1. Determining Market Price
We are now ready to combine supply and demand curves into a single figure in order to study how the market price is determined in a competitive free market (i.e., what we can define as the so called equilibrium price and quantity or competitive free market equilibrium). Our goal is to understand the (very) basics of how markets operate.
Figure E4 shows hypothetical (and simplified) demand and supply curves for seedlings in a large market with an x-axis in 100,000 seedlings. Demand and supply curves are normally plotted so that price, marginal cost and marginal willingness to pay are presented in a vertical y-axis and quantity, respectively, in a horizontal x-axis. Consequently, we often call curves like these plotted here as "inverse demand and supply curves." Under perfect competition there is a balance between the quantity demanded and the quantity supplied in market equilibrium. This would imply that in the equilibrium market, demand and market supply curves intersect. We can see that at the intersection, (equilibrium) price, P*, is 2,000 € per 10,000 seedlings (i.e., 0.20 € per seedling) and (equilibrium) quantity, Q*, 1 million (10 times 100,000) seedlings. At any other price, there is a discrepancy between quantity demanded and quantity supplied.
Note also that the market price is affected by both demand and supply factors. The intersection changes if either the supply or demand curves shift. By drawing demand and supply curves in Figure E4, we have expressed a quantity demanded (and supplied) as a function of price alone. This means that various demand and supply shifters have been held constant. We return to supply shifters in more detail in ECON6.
Figure E4: Market equilibrium for seedlings
In a market economy, price has at least three critically important functions in coordinating voluntary transactions between decentralized decision makers. First, price transmits information. Secondly, it works as an incentive and finally it determines income distribution. According to Randall (1987):
"...one of the greatest virtues of price is its tendency to adjust rapidly to changing conditions, and by so doing, it transmits information and relays incentives for equilibrium adjustments."
The aggregate total willingness to pay above the market price is called "consumer surplus." Consumer surplus is the area below the demand curve and above the price line (area X in Figure E4). Market price multiplied by the quantity (P*Q*) results in total expenditure on seedlings for forest owners and therefore the consumer surplus is the actual net benefit from the use of seedlings to forest owners.
In a similar way we can define the concept of producer surplus. Again, we note that all sellers get the same price for each unit of good, but some nurseries would be able to supply at least some units of seedlings at lower prices since the marginal costs for the first units remain lower than market price. The difference between market price multiplied by quantity and the aggregate total marginal cost is called "producer surplus." It is the area below the price line and above the industry supply curve (area Y in Figure E4). Producer surplus is also extra income to some firms which is above the minimum required to produce the current output.
From Figure E4 we can also see that in market equilibrium the marginal benefit (marginal willingness to pay) is equal to marginal cost. We have already seen that this is the general (and necessary) condition for optimization. In this case, market equilibrium illustrates the quantity of seedlings that maximize the sum of consumer and producer surpluses. For example, the net benefit for consumers (forest owners) and producers (owners of nursery firms).
There exists a following rule of thumb: if the market is perfectly competitive, the market equilibrium is also socially optimal. Given the demand and supply curves as shown in Figure E4, it is possible to test this rule graphically: by changing the quantity produced (i.e., resource allocation) and we can now observe how the sum of consumer and producer surpluses changes. We can also show that it is not possible by any reallocation to increase this sum, (i.e., the net benefit to society).
Let us assume for that for a wood product (inverse) market demand simply as P=4000-200QD, where QD is quantity demanded and P is price (marginal willingness to pay). The inverse market supply is respectively P=1000+100QS, where QS is the quantity supplied and P is the price (marginal cost). NOTE: We saw above that in equilibrium market demand and market supply curves intersect.
We can solve the equilibrium price and quantity from this system of two equations for two unknowns by example of substitution.
"Supply equals demand" thus (QD=QS) leads to 3000=300Q which results in Q=10. By substituting Q into a demand or a supply equation we can compute that P=2000 (so we actually mathematically solve the market equilibrium presented in Figure E4). It is also possible to present these curves as QD=-P/200+20 (demand) and QS=P/100-10 (supply). By equalizing the quantity demanded and supplied we can get the same result.
With this example we have briefly shown how "a free market" could in theory maximize "social welfare." If this were the case, it would be difficult to call for any public policy intervention (since, by definition, it is not possible by any reallocation to increase "social welfare"). But what is meant by "in theory"? For this outcome (or ideal) several conditions are required.
At this point, we would like to list a few ideal conditions. We are assuming "perfect competition" - that individual forest owners and nurseries have to be so small that they are not able to change the price by their own consumption or production decisions. This implies that individual consumers (and producers) face horizontal supply (and demand) curves.
In addition, this ideal is only possible if there are unpriced negative (or positive) side effects that are neither found in production nor in the consumption of seedlings. For example, all costs that are imposed on others have to be included in the production costs. This is not necessarily the case (if for example) the use of fertilizers and herbicides in the production of seedlings cause uncompensated damages in the form of groundwater pollution. Due to free access to use groundwater for waste disposal, pollution has no effect on a nursery's production decisions and consequently marginal private costs will differ from marginal social costs.
Uncompensated environmental damages are typical examples of negative externalities. However the use of seedlings in plantations can also cause unpriced positive side effects, (i.e., climatic benefits as increased carbon sequestration) which can result in the difference between private and social benefits derived from the use of seedlings. Environmental externalities also illustrate the need for pricing all the inputs and outputs including the enforcement of property rights to resources.