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).