Summary from last class

• Price setting (monopolistic) firms:

• produce differentiated or unique goods
• maximize profit by choosing the quantity where:
MR = MC
MR – MC = ∆𝛑 when ∆Q = 1
If MR > MC, then ∆𝛑 > 0 à producing the extra unit increases overall profit
If MR < MC, then ∆𝛑 < 0 à producing the extra unit decreases overall profit

• Can’t charge any price they want (only what is feasible)

• Have downward sloping demand curves
• MR lies below the demand curve (P > MR)
Profit maximization
𝜋 = 𝑃 − 𝐴𝐶 × 𝑄
Price, cost >0
and revenue

MC
P 𝛑max
𝑃 − 𝐴𝐶

AC

AC 𝛑max
𝑄
D

MR
Quantity
Q𝛑max
Profit maximization
𝜋 = 𝑃 − 𝐴𝐶 × 𝑄
Price, cost <0
and revenue

MC AC
AC 𝛑max
𝑃 − 𝐴𝐶

P 𝛑max 𝑄

MR
Quantity
Q𝛑max
Profit maximization
𝜋 = 𝑃 − 𝐴𝐶 × 𝑄
Price, cost =0
and revenue

MC AC
P 𝛑max
= AC 𝛑max

MR
Quantity
Q𝛑max
Profit markup / margin
• If demand is downward sloping, then P > MR.
• If P > MR and MR = MC, then P > MC:

• There is a price markup / profit margin:

P − MC > 0

• The profit margin can be expressed as a ratio of the price:

P − MC
profit margin ra+o =
P
Algebraic example
”Mimi’s Bakery” is the only producer of croissants in a small karoo town.
The daily demand for croissants in this town is given by:
Q = 1200 – 2P
Mimi’s Bakery’s total daily cost of producing croissants is given:
TC = 2000 + 40Q + 3Q2
How many croissants should Mimi’s Bakery bake per day, and what price
should be charged per croissant, in order to maximise profit?
Is this a good way of organizing a market?

• For the consumers, the higher prices make monopoly undesirable.

• For the owners of the firm, the higher prices make monopoly very
desirable.
• Can an objective assessment be made?
• Pareto efficiency! (more on this later)
UNIT 7 & 8: Part 2
Supply and Demand
and
Competitive
Equilibrium
In April 2019, the In April 2020, the
average price of a average price of a
pineapple was pineapple was
R4.96/kg R15.72/kg
Google’s 2020 “Year in Search”
Pineapple prices have skyrocketed as South Africans – desperate for booze
during lockdown – turn their hand to amateur brewing.

According to numbers from the Johannesburg market, pineapple prices have

more than tripled between April 2019, when it traded at an average price of
around R4.96/kg, and April 2020, when it hit R15.72/kg. Mark Harris of Langholm Farms in
Bathurst, the largest pineapple
In April, pineapples worth more than R14 million were sold at the producer in South Africa, says demand
Johannesburg market - double the amount sold in March. from Western Europe for South African
pineapples has been good in recent
Joe Mazibuko, the acting CEO of the Joburg market, notes that pineapple weeks. Anecdotal reports claim that the
prices since the start of the year are 82% higher than in the same period last coronavirus pandemic has bolstered
year, due in part to strong demand from retailers. sales of fruit in parts of Europe as
consumers go on a health kick amid the
“It is suspected that most pineapples went towards the brewing of pandemic.
homemade beer in the face of the closure of bottle stores.”
Prices as information
The US Navy’s blockade of Confederate states led to:
• 75% reduction in the supply of American cotton to Britain’s
textile mills
• This led to a six-fold increase in cotton prices
• Mill owners’ costs increased
• Mill owners shifted their sourcing of cotton to India, increasing
demand for Indian cotton
• Development of technologies (new machinery) to process Indian
cotton
• Increased demand for new machinery by mills and surge in jobs
• This led to thousands of independent actors changed their
actions in response to the blockade
Prices as information
Market prices act like messages:
• In some conditions, prices provide an accurate measure of the
scarcity of a good
• Higher prices provide individuals and firms with an incentive to
conserve society’s scarce resources
Demand and Supply
Consider a market for second-
hand economics textbooks
Demand comes from students who are about to take
the course and they will differ in their willingness to
pay (WTP)
No one would be willing to pay more than the price of a new
copy for a secondhand textbook.

Supply comes from students who have previously

completed the course, who will differ in their
willingness to accept (WTA)
That is their reservation price – lowest price at which
someone is willing to sell a good.
 Demand for used textbooks
$25 1 Q WTP Demand curve represents the WTP of
𝑊𝑇𝑃 = 20 – 𝑄 = 𝑃 0 20.00
2 buyers
1 19.50 • i.e. number of students willing to buy at
$20
2 19.00 a given price
Price, P (buyers' willingness to pay)

3 18.50
4 18.00
Students’ willingness to pay depends
$15
.. .. on:
39 0.50 • how interested they are in the subject
$10 40 0.00 • how useful they think the textbook will
be
• how much money they (or their
$5 Demand curve parents) have
Demand can also be represented as
$0 • a table
0 5 10 15 20 25 30 35 40 45 • an equation
Quantity, Q, of books (number of buyers)
 Supply of used textbooks
1 Supply curve is drawn by lining up
𝑊𝑇𝐴 = 2 + 𝑄 = 𝑃 sellers from those with the lowest
4 Supply
$14
curve
reservation price to those with the
highest reservation price
$12
• Minimum price they are willing to accept
Price, P (sellers' reservation prices)

$10
Willingness to accept (WTA):
$8 • First seller has reservation price (WTA) of $2
• 20th seller has WTA $7
$6
• 32nd seller has WTA $10
$4
• 40th seller has WTA $12
• This produces the supply curve
$2
Supply can also be represented as
$0 • an equation
0 5 10 15 20 25 30 35 40 45 • a table
Quantity, Q, of books (number of sellers)
The market and the equilibrium price
Markets (and their institutions) bring many buyers and sellers together:

Grand Bazaar, Istanbul Chicago Mercantile Exchange Amazon.com

 Alfred Marshall (1842-1924)
Marshall introduced his model of supply and demand at the
end of the 19th century using an example similar to our
market for secondhand textbooks.
Grain exchange:
• Marshall describes how supply curve would be determined by
the prices farmers would be willing to accept, and the demand
curve by the willingness to pay of merchants.
• Marshall called the price that would equate quantity supplied
and quantity demanded the equilibrium price.
• That is, it is the price that brings the purchasing plans of
consumers in line with the sales plans of producers.
 Alfred Marshall (1842-1924)
If a price was above equilibrium price, then farmers would want
to sell more…
… BUT fewer merchants would want to buy at the higher price.

This would result in an excess supply (surplus). Eventually the

price will adjust downwards, so a new equilibrium is reached.

If a price was below equilibrium price, then merchants would

want to buy more…
… BUT fewer farmers would want to sell at the lower price.

This would result in an excess demand (shortage). Eventually

the price will adjust upwards, so a new equilibrium is reached.
Demand and quantity demanded
• Marshall described how the demand curve would be determined by prices buyers
would be willing to pay
• That is, quantity demanded is a function of price:
Qd = f P , e.g:
Qd = 40 − 2P
• Rearranging this function so that P = f Qd gives us the inverse demand function,
which, when plotted, gives us the demand curve:
Qd = 40 − 2P
2P = 40 − Qd
1
P = 20 − Qd
2
Supply and quantity supplied
• Similarly, Marshall described how the supply curve would be determined by
prices sellers would be willing to accept
• That is, quantity supplied is a function of price
Qs = f P , e.g:
Qs = 4P − 8
• Rearranging this function so that P = f Qs gives us the inverse supply function,
which, when plotted, gives us the supply curve:
Qs = 4P − 8
4P = 8 + Qs
1
P = 2 + Qs
4
 Competitive equilibrium • The price (P*) that
𝑸𝒅 = 𝑸𝒔 equates quantity
$25 40 – 2𝑃 = 4𝑃 − 8 supplied and quantity
48 = 6𝑃 demanded is the
$20 à
∗
𝑷 =𝟖 equilibrium (market
à Q* = 24 clearing) price
$15 Supply • All buyers and sellers can
execute their planned
Price, P

curve
$10 sales / purchases
A
P* • There is neither an
$5 excess supply nor an
Demand
curve
excess demand of books
$0
0 10 20 30 40
Q*
Quantity, Q, of books
Price taking
• Why would students in a secondhand market for a first-year economics
textbook have to accept the prevailing market price?
• Let’s consider some important characteristics of this market:
• The product is identical (the same textbook)
• There are many buyers and many sellers (each year, there are at least 1700 first-year
students)
• Each seller has only a small quantity of books to sell (in this case, one), and each buyer is
only looking to buy a small quantity of books (in this case, one)
• There is (almost) perfect information (sellers and buyers are well informed on the prices
that students are WTA and WTP)
• If a seller asked a higher price, the buyer would look for someone with a lower
WTA
• Why would a seller not ask a lower price than the prevailing market price?
• If a buyer offered a lower price, the seller would look for someone with a
higher WTP
Competitive equilibrium
• The market equilibrium is a Nash equilibrium:
• Selling at a price higher than P ∗ → zero sales
• Selling at a price lower than P ∗ → no benefit to them.

• Buyer offering to pay less than P ∗ → no seller will agree to sell

• Buyer offering to pay more than P ∗ → no benefit to them.

No one has an incentive to change behaviour.

• All buyers and sellers are price takers.

 Competitive equilibrium • Alternative way to finding
𝑾𝑻𝑷 = 𝑾𝑻𝑨 equilibrium: equating
1 1 inverse demand and
$25 20 – 𝑄 = 2+ 𝑄
2
3
4 supply functions.
18 = 𝑄
$20 ∗ 4 • Clearly this will give the
à 𝑸 = 𝟐𝟒 same P∗ and Q∗ as
∗
à 𝑷 = $𝟖 = 𝑾𝑻𝑷 = 𝑾𝑻𝑨
$15 Supply
obtained from setting:
Q" = Q#
Price, P

curve
$10
A
• At the margin, the buyer
P* and the seller of the last
$5 unit traded have equal
Demand
curve
WTP and WTA.
$0 • How does the market
0 10 20
Q*
Quantity, Q, of books
30 40
price adjust to P∗ ?
 Competitive equilibrium If the price is too high, there
is excess supply (surplus)
Inverse demand function Inverse supply function e.g. if P = $11, Qd = 18
$25
1 1
𝑃 = 20 – 𝑄𝑑 𝑃 = 2 + 𝑄𝑠 Qs = 36
2 4
$20 • There is a surplus of
surplus 36 − 18 = 18 units: some
$15 sellers have unsold stock
Supply
Price, P

curve • Only 18 units are bought

$10 and sold
A
P* • P = WTP > WTA (at Q=18)
$5 • Some sellers and buyers
Demand
curve would both agree to price
$0 discount
0 10 18 20 30 36 40
Q*
Quantity, Q, of books • This pushes price down
 Competitive equilibrium
If the price is too low there is
Inverse demand function Inverse supply function
excess demand (shortage)
$25 1
𝑃 = 20 – 𝑄𝑑 𝑃 = 2 + 𝑄𝑠
1 e.g. if P = $5, Qd = 30
2 4
Qs = 12
$20
• There is a shortage of 30 −
12 = 18 units: some
$15 Supply buyers cannot find stock
Price, P

curve
• Only 12 units are bought
$10
A and sold
P*

$5
• WTP > WTA = P (at Q = 12)
shortage Demand • Some sellers and buyers
curve
$0 would both agree to price
0 10 12 20 30 40 increase
Q*
Quantity, Q, of books
• This pushes price up
 Competitive equilibrium Competition (many buyers
and sellers selling identical
products) drives the price
$25 towards this competitive
equilibrium:
$20 The market clears at
P* = $8
$15 Supply Q*= 24 (where Qd = Qs)
Price, P

curve
All sellers can easily sell the
$10
A number of units they want
P*
to → no reason to lower
$5 price
Demand
curve All buyers can buy the
$0 number of units they want
0 10 20 30 40 to → no reason to offer a
Q*
Quantity, Q, of books
higher price
Exercise
?
Inverse demand is 𝑃 = 600 − 𝑄A and inverse supply is 𝑃 = 100 + 𝑄B .
@
1. What are the demand and supply functions? (Q C =...., Q D =....)
2. What are the equilibrium price P ∗ and quantity Q∗ ?
3. Describe the situation in this market if the price is 300.
4. Draw a graph to illustrate the situation.
Price setters vs. price takers
ØThe model of perfect competition describes an idealised market structure.
ØFor a market to be perfectly competitive:
• there must be many buyers
• there must be many sellers
• the product must be homogeneous (or undifferentiated)
• buyers and sellers must know the market price and all other relevant information
Ø In the long run, there is free entry and exit
Commodity markets

Brent crude oil is selling Coffee is selling for Copper is selling for Lean hogs are selling
for $77/barrel. $1.92/pound. $3.90/pound. for $0.90/pound.
Commodity markets… a year ago

Brent crude oil is selling Coffee is selling for Copper is selling for Lean hogs are selling
for $104/barrel. $2.16/pound. $4.43/pound. for $1.04/pound.
Market for soybeans
The market for soybeans is perfectly competitive.

Brazil, Argentina, and Paraguay, which account

for more than 50% of the world’s soybean
supply, were expected to suffer smaller harvests
in 2022 due to unfavourable weather.

Drought conditions continued in 2023.

Impact of Russia’s military attack on Ukraine.

Price setters vs. price takers

Is Amazon.com a price setter or price taker?

Check out Hasan Minhaj’s Patriot Act episode on Amazon.com on Netflix or Youtube.
The model of Perfect competition
ØCompetition eliminates bargaining power:
• There are many buyers and sellers.
• Each buyer and seller is a small player in the market.
• No buyer or seller has power to change the market price.
• All transactions occur at a single (market) price.
• If a seller asked a higher price, a buyer would look for someone with a lower WTA.
• If a buyer offered a lower price, the seller would look for someone with a higher
WTP.
• At the margin (i.e. the last unit sold and bought) there is no rent to
bargain over because WTA = WTP.
The model of Perfect competition
• At this market price, the quantity supplied equals the quantity
demanded and the market clears.
• There are no shortages / surplus in equilibrium.
• All buyers and sellers can execute their plans.
• There is no need to search around for better quality or prices.
• The result is Pareto efficient
• we will cover this in the coming week.
Price setters vs. price takers
Even if some conditions for perfect competition are not met, there
may be enough competition that we can assume firms are price
takers.
A simplified model can provide useful predictions when its
assumptions are only approximately true.
For example, the model of supply and demand can be useful for
understanding markets of somewhat differentiated products.
Price-taking firms
Consider the daily market demand for bread in a city:
€ 4.5
(recall: we would find this demand curve by summing up all the individual
€ 4.0 consumer demand curves)

€ 3.5 No one is willing to pay more than €4.25 for a loaf of bread i.e.
Qd = 0 if P = 4.25
€ 3.0

€ 2.5
At P = €0.50, people would demand 10 000 loaves.
Price, P

The lower the price, the greater Qd .

€ 2.0

€ 1.5

€ 1.0
Market demand
€ 0.5
curve
€ 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

Price-taking
ØPrice-setting firms choose the price-quantity combination that maximizes
profits.
ØPrice-taking firms take the price as given and choose the quantity that
maximizes profits.
ØThe competitive market model assumes that a firm in a competitive
market
‒ can sell any quantity it wants to at the market price
‒ will not influence the market price
 Price-taking firms
€7
Suppose you are the owner of a small bakery with:
€6 • a fixed cost (e.g. rent of premises)
• rising marginal costs (MC)
€5
• Average costs (AC) that fall and then rise (U-shaped)
€4 Marginal cost curve
Price, P; Cost

€3

€2 Average cost curve

€1

€0
0 20 40 60 80 100 120 140 160 180
Quantity Q: number of loaves
 Price-taking firms
€7

€6 How do you make decision on P and Q?

€5

€4 Marginal cost curve

Price, P; Cost

€3

€2 Average cost curve

€1

€0
0 20 40 60 80 100 120 140 160 180
Quantity Q: number of loaves
 €7
Price-taking firms
• Neighbouring bakeries sell identical loaves for €2.00
Price, P; Cost

€6 • Price- taker à your demand curve is a straight

horizontal line at €2.00
€5 • You cannot charge
a higher price.
€4 Marginal cost curve • You could charge a
Average cost curve

€3
lower price (BUT
would you want
P*= € 2 Firm’s demand curve to?)

€1
Feasible set

€0
Q
0 20 40 60 80 100 120 140 160 180
 €7
Price-taking firms
For price-taking firms, MR = P
Price, P; Cost

€6
(TR increase by P when Q increases by 1)
€5
Maximize profit by choosing the quantity where MR = MC
€4 Marginal cost curve
Average cost curve

€3

P*= € 2 Firm’s demand curve

€1

€0
Q
0 20 40 60 80 100 120 140 160 180
 €7
Price-taking firms
• At A, MR = P = MC
Price, P; Cost

€6
• Price-taking firms choose the quantity where P = MC
€5

€4 Marginal cost curve

Average cost curve

€3

A
P*= € 2 Firm’s demand curve

€1

€0
Q
0 20 40 60 80 100 120 140 160 180
 €7
Price-taking firms
• What would happen if P ≠ MC?
Price, P; Cost

€6

€5
MR > MC MR < MC
€4 Increase production Decrease production
Marginal cost curve

€3

A Average cost curve

P*= € 2 Firm’s demand curve

€1

€0
Q
0 20 40 60 80 100 120 140 160 180
 €7
Price-taking firms
Price, P; Cost

€6 Are you making a profit?

€5

€4 Marginal cost curve

Average cost curve

€3

A
P*= € 2 Firm’s demand curve

€1

€0
Q
0 20 40 60 80 100 120 140 160 180
 Price-taking firms
€7 €7
• A firm’s supply
€6 €6
depends on the
market price:
€5 €5 • €2.35 → 120
loaves
MC
€4 • €3.20 → 163
Price, P; Cost

€4
loaves
€3 €3 • €1.52 → 66
loaves
AC
€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
 Price-taking firms
€7 €7
• A firm’s supply
€6 €6
depends on the
market price:
€5 €5 • €2.35 → 120
Supply loaves
MC curve
€4 • €3.20 → 163
Price, P; Cost

€4
loaves
€3 €3 • €1.52 → 66
loaves
AC
€2 €2 • The MC curve is
the supply curve
€1 €1 for price-taking
firms
€0 €0
0 40 80 120 160 200 0 40 80 120 160 200
Quantity Q: number of loaves Quantity, Q: number of loaves
 Price-taking firms
€7 €7
• If the price falls
€6 €6
below €1.52:
• P < AC
€5 €5 • The firms makes
Supply a loss in the
curve
MC
€4
short run
Price, P; Cost

€4
• Decision to stay
€3 €3
in business
depends on
AC expectations
€2 €2
about future
prices
€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
Market supply
Suppose the city has 49 other bakeries with identical cost functions.

If the price is €2.35:

• Each bakery supplies 120 loaves
• Market supplies 50 × 120 = 6 000 loaves

If the price is €1.52:

• Each bakery supplies 66 loaves
• Market supplies 50 × 66 = 3 300 loaves
 Market supply Market
€5 Firm supply € 5 supply
(marginal (marginal
cost) cost)
€4 €4

€3 €3 The market supply is the

horizontal summation of
Price, P

Price, P

firm’s supply curves.

€2 €2 Market’s supply curve is the
market’s MC curve.
The MC of the 6 001st loaf is
€1 €1
about €2.35.

€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
 Competitive market equilibrium We now have both the
supply and demand
curves.
€ 4.50
S
€ 4.00 The competitive
€ 3.50 equilibrium price is €2.00
• The market supplies 5 000.
€ 3.00 • Each firm supplies 5 000/50 = 100
€ 2.50
Price, P

A Does any individual or

€ 2.00
firm have an incentive to
€ 1.50 change behaviour?
• Would consumers purchase if
€ 1.00
P > €2.00?
€ 0.50 D • Would firms produce if
MC < €2.00?
€ 0.00
0 1000 2000 3000 4000 5000 6000 7000 8000 9000 10000
Quantity, Q: number of loaves