Aggregate Demand and Supply
What is Agregate Demand?
Aggregate demand (AD) is the total demand by domestic and foreign  households and firms for an economy's scarce resources, less the demand by domestic households and firms for resources from abroad.

Aggregate demand consists of the amount households plan to spend on goods (C), plus planned spending on capital investment, (I) + government spending, (G) + exports (X) minus imports (M) from abroad. The standard equation is: 

AD = C + I + G + (X – M)

The aggregate demand curve:

The AD curve shows the relationship between AD and the price level. It is assumed that the AD curve will slope down from left to right. This is because all the components of AD, except imports, are inversely related to the price level.

What is aggregate supply:

Aggregate supply (AS) is defined as the total amount of goods and services (real output) produced and supplied by an economy’s firms over a period of time. It includes the supply of a number of types of goods and services including private consumer goods, capital goods, public and merit goods and goods for overseas markets.

Coponents of AS :

• Consumer goods 
• Capital goods
• Public and merit goods
• Traded goods

The aggregate supply curve:

Perfect Competition

What is perfect competition?

A perfectly competitive market is a hypothetical market where competition is at its greatest possible level. It is argued that this type of market gives the best results for consumers and for society overall.

What are the assumptions of this model?

1. The market consists of many firms which are relatively small as compared to the overall market size. 
2. All products which all the firms in an industry produce are considered to be homogenous. 
3. There is Perfect Knowledge for all stakeholders in the market.
4. There are no Barriers to Entry or Exit.
5. Firms are Profit maximizing.
6. Firms are Price Takers due to the Perfect Knowledge available. 

Explanation:

The single firm takes its price from the industry and is referred to as a price taker. The industry is made up of all firms in the industry and the market price is where demand is equal to supply. Each single firm must charge this price. Any other price will lead to consequences which will have a negative impact on the business.

Under perfect competition, firms can make abnormal profits or losses.

However, in the long run firms are attracted into the industry if businesses are making abnormal profits. This is due to the availability perfect knowledge and the lack of barriers to entry. The effect of this entry into the industry is to shift the supply curve to the right, which decreases price until there are no abnormal profits anymore. If firms are making losses, they will leave the market as there are no exit barriers, and this will shift the supply curve to the left, which increases price and enables those left in the market with just normal profits.

Advantages:

1. No monopoly power
2. no information failure
3. allocatively and productively efficient
4. more choice
5. lower prices (as compared to other market structures)

Disadvantages:

1. No abnormal profits possible - no dynamic efficiency.
2. less choice to consumers - due to less product differentiation.
3. benefits of economies of scale are lost.
4. no profits for research and development.

Examples:

 - Agricultural markets.

In some cases, there are several farmers selling identical products to the market, and many buyers. At the market, it is easy to compare prices. Therefore, agricultural markets often get close to perfect competition.

 - Financial markets

eg. Currency markets.

Sources: http://www.economicsonline.co.uk/

                                        Monopolistic Competition

1903-1982

1899-1967

What is monopolistic competition?

It is a common market structure in which firms have many competititors, but each one sells a slightly different product. The market structure was first identified in the 1930s by the american economics Edward Chamberlin and the english economics Joan Robinson.

So what are the characteristics of monopolistic competition?

• The industry is made up of a fairly large number of firms
• The firms are small, relative to the size of the industry. This means that the actions of one firm are unlikely to have a significant effect on its competitors- the firms assume they are able to act independently of each other
• The firms all produce slightly differentiated products. This means that it is possible for a consumer to tell one firms product from another
• Firms are completely free to enter or leave the industry- so there are no barriers to entry or exit
• Knowledge is widely spread between participants, but it is unlikely  to be perfect                   For example, diners can review all the menus available from restaurants in a town, before they make their choice. Once inside the restaurant, they can view the menu again, before ordering. However, they cannot fully appreciate the restaurant or the meal until after they have dined.

Monopolistic competition in the short run:

At profit maximisation, MC = MR, and output is Q and price P. Given that price (AR) is above ATC at Q, abnormal profits are possible (area PABC).As new firms enter the market, demand for the existing firm’s products becomes more elastic and the demand curve shifts to the left, driving down price. Eventually, all abnormal profits are eroded away.

Monopolistic competition in the long run:
Abnormal profits attract in new entrants, which shifts the demand curve for existing firm to the left. New entrants continue until only normal profit is available. At this point, firms have reached their long run equilibrium.

Inefficiency:

The firm is allocatively and productively inefficient in both the long and short run.There is a tendency for excess capacity because firms can never fully exploit their fixed factors. This means they are productively inefficient in both the long and short run. However, this is may be outweighed by the advantages of choice.

Examples of monopolistic competition:

• nail salons
• car mechanics
• plumbers
• jewellers
• hotels
• restaurants

Advantages of monopolistic competition:

• Markets are contestable, because there are no entry barriers
• There is more choice and freedom for consumers due to the product differentiation
• The market is more efficient than monopoly but less efficient than perfect competition - less allocatively and less productively efficient. However, they may be dynamically efficient, innovative in terms of new production processes or new products

Disadvantages of monopolistic competition:

• There is allocative inefficiency in the short run as well as in the long run
• Some differentiation does not create utility but generates unnecessary waste, such as excess packaging

All information was taken from : 

http://www.economicsonline.co.uk