04. Demand, Supply, and Equilibrium

04. Demand, Supply, and Equilibrium - The Market Mechanism...

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The Market Mechanism A. The Basics 1. The foundation for demand is marginal value (common synonyms include: marginal benefit, willingness-to-pay, or reservation price ), which generally declines as quantity increases. The rational consumer will increase purchases up to the point where marginal value (MV) is equal to the market price. 2. So, as price increases (decreases), the rational consumer buys less (more). This is the so-called “law of demand”, which is derived from the two key postulates of economic rationality and diminishing MV. 3. Similarly, the foundation for supply is marginal cost, which generally increases as quantity increases. The two postulates of increasing marginal cost plus rationality yields the “law of supply”, as rational sellers increase quantity supplied up to the point where marginal cost is equal to the market price. 4. In a free (competitive) marketplace, prices will adjust so that quantity demanded is equal to quantity supplied, illustrated as the intersection of D and S curves, with P on the vertical axis and Q on the horizontal. B. Efficiency Implications 1. Markets are “self-regulating” in the sense that they yield goods and services in the amounts and quality that buyers want. In short, as long as consumers are willing to pay the costs of production, the market provides the goods. Consumers reveal their preferences by voluntary payment. 2. It is important to emphasize voluntary payment by buyers, along with voluntary sale by suppliers. Because participation in the market is voluntary, both buyers and sellers gain from the transaction. 3. The aggregate gain to buyers is represented by consumer surplus (area below D curve and above P line). The aggregate gain to sellers is represented by producer surplus (area above S curve and below P line). The sum of the two areas (producer surplus plus consumer surplus) is known as economic surplus. 4. The graphics of this process are worked out in considerable detail in the power point slides (incentive structures). In market equilibrium, economic surplus is maximized, as illustrated in Figure 1 below. If Q were increased above Q*, additional units would cost more than they are worth (MC > MV). Marginal Value Value D Quantity $/Q 0 Q* Marginal Marginal Cost Cost S Competitive Market Equilibrium Maximizes Economic Surplus Maximizes Economic Surplus Total Cost Total Cost of production of production Consumer Surplus Producer Surplus P* . Figure 1
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This note was uploaded on 05/09/2008 for the course ECN 212 taught by Professor Nancy during the Fall '07 term at ASU.

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04. Demand, Supply, and Equilibrium - The Market Mechanism...

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