Carmen Pérez Gómez

Doble Grado en Estudios Internacionales y Ciencias Políticas 2019/20

CHAPTER 8 – LECTURE 9: SUPPLY AND DEMAND (PRICE-TAKING

AND COMPETITIVE MARKETS)
INTRODUCTION
Firms can choose simultaneously which quantity they want to sell and at which price. Firms have
very little flexibility in fixing the price.

▪ Competition can constrain buyers and sellers to be price-takers.

▪ The interaction of supply and demand determines a market equilibrium in which both
buyers and sellers are price-takers, called a competitive equilibrium.
▪ Prices and quantities in competitive equilibrium change in response to supply and
demand shocks.
▪ Price-taking behaviour ensures that all gains from trade in the market are exhausted at
a competitive equilibrium.
▪ The model of perfect competition describes idealized conditions under which all buyers
and sellers are price-takers.
▪ Real-world markets are typically not perfectly competitive, but some policy problems
can be analysed using this demand and supply model.
▪ There are important similarities and differences between price-taking and price-setting
firms.

We will analyse markets from a perspective of “perfect competition” and the problems that
makes difficult a perfect competition market to arise.

PERFECT COMPETITION = special casein which price-taking firms and customers are a special
case of “price-setters;” and similarities and differences between price-taking and price-setting
firms. Is only perfect competition markets exist, the economic study of markets wouldn’t be
necessary.

COMPETITIVE EQUILIBRIUMS: KEY CONCEPTS

E.g. The market for second-hand textbooks.

✓ There are many ‘firms’ (the previous years + bookstores).

✓ There are many consumers (this year’s cohort).
✓ Every book of reasonable quality will do (consumers do not care where to buy;
“freshness“of the book in not evaluated).

DEMAND CURVE VS. SUPPLY CURVE

A. Demand curve: total quantity that all consumers together want to buy at any given
price. It represents the willingness to pay (WTP) of buyers. Applied to consumers.
B. Supply curve: The curve that shows the number of units of output that would be
produced at any given price. For a market, it shows the total quantity that all firms
together would produce at any given price. Applied to firms (willingness to “accept”
(WTA) → reservation price: The lowest price at which someone is willing to sell a good
(keeping the good is the potential seller’s reservation option)).
C. At the equilibrium (market-clearing) price, supply equals demand.
 Carmen Pérez Gómez
Doble Grado en Estudios Internacionales y Ciencias Políticas 2019/20

The market-
clearing price:

At a price P*=$8,
the quantity
supplied is equal
to the quantity
demanded:
Q*=24. The
market is in
equilibrium. We
say that the
market clears at
a price of $8.

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. We Assume
the products are identical, so buyers would be willing to buy from any seller.

MARKET-CLEARING PRICE: At this price there is no excess supply or excess demand.

We say that a market is in equilibrium (a model outcome that is self-perpetuating. In this case,
something of interest does not change unless an outside or external force is introduced that
alters the model’s description of the situation) if the actions of buyers and sellers have no
tendency to change the price or the quantities bought and sold, unless there is a change in
market conditions such as the numbers of potential buyers and sellers, and how much they value
the good. At the equilibrium price for textbooks, all those who wish to buy, or sell can do so, so
there is no tendency for change.

PRICE-TAKING FIRMS
A price-taking firm maximizes profit by choosing a quantity where the marginal cost is equal to
the market price (MC = P*) and selling at the market price P*.

If there are many firms producing identical products, and consumers can easily switch from one
firm to another, then firms will be price-takers in equilibrium. They will be unable to benefit
from attempting to trade at a price different from the prevailing price.

At higher quantities the marginal cost is above the average cost; then average costs rise again.
If price were equal to average cost (P = AC), your economic profit would be zero.

The profit-maximizing quantity (Q*) is found at the point where P*=MC → the MC of the Q*
unit loaf is equal to the market price.

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. → The feasible set of prices and
quantities is the area below the horizontal line at P*.
- Profit is maximized when MC = MR = P* (slope of isoprofit = 0)
 Carmen Pérez Gómez
Doble Grado en Estudios Internacionales y Ciencias Políticas 2019/20

- Firm’s supply curve = MC curve

Firm chooses quantity, not price

For a price-taking firm, the marginal cost curve is the supply curve: for each price it shows the
profit-maximizing quantity—that is, the quantity that the firm will choose to supply.

In each case, you

choose the point on
your MC curve where
MC = P*. Your MC is
your supply curve.

𝑸𝑺𝑴 (𝑷) = 𝑵 · 𝑸𝑺𝒊 (𝑷)

𝑷
𝑷 = 𝟒𝑸; 𝑸𝑺𝒊 =
𝟒
𝑷
𝑵 = 𝟐𝟎 → 𝑸𝑺𝑴 (𝑷) = 𝟐𝟎 · = 𝑺𝑷
𝟒

If P = MC, we can write the equation in function of the quantity.

 Carmen Pérez Gómez
Doble Grado en Estudios Internacionales y Ciencias Políticas 2019/20

COMPETITIVE EQUILIBRIUM

Competitive equilibrium: All buyers and sellers are price-takers. At the prevailing market price,
supply = demand.

All gains from trade are exploited in equilibrium (no deadweight loss):

a) Equilibrium allocation is Pareto efficient, assuming:

b) Participants are price-takers.
c) Contracts are complete.
d) Transaction only affects buyers and sellers (no external effects; e.g. environmental
stuff)

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.

The competitive equilibrium allocation of bread has the property that the total surplus is
maximized.

FACTORS THAT AFFECT EQUILIBRIUM

CHANGES IN SUPPLY AND DEMAND
The entire supply to demand curve can shift due to exogenous shocks e.g. technological change,
popularity… Buyers and sellers adjust their behavior 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.

As in the following example of an increase in demand, an adjustment of prices is needed to bring

the market into equilibrium. Such shifts in supply and demand are often referred to as shocks
 Carmen Pérez Gómez
Doble Grado en Estudios Internacionales y Ciencias Políticas 2019/20

(an exogenous change in some of the fundamental data used in a model) in economic analysis.
We start by specifying an economic model and find the equilibrium. Then we look at how the
equilibrium changes when something changes—the model receives a shock. The shock is called
exogenous (coming from outside the model rather than being produced by the workings of the
model itself) because our model doesn’t explain why it happened: the model shows the
consequences, not the causes.

MARKET ENTRY
Economic rent in a market = low cost of entry. → If existing firms are earning economic rents
and costs of entry are not too high, other firms may enter the market.

TAXES AND WELFARE EFFECTS

Throughout history, governments have used taxes to raise revenue. Taxes on suppliers/
consumers shift to supply/ demand curve because the price is higher at each quantity.

Consumer surplus – red

Producer surplus – purple.

Government revenue –
green.

Deadweight loss – white

triangle
 Carmen Pérez Gómez
Doble Grado en Estudios Internacionales y Ciencias Políticas 2019/20

The consumer is not affected by the taxes paying from firms to the government. On the contrary,
firms really care about this because it increases their MC.

When a tax is imposed, the total surplus from trade in the market is given by:

𝑻𝑶𝑻𝑨𝑳 𝑺𝑼𝑹𝑷𝑳𝑼𝑺 = 𝑪𝑶𝑵𝑺𝑼𝑴𝑬𝑹 𝑺𝑼𝑹𝑷𝑳𝑼𝑺 + 𝑷𝑹𝑶𝑫𝑼𝑪𝑬𝑹 𝑺𝑼𝑹𝑷𝑳𝑼𝑺 + 𝑮𝑶𝑽𝑬𝑹𝑵𝑴𝑬𝑵𝑻 𝑺𝑼𝑹𝑷𝑳𝑼𝑺

The supply curve increases when there is a tax and the elasticity of demand decreases.

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.

In 2011, Denmark introduced a tax (per kg) on sutured fat, which was equivalent to 22% of the
average butter price.
 Carmen Pérez Gómez
Doble Grado en Estudios Internacionales y Ciencias Políticas 2019/20

- Consumption of butter and related products fell by 15-20%.

- But the tax was eventually removed due tot the administrative burden collecting it.

If demand is more elastic the supply, the consumers suffer less from the tax. Whoever has the
more inelastic function duffers more from the tax.

The producer has an elastic function (flat), so they suffer little from the tax. On the contrary,
consumer’s function (demand curve) is more inelastic so they suffer more from the tax.

SUMMARY
1. Model of price-taking firms .
- Competitive equilibrium where demand = supply.
- Firms maximize profits where MC = MR = Price.
- 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

REDUCED CLASS
The WTP reflects the Marginal Utility.

Types of goods:
- Normal goods: demand increases.
- Inferior goods: demand decreases.

Who benefits more in a market depends on the relative elasticity of the demand and the
supply. The more inelastic one in the one that benefits the most. (See problem set 9 graph)

The DWL = 0 if the demand curve is completely elastic (flat line).