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Equilibrium

Summary and Introduction to Equilibrium


So far, we've looked at supply, we've looked at demand, and the main question that now arises is, "How do these two opposing forces of supply and demand shape the market?" Buyers want to buy as many goods as possible, as cheaply as possible. Sellers want to sell as many goods as possible, at the highest price possible. Obviously, they can't both have their way. How can we figure out what the price will be, and how many goods will be sold? In most cases, supply and demand reach some sort of compromise on the price and quantity of goods sold: the market price is the price at which buyers are willing to buy the same number of goods that sellers are willing to sell. This point is called market equilibrium. Because supply and demand can shift and change, equilibrium in a standard market is also fluid, responding to changes in either market force. There are, however, some cases in which the normal fluidity of equilibrium does not exist, whether due to the structure of the market or inefficiencies within the market. We will examine some of these cases, such as monopolies or markets with government intervention, which are not "traditional" market economies. In this unit, we will learn how to find market equilibrium to determine the prices and quantities of goods sold, we will calculate firms' profit margins, and we will study ways in which a market can deviate from this traditional

Terms
Aggregate Demand - The combined demand of all buyers in a market. Aggregate Supply - The combined supply of all sellers in a market. Average Cost - Average cost incurred per unit of goods produced. Is equal to Total Cost divided by quantity, TC/q. Average Fixed Cost - Average amount of fixed costs incurred per unit of goods produced. Is equal to Total Fixed Costs divided by quantity sold, TFC/q. Average Revenue - Average amount of income generated per unit of goods sold. Is equal to Total Revenue divided by quantity sold, TR/q. Average Variable Cost - Average amount of variable costs incurred per unit of goods produced. Is equal to Total Variable Costs divided by quantity sold, TVC/q. Buyer - Someone who purchases goods and services from a seller for money. Competition - In a market economy, competition occurs between large numbers of buyers and sellers who vie for the opportunity to buy or sell goods and services. The competition among buyers means that prices will never fall very low, and the competition among sellers means that prices will never rise very high. This is only true if there are so many buyers and sellers that no single one of them has a significant impact on the market equilibrium. Demand - Demand refers to the amount of goods and services that buyers are willing to purchase. Typically, demand decreases with increases in price, this trend can be

graphically represented with a demand curve. Demand can be affected by changes in income, changes in price, and changes in relative price. Demand Curve - A demand curve is the graphical representation of the relationship between quantities of goods and services which buyers are willing to purchase and the price of those goods and services. Equilibrium Price - The price of a good or service at which quantity supplied is equal to quantity demanded. Also called the market-clearing price. Equilibrium Quantity - Amount of goods or services sold at the equilibrium price. Because supply is equal to demand at this point, there is no surplus or shortage. Fixed Costs - Costs which vary with quantity produced that a firm has to pay in order to produce and sell its goods. Firm - Unit of sellers in microeconomics. Because it is seen as one selling unit in microeconomics, a firm will make coordinated efforts to maximize its profit through sales of its goods and services. The combined actions and preferences of all firms in a market will determine the appearance and behavior of the supply curve. Goods and Services - Products or work that are bought and sold. In a market economy, competition among buyers and sellers sets the market equilibrium, determining the price and the quantity sold. Horizontal addition - The process of adding together all quantities demanded at each price level to find aggregate demand Household - Unit of buyers in microeconomics. Because it is seen as one buying unit in microeconomics, a household will make coordinated efforts to maximize its utility through its choices of goods and services. The combined actions and preferences of all households in a market will determine the appearance and behavior of the demand curve. Long Run - The distant future, for which buyers and sellers make "permanent" decisions, such as exiting the market or permanently decreasing consumption. Marginal Cost - Additional cost incurred from each additional unit of goods produced. Marginal Revenue - Additional income derived from each additional unit of goods sold. Marginal Utility - Additional utility derived from each additional unit of goods acquired. Market - A large group of buyers and sellers who are buying and selling the same good or service. Market Economy - An economy in which the prices and distribution of goods and services are determined by the interaction of large numbers of buyers and sellers, none of whom have significant individual impact on prices or quantities. Market Equilibrium - Point at which quantity supplied and quantity demanded are equal, and prices are market-clearing prices, leaving no surplus or shortage. Market-Clearing Price - The price of a good or service at which quantity supplied is equal to quantity demanded. Also called the equilibrium price. Monopoly - A firm that is the only seller of a good, with no competition. Natural Monopoly - A monopoly that exists because, for that specific good, the average cost curve is downward-sloping, making it difficult for new firms to enter the market. Optimization - To maximize utility by making the most effective use of available resources, whether they be money, goods, or other factors.

Price Ceiling - Maximum price set by the government on a specific good. Usually is set below market price, causing a shortage. Price Floor - Minimum price set by the government on a specific good. Usually is set above market price, causing a surplus. Price-taker - Concept that in a competitive market, buyers and sellers cannot decide what price they will accept, since they have no significant influence on the much larger market. Instead, they have to accept the market price and make their decisions accordingly. Profit - Actual amount that a firm makes from selling a good. It is equal to Total Revenue (TR) - Total Cost (TC). Seller - Someone who sells goods and services to a buyer for money. Shortage - Situation in which the quantity demanded exceeds the quantity supplied for a good or service; price is below equilibrium price. Short Run - The immediate future, for which buyers and sellers make "temporary" decisions, such as shutting down production or increasing consumption, for the time being. Supply - Supply refers to the amount of goods and services that sellers are willing to sell. Typically, supply increases with increases in price, this trend can be graphically represented with a supply curve. Supply Curve - A supply curve is the graphical representation of the relationship between quantities of goods and services that sellers are willing to sell and the price of those goods and services. Surplus - Situation in which the quantity supplied exceeds the quantity demanded for a good or service; price is above equilibrium price. Total Cost - All of the money a firm has to pay in order to be able to sell its products. Includes total variable costs and total fixed costs. Total Fixed Costs - All costs which do not vary with quantity produced that a firm has to pay in order to produce and sell its goods. Example: rent. Total Revenue - All of the income a firm makes from selling its products. Is equal to price per unit times quantity sold, (P)x(Q). Total Variable Costs - All costs which vary with quantity produced that a firm has to pay in order to produce and sell its goods. Example: materials used in production. Utility - An approximate measure for levels of "happiness." Variable Costs - Costs which do not vary with quantity produced that a firm has to pay in order to produce and sell its goods.

Two Approaches to Market Equilibrium

The Graphical Approach


By now, we are familiar with graphs of supply curves and demand curves. To find market equilibrium, we combine the two curves onto one graph. The point of intersection of supply and demand marks the point of equilibrium. Unless interfered with, the market will settle at this price and quantity. Why is this? At this point of intersection, buyers and sellers agree on both price and quantity. For instance, in the graph below, we see that at

the equilibrium price p*, buyers want to buy exactly the same amount that sellers want to sell.

Figure %: Market Equilibrium If the price were higher, however, we can see that sellers would want to sell more than buyers would want to buy. Likewise, if the price were lower, quantity demanded would be greater than quantity supplied. The following graph shows the discrepancy in supply and demand if the price is higher than the equilibrium price:

Figure %: Price Higher than Equilibrium Price Note that the quantity that sellers are willing to sell is much higher than the quantity that buyers are willing to buy. We can also see what happens when one of the curves shifts up or down in response to outside factors. For example, if we were to look at the market for Beanie Babies before and after they became a popular fad, we would see a shift outwards from the initial demand curve over time. The reason for this is that as people began to like Beanie Babies, their preferences changed, and they began to want Beanie Babies enough that they would pay much more for each Beanie Baby than they would have previously. We

can see this new preference for Beanie Babies in the outward shift of the demand curve: for every price, buyers will buy more Beanie Babies than they would have before the fad.

Figure %: Shift in the Demand for Beanie Babies Note that this combines two effects we studied earlier: there is a shift in the demand curve, which causes a movement up the supply curve. These two effects combine to reach the new market equilibrium, which has both a higher price and a higher quantity than the previous market equilibrium. It is only through a shift in either the supply or the demand curve that the market equilibrium will change. Why is this? If neither curve shifts, and we move along one of the curves, the market will naturally shift back to equilibrium. For example, if we look at a market in equilibrium, and a store tries to move up its supply curve by selling goods at a higher price, the result will be that no one will buy the goods, since they are less expensive at the store's competitors. The store will have to either go out of business, or move its prices back down to equilibrium. What happens if both curves shift? Will we end up at the same equilibrium point? In this model, it is not possible to reach the same equilibrium: either the price or the quantity can be the same as the previous equilibrium, but not both, unless the curves shift back to their original positions. To illustrate why this is true, consider the graph below. The initial equilibrium, between supply curve 1 and demand curve 1, has price p* and quantity q*. If supply shifts to supply curve 2, both equilibrium price and quantity change. It is now possible to change back to our original price by shifting the demand curve to position 2 or it is possible to revert to our original quantity by shifting the demand curve to position 3. Note that we cannot reach the original equilibrium point unless we move the curves back to their original points.

Figure %: Shift in Supply and Demand For a real world example, consider the market for oil. The initial supply and demand curves would be at position 1 (p1). When the suppliers decide to collaborate and supply less oil for every price, this causes a backwards shift in the supply curve, to supply curve 2. This cuts the quantity supplied from quantity 1 (q1) to quantity 2 (q2) and raises the price paid for oil along demand curve 1. We can either shift the demand curve in to curve 2, maintaining previous price levels, but decreasing consumption even more, or we can shift our demand curve out to curve 3, maintaining previous levels of consumption but raising prices. Since there is a tradeoff between having steady prices or steady consumption, the consumers have to make a decision about which is more important to them. In the short run, they will probably decide to pay the higher prices to keep consumption steady (that is, they will shift out to curve 3), but if the prices stay high for a long time, they will start finding ways to economize, (thereby shifting in to curve 2).

The Algebraic Approach


We have worked with supply and demand equations separately, but they can also be combined to find market equilibrium. We have already established that at equilibrium, there is one price, and one quantity, on which both the buyers and the sellers agree. Graphically, we see that as a single intersection of two curves. Mathematically, we will see it as the result of setting the two equations equal in order to find equilibrium price and quantity. If we are looking at the market for cans of paint, for instance, and we know that the supply equation is as follows: QS = -5 + 2P And the demand equation is: QD = 10 - P Then to find the equilibrium point, we set the two equations equal. Notice that quantity is on the left-hand side of both equations. Because quantity supplied is equal to quantity demanded at equilibrium, we can set the right-hand sides of the two equations equal. QS = QD -5 + 2P = 10 P 3P = 15 P = 5

At equilibrium, paint will cost $5 a can. To find out the equilibrium quantity, we can just plug the equilibrium price into either equation and solve for Q. Q* = QS QS = -5 + 2(5) QS = Q* = 5 cans Shifts up and down supply and demand curves are represented by plugging different prices into the supply and demand equations: different prices yield different quantities. For example, changing the price to $6 a can would decrease quantity demanded from 5 cans to 4 cans, as we can see when we plug the two prices into the demand function: P QD = = 10 5 = 5 5 cans

P = 6 QD = 10 - 6 = 4 cans The equivalent of shifting supply and demand curves is changing the actual supply and demand equations. Let's say that everyone in a small town just recently painted their houses, and therefore no longer need any paint. This means that they will be less willing to buy paint, even if the price doesn't go up. Their new demand function might be: QD = 7 - P We can see that for any price, they will demand fewer cans of paint. At the old equilibrium price of $5, they will only buy: QD = 7 - 5 = 2 cans of paint This new equation, representing a shift in demand, also causes a shift in market equilibrium, which we can find by setting the new demand equation equal to supply: QS = -5 + 2P = 7 3P = P = $4 a can Now to solve for the equilibrium quantity: Q* = QS = -5 + 2P = -5 QS = Q* = 3 cans of paint At the new equilibrium, 3 cans of paint will be sold at $4 each. QD P 12 QS 2(4)

Government Intervention with Markets


Theoretically, if left alone, a market will naturally settle into equilibrium: the equilibrium price ensures that all sellers who are willing to sell at that price, and all buyers who are willing to buy at that price will get what they want. At equilibrium, supply is exactly equal to demand. However, in some cases, the government will interfere with the market,

putting in price ceilings or price floors, charging taxes, or using other measures to reshape the economy.

Price Ceilings
A price ceiling is an upper limit for the price of a good: once a price ceiling has been put in, sellers cannot charge more than that. In most cases, price ceilings are below market price. If a price ceiling is set at or above market price, there will be no noticeable effect, and the ceiling is only a preventative measure. If the ceiling is set below market price, however, there will be a shortage of goods. For instance, if the government thinks 1) that people need bread to live, and 2) that the market price of bread is too high, then they might install a price ceiling. Assume that the following graph represents the market for bread. At equilibrium, the price will be p*, and the quantity will be q*.

Figure %: Price Ceiling If the government puts in a price ceiling, we can see that the quantity demanded will exceed the quantity supplied, meaning that not enough bread will be supplied to satisfy demand. Such a situation is called a shortage. Because price ceilings are installed in the interests of the buyers, the government has to decide which situation is preferable for the buyers: not being able to afford any bread, or not having enough bread to go around.

Price Floors
The opposite of a price ceiling is a price floor. A price floor is an artificially introduced minimum for the price of a good. In most cases, the price floor is above the market price. Price floors are usually put in to benefit sellers. For example, price floors are sometimes used for agricultural products. The market price can sometimes be so low that farmers cannot make enough money to support themselves. In such cases, the government steps in and sets a price floor, which can cause problems of its own:

Figure %: Price Floor Notice that when the price is artificially raised above p*, the quantity supplied exceeds the quantity demanded. Such a situation is called a surplus: farmers produce many more crops than buyers want to buy at the new, higher price.

Taxes
Another way in which the government can alter the market is through taxes. One such example is in the tobacco market: if the government would like to discourage the sale and use of tobacco, they would charge tobacco sellers a tax on tobacco products. In most cases, sellers pass as much of the added cost on to buyers as possible. Because the sellers don't want to lose any profits, they have to increase their selling price in order to maintain the same profit margin, since they had to pay an extra tax when obtaining the products for resale. In such cases, the supply curve will shift vertically by the exact amount of the tax. So, if the government charges a $1 tax on every pack of cigarettes, and the cigarette sellers want to pass this tax on to the buyers, then the supply curve will shift upwards by $1. (Note that the $1 shift is the vertical distance between the pre-tax and post-tax curves). The net result is that for any price, the stores will sell fewer packs of cigarettes, to make up for the extra cost of the tax. In effect, if consumers want to maintain their previous levels of consumption, cigarettes would now cost $1 more per pack. However, the new equilibrium shows that prices will be in between p and (p+1), and the new quantity will be less than the initial quantity. We can see how this works on the graph below.

Figure %: Change in Equilibrium Due to Tax

Profits for Competitive and Monopolistic Firms

Profit
In the unit on supply, we established that sellers derive their utility from profits, or the amount of money that they actually make from a sale. Roughly speaking, this means that when the price of a good goes up, the seller will be happier, but there is more to profit than the sale price of a good. For instance, we would think that Kenny, who sells shirts, would be happier if the selling price went from $20 a shirt to $25 a shirt. If nothing else changes, then that's true: he will be happier at the higher price. If with the higher sale price his costs change, however, from an initial cost of $10 a shirt to a cost of $17 a shirt, then he would have been happier at the lower price, since his profits now are actually decreased. Profit = Total Revenue (TR) - Total Cost (TC) Kenny's initial profit per shirt is: Profit = 20 - 10 = $10 a shirt After the change in both selling price and costs, however, his new profit per shirt is: Profit = 25 - 17 = $8 a shirt This is a very basic look at why there is more to seller utility than just selling price. If we look more closely, we can find better ways to represent costs, revenue, and profits. The following graphs shows different ways of looking at revenue:

Figure %: Revenue Total revenue (TR)is the total amount of money that a firm gets for selling a certain amount of goods. To find TR, multiply the price of the goods by the quantity of goods sold: TR = pq Average revenue (AR) is the average amount of money that the firm gets per unit of goods. This is equal to p, the market price, since the firm cannot decide how much people will pay for its goods. AR = TR/q AR = p Marginal revenue (MR) is the extra amount of revenue generated by selling one additional unit of goods. It is equal to the slope of the TR curve: MR = (change in TR)/(change in q) MR will also be equal to p, since we assume that the firm is not big enough to significantly affect the market through its actions. That is, the firm will not affect the market price of a good, no matter how much or how little it sells. Thus, for every additional unit it sells, its marginal revenue will be p: MR = p Note that we can draw the graph of market equilibrium next to the graph of marginal revenue and average revenue. Extending the revenue line into the equilibrium graph, we see that this line hits right at the equilibrium point. The following graph shows different ways of measuring and representing costs of production:

Figure %: Costs Total cost (TC) is the sum of all the different costs they incur when producing and selling their product. Average cost (AC) is the total cost divided by the quantity of goods: AC = TC/q Marginal cost (MC) is the extra cost incurred in producing one more of the product. This can be found by measuring the slope of the TC curve: MC = (change in TC)/(change in q) Costs can also be broken down into types of costs: 1. Total variable costs (TVC) refers to costs which vary with the amount of goods a firm makes and sells. An example of TVC could be the cost of chocolate chips, if the firm makes chocolate chip cookies. 2. Total fixed costs (TFC) refers to costs THAT a firm has to pay, no matter how much or how little it produces. One example might be the monthly rent on a store. Added together, TVC and TFC are equal to TC: TVC + TFC = TC TVC and TFC, when divided by q, yield average variable cost (AVC) and average fixed cost (AFC): AVC = TVC/q AFC = TFC/q Added together, AVC and AFC are equal to AC: AVC + AFC = AC We can also find the marginal variable cost (MVC) and the marginal fixed cost (MFC) by taking the slopes of the two curves. Because fixed costs don't change with quantity, however, the MFC will be 0: MVC = (change in TVC)/(change in q) MFC = (change in TFC)/(change in q) = 0 Added together, MVC and MFC are equal to MC, but since MFC is 0, the marginal cost is equal to the marginal variable cost:

MVC MVC MVC = MC

+ +

MFC 0

= =

MC MC

If we can combine a firm's costs and revenues, we can calculate the firm's profits. Using the variables we have been working with, we can represent profit as: Profit = TR TC TR TC = q(AR AC) = q(P AC) Profit = q(P - AC) Firms will try and maximize their profits, since it is through increasing profits that firms increase their utility. To maximize profits, firms will choose to sell the quantity at which the marginal cost is equal to the marginal revenue. Why is this true? If MC were greater than MR, then the firm would be losing money for each additional unit of product. If MR were greater than MC, the firm would be losing out on extra profit by not making another unit. The following graph shows this ideal quantity as q*. The shaded region is the amount of profit that the firm generates:

Figure %: Calculating Profit The amount of profit will appear as a rectangle whose length is the distance between average cost and average revenue (since that reflects the average amount gained per unit) and whose width is the number of units sold. To calculate the actual amount of the profits, you would multiply the length (dollars per unit) and the width (quantity) of the shaded rectangle. It is possible for profits to be negative (in the case that the "profit" rectangle is above the average revenue curve, instead of below it. If the firm is making profits, that is, if P is greater than the average cost, then all is well, they will continue producing and selling goods. If P is less than AC, however, the firm is losing money. P < AC : the firm is losing money How will the firm respond to this? Firms make decisions differently for the short run and the long run.

In the short run, (in economic terms, the immediate future), it is not feasible to "close shop" immediately. There are leases to end, bills to pay, creditors to pay off, and other concerns to take care of first. In such a case, the firm can make two choices: either to continue producing and selling goods for the time being (in order to minimize losses), or to stop production altogether (to cut losses). How does a firm decide which path to take? This decision is based on the firm's variable costs. If the price is still higher than the average variable cost, it will continue production, if the price is lower than the average variable cost, it will shut down. P > AVC : continue production in the short run

P < AVC : stop production in the short run Why is this? Think about it this way: in the first case, the firm is losing money in the big picture. Each unit that they make incurs some variable cost, but because that cost is lower than the price, they keep producing, since they can still recoup some of their losses by continuing production. In the second case, each additional unit of goods incurs more costs than revenue, since the average variable costs are higher than the selling price of the goods. It doesn't make sense for the firm to keep producing, since it will only make their losses even greater. In the long run, firms make the decision either to stay in the market, or to leave the market. (Leaving the market is different from stopping production: a firm can temporarily halt production with the intention of starting up once it becomes profitable again. Leaving the market is much more permanent.) How do they make this decision? Firms still look at the relationship between their average cost (AC) and price. In the short run, firms will sometimes decide to continue production even if their costs exceed the market price, in the long run firms will exit the market if P < AC, since they are losing money, and they have the option to leave the market. When prices rise in a market, more firms will enter, since they will be able to produce goods at a lower average cost than the market price. When the price falls, however, those firms who cannot produce at AC < p have to exit. Firms will produce at their minimum AC in order to make as much money as possible, and to avoid having to leave the market. This means that any firm that cannot produce at an average cost below the market price will be forced out of the market, and in the long run, firms will earn no profits from producing and selling their goods. Competition forces firms with higher costs to either cut costs or leave the market until the market price is equal to the average cost incurred by firms still in the market. In the long run, P = AC

Special Case: Monopolies


Monopoly refers to a situation in which one firm is the only seller in a market. This usually results in very high prices, since there is no competition to keep prices in check. For example, Pepsi and Coke cost about the same amount of money. If Pepsi were to charge twice as much, most people would choose to buy Coke, and Pepsi would lose business and revenue. However, if Coke did not exist, and Pepsi were the only cola supplier in the market, Pepsi could charge twice as much; without any other options, people would buy Pepsi at the higher price, and Pepsi would have a huge profit margin. In a competitive market, firms are price-takers, that is, they are too small to be able to set prices for the market to follow, so they cannot charge as much as they want, since their competitors can undercut them and win all of the customers. Monopolists, however, can set prices as they please, since they have no fear of competition. You may recall that in a competitive market, firms decide how much output to produce by finding the point at which marginal revenue is equal to marginal cost. Since MR = P, they simply find the intersection of their MC curve and price. In competitive markets where firms are price-takers, the demand curve is horizontal along the price level, so that D = AR = MR = P:

Figure %: Demand for a Price-taking Firm In noncompetitive markets, however, monopolists face our more familiar downwardsloping demand curve, which makes it more difficult to find the point where MR = MC. Here is where it gets a little tricky: competitive firms receive exactly the same amount of revenue (P) for each additional unit of product. They are price-takers, (as are households in a competitive market). A monopolist doesn't have this fixed marginal revenue. Let's take another look at Pepsi-as-a- monopolist: Pepsi could try selling its cola at $10000 a can. They might be able to sell one can. The marginal revenue on that first can is $10000. To sell two cans, however, Pepsi might have to lower its price to $7000 a can, to make a total of $14000. The marginal revenue on the second can is less than $10000. As Pepsi sells more and more cans of soda, the marginal revenue continues to drop.

Monopolists will find their profit-maximizing point by finding the intersection between their downward-sloping MR curve and their MC curve. Note that in a monopolist market, MR does not equal D, so the profit-maximizing point chosen by a monopolist results in higher prices and lower consumption than in a competitive market.

Figure %: Demand for a Monopolist Monopolists are able to sell their products at well above their marginal cost, thereby earning much higher profits than competitive firms:

Figure %: Profits for a Monopolist In certain markets there are natural monopolies, monopolies that will naturally occur in the market (as opposed to a monopoly that occurs because one firm pushes or buys other firms out). What kind of market would naturally lead to the formation of a monopoly? If there is a product that has a downward- sloping average cost curve (as opposed to the Ushaped curves we have been working with), then it is likely that a natural monopoly will form.

Figure %: Natural Monopoly Why is this true? Let's say that in the market for computers, Eliot Computer Lab ("ECL") gets a head start on production, and has already made 1000 units before its competitors get started. At that point, ELC has a much lower average cost than the new firms, and therefore has a significant advantage over its competitors, since it can charge lower prices and make more profits. If it ever feels threatened by new firms, it can increase production and lower the price even more, so that the new firms cannot compete, since they are still further back on the cost curve. In such a case, ECL would have a natural monopoly in the computer market, and other firms would exit the market.

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