changes as Supply and Demand shifts. You can use Microsoft Word or Excel to draw your graphs. Each graph should have a title, a label for each axis and you

changes as Supply and Demand shifts. You can use Microsoft Word or Excel to draw your graphs. Each graph should have a title, a label for each axis and you must show the direction of the shift using an arrow. Each line should be labeled also ( Supply or Demand). For each graph you will need both Supply and Demand lines. Before starting this assignment, you might want to refer to Chapter 8: Market Equilibrium, Page 140. 1. Create a graph using supply and demand lines to show how prices and quantity would be affected by an economic downturn such as a recession. (A recession causes a decrease in demand). 2. Create a graph using supply and demand lines to show how prices and quantity would be affected by a decrease in the price of a substitute. 3. Create a graph using supply and demand lines to show how prices and quantity would be affected by a “bumper crop” year. 4. Create a graph using supply and demand lines to show how prices and quantity would be affected in agriculture by an increase in production costs. Chapter 4 discussed the derivation of the market demand curve, based on the
demands of individual consumers, and its elasticity. This represented exactly
one-half of the relationships needed to understand changing market conditions,
including the market equilibrium price. The other part of the puzzle is the market
supply curve.
The purpose of this chapter is to explain how we can derive the market sup-
ply curve for a particular product under conditions of perfect competition and
interpret what equilibrium means for consumers and producers. Attention will
also be given to the forces that cause changes in the market equilibrium price, and
to the nature of the adjustment to the new equilibrium.
DERIVATION OF THE MARKET SUPPLY CURVE
The market supply curve for a particular product is based on the decisions of
what and how much to produce made by individual businesses in an industry.
Firm Supply Curve
The marginal cost curve and the average variable cost curve determine the min-
imum price at which a business can justify operating from an economic perspective.
For our hypothetical business TOP-AG, whose costs of production were presented
in Table 6-3, the minimum acceptable product price would be approximately $16,
which is far below the $45 TOP-AG is currently receiving for its product. If the
price of TOP-AG’s product fell to $10, should the business continue to operate? Holstein cows in a milking power on a dairy farm. The number of dairy farmers producing fluid
milk is just one example of the type of enterprises in the farm sector that approximate the
conditions of perfect competition. Credit: Inzyx/Fotolia.
Would TOP-AG be covering all of its costs of production at this product price? Would
the business even be covering its variable costs of production? In the discussion to fol-
low, we will see that the marginal cost curve lying above the minimum average variable
curve
cost represents the firm supply curve in the current period.
iat
Output OBE in Figure 8-1 represents the breakeven level of production for
na cost
e its
TOP-AG, or the point at which the marginal cost curve in Figure 6 4 intersects the
st curve.
average total cost curve. At this level of output, average revenue is just equal to aver-
age total cost. This means that at BE, economic profits are equal to zero. Output
On in Figure 8-1 is identical to the point in Figure 6-4 at which the marginal cost
curve intersects the average variable cost curve. This means that if the price fell to
P’sD average revenue would just equal average variable cost. The business could mini-
mize its losses in the current period by continuing to produce if prices were below
price PRE. If the product price corresponding to the segment of the marginal cost
curve lies between prices BE and Pep, the firm could cover all of its variable costs and
some, though not all, of its fixed costs by continuing to produce.
A rational competitive firm will cease producing in the short run only when
the product price falls below the average variable costs of production, which occurs
at price Pop in Figure 8-1. Operating when price is below point Asp on the marginal
cost curve will only add to the firm’s losses because TOP-AG is no longer covering
all variable costs. Furthermore, the suppliers of variable inputs (such as fuel and hired
labor) will likely cease supplying these services to the business when the checks start to
bounce. This is why the level of output associated with price P’sp on the marginal cost
curve (output Op) is known as the shutdown point. This is also the reason why we
present only the portion of TOP-AG’s marginal cost curve appearing above its average
variable cost curve when illustrating this business’s supply curve in Figure 8-1.
curve
mmation
Market Supply Curve
y curves.
1 firm
Figure 4-6 illustrates the fact that the market demand curve represents the sum-
supply
mation of the quantities desired by all consumers at specific market prices. The
market demand curve for the two-consumer example depicted in that figure was TOP-AG’s Firm-Level Supply Curve
70
60
Marginal
cost
50
Marginal
40
: revenue
Dollars
30
20
10
3
4.8
6.5
8.5
9.6
10.8
11.6
Output
found by horizontally summing the individual demands of both consumers. The
firm’s supply curve is the portion of its average variable cost curve as illustrated in
Figure 8-1. The market supply curve under conditions of perfect competition is
determined in a similar manner. The market supply curve represents the summa-
tion of the quantities all firms are willing to supply at specific market prices.
Figure 8-24 suggests that Gary Grower would be willing to supply 1 ton of
fresh broccoli if the market price were $1.00 per pound, 2 tons if the price were
$1.50 per pound, and so on. Figure 8-2B shows that Ima Gardner would decline to
produce at a market price of $1 per pound, but would supply 1 ton of broccoli at a
market price of $1.50 per pound, and so on. Figure 8-2C shows that if the market
supply were limited to these two producers, the total supply of broccoli forthcoming
at a market price of $1 per pound would be 1 ton, 3 tons at a market price of $1.50
per pound, and so on.
Like the demand curve, we can also characterize the properties of the market
supply curve by examining the elasticity of this curve.
Own-Price Elasticity of Supply
The market supply curve for a particular product generally has a positive slope
because the quantity supplied by businesses increases when the price it receives goes
up. It is ful to think of the behavioral response of producers in the context of
their own-price elasticity of supply. This elasticity is expressed as
own-price
(QSA – QSB) / [(QSA + QSB)/2]
(8.1)
elasticity of supply
(PA – P) / [(PA + PB) /2]
in which QsA is the quantity supplied after the change in price from P to PA and QB
is the quantity before the change in price. An own-price elasticity of supply exceeding
one indicates an elastic supply, and an own-price elasticity of less than one suggests an
inelastic supply.
For example, if the own-price elasticity of supply for a product is 1.5, a 1%
increase in product price would cause businesses producing this product to increase
their production by 1.5%. Because the percentage change in revenue is equal to the Producer and Market Supply Curves
A
B
C
Gary Grower
Ima Gardner
Market supply (Gary & Ima)
$3.00
$3.00
$3.00
2.50
2.50
2.50
2.00
2.00
2.00
Price of broccoli
Price of broccoli
Price of broccoli
1.50
+
1.50
=
1.50
1.00
1.00
1.00
0.50
0.50
0.5
1 2 3 4 5 6 7
1 2 3 4 5 6 7
1 2 3 4 5 6 7
Quantity of broccoli (tons)
Quantity of broccoli (tons)
Quantity of broccoli (tons)
Figure 8-2
The market supply curve is found by horizontally summing the quantities supplied by all
producers for given levels of market price.
percentage change in price plus the percentage change in the quantity supplied, the
total revenue of producers would increase by 2.5%
Finally, the more (less) elastic or flatter (steeper) the market’s supply curve is,
the greater (lower) the impact a price change will have on total revenue, all other
things constant.’ would the impact of a 1% increase in product price be on
quantity supplied if the market supply curve were perfectly inelastic? would the
change in total revenue be under these conditions?
Producer Surplus
Producer surplus rep-
Economic profit, or producer surplus, is the economic return above the firm’s cost
resents the profit realized
of production. When economic profit exists, surpluses are accruing to businesses
by firms in the market for
specific quantities supplied.
This surplus may be measured for an individual business by examining the business’s
returns above costs of production.
A business will supply the first unit of output at a price equal to the mar-
ginal cost of producing the first unit. If this marginal cost were $1 and the price of
the product were $4, the business would receive a $3 surplus from producing and
exchanging the commodity. If the marginal cost of producing the one-hundredth
unit were $3, the surplus would be $1 for producing the unit.
By similar reasoning, the area above the market supply curve and below mar-
ket price represents the producer surplus accruing to businesses participating in the
market. This surplus is represented by area ABC in Figure 8-3 when the product
price is $4. If the product price rises to $6, producer surplus increases to area CED.
These areas represent the total economic profit received by firms in their market.
Area AEDB represents the gain in producer surplus resulting from the rise in the
product price from $4 to $6. Hence, producer surplus represents a measure of the
gain in economic welfare that businesses receive from producing a particular product
in the current period.
"If firms produce more than one product, and these products are independent of one another, the discussion pre-
sented earlier applies to each product considered separately.
"This reflects both variable and fixed costs as the supply curve reflects the marginal cost curves of firms in the industry. Concept of Producer Surplus
Economic welfare
Price of $4 = CAB
Price of $6 = CED
Gain from price rise = AEDB
Market supply
D
$6
Price
A
$4
Product price
C
Output
Figure 8-3
The change in the economic welfare of businesses can be approximated through the concept
of economic rent or producer surplus. The value of this surplus at a price of $4 is given by the
darkly shaded area above the market supply curve and below the $4 equilibrium market price
for the product. This area reflects the revenue received by a business above the minimum price
at which it would have been willing to supply its product.
MARKET EQUILIBRIUM UNDER PERFECT
COMPETITION
One of the conditions for perfect competition presented at the beginning of Chapter 6
is that the business’s product is homogeneous, or a perfect substitute for the product
sold by the other businesses in this market. Perfect competition enables buyers in the
market to choose among a large number of sellers. Another condition enables any
business that desires to enter or leave the sector to do so without encountering serious
barriers. There must be a large number of sellers and buyers in the market to have a
perfect competition. No single buyer or seller should have a disproportionate influ-
ence on price. Finally, adequate information must exist for all participants regarding
prices, quantities, qualities, sources of supply, and so on.
When all four conditions hold, we can say the market’s structure is perfectly
competitive. Businesses supplying goods in this market are also, by definition, per-
fectly competitive. Each is a price taker, or accepts the price of the product as given.
Agriculture probably comes as close as any sector in the economy to satisfying these
conditions. There are thousands of corn growers in the United States producing no.
2 yellow corn, each having similar access to market information, and none confront
legal barriers to enter or leave the sector."
Market Equilibrium
The equilibrium price in a perfectly competitive market is established by the point
of intersection of the market’s demand and supply curves. Let Dy represent the mar-
ket demand schedule for the sector’s product and SM represent the market supply
The corresponding economic profit of the individual firm operating at MR = MC is equal to the average profit, or
average revenue (") minus average total cost, times the quantity produced. Equilibrium Price under Perfect Competition
Consumer one
Consumer two
PE
PE
6
3
Q
Quantity demanded = 6 + 3 =9
Producer one
Producer two
Market equilibrium
P
S2
PE
PF
PE
5
QE =9
Quantity supplied = 5 + 4 = 9
Figure 8-4
The equilibrium price in a competitive market is given by the intersection of the market
demand and supply curves. As shown in this figure, this would result in a price PE and quantity
Q:. At this price, consumers collectively would demand nine units, and producers collectively
would supply nine units.
schedule for all businesses in the sector. We have assumed, for ease of presentation,
that there are only two buyers (consumers) and two sellers (producers) in this market
Figure 8-4 shows that the equilibrium price in this market would be equal to PE. At
this price, businesses would be willing to supply quantity OF (or 9 units) and the
buyers of this product would desire to purchase quantity QE (also 9 units). Thus, PE
and only P: is the price per unit that will "clear the market."
Shifts in either the demand curve or the supply curve will result in a new equi-
librium market price. Four possible events can occur that will affect the market equi-
librium price and quantity:
1. Demand increases, shifting the demand curve to the right.
2. Demand decreases, shifting the demand curve to the left.
3. Supply increases, shifting the supply curve to the right.
4. Supply decreases, shifting the supply curve to the left.
The effects of each situation on the equilibrium price that clears the market are
illustrated in Figure 8 5. In Figure 8-54, for example, we see that an increase in demand
(perhaps consumer disposable income increased) will result in a higher market price
(P*). Buyers will now demand, and businesses will supply, a quantity equal to Q Price Effects of Shifts in Supply and Demand
A
B
Increase in demand
Decrease in demand
Increase in quantity supplied
Decrease in quantity supplied
S
S
P"
P
Qe
Q e
C
D
Increase in supply
Decrease in supply
Increase in quantity demanded
Decrease in quantity demanded
PA
Qa
Qe
Figure 8-5
It is important to distinguish between changes in supply or demand and changes in the
quantity supplied or demanded.
instead of Q: The opposite effect occurs when demand decreases (see Figure 8-58).
In both cases there is a change in demand and a change in the quantity supplied
Turning to supply, let us assume that the supply of the product increases or
that the supply curve shifts to the right. Figure 8-5C illustrates that this shift will
lead to a decline in the market-clearing price from P, to *. At this new price, firms
will supply, and buyers will demand, a quantity equal to Q". Figure 8-5D shows
that the opposite outcome will occur if there is a decrease in supply. In both cases,
there is a change in supply and a change in the quantity demanded.
The elasticity of the demand and supply curves plays an important role in
determining how much the equilibrium price will change if either demand or supply
changes. For example, the more inelastic or steeper the demand curve, the greater
the rise (fall) in the market price will be for a given decrease (increase) in supply.
The relatively inelastic nature of the demand for farm products, coupled with a vola-
tile supply curve that can shift to the right or to the left depending on the vagaries of Price Effects of Shifts in Supply and Demand
A
Increase in demand
Decrease in demand
Increase in quantity supplied
Decrease in quantity supplied
D
PA
P
Qe
Q –
C
D
rease in
Decrease in supply
Increase in quantity demanded
Decrease in quantity demanded
P
Qe
Figure 8-5
It is important to distinguish between changes in supply or demand and changes in the
quantity supplied or demanded.
instead of Q- The opposite effect occurs when demand decreases (see Figure 8-58).
In both cases there is a change in demand and a change in the quantity supplied
Turning to supply, let us assume that the supply of the product increases or
that the supply curve shifts to the right. Figure 8-5C illustrates that this shift will
lead to a decline in the market-clearing price from P, to P. At this new price, firms
will supply, and buyers will demand, a quantity equal to Q". Figure 8-5D shows
that the opposite outcome will occur if there is a decrease in supply. In both cases,
there is a change in supply and a change in the quantity demanded.
The elasticity of the demand and supply curves plays an important role in
determining how much the equilibrium price will change if either demand or supply
changes. For example, the more inelastic or steeper the demand curve, the greater
the rise (fall) in the market price will be for a given decrease (increase) in supply.
The relatively inelastic nature of the demand for farm products, coupled with a vola-
tile supply curve that can shift to the right or to the left depending on the vagaries of weather, s explain the high variability of farm income that we often see from one
period to the next. More will be said about this when we discuss the traditional farm
problem in subsequent chapters.
Total Economic Surplus
In Figure 4-9, we learned that consumer surplus is given by the area below the
demand curve and above the equilibrium price. We also learned that producer sur-
plus is given by the area above the supply curve and below the equilibrium price (see
Figure 8-3). These areas represent the economic well-being achieved by consumers
and producers at the equilibrium or market-clearing price. If we add these two tri-
angular areas together, the newly formed triangle represents the economic well-being
achieved by all market participants in this particular market. In Figure 8-6, the sum-
mation of consumer surplus (area 1) plus producer surplus (area 2) represents the
Total economic surplus is
total area above the supply curve and below the demand curve, and hence the total
equal to consumer plus
economic surplus received by all market participants.
producer surplus.
Now suppose that because of low yields, the supply curve for this market
shifts inward to the left from $ to S* (Figure 8-7). Producer surplus would now be
Figure 8-6
Consumer and Producer Surplus
Area 1 represents consumer
surplus and area 2
represents producer surplus.
The sum of both areas
represents the economic
well-being of society from
participating in this market.
Price per unit
Quantity
Figure 8-7
Impact of Drought on Consumers
This figure shows what
would happen to the
economic welfare of
consumers and producers
if a drought caused the
Welfare effects
aggregate supply curve to
shift from S to 5*.
Consumer surplus
P .
Before drought = 3 + 4 +5
15
After drought = 3
Price per unit
P.
Loss = 4 +5
Producer surplus
Before drought = 6 + 7
After drought = 4 + 6
Loss = 4 – 7
Quantity equal to area 4 plus area 6. Thus, if areas 4 plus 6 sum to less than areas 6 plus 7,
we may conclude that the economic well-being of producers would have declined.
We can also conclude that consumer surplus declined because consumers received
the equivalent of areas 3, 4, and 5 before but now receive only area 3. Finally, we
can conclude that this decrease in supply means that the economic well-being of
market participants in general would have fallen by an amount equal to area 5 plus
area 7.
Applicability to Policy Analysis
The concept of producer and consumer surplus is an important analytical tool to
economists. We may be examining the economic welfare implications of a major
drought, such as the drought of 1988, which results in a shift in the current sup-
ply curve as discussed previously. Or we may be examining a change in agricultural
or macroeconomic policy that causes a shift in either the demand or the supply
curve in the current period. The concept of producer and consumer surplus s in
assessing the relative effects of these externalities. It is not unusual for economists,
when testifying before Congress on the effects of a drought or a particular policy
change, to use the concept of consumer and producer surplus to illustrate the effect
this would have on the economic well-being of market participants.
The concept of producer and consumer surplus will be used in Chapter 9 when
we assess the economic welfare implications of imperfect competition. It will also be
used extensively later in this book when we examine the effects of agricultural policy
on consumers and farmers.
ADJUSTMENTS TO MARKET EQUILIBRIUM
Markets are not always in equilibrium. In fact, many rarely are. Instead, changing
demand and supply conditions across numerous markets result in market disequilib
rium. This section describes the symptoms of market disequilibrium and how mar-
kets adjust to a new equilibrium.
Market Disequilibrium
At prices above the market-clearing price ,, there would be an excess quantity sup-
plied by businesses, or a commodity surplus. At prices below the market-clearing
price, an excess quantity demanded, or commodity shortage, would exist. For
example, Figure 8 84 shows that at price , buyers would wish to purchase Qad
and sellers would want to supply Q,. The difference between these two quantities
(Q, – Q ) represents the surplus available on the market at the price P. This sug-
gests that the market is in disequilibrium instead of equilibrium because the market
has not been cleared at this price. The opposite is illustrated in Figure 8-8B. At a
price of Pa, buyers would wish to purchase quantity Qa, and sellers would only want
to supply quantity Q.. Thus, a shortage equal to Q1 – Q, would exist in the market
at a price of Pa.
The existence of these disequilibrium situations will modify over time if prices
and quantities are free to seek their equilibrium levels. If a surplus exists, for example,
the inventories of unsold production will be unintentionally high. Firms will have
incurred costs but received no revenues for this unplanned inventory buildup. As
long as these inventories remain unsold, firms will also be incurring storage costs
in one form or another. Because they are not maximizing their profits at this point,
firms will find it profitable to decrease their level of production and accept a lower
price for their inventories. B
Market Surplus
Market Shortage
Surplus
S
Price per unit
P
Price per unit
P
P
PA
Shortage
Q.
Quantity
Quantity
Figure 8-8
The equilibrium price in a competitive market is given by the intersection of the market
demand and supply curves. If, instead, the price were equal to P, (A), producers would be
willing to supply more than consumers would demand. This phenomenon is referred to as
surplus. If the price were instead equal to Pa, the quantity demanded by consumers would be
greater than the quantity producers would be willing to supply. This excess demand situation is
commonly referred to as a shortage.
This adjustment process will stop after prices have fallen from P, to P. If a
shortage exists, buyers would compete for available supplies by offering to pay higher
prices. This will encourage firms to raise and market more of this commodity. This
adjustment process will stop after prices have risen from Pa to P. At this point, the
quantity demanded will be exactly equal to the quantity supplied, and market equi-
librium will be restored.
Length of Adjustment Period
The adjustment processes discussed earlier may suggest that the quantities demanded
and supplied are both determined by current prices. In some sectors like agriculture,
however, adjustment to market equilibrium takes time. One reason is the biological
nature of the production process itself. Once the crop has been planted, for example,
little can be done to adjust the supply response of producers until the next produc-
tion season. Furthermore, when farmers plant their crop, they do not know what the
market price will eventually be when they sell their crop several months later.
Let us assume for the moment that farmers base their production plans for this
year on last year’s price. Price and quantity are now sequentially determined rather
than simultaneously determined. Last year’s price determines this year’s production
response. This year’s quantity marketed, however, will affect this year’s price, which
will affect next year’s production, and so on.* If prices were high last year, for example,
farmers under free-market conditions would respond by expanding their production
activities with the anticipation of eventually marketing more output. The increased
level of production will lead to lower prices, all other things constant. This pattern of
price and quantity responses forms a pattern like a spider’s cobweb over time.
"The demand and supply functions in this instance would be given by R = (Q) and Q, = AR-1), respectively.
The response to last period’s price in the supply function is thus different from the response to current price assumed
thus far. Cobweb Adjustment Cycle
To illustrate cobweb market behavior, let us examine Figure 8-94. Given the demand
Cobweb adjustment
and supply curves D and S, let’s suppose that the price of corn last year (year one) is
One way to think of how
equal to Pi. Because corn farmers base their production for year two on A, they will
markets adjust to a new
produce Q2 in year two. This quantity, however, will cause prices in year two to fall
equilibrium is the Cobweb
theorem, which leaves a
to P. As shown in Figure 8-98, corn farmers will respond to this lower price by pro-
pattern much like a spider
ducing only Q3 in year three, which will cause market prices to rise to ‘3.
web.
This behavior of prices and quantities over time is referred to as a cobweb pat-
tern, after the cobweb-like nature of the solid lines tracing the movements of prices
and quantities shown in Figure 8-9C. This panel illustrates the nature of a converg
ing cobweb. Here, prices and quantities will eventually converge to a market equilib
rium at price PE. This cobweb pattern will occur when the slope of the supply curve
is steeper or more inelastic than the slope of the demand curve. A diverging cobweb
occurs when the slope of the demand curve is steeper or more inelastic than the slope
of the supply curve.’
Events causing changes in demand or supply can cause an interruption to these
cycles and lead to a new set of market adjustments over time. As we will discuss later
in Chapter 11, federal programs that are designed to modify the booms and busts
associated with fluctuating prices and quantities exist for some commodities.
A
B
Year 2
Year 3
S
S
Producer decision
based on year 1 price
P
Consumer decision
based on year 3 price
Price
Price
Producer decision
Consumer decision
based on year 2 price
based on year 2 price
P.
Q,
Quantity
Quantity
C
Cobweb Pattern
PE
Price
X-
Market equilibrium
QE
Quantity
Figure 8-9
When producers respond to the previous period’s price, markets will adjust to market
equilibrium in a cobweb pattern.
‘A persistent cobweb would occur if the demand and supply curves have identical slopes, which means that the mar-
ket would continue to oscillate around the market’s equilibrium, never converging or diverging.

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