The equilibrium of a competitive market

Now that we have examined both market demand and supply curves, we can consider how they jointly determine the price of the good and the amount sold. In a competitive market, the equilibrium price, and the equilibrium quantity sold, are determined by the intersection of the market supply and demand curves. In Figure 1.2, the demand and supply curves

Figure 1.2 The equilibrium of a competitive market.

intersect at point E, and this determines both the market price P* and the quantity sold Q*. Notice that at a price lower than P*, such as Pi. the amount demanded, PjC, exceeds the amount offered for sale by suppliers, PJ3. Accordingly if Pi were the market price, some of the buyers, in the amount BC, would not be able to obtain any goods. Yet we know that the value of the good to these buyers is represented by the height of the demand curve above the line segment BC. and in this region the demand curve is everywhere higher than Pi. We would expect that some buyers would then offer to pay sellers a premium - a price greater than Р» - to avoid having to go home with no merchandise. This will cause upward pressure on the price. On the other hand, if the price happened to be above P*, such as Ph, the amount offered for sale by suppliers, Pi,J. exceeds the amount demanded at that price, PiJF. Thus if Ph were the market price some of the sellers, in the amount FJ, would be unable to find buyers for then goods. Yet we know that the amount the sellers are willing to sell the good for is represented by the height of the supply curve below the line segment FJ, and in this region the supply curve is everywhere lower than Pi,. Under these conditions one would expect that some sellers would offer discounts to avoid being left with then inventory. This would cause downward pressure on the price. Accordingly if the current market price happens to be something other than P*, market forces will tend to push the price back toward equilibrium.

Price ceilings

Sometimes the law prevents the price from moving toward equilibrium. For example, some cities have statutes on rent control that make it unlawful for landlords to charge more than a specified amount, which is often much less than the equilibrium rental. Rent control is an example of a “price ceiling.” hi Figure 1.3, P_c is the maximum rent allowed by law. At P_c there is excess demand for apartments in the amount AB, yet buyers cannot legally compete for apartments by raising their bids above P_c. hi this kind of situation competition among

Figure 1.3 The effects of rent control, a price ceiling.

buyers who do not want to be excluded will be diverted into other channels. One form of competition is waiting in line; in many cities with rent control, apartments have long waiting lists. Another way of competing is through the quality of the buyer; a landlord who chooses a tenant from hundreds of applicants will be inclined to choose one whom he finds personally attractive: perhaps someone who is quiet, or highly educated, or from an ethnic or religious background favored by the landlord, or an applicant without small children, who may be expected to cause more wear and tear to the apartment. Thus, as has often been noted, low- income persons and members of minority groups, whose types by definition are underrepresented in the landlord population, do not necessarily benefit from rent control.

A price ceiling can also be avoided by “black market” transactions: applicants may surreptitiously give landlords “key money” to move ahead of others on the waiting list, or may agree to purchase worn-out furniture from the landlord at inflated prices. The point is that competition among buyers for the scarce commodity cannot be suppressed by law, and will, without fail, find a way to express itself.

Rent control laws have some effects that develop over tune (there is a general distinction between static and dynamic analysis: a static analysis examines market forces at a given point in time, while a dynamic analysis considers changes that occur over time). In the case of rent control, owners of apartment buildings have little incentive to maintain their buildings, since they will receive a rent of only P_c rather than P*. Consequently many property owners simply allow their buildings to deteriorate to the point where their rental value reaches P_c. On the extensive margin, some owners will convert their apartment buildings to office space, or to other uses that are not subject to rent control ordinances. In addition, developers may well choose not to construct new buildings in areas where there is rent control.

In Chapter 5 on property law we will encounter other price ceilings in a number of different contexts: in the procurement of transplantable human organs, in the adoption of babies, and the protection of endangered species such as African elephants.

An important feature of competitive equilibrium is its effect on social welfare. Competitive equilibrium maximizes the net social benefits of exchange, i.e., the total social benefits of exchange, minus the total social costs. Net social benefits are maximized when, in deciding how much output to produce, suppliers produce more output as long as the social value of

Table 1.2 Market demand and supply curves

an additional unit of the good (the height of the demand curve) exceeds its social cost (the height of the supply curve); when total output reaches a point where this is no longer true, production should cease. The optimal level of output will emerge as the natural outcome (the equilibrium) of a competitive market.

Suppose the height of the demand and supply curve for different amounts of the good are as shown in Table 1.2. Note that the fourth unit is the last one for which the height of the demand curve exceeds the height of the supply curve; thus four units of output will be produced in equilibrium. The social value of four units of output is

• (40 + 30 + 20+ 15) = S105 and the social cost is:
• (6 + 10 + 12 + 14) = $42

Therefore the net social benefit from producing and selling four units of output is $63. If only three units were produced, the net social benefit would be (90-28) = $62, and if five units were produced, the net social benefit would be (119-58) = $61. Net social benefits are maximized when suppliers produce and sell exactly four units, and this will occur in equilibrium.

One normally thinks of demand and supply curves as being continuous, rather than the discrete step functions shown hi Table 1.2. Figure 1.4 shows the competitive equilibrium for continuous demand and supply curves. The net social benefit of a market in avocados is represented by the area AEB, which equals (1) the area under the market demand curve AEQ*0 (representing the total social value of the avocados) minus (2) the area under the market supply curve BEQ*0, (representing the total social cost of the avocados). Subtracting the total social cost from the total social value yields the net social value, or net social benefit, of having a market for exchange of the avocados.

The market for lawyers

Let us now apply the ideas introduced above to a real-world example: the market for lawyers in the United States. Figure 1.5 shows the supply curve for legal sendees in the United States. The wage of lawyers is on the vertical axis, and the amount of legal sendees provided is on the horizontal axis. The amount of legal sendees could be measured, for example, in millions of man-hours of legal work per year. If there is an increase in demand for legal services, as there was between 1975 and 1987, the relative wage of lawyers will increase, and more legal sendees will be provided. In Figure 1.5, the demand curve shifts from Di to D2, the wage increases from W] to Wi, and the quantity of legal sendees increases from Li to Lt.

On the intensive margin, lawyers may choose to work longer hours. On the extensive margin, more college graduates wdll choose to enter law school. Some individuals wdio were

Figure 1.4 The net social gain from a market for avocados.

Figure 1.5 An increase in demand for legal services.

trained as lawyers blit left law’ practice may be attracted back into legal work, and some older lawyers who were previously planning to retire may now decide to postpone their retirement. Overall, in the United States the number of lawyers per capita doubled between 1967 and 1979, and increased by almost an additional 50 percent between 1979 and 1987.¹⁰

To provide the additional lawyers for the U.S. economy, there were changes in law schools at both intensive and extensive margins. The number of law' schools grew’ at an annual rate of 2.35 percent from 1967 to 1975, and then slowed to 0.64 percent, reaching a peak of 175 schools in the mid-1980s. Over the same period, the average size of each law school increased by 75 percent.¹¹ Most of the adjustment occurred at the intensive margin, since change at the extensive margin is more costly: it takes time to plan and build a new school, recruit faculty and students of high quality, assemble a library, and the like.