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Unformatted text preview: Chapter 14 Competitive Market Equilibrium We have spent the bulk of our time up to now developing relationships between economic variables and the behavior of agents such as consumers, workers and producers. 1 To be more precise, we began by developing models simplified versions of reality in which we then assumed that economic agents do the best they can given their economic circumstances. This process of optimizing results in the relationships between prices and behavior such as demand curves, supply curves, and cross-price demand and supply curves. And it is these relationships we can now use to take the economic analysis to its final step: describing how the economic environment (that agents take as given) arises within the model as many individuals optimize. This economic environment is called a competitive equilibrium . In this and the next chapter, we will focus on a market or an industry terms we will use interchangeably. Firms are considered to operate in the same market (or industry) if they produce the same goods and the market (or industry) is considered competitive if all firms are sufficiently small such that they cannot individually manipulate the economic environment. We will discover the important role played by equilibrium market prices in such competitive industries. Perhaps the most fascinating aspect of such prices is that they emerge spontaneously without anyone planning the process. Thus, the equilibrium we are about to analyze is a decentralized market equilibrium in the sense that it comes into being without central planning and only from the decentralized decisions of individuals who have no control over or even awareness of the process. In fact, production, guided by self-interest and the emergence of market prices , occurs in many cases without most of the participants in the process even knowing the nature of the final product they are producing. And we will see in Chapter 15 that the spontaneous order that is generated by this combination of self-interest and prices can create enormous benefits for society. The insights emerging from the analysis in chapters 14 and 15 are perhaps the most significant to come out of the discipline of economics. They derive from an internally consistent model in which the counterintuitive happens: order emerges without planning, and self-interest does not (necessarily) conflict with the social good . The same model, as we will see in upcoming chapters, also illustrates that real-world frictions may create circumstances in which the order that emerges entails conflict between private self interest and the social good. We will thus begin the process 1 This chapter requires a good understanding of consumer theory as exposited in Chapters 2, 4 through 6 and Sections 9A.1 and 9B.1 of Chapter 9 while making only a brief reference to consumer theory as it pertains to labor and capital markets. It also relies on a good understanding of cost curves as covered in Sections 13A.1 and 13B.1 of Chapter 13....
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