Question

Suppose that, in a perfect competitive market, an equilibrium point is generated by intersecting downward sloping market demand curve and upward sloping market supply curve. Explain step by step how to get this equilibrium point from the decision making of INDIVIDAL consumers and producers. In your answer individual consumer's decision making must start from preference ordering and utility maximizing process. Producer's decision making must start from budget constraint, production function and go to the process of cost minimization and profit maximization. Also explain how to move from individual decision makings to the entire market interaction. In your answer, include all necessary steps, concepts, graphs, formulas, etc. which you have learned during this course. Make a coherent, analytic essay (Note: in perfect competitive market, a supply curve of individual firm is different to the market supply curve.)

Answer 1

An intersection of a downward sloping demand curve and the upward sloping supply curve gives the equilibrium point. The demand curve is downward sloping because an increase in the price of the good leads to the decrease in the quantity demanded by the consumer and vice-versa. Similarly, a supply curve is upward sloping because an increase in the price leads to the increase in the supply by the producers.

To understand this equilibrium point, the decision making by the individual consumers and the producers, as well as, the demand of all the consumers in the market and the market supply of all the producers is considered.

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The individual demand is the function of price,

$Q_{D}=f(P)$

The demand decision starts from the preference ordering by the individual consumers. From the bundle of all the goods, the consumers rank the given goods in the order of their preferences. After the ordering, the consumers take decisions with the aim of utility maximizing. The consumers aim at maximizing their utility and therefore, choose the bundle of goods which maximizes the utility. After choosing the bundle, the desired and the feasible allocation is found and the indifference curve is drawn. Now, the budget constraint is considered. Budget constraint is given as:

$M=(P_{X}\times X)+(P_{Y}\times Y)$

Here, X and Y are the two goods. P_X is the price of good X and P_Y is the price of good Y. M is the income.

With the given income, the bundle of the good is selected by the consumer which satisfies the budget constraint and also maximizes the utility.

Market demand is the summation of the individual demands. In market demand, the preferences of all the consumers are summed up.

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The individual supply is the function of price,

$Q_{S}=f(P)$

A producer starts his decision making by considering his budget constraint. With the given income, a producer first lists down all the possible bundles of the goods which are feasible. After considering the budget constraints, the production possibility frontier is constructed which is the bundles of all the goods that can be produced with the given resources that the firm have. Now, the producer has all the combinations of the goods which can be produced with the amount of money that the producer has and the given resources.

After this, the producer considers minimizing the cost, in order to maximize his profits. Therefore, the bundle is chosen which is feasible with the given resources and the cost and also, which minimizes the cost of production.

Now, the short-run market supply is the envelop of the short-run individual supplies by all the firms. In the short run, there are some fixed factors and some variable factors. In the long run, all the factors are variable and therefore, considering all the factors of production gives the long run supply curve of the firm.