Lecture 8

SUPPLY AND DEMAND:

PRICE-TAKING AND COMPETITIVE MARKETS
OUTLINE
A. Introduction
B. Competitive equilibrium: Key concepts
C. Factors that affect equilibrium
D. Perfect competition
A. Introduction
 The Context for This Unit
Firms with market power can set their own price.
Market outcomes are generally not Pareto-efficient.

In reality, many firms are price-takers.

• How does their behaviour differ from price-setting firms?
• Can competition improve market outcomes?
 This Unit
• Model of interactions between price-taking firms and
customers

• Perfect competition = special case of the model

• Similarities and differences between price-taking and

price-setting firms
B. Competitive equilibrium:
Key concepts
 Demand curve
Demand curve = total quantity
that all consumers together want
to buy at any given price.
• Represents the willingness to
pay (WTP) of buyers.
Example: Secondhand textbook
market.
 The supply curve for books.

Supply
$14 curve

$12
Price, P (sellers' reservation prices)

$10

$8

$6

$4

$2

$0
0 5 10 15 20 25 30 35 40 45
Quantity, Q, of books (number of sellers)
 Supply curve
Supply curve = total quantity that
all firms together would produce at
any given price.
• Represents the willingness to
accept (WTA) of sellers.
• Sellers may have different
reservation prices.
 Equilibrium in the market for second-hand books.

$25

$20

Supply
$15
curve
Price, P

$10
A
P*

$5
Demand
curve
$0
0 10 20 Q* 30 40
Quantity, Q, of books
 Equilibrium price
At the equilibrium (market-clearing) price, supply equals demand.
• Any other price is not a Nash
equilibrium e.g. if price was
above P*, then there would be
excess supply, so some sellers
could benefit from charging a
lower price.
• Assumes the products are
identical, so buyers would be
willing to buy from any seller.
The market demand curve for bread.

€ 4.5

€ 4.0

€ 3.5

€ 3.0

€ 2.5
Price, P

€ 2.0

€ 1.5
Demand
€ 1.0 curve

€ 0.5

€ 0.0
0 1,000 2,000 3,000 4,000 5,000 6,000 7,000 8,000 9,000 10,000

Quantity, Q: number of loaves

The profit-maximizing price and quantity for a bakery.

€7

€6

€5

Marginal cost curve

Price, P; Cost

€4

Isoprofit curve: €200

€3
Isoprofit curve: €80
A
P* Firm’s demand curve
€2 Zero-economic-profit curve (AC
curve)

€1
Feasible set

€0
0 20 40 60 80 100 120 140 160 180
Quantity Q: number of loaves
 Price-taking firms
Price-taking firms cannot benefit from choosing a different price
from the market price, and cannot influence the market price.
• Demand curve (feasible set) is
completely flat
• Maximize profits when MC=P
(slope of isoprofit = 0)
• Firm’s supply curve = MC curve
Firm chooses quantity, not price
The firm’s supply curve.

€7 €7
Marginal cost curve

Isoprofit curve: €200 €6

€6
Isoprofit curve: €80
€5 Zero-economic-profit curve (AC €5
Supply
curve)
MC curve
Price, P; Cost

€4 €4

Price, P; Cost
€3 €3

€2 €2

€1 €1

€0 €0
0 40 80 120 160 200 0 40 80 120 160 200
Quantity Q: number of loaves Quantity, Q: number of loaves
 The firm and market supply curves.

Market
€5 Firm supply €5
supply
(marginal cost) (marginal
cost)
€4 €4

€3 €3
Price, P

Price, P
€2 €2

€1 €1

€0 €0
0 40 80 120 160 200 0 2,000 4,000 6,000 8,000 10,000
Quantity, Q: number of loaves Quantity, Q: number of loaves
 Price-taking firms: Market supply curve

Market supply curve – the total amount produced by all firms

at each price. If firms have identical cost functions,
market supply curve = market marginal cost curve.
 Competitive equilibrium
Competitive equilibrium:
• All buyers and sellers are price-takers
• At the prevailing market price, supply = demand
 Equilibrium in the bread market: Gains from trade.

€ 4.5
Supply (marginal
€ 4.0 cost)

€ 3.5

€ 3.0

€ 2.5 Consumer surplus

Price, P

A
€ 2.0

€ 1.5 Producer surplus

€ 1.0
Demand
€ 0.5

€ 0.0
0 1,000 2,000 3,000 4,000 5,000 6,000 7,000 8,000 9,000 10,000

Quantity, Q: number of loaves

 Competitive equilibrium: Characteristics
All gains from trade are exploited in
equilibrium (no deadweight loss).
Equilibrium allocation is Pareto
efficient, assuming:
• Participants are price-takers.
• Contracts are complete.
• Transaction only affects buyers
and sellers (no external effects)
 Deadweight loss.

€ 4.5
Supply (marginal
€ 4.0 cost)

€ 3.5

€ 3.0

€ 2.5
Price, P

Total surplus A
€ 2.0 DWL

€ 1.5

€ 1.0
Demand
€ 0.5

€ 0.0
0 1,000 2,000 3,000 4,000 5,000 6,000 7,000 8,000 9,000 10,000

Quantity, Q: number of loaves

 Competitive equilibrium: Caveats
• Allocation may not be Pareto
efficient if assumptions do not hold.
• Fairness: The distribution of total
surplus depends on the elasticities
of demand and supply (share of
total surplus inversely related to
elasticity)
• Hard to find price-takers in real life.
C. Factors that affect equilibrium
An increase in the demand for books.

$25

$20

Supply
$15
Price

B
$10
A
Excess demand

$5
Original New
demand demand
$0
0 5 10 15 20 25 30 35 40 45 50 55 60
Quantity of books
 An increase in the supply of bread: A fall in MC.

4.50
Original supply (MC)
4.00

3.50

3.00 New supply (MC)

2.50
Price, €

A
2.00
B Excess
1.50 supply

1.00
Demand
0.50

0.00
0 1,000 2,000 3,000 4,000 5,000 6,000 7,000 8,000 9,000 10,000
Quantity: number of loaves
 Changes in supply and demand
The entire supply or demand curve can shift due to
exogenous shocks e.g. technological change, popularity
Buyers and sellers adjust their
behaviour so that the market clears.
E.g. Improved baking technology
1. Supply of bread increases at every
price (supply curve shifts)
2. Excess supply at the going market
price (move along demand curve)
3. Price falls to a new equilibrium
 Market Entry
The supply curve can also shift due to market entry/exit.

If existing firms are earning economic rents and costs of entry are
not too high, other firms may enter the market.
The effect of a 30% salt tax.
Market Supply,
with tax
Price
of
salt

Market Supply
B
P1
A
P*
P0

Market Demand

Q1 Q* Quantity of salt
Taxation and deadweight loss.
Market Supply,
with tax
Price
of
salt

Market Supply
B
P1
A
P*
P0

Market Demand

Q1 Q* Quantity of salt
 Taxes
Throughout history, governments have used taxes to raise revenue.
Taxes on suppliers/consumers shift
the supply/demand curve because
the price is higher at each quantity.
Taxes lower surplus:
• Consumer surplus – red
• Producer surplus – purple
• Government revenue – green
• Deadweight loss – white triangle
 Taxes: Welfare effects
• Fall in total surplus is positively
related to elasticity of demand
• Tax incidence depends on relative
elasticity of consumers and
producers. The less elastic group
bears more of the tax burden.
• Taxes can still raise welfare if
governments use tax revenue to
provide beneficial goods/services.
D. Perfect competition
 Definition
A perfectly competitive market has the following properties:
• The good or service being exchanged is homogeneous
• Very large number of potential buyers and sellers
• Buyers and sellers all act independently of one another
• Price information easily available to buyers and sellers
 Characteristics of perfect competition
• Law of One Price: All transactions take place at a single price.
• At that price, the market clears (supply = demand).
• Buyers and sellers are all price-takers.
• All potential gains from trade are realized.

Perfect competition may not hold completely in reality,

but can be a good approximation to actual firm behaviour.
The market for Choccos and chocolate bars.

Marginal cost of Market supply

Choccos (MC)

Isoprofit
curve
A
B
Price

Price
P*
Demand
curve

Demand for
chocolate
bars

Q*
Quantity of Choccos Total quantity of chocolate bars
 Evidence of perfect competition?
Economists have used two tests for competitive equilibrium:
1. Do all trades take place at the same price?
2. Are firms selling goods at a price equal to marginal cost?

It is hard to find examples of perfect competition:

• Even when consumers can easily check the price of products
(online shopping sites), prices of the same product differ.
• Fulton Fish Market study – within the same market, prices of the
same fish product differed for different customer types.
 Price-setters vs. Price-takers
Price-setters (Monopoly) Price-takers (Perfect Competition)
MC < Price MC = Price
Deadweight losses (Pareto No deadweight losses (can be Pareto
inefficient) efficient)
Owners receive economic rents in No economic rents in the long-run
both long- and short-run
Firms advertise their unique product Little advertising expenditure
Firms invest in R&D, seek to prevent Little incentive for innovation
copying
 Summary
1. Model of price-taking firms
• Competitive equilibrium where demand = supply
• Firms maximize profits where MC = Price
• Perfect competition is a special case
• Comparison with price-setting firms

2. Used model to show how equilibrium can change

• Exogenous shocks to demand/supply or market entry
• Effect of taxation on surplus
 In the next unit
• The labour market – how it functions differently from
markets for goods

• Model of the labour market – how wages, employment,

and distribution of income between owners and
employees are determined

• Changes in supply and demand – the effect of unions

and public policy on wages and employment