Lecture 11 Class Notes

Supply Curves and Market Equilibrium

Firms

  • Firms maximize profits by generating MR >= MC.
  • Firms consider a combination of inputs (labor, capital, etc.) while optimizing marginal costs so as to optimize profits.

Consumers

  • Consumers maximize utility constrained by a fixed budget.

Marginal Revenue (MR)

  • MR is defined as the additional revenue achieved by increasing by one additional unit of supply/production.

Marginal Cost (MC)

  • MC is defined as the additional cost incurred by increasing by one additional unit of supply/production.
  • MC = change in total cost divided by marginal profit

Profit Maximization under Perfect Competition

  • Firms are price takers.
    • Price is determined by the market, and a single firm's decrease or increase in supply has no effect on price.
  • P = MC is the profit-maximization formula under perfect competition.
    • If P > MC, expand production until P = MC.
    • If P < MC, cut production until P = MC.
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Profit Maximization under Competitive Equilibrium

  • P is determined by marginal buyer and seller.
  • P is constant (every unit sells at the same price).
  • Surplus occurs when P > Pc. To restore equilibrium, firms sell at a lower price to shed surplus.
  • Shortage occurs when P < Pc. To restore equilibrium, buyers with a higher willingness to pay will pay a higher price, driving out those buyers with a willingness to pay greater than the old price but less than the new price.
  • Consumer surplus is graphically defined as the area of the triangle bound on the left by the y-axis, above by the MR or demand curve, and below by Price.
    • Customers whose willingness to pay is greater than the market price benefit, resulting in consumer surplus.
  • Producer surplus is graphically defined as the area of the triangle bound on the left by the y-axis, below by the MR or supply curve, and above by the Price.
    • Producers whose willingness to sell is less than the market price benefit, resulting in producer surplus
  • Total net benefits are the sum of the producer and consumer surpluses.
  • Deadweight loss is defined as forgone value.
    • Deadweight loss occurs when the quantity supplied is less than the optimal quantity, therefore MC (supply) does not equal MR (demand).
    • Deadweight loss occurs when the price is increased, therefore the quantity shifts to the left.
    • Deadweight loss occurs when MC > P.

Adam Smith

  • "Competitive markets coordinate individual, self-interested decisions to yield a good collective outcome."
  • "It is not from the benevolence of the butcher, the brewer, or the baker, that we can expect our dinner, but from their regard to their own interest…. By directing that industry in such a manner as its produce may be of greates balue, he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention."

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Central Planning of Production

  • Tried in communist states with a poor record