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ECON1101 PRINCIPLES OF MICROECONOMICS NOTES

4.1 Demand and Supply Aggregation

Move from individual demand and supply curves to aggregate ones which include a large number of buyers and
sellers.

Apple Juice Market Theoh, Tai, Ting and Isa

Supply Curve

x Theoh and Tai produce and offer identical

products different supply curves
x How to find supply curve for whole market?
- Sum up the supple curves horizontally -
Check how much Theoh and Tai are
willing to produce at that price and then
sum up the quantities
- Repeat the process for a number of prices

Demand Curve

x Ting and Isa want to consume and buy apple

juice
x How to find demand curve for whole market?
- Sum up the supple curves horizontally -
Check how much Ting and Isa are willing to
consume at that price and then sum up the
quantities
- Repeat the process for a number of prices

Aggregate Demand or Supply: Represents the horizontal sum

of the individual demand or supply curves

Excess Supply: depicts situation where quantity supplied is

larger than the quantity demanded QS > QD -> ES = QS - QD

Excess Demand: depicts situation where quantity demanded

is larger than the quantity supplied QD > QS -> ED = QD - QS

Equilibrium Price and Quantity: Equilibrium price (quantity)

represents the price (quantity) such that the quantity supplied
equals the quantity demanded at the equilibrium there is no
incentive to change the prevailing behavior

Demand and Supply Graph for Apple Juice

x $0.80 is the only price at which the quantity demanded equals the quantity supplied any other price
would create an excess demand or an excess supply
x any other price that generates an excess in the market is unlikely to be an equilibrium because either
buyers or sellers have an incentive to change their behavior
- excess supply sellers who dont have a buyer will find it desirable to lower the price in order to
attract a buyer
- excess demand buyers who are unable to secure the good will be willing to pay a higher price in
order to get some
- Adjustment process will continue until this excess is eliminated

Reservation Price (Buyer): the highest price a buyer is willing to pay for a given good

Reservation Price (Seller): the lowest price a seller is willing to accept for a given good

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ECON1101 PRINCIPLES OF MICROECONOMICS NOTES

Consumer Surplus: represents the difference between what a consumer pays for a good or service and what they
are willing to pay for that good or service (reservation price)

x The reservation prices indicate the opportunity costs

associated with acquiring (for the buyers) and
producing (for the sellers) the good, measured in dollars
- Buyer - if the price at which the good is sold is
above their reservation price then the buyer will
not buy it
- Seller - if the price at which the good is sold is
below the sellers reservation price then the seller
will not supply it
x Assumption - Rationing Rule: states that buyers who
value the good more will be the first to buy it
- allocation mechanism can then be construed as a
sequential game where the buyer with the highest
reservation price approaches a seller and pays the price and the seller produces the good and
transfers it to the buyer repeated with buyer with second highest evaluation and so on
x In equilibrium:
- every seller sells at the same price
- price is such that the quantity demanded is equal to the quantity supplied

Consumer surplus: represents the difference between what a consumer pays for a good or service and what they
were willing to pay for that good or service (reservation price)

Producer Surplus: represents the difference between the price a seller receives for a good or service and what
they were willing to receive for that good or service (reservation price)

x Price demanded is $5 for a good

x Buyer 1 buys the good from Seller 1 she pays less than what she is willing to pay
x Consumer surplus for Buyer 1 is reservation price $6 actual price $5 = $1
x Consumer surplus is positive cost-benefit principle suggests that Buyer 1 and 2 should buy the good
but not Buyer 3 because surplus is negative $3 - $5 = <0
x Similar thing happens for Seller 1 price received was higher than what they were willing to accept
(reservation price)
x Produce surplus for Seller 1 is price received $5 reservation price $1 = $4
x Does any participant have the incentive to modify their behavior?
- Yes! Seller 3 has an incentive to lower the price to $4
- Buyer 1 will now buy from Seller 3 who is selling at $4 compared to others selling at $5
- Seller 3 makes a positive surplus of $4 - $3 = $1
- Buyer 2 will sell from Seller 2 and Buyers 3, 4 and 5 will refrain from buying
x Given this new outcome, does any participant have an incentive to modify their behavior?
- Yes! Since Seller 1 has lost a client to Seller 3 he has suffered a reduction in his surplus
- Therefore Seller 1 must lower his price to $4 and undercut Seller 2
- This adjustment process will continue until the point where all sellers sell at a price of $3
- Similarly if the market price starts from a value below $3, some buyers will find it optimal to
announce that they will pay a higher price for the good adjustment process would begin again
until all sellers are offering a price of $3
x Thus this is a perfectly competitive market buyers and sellers are price-takes in the sense that if they
were to try to change the price away from the equilibrium level, they would be unable to buy or sell
anything

4.3 Consumer and Producer Surplus

Total Consumer Surplus: represents the sum of the economic surplus

of all consumers

Total Producer Surplus: represents the sum of the economic surplus of

all producers

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ECON1101 PRINCIPLES OF MICROECONOMICS NOTES

Total Surplus: represents the sum of the total consumer surplus and the total producer surplus

x Area comprised between the reservation price and the market price for each consumer and producer
represents their economic surplus
x In a perfectly competitive market total surplus is max
maximized
ax
xim
i iz
ized exactly at the equilibrium price

x If you increase the number off bbuyers

uyers and sellers, thee demand and supply graph would lookk like
lik
ke the left
graph
x A larger market would be represented by straight lines as depicted in the right hand side graph
- Total consumer surplus is equal to the area below the demand curve and above the market
equilibrium price
- Total producer surplus is equal to the area above the supply curve and below the market
equilibrium price
- Sum of the two areas is maximized at the equilibrium price and quantity

4.4 This Toy is Yours to Play With

Demand-supply model is called a toy model: not a perfect representation of reality but an interesting tool to
discuss about, provided that it is used wisely and the limitations are recognized

x Is a simple tool to make quick predictions based on reasonable

assumptions regarding:
- Customers preferences (decreasing marginal utility)
- Suppliers cost structures (increasing marginal cost)
- Market condition (no single customer or supplier can affect the
market price)

Sailboat Example

1. Increase in number of people with an interest in sailing boats

- Is Dad going to end up paying more for his sailing hobby?
o Recall that increase in number of consumers will shift
demand curve to the right
- How will this effect equilibrium price?
o Price will increase

2. Increase in number of suppliers renting out boats

- What will happen?
o Supply curve shifts to the right
o Equilibrium price decreases

3. Answer is unclear equilibrium price might increase or decrease as

a result of a simultaneous change in both supply and demand
- Example
o Following a successful advertising campaign, people
are more keen on sailing (demand shifts to the right)
o Also the cost of producing boats decreases due to an excess
in the supply of a type of wood, hence old boats that are no
longer useable are replaced at a faster rate than before
(supply shifts to right)

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ECON1101 PRINCIPLES OF MICROECONOMICS NOTES

- What is the effect on equilibrium?

o Can not conclude number of different scenarios

4.5 Competitive Markets are Great! Pareto Efficiency (Short Run)

Pareto Efficiency: An outcome situation in which it is impossible to make any individual better off without
making at least one other individual worse off

Vilfredo Pareto (1984-1923): An Italian economist who studied economic efficiency and income distribution

Pareto Improving Transaction: A transaction where all parties involved are better off

Problems with concept of Pareto Efficiency:

x The perfectly competitive market equilibrium is Pareto efficient however an efficient outcome does
not need to be a desirable one
x Is agnostic when it comes to equity
x Makes no statement about the overall well-being of a society
x Pareto efficiency is a valuable objective but it cannot be a final goal

A society should facilitate markets in their quest of maximising social surplus and achieve Pareto efficiency -
once objective is achieved, society should consider how to redistribute the surplus in order to realise other goals
such as equality of resources and opportunities

4.5 Competitive Markets are Great! The Invisible Hand (Long Run)

The Invisible Hand Principle: states that individuals independent efforts to maximise their gains (profits for the
sellers and utility for the buyers) will generally be beneficial for society and result in the socially optimal
allocation of resources

x Perfectly competitive markets push firms to produce at the lowest possible total cost most likely to
happen in the long run where:
- Existing firms can adjust all their factors of production and perhaps exit
- New firms can enter the market
x If firms in the market are making positive profits, there is an incentive for new ones to enter the market
an increase in the number of firms shifts the supply curve to the right which would reduce
equilibrium price and there would be a reduction in profit

x If all firms have the same productive technology the cost curves would be identical
- Entry will continue until the point where all firms in the market are making 0 profit
- At this long run equilibrium price, each firm produces a quantity such that the ATC is minimised,
therefore the long run equilibrium price is just equal to the minimum ATC

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ECON1101 PRINCIPLES OF MICROECONOMICS NOTES

x Similar process occurs when firms make a negative profit and in some cases the firm would exit the
market
- Supply curve shifts to the left and equilibrium price increases effectively reducing the loss
incurred by surviving firms
- Exit process followed by an increase in price continues until firms remaining in the market make 0
profit

4.6.1 The Long Run Supply Curve

What does the long run supply curve look like in this
type of market?

x Assumed that there was a large number of

firms all producing the same good using
same technology
- In the long run, consumers can buy as
many units as they want at a price
equal to the minimum ATC
- Long run supply curve for the whole
market is going to be a horizontal line with vertical intercept equal to the minimum ATC

Sailing Boat Example

x Short Run
- Increase in demand puts pressure on existing suppliers to
rent out sailing boats for more hours each day
- Increasing marginal costs suppliers find it more costly to
rent out for the extra hours and pushes the price up
- Quantity of boats rented out per day will increase and so
will the equilibrium price
- An increase in the quantity demanded raises the price and
quantity
x Long Run
- An increase in demand would have no effect on the market
- New suppliers enter the market effectively nullifying pressure on existing suppliers
- Entry continues and price remains stable at the level of the minimum ATC
- Supply curve is more elastic in the long run
- The price is more likely to be stable and all the adjustments occurs via the quantity offered in the
market

4.7 The Long Run Supply Curve in a More General Model

x Long run supply curve is horizontal only if all firms have the same identical productive technology
x Model with heterogeneous firms would be more complicated to present and may result in long run
market supply curves that are upward or downward sloping

Appendix: Computing the Analytical Solution to the Equilibrium Problem

Equation 1: QD = 200 5P Equation 2: QS = 5P

What is the equilibrium price and quantity in this market?

In equilibrium, QD = QS

Thus,
200 5P = 5P
10P = 200
P = $20

Sub P = $20 into either Equation 1 or 2.

QD = 200 5P

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