehiclesTobaccoChocolateElectrical Computers • There is a set of prices for every market such that, ceteris paribus , each is in equilibrium as well as efficient. • Prices move to realise maximum total surplus in every market. All mutually beneficial trades are realised.• Prices signal value and coordinates between producers and consumers without central control (invisible hand).3.1.3. General equilibriumCocoa3.2. Market efficiency – Welfare economicsQuestion: Is market equilibrium efficient?Pareto efficiency: A situation where resourcescannot be re-allocated so as to make one personbetter off without making another worse off.Suppose a social planner (e.g. the Government) wants to maximise the economic wellbeing of everyone in society. To do this effectively, the planner must first decide how to measure the economic wellbeing of a society.Welfare economics: the study of how the allocation ofresources affects the economic wellbeing of societyHow we measure economic wellbeing? Using the concepts of consumer surplus andproducer surplus.=-Consumer value Amount paid Consumer surplusQ0 p*q* DemandPConsumer surplus is the area between the demand curve and the price line.The demand curve reflects the value consumers receive from consuming.We measure the value consumers received from consuming by their willingness to pay , i.e. the maximum price they are willing to pay at every quantity demanded.Consumer surplus: the difference between consumers’ willingness to pay and the amount they actually pay. It is the consumers’ gains from trade, i.e. the benefit of consumers from participating in the market.Producer surplus: the difference between producers’ willingness to sell and the amount they actually receive. It is the producers’ gains from trade, i.e. the benefit of producers from participating in the market.PQ0 p*Supplyq* =-Amount received Producer surplus Producer costThe supply curve reflects the cost firms incur in producing.We measure producer cost of production by their willingness to sell , i.e. the minimum price they are wiling to accept at every quantity supplied.Producer surplus is the area between the supply curve and the price line.PQ 0 p*Supplyq* =+DemandProducer surplus Consumer surplus Total surplus Measures the benefit of buyers and sellers from participating in the market, the total gainsfrom trade. It is the sum of consumer and producer surplus.Conversely, it is the value to buyers minus the cost to sellers.=-Total surplus Producer cost Consumer value The total benefit to society is the value of consuming the product minus the cost of producing it. 3.2.3. Total surplus from tradeP0 DemandQ SupplySociety should continue to produce more as long as the marginalconsumer value is greater than the marginal cost of productionThis will maximise total surplus and the gains from trade in the market.p*q* 3.2.3. Total surplus from trade: how much should society produce?At equilibrium (p*q*), the value to the marginal consumer = the cost of the marginal producer. Total surplus is maximised . Hence, the free market at equilibrium allocates resources efficiently: • the supply of goods is allocated to the buyers who value them most highly; • the demand for goods is allocated to the sellers who can produce them at lowest cost; and • the quantity of goods that is produced maximises the sum ofconsumer and producer surplus.Inputs for production Wages, rent & profitLabour, land & capitalIncomeRevenueFirmsGoods &servicessold HouseholdsMarkets for goods& servicesGoods &services bought Spending Government Markets for the FOPs When does/should Government intervene in the market?At equilibrium, the market outcome is efficient; total surplus is maximised. Policy makers/Government cannot improve on it. However, as we will see:• Intervention by Government may be desirable if the efficient outcome is considered inequitable;• Or if Government wishes to disregard consumer preferences;• Sometimes, a market failure happens – where the market does not achieve efficient an outcome – in such cases, intervention is warranted.。