92 Microeconomics for MBAs Competitive product markets and firm decisions 93

tigure 3.1 Shiftr in the supply curve Flgur. 3.t Markel surplus
s"
,/, A rightward, or outward, shift in the
supply curve, from 5r to 52, represents
A10
lf a price is higher than the
intersection of the supply and

/ ./'' an increase in supply. A leftward, or demand curves, a market surplus - a

(§a
inward, shift in the supply curve, from o greater quantity supplied, Q., than
,/ / ,'q Sr to 51, represents a decrease in Ea demanded. Qr - results. Competitive
E
o I will push the pri(e down to
o
Ddease / / / supply.
o
pressure

Ep"
insuppty / ,/ ,/ 56 the equilibrium price, Pr, the pri(e at

Ä74/:r"a
o9Pt
which the quantity supplied equals
!
b4 the quantity demanded, Q:.
o
o o
o
,9o c2
i 'r

0 20 40 60 80 100 120
qQzo3 Q1 Qz Os
Bushels of tomat@s per we€k (000) Bush€ls of tomatoos por weok (00o)

each other, and why a market surplus or shortage of tomatoes will result. We can
instead ofP2 for quanti§ the decrease in supply represented by the
Q2. Conversely,
also illuminate the competitive market forces at work to push the market price
shift from 51 to S, means that producers will offer less at each price - 0r instead of
toward the market-clearing price - or the price at
Q, at price P2. They must also have a higher price for each quantity - P3 instrad ofP2
which the market is said to be in equilibriunr, at Marketequilibriumo(cußwh€nthefor(eiof
for quanti§ Q2.
which the forces of supply and demand balance supplyanddemandäreinbalancewithnonet
A few examples will illustrate the impact of changes in the determinants of t" tnt o''* and output lcvel to
one another with no net pressure for rhe price and :;:;;:t
supply. Iffirms learn how to produce more goods with the same or fewer resources,
output to move up or down.
the cost of producing any given quantity will fall. Because of the technological
improvement, frrms will be able to offer a larger quantity at any given price or the
same quantity at a lower price. The supply will incrcase, shifting the supply curve
Market surpluses
outward to the ri8ht.
Suppose that the price of a bushel of tomatoes is $9, or P, in frgure 3.5. At this
Similarly, ifthe profitabili§ ofproducing oranges increases relative to grapefruit,
price, the quantity demanded by consumers is 20,000 bushels, much less than the
grapefruit producers will shift their resources to oranges. The supply oforanges will
quanti§ offered by producers - 90,000. There is a
increase, shifting the supply curve to the right. Finally, if lumber (or labor or
market surplus, or excess supply, of 70,000 bushels. A market surplus is the amount by which the
equipment) becomes scarcer, its price will rise, increasing the cost of new housing
and reducing the supply ofnew houses coming onto the market. The supply cuwe of
Graphically, an excess quanriry supplied occurs ar
::ilXY$:lj:i;i'.1"X1*-"0*"'o
any price above the intersection of the supply and
new houses will shift inward to the left.
demand curves.
What will happen in this situation? Producers who cannot sell their tomatoes will
have to compete by offering to sell at a lower price, forcing otherproducers to follow
Market equililrrium
suit. All producers might agree that holding the price above equilibrium can be in
Supply and demand represenl the two sides ofthe market - sellers and buyen. By their "common interest," since an above-equilibrium price can generate extra
plotting the supply and demand curves together,as in figure 3.5, we can explore the profits for all (even though sales might be undercut). However, in competitive
conditions under which the drcisions ofbuyers and sellen will be inconsistent with markets producers are in a large-group setting in which their individual curbs on
94 Microeconomics for MBAs Competitive product markets and firm decisions 95

production to pursue their common intercst will have an inconsequential impact on tigule 3.6 Market shortag€s
total market supply. They each can reason that they can possibly gain market share A price that is below the
by individually lowering their price, if all others hold to the higher price. And each intersection of the supply and
can reason that all others are thinking the same way, which means they can expect demand curves will create a
o shortage - a greater quantity
other producers to lower their prices. The logic leads the producers to do what is not 6
E demanded, Oi, than supplied, Qr.
in their common interest and to act competitively, which is cut their prices. Competitive pressure will push the
o
As the competitive process forces the price down, the quantity that consumers are price up to the equilibrium price
willing to buy will expand, while the quantity that producers are willing to sell will
Ep" the price at which the quantity
Pr,
l
decrease. The result will be a contraction ofthe surplus, until it is frnally eliminated supplied equals the quantity
d
at a price of $5.50 or P1 (at the intersection of the tlvo curves). At that price, demanded (Qz).
'tr
producers will be selling all they want; they will see no reason to lower prices L
further. Similarly, consumers will see no reason to pay more; they will be buying all
they want. This point at which the wants ofbuyers and sellers intersect is called the
equilibiun, with the price and quantity at that point called equjlibrium price and o 20 40 60 80 100 120
qQ2o3
equilibriilm quantity: Bushels ot tomaloos per weok (0@)

o The equilibrium pnce is the price toward which a competitive market will move,
and at which it will remain once there, eveqrthing else held constant. It is the price
at which the market "clears" - that is, at which the quantity demanded by
corsumers is matched exactly by the quantity offered by producers. At the
equilibrium price, the quantis sellers are willing to supply and the quantity
buyers want to consume are equal. This is the equilibrium quantity.
c The equilibiun quantity is the output (or sales) level toward which the market
will move, and at which it will remain once there, everything else held constant,
In sum, a surplus emerges when the price asked is above the equilibrium price. It will
be eliminated, through competition among sellers, when the price drops to the
equilibrium price.
Market shortaqes
Supposethat the price asked is below the equilibrium price, as in figure 3.6. At the
rclatively low price of $ 1, orP,, buyen want to puchase 100,000 bwhels - substantially
more than the 10,000 bushels pmducen are willing to
Amarketshortngeistheämountbywhichthe offer. The rrsult is a Dlrrket short.rge. Graphically, a
quantitydemandedexceedsthequantity
market shortage is the shortfall that occus at any
supplied at äny given price'
price below the intersection ofthe supply and demand
curyes.
As with a market surplus, competition will correct the discrepanry between
buyers' and sellers'plans. Buyers who want tomatoes but are unable to get them
at a price of $ 1 will bid higher prices, as at an auction. Many buyers might have a
"common interest" to hold the price below the equilibrium price (even with fewer
units of the good they can buy). However, as with producers when there was a
market surplus, buyers are in a large-group setting, with each individual buyer
reasoning that not offering a higher price will not affect the market outcomes,
because otherbuyers will offer a higher price. Each buyer can reason that they might
as well offer a higher price just to get the units they want.
As the price rises, a larger quantity will be supplied because suppliers will be
better able to cover their increasing production costs. Simultaneously, the quantity
demanded will contract as buyers seek substitutes that are now relatively less
expensive compared with tomatoes. At the equilibrium price of $5.50, or Pr, the
market shortage will be eliminated. Buyers will have no reason to bid prices up
further; theywitl be getting all the tomatoes they want at that price. Sellers will have
no reason to expand production further; they will be selling all they want at that
price. The equilibrium price will remain the same until some force shifts the position
ofeither the supply or the demand curve. Ifsuch a shift occurs, the price will move
toward a new equilibrium at the new intersection ofthe supply and demand curves.
In our graphical treatment ofsupply and demand, movement toward equilibrium
can be thought ofas instantaneous. Real-world movements in price will necessarily
take some time, which means that the equilibrium price and quantity toward which
the market will ultimately settle can shift with changes in supply and demand.
The effect of rhanqes in demand arid supply
Figure 3.7 shows the effects ofshifts in demand and supply on the equilibrium price
and quantity. In flgure 3.7(a), an increase in demand from D, to D, raises the
96 Microeconomics for MBAs Competitive product markets and firm decisions 97

(a) (b) Figure 3.7(b) shows the revene effec1s of a decrease in demand. When the demand

X
initially falts, a market surplus develops at price P2. At P2, the quanti§ demanded is Q1
o e while the quantity supplied is Q. Producers who want to sell their output will put
6 downward pressure on the price. As the price falls, buyers increase their purchases while
E E
a price ofPl and quantity Q2.
producers curb their output. Equilibrium is reestablished at
2e^ o
6 An increase in supply from S1 to 52 - figure 3.7(c) - has a different effect. The
E
9e- 3p^ equilibrium quantity rises fiom 0r to 0u, but the equilibrium price falls from P, to
8P1 P1. When supply initiatly expands, a market surplus emerges at price P2. The
o
,9 'c quantity demanded is Q1 while the quantity supplied is Qr, which makes for a
L o
market surplus. As producers try to sell what they produce, they put downward
pressure on the price. As the price falls toward P1, the quanti§ produced contracts
Or Op 03 01 orQ
Bushels ol tomatoes per week Bushels ot tomatoas psr we6k
from Q3 to Q2. The quanti§ demanded rises from Qr to Qz.
A decrease in supply from 51 to S, - frgure 1.7(d) - causes the opposite effect: the
(c) (d) equilibrium quantity falls from 0r to Q2, and the equilibrium price rises from Pr to P2.
At the time supply decreases, a shortage develops, with the quantity supplied at Q,
q and the quantity demanded at Q3. Buyers who want more units ofthe good than are
available at P1 will bid the price up. lts the price rises from P1 toward &, the quantity
E
o
demanded decreases from 0, to Qz; the quanti§ supplied rises from Q1 to Q2.
o EPz
Ep" [See online Video Modules 3.3 Changes in supply and demand and ].4
5Pt Applications ofsupply and demand]
ip.
o
e
.9
c L The elficiency of the competitive market rrrodel
{. Early in this chapter we asked how Fred Lieberman knows what prices to charge for
QrQos qQ2a3
the goods he sells.The answer is now apparent: he adjusts his prices until his customers
Bushels ol lomato€s per week Bushels of lomatoes per w€ek
buy the quantities that he wants to sell. Ifhc cannot sell all the fluits and vegetables
tigure 3.7 The effects oI changes in supply and demand
he has, he lowers his price to aftract custonl$s and cuts back on his orders for those
Ar in(re;rse in demand - 1;anel (a) - rajles both the t'quilibriurrr grrire ancl the equiirbri{rm
quantity. A rlccrcasc irr dc,tnarrd .pancl (b) iras tlrc oppositL'ct{c(t: a (je(rrldle ir the goods. Ifhe runs short, he knowsthat he can raise his prices and increase his orden. His
equili[rriutn price ancl quantrty. An irrcrease ir, strpply panel (<) causes the equilibrium customers then adjust their purchases accordingly. Similar actions by other producers
quantity to rise but the equilil:riurn prico to foll. A decrerse in supply - panel (cl)' lras rhe and customers all over the city move the market for produce toward equilibrium.
oppolite etfe(Ti a n5e in the eqtrilibrir;rn prire atrd a lall in the e(luilibriilm quailtity. The information provided by the orders, reorders, and cancellations from stores
such as Lieberman's eventually reaches the suppliers of goods and then the suppliers
equilibrium price from P1 to P, and quantity from 0, to Q2. The equilibrium price of resources. Similarly, wholesale prices give Fred Lieberman information on
rises because at the moment the demand curve shifts out to the right, a market suppliers' costs of production and the relative scarcity and productivi§ of resources.
shortage develops at the initial price Pr. The quanti§ demanded at that initial price The use of the competitive market system to determine what and how much to
is 0:; the quantity supplied is less, Q', Those buyers who want the good but are produce has two advantages. First, it coordinates the decisions of consumers and
unable to get it will bid the price up. As the price goes up, producers can justiry producers very effectively. Most of the time the amount produced in a competitive
incurring the higher marginal costs ofproducing more, but some buyers will retreat market system is very close to the amount consumers want at the prevailing price -
on their purchases. The market will clear - or quantity supplied and demand will be no more, no less. Second, the market system maximizes the amount ofoutput that is
equal - at the higher price ofP2. acceptable to both buyer and seller. In frgure 3.8(a), note that all the price-quanti§
98 Microeconomics for MBAs Competitive product markets and firm decisions 99

(a) Consumers'prefeiled (b) Producer§' preferred (c) Mutually acceptable The market that produces at the intersection ofsupply and demand in frgure 3.8(c)
prirquantity combrnation pricFquanlity combination pricFquantity combination
is said to be effrcient in another regard, The demand curve shows consumers'
marginal value of each unit. The total valur of all Qr units is the area under the
6 demand curve bounded by OabQ,. The supply curve shows the marginal cost of
c t2 c
wery unit produced. The producers'total production cost for 0r units is the area
oI ,3
q underthe supply curve bounded by OcbQr. The potential net gain from production is
äPr
o the differences betlyeen consumers' total value of 0r [Oaä0r) minus the producers'
'i ,§l
q I total cost [0cb0r), or the triangle area bounded by abc. In a conrpetitive market, with
production at Qr, all ofthose net gains are generated
oq 0q 0q and split between prodUcers and consumers by way Market inelfitiercy i5 the ?xtent to which
potential net qain5 ftom trads are not
Bushsls ol tomatoes per week Bushels ot tomato€S por woak Bushols ot tomatoos per week of the price charged, P,. If production fell short of
generated'
tigure 3.8 The efficiency of the (ompelitive market 0r, then some ofthose potential net gains would not
Only thole pri(c-qudItity (onrbiI,]tions on or belorr' ti]o (1rDländ crrrve panei (a) arr ar<cptrblc: to be generated. Ifproduction were greater than 0r, then the cost ofthe added units to
hl,yqrr- Orrly tho:r: pric{' (lu,lIlity conrbinatiorrr orr or;rltove tlre rtrpgrly rurvr: penei (b) Jre i]crelttdblil producers would exceed their added value to consumers. The net gains would again
toprorlttcr:rr.-llroscprire quüntity(orrbination5lhdtdred((elltdbletobolhbuyr-'r:andyyoduterrrrr:
fall short of the potential net gains of the triangle aäc. If more or less is produced
rhorvtt ttt the drrkest ,ih,r(jed area ol panel (c). Ihe (ornpetitive rrdrkei i., "effi<icn1 " nr tlle srnlr {lr,it rt
reslritt in oLrtput Q!, tlre Irnxinrirrri oL][l)u1 levL,l a((ept,rble to l]otlr buycrs,rrd J:roduccrs. than 0r, the market is said to be ineffitient.
In the foregoing section, the focus has been on the effrciency of markets, or how
well they operate. However, problems abound in markets, with the most notable
combinations acceptable to consumers lie either on or below the market demand being pollution in product markets and discrimination in labor markets. We will
curve, in the shaded area. fifconsumers are willing to pay P2 for Q,, t]ren they should take up these and otherproblems in Part B ofthis chapter and atvarious other points
also be willing to pay less for that quantity - for example, Pr.) Furthermore, all the in the book.
price-quantity combinations acceptable to producers lie either on or above the ISee online Video Module 3.5 Competitive market effrciency]
supply curve, in the shaded area shown in figure 3.8(b). (Ifproducers are willing
to accept P, for quanti§ Q1, then they should also be willing to accept a higher
price - for example, P2.) When supply and demand curves are combined in frgure 3.8 Nonprice c0mpetitic'n
[c), we see that all the price-quanti§ combinations acceptable to both consumers Markets in which suppliers compete solely in terms of price are rclatively rare {with salt
and producers lie in the darkest shaded triangular area. From all those acceptahle being one of those mre products). In fact, price competition is not always the best
output leve'ls, the competitive market produces 0r, the maximum output level that method of competition, not only because pdce reductions mean lower average rev-
can be produced given what producers and consum- enues, but also because the reductions can be costly to communicate to consumeß,
Efri(iercy is the maximization of output ers are willing and able to do. In this respect, the Advertising is expensive, and consumers may not notice price reductions as readily as
through careful allocätion of rsources,given
competitive market can tre said to be qficienf, or to they do improvements in quality. Quality changes, furthermore, are not as readily
the constraint5 of supply (producers'cods)
and demand (consumers,preferencm). allocate lesources With effitiency. The achievement duplicated as are price changes. Consumers'preferences for quality over price should
of efhciency means that an expansion or contrac- be reflected in the profrtability of making such improvements. If conzumers prefer a
tion ofoutput will reduce consumers' and/or producers' welfare. top-of-the-line MP4 player (iPod) to a cheaper basic model, then producing the mort
The competitive market exploits all the possible trades between buyers and sell- sophisticated model could, depending on the cost ofthe extra features, be more profit-
ers. Up to the equilibrium quanti§, buyers will pay morc than suppliers require able than producing the basic model and communicating its lower price to consumers.
[those points on the demand curve that lie above the supply curve). Beyond 0r,
buyers will not pay as much as suppliers need to produce more (those points on the Changes in one featirre, product size
supply curve that lie above the demand cuweJ. Again, in this regard the market can If allconsumers had exactly the same preferences - size, color, and so on -
be called efficient. producers would presumably make uniform products and compete through price