Equilibrium in the Product Market – Competitive Industry

Abstract

The preceding chapter was devoted to an optimization problem: in a competitive industry, what level of output maximizes the firm's profits? For example, how many shoes will a footwear manufacturer want to produce? This chapter moves on to the equilibrium problem. Looking now at the industry as a whole, we ask when shoe prices will be high and when they will be low. What about the quantities produced and consumed? The answers of course depend upon supply and demand. Chapter 4 analyzed how the market demand curve for a good was derived from the consumption choices of individuals. Similarly, this chapter will show how the separate decisions of the different firms lead to an industry's market supply curve . Together, the market demand curve and the market supply curve determine the equilibrium price and the overall quantities produced and consumed. Later in the chapter Consumer Surplus will be introduced as a measure of the gains to buyers from market exchange, and Producer Surplus as a measure of the gain to suppliers. The analysis will be extended to demonstrate how “hindrances to trade” – such as transaction taxes – affect market equilibrium and prevent full achievement of the benefits of exchange. THE SUPPLY FUNCTION From Firm Supply to Market Supply: The Short Run For a competitive (price-taking) firm, the preceding chapter showed that the price P of its product is necessarily identical to its Marginal Revenue (the additional revenue per additional unit sold).