EC107

Economics 1

Term 1

Feedback on In-Class Questions

Week 9 Support and Feedback Class

Unit 8

Supply and Demand; Price-taking & Competitive Mkts

In-Q8.1: Explain why the supply curve of a price-taking firm is given by its marginal cost
curve.

A complete answer has the following elements:

1. In the case of a price-taking firm in a competitive market, demand is perfectly

price-elastic and the demand curve is horizontal. The firm in a competitive market
is unable to charge a price higher than the competitive market price as to do so
would be to lose all its customers: because demand is perfectly elastic.
2. In the diagram above, marginal cost is upward-sloping. This means that the
firm’s iso-profit curves are U-shaped. At low output, when marginal cost is low
and price exceeds marginal cost, additional output will increase profit: for profits
to be constant (as they must by definition along an iso-profit schedule) as output
rises, price must be falling and hence the iso-profit schedule is downward-
sloping. Conversely, at high output, when marginal cost exceeds price, additional
output will decrease profit: for profits to be constant (as they must by definition
along an iso-profit schedule) as output rises, price must be also be rising and
 hence the iso-profit schedule is upward-sloping. Only when price and marginal
cost are equal can it be the case that the iso-profit curve is neither downward nor
upward-sloping. It follows that the iso-profit curves are U-shaped and cut at their
minimum points by the upward-sloping marginal cost curve.
3. The objective of the firm is to maximise profits and in the diagram this occurs
where the firm attains the highest feasible iso-profit curve. This is where the
horizontal demand curve is just tangent to an iso-profit curve and, with U-shaped
iso-profit curves, this is at the minimum point of the curve – where it is
intersected by the marginal cost curve. Hence, at any given price, the firm’s choice
of output is given by the point on the marginal cost curve where price equals
marginal cost: thus the supply curve (which indicates chosen supply at each price)
coincides with the marginal cost curve.

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In-Q8.2: Represent the competitive market-clearing equilibrium in a diagram and show

the extent of total economic surplus.

Total economic surplus is the sum of producer surplus and consumer surplus – under
certain conditions, including that there are no external effects, for example. This outcome
reflects a Pareto efficient allocation with no deadweight loss. Notice that in this
equilibrium demand equals marginal cost. In other words, marginal willingness to pay
equals marginal cost – another way of seeing that the equilibrium is Pareto efficient.

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In-Q8.3: What is the likely impact of a tax in a competitive market?

The imposition of a tax on the transaction implies that the price the consumer pays will
be equal to the price charged by the suppliers (given by their willingness to accept – i.e.,
supply – curve) plus the amount of the tax per unit. So the tax causes the market supply
curve to shift upwards by the amount of the tax per unit. The market-clearing
equilibrium shifts from A to B in the diagram. Consumer surplus falls. Producer Surplus
falls. Part of these reductions in surplus are attributable to a transfer to government
through the tax revenue (the green-shaded area). But there is also a deadweight loss
arising out of the reduction in trade: units that had previously generated surplus are no
longer being produced as demand is lower at the new higher equilibrium price.

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In-Q8.4: With the use of a diagram, show how the incidence of a tax depends on the
elasticities of supply and demand.

To examine this, you should add a panel to the diagram below for (i) the case of a less
elastic demand curve and (ii) a less elastic supply curve. And comment on your findings.

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Following your Class meeting of Week 9, you should ensure that you are able
independently to be able to produce clear and comprehensive answers to these
questions. To support you further in this, you should use all the resources available to
you on the module, including:

Lecture Videos and Slides; the online textbook CORE: The Economy; the peer-support
Forum for Unit 8; the Feedback on In-Class Questions for Unit 8; the FAQs resource. All
of these resources are clearly linked on the module Moodle page.

Professor Robin Naylor