2.3 competitive market equilibrium

How are prices for goods/services determined in a market system?

Prices are determined by the interaction of demand and supply.

What is a market?

A market is any place that brings buyers and sellers together. Markets can be physical (e.g., McDonald's) or virtual (e.g., eBay).

What is consumer sovereignty?

Consumer sovereignty is exercised by buyers when they choose not to purchase a good/service if they do not agree on the price.

When does market equilibrium occur?

Equilibrium in a market occurs when demand = supply.

What is the equilibrium or market-clearing price?

This is the price at which sellers are clearing their stock at an acceptable rate and buyers are satisfied with the product's utility.

What creates disequilibrium in a market?

Any price above or below the equilibrium price creates disequilibrium. Disequilibrium occurs whenever there is excess demand or excess supply in a market.

What is excess demand?

Excess demand occurs when the demand is greater than the supply. It can occur when prices are too low or when demand is so high that supply cannot keep up with it.

What is the market response to excess demand (shortage)?

Sellers will gradually raise prices. This causes a contraction in quantity demanded (QD) and an extension in quantity supplied (QS) until equilibrium is reached.

What is excess supply?

Excess supply occurs when the supply is greater than the demand. It can occur when prices are too high or when demand falls unexpectedly.

What is the market response to excess supply (surplus)?

Sellers will gradually lower prices. This causes a contraction in quantity supplied (QS) and an extension in quantity demanded (QD) until equilibrium is reached.

How are prices for goods/services determined in a market system?

Prices are determined by the interaction of demand and supply.

What is a market?

A market is any place that brings buyers and sellers together. Markets can be physical (e.g., McDonald's) or virtual (e.g., eBay).

What is consumer sovereignty?

Consumer sovereignty is exercised by buyers when they choose not to purchase a good/service if they do not agree on the price.

When does market equilibrium occur?

Equilibrium in a market occurs when demand = supply.

What is the equilibrium or market-clearing price?

This is the price at which sellers are clearing their stock at an acceptable rate and buyers are satisfied with the product's utility.

What creates disequilibrium in a market?

Any price above or below the equilibrium price creates disequilibrium. Disequilibrium occurs whenever there is excess demand or excess supply in a market.

What is excess demand?

Excess demand occurs when the demand is greater than the supply. It can occur when prices are too low or when demand is so high that supply cannot keep up with it.

What is the market response to excess demand (shortage)?

Sellers will gradually raise prices. This causes a contraction in quantity demanded (QD) and an extension in quantity supplied (QS) until equilibrium is reached.

What is excess supply?

Excess supply occurs when the supply is greater than the demand. It can occur when prices are too high or when demand falls unexpectedly.

What is the market response to excess supply (surplus)?

Sellers will gradually lower prices. This causes a contraction in quantity supplied (QS) and an extension in quantity demanded (QD) until equilibrium is reached.

What is the primary role of the price mechanism?

It's the interaction of demand and supply in a free market that determines prices, which are the means by which scarce resources are allocated between competing wants/needs.

What did Adam Smith call the functions of the price mechanism?

The 'mystery of the invisible hand'.

What are the two main functions of the price mechanism?

1. Resource allocation (signalling and incentive).

2. Rationing.

How do prices act as a 'signal' in resource allocation?

They inform producers and consumers where resources are wanted (increasing prices) and not wanted (decreasing prices).

How do prices provide an 'incentive' for resource allocation?

Rising prices encourage producers to shift resources to more profitable markets, while falling prices encourage reallocation to new markets.

How does the price mechanism 'ration' scarce resources?

When resources are scarce, prices rise, limiting consumption to those who can afford them. Falling prices (due to surplus) make resources available to more consumers.

How does an increase in demand for honey (e.g., from D_{1} to D_{2}) affect a local honey market?

It causes the price to rise (e.g., from 15 to 18), which rations the product, incentivises producers to increase quantity supplied (extension from Q_{1} to Q_{2}), and signals strong demand to potential new producers.

How does decreased production cost impact a national market (e.g., T-shirts), and what are the market responses?

A decrease in production costs shifts supply right (e.g., S_{1} to S_{2}), leading to a lower price (P_{1} to P_{2}) and higher quantity (Q_{1} to Q_{2}). This rations the product more widely, incentivizes consumer purchases (demand extension), and signals excess supply, potentially causing some producers to exit.

How does the price mechanism guide global cash crop markets?

Producers use world prices to direct production decisions, especially for cash crops in competitive supply (e.g., wheat, corn) which share factors of production.

How does rising global demand for one cash crop (e.g., potatoes) affect its market and other competitive crops (e.g., corn)?

Increased global demand for potatoes (e.g., D_{1} to D_{2}) raises its price (e.g., 2/kg to 3/kg), rationing the product and incentivizing producers to increase supply (e.g., Q_{1} to Q_{2}). This signals to farmers in competitive markets (like corn) to reallocate resources to potatoes, potentially reducing corn supply.

What is consumer surplus, as represented in a market diagram?

Consumer surplus is the monetary gain consumers get when they purchase a product for a price lower than the highest price they were willing to pay. Graphically, it is the triangular area below the demand curve and above the equilibrium price, for example, the area labeled ABPe in a standard market diagram.

What is producer surplus, as represented in a market diagram?

Producer surplus is the benefit producers receive when they sell a product for a price higher than the lowest price they were willing to accept. Graphically, it is the triangular area above the supply curve and below the equilibrium price, for example, the area labeled CBPe in a standard market diagram.

What is social or community surplus?

Social or community surplus is the total welfare generated in a market, calculated as the sum of Consumer Surplus + Producer Surplus.

How does disequilibrium affect social surplus, as generally observed in market diagrams?

Any disequilibrium (price above or below equilibrium) reduces the overall social surplus. This means the combined area of consumer and producer surplus is smaller than at equilibrium, indicating a less efficient allocation of resources.

How does an increase in supply affect consumer and producer surplus, as illustrated in a market diagram (e.g., S_{1}\rightarrow S_{2})?

As shown in the diagram, a rightward shift of the supply curve (from S_{1} to S_{2}) increases consumer surplus (from area ACE to the larger area BED) and producer surplus (from area ACF to BDG), leading to a larger social surplus.

How does an increase in demand affect consumer and producer surplus, as illustrated in a market diagram (e.g., D_{1}\rightarrow D_{2})?

As depicted in the diagram, a rightward shift of the demand curve (from D_{1} to D_{2}) increases producer surplus (from area ACE to the larger area BED) and consumer surplus (from area ACF to BDG), resulting in a larger social surplus.

How are consumer and producer surplus calculated from a market diagram using the area of a triangle formula?

To calculate, first identify the equilibrium price and quantity. Then, for consumer surplus, calculate the area of the triangle formed by the demand curve, the Y-axis, and the equilibrium price line. For producer surplus, calculate the area of the triangle formed by the supply curve, the Y-axis, and the equilibrium price line. The formula is 1/2 \times base \times height for both.

How is the change in consumer surplus calculated from a diagram when supply increases (e.g., from new technology)?

As shown in the diagram for an increase in supply (e.g., from S_{1} to S_{2}), the consumer surplus changes from the initial triangular area ACE (before the shift) to the larger area BDE (after the shift) at the new equilibrium. The change in consumer surplus is BDE - ACE.

How is the change in producer surplus calculated from a diagram when supply increases (e.g., from new technology)?

As shown in the diagram for an increase in supply

What are the two main types of efficiency economists identify?

Productive efficiency and allocative efficiency.

When does allocative efficiency occur?

It occurs at the level of output where the marginal utility (marginal benefit) = marginal cost (MB = MC), ensuring consumers and producers get maximum possible benefit with no excess demand or supply.

When does productive efficiency occur?

It occurs at the level of output where average costs are minimized, indicating no wastage of scarce resources and a high level of factor productivity.

In a market diagram, how are marginal benefit (MB) and marginal cost (MC) represented?

The demand curve represents the marginal benefit (MB) to the consumer, and the supply curve represents the marginal cost (MC) to the producer.

What characterizes a market as allocatively efficient, and what is its impact on community surplus?

A market is allocatively efficient when MB = MC. At this point