‘The markets we will be examining are highly competitive ones, with many firms competing against each other. In economics we call this perfect competition. This is where consumers and producets are too numerous to have any control over prices: they are price takers. In the case of consumers, this means that they have to accept the prices as given for the things that they buy. On. ‘most occasions thisis true; when you get to the supermarket checkout you cannot start haggling with the checkout operatorover the price ofa can of beans or atub ofice cream. In the case of firms, perfect competition means that producers are small and face too much competition from. other firms to be able to raise prices, Take the case of foreign, exchange traders selling euros. They have tosell the currency at the current market price, If individually they try to sell at ‘higher price, no one will buy, since purchasers of currency can get all the euros they want at the market price. Of course, many firms do have the power to choose their prices. This does not mean that they can simply charge whatever they like. They will still have to take account of overall consumer demand and their competitors’ prices. Hewlett-Packard (HP), when setting the price of its laptop 2.1 DEMAND 35 computers, will ave to ensure that they remain competitive with those produced by Dell, Toshiba, Lenovo, et. Nevertheless, most firms have some flexibility in setting thelr prices: they have a degree of ‘market power. If this the case, then why do we study perfect markets, ‘where firms are price takers? One reason is that they provide 2 useful approximation to the real world and give us many insights into how a market economy works. Many markets, such as those in agriculture and finance, do function very similarly to those we shall be describing, ‘Another is that perfect markets provide an ideal against ‘whieh to compare the real world, since in perfect markets we see resources being used and allocated efficiently. Economists can therefore use them as abenchmark when comparing the prices, output, profit etc. in different types of market. For example, will the consumer end up paying higher prices ina market dominated by usta few firms than in one operating under peefect competition? Will Sky respond to an increase indemand for television services in the same way asa farmer does to an increase in the demand for cauliflowers? ‘Markets with powerful firms are examined in Chapters 7 and 8. For now we concentrate on price takers. a The relationship between demand and price ‘The headlines announce’Major crop failures in Brazil and East Aca: coffee prices soar, Shortly afterwards you find that coffee prices have increased sharply in the shops. What do you do? You will probably cut back on the amount of coffee you drink. Perhaps you will reduce it from, say, six cups per day to four. Perhaps you will give up drinking coffee altogether. ‘This is simply an illustration of the general relationship between price and consumption: when the price ofa good rises, the quantity demanded will fall. This relationship is known as the Jaw of demand. There ae two reasons for this law: = People will feel poorer. They will not be able to afford to buy as much of the good with their money. cS atu Perfect competition (preliminary definition) A situation ‘where the consumers and producers ofa product ae price takers. (There are other features of a perfectly competitive ‘market; these ze examined in Chapter 7.) Price taker A person or firm with no power to beable to ‘fluence the market price, Law of demand The quantity ofa good demanded per period of time wil fall a price rises and will ise as price falls, other things being equal (eters paribus). Similarly, when the price of a good falls, the quantity demanded will rise. People can afford to buy mare (the income effect), and they will switch away from consuming alternative goods (the substitution effec) ‘Therefore, returning to our example ofthe increase inthe price of coffee, we will not be able to afford to buy as much as before, and we will probably drink more tea, cola, fruit juices or even water instead. Income effect The effect ofa change in price on quantity, demanded arising from the consumer becoming better ot worse off asa result ofthe price change. Substitution effect The effect ofa change in price on {quantity demanded arising from the consumer switching to or from alternative (substitute) products.