•••
THEMES AND CAPSTONE UNITS
17: History, instability, and growth
18: Global economy
22: Politics and policy
UNIT 8
SUPPLY AND DEMAND: PRICE-
TAKING AND COMPETITIVE
MARKETS
HOW MARKETS OPERATE WHEN ALL BUYERS AND
SELLERS ARE PRICE-TAKERS
• Competition can constrain buyers and sellers to be price-takers.
• The interaction of supply and demand determines a market equilib-
rium 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.
Students of American history learn that the defeat of the southern
Confederate states in the American Civil War ended slavery in the produc-
tion of cotton and other crops in that region. There is also an economics
lesson in this story.
At the war’s outbreak on 12 April 1861, President Abraham Lincoln
ordered the US Navy to blockade the ports of the Confederate states. These
states had declared themselves independent of the US to preserve the
institution of slavery.
As a result of the naval blockade, the export of US-grown raw cotton to
the textile mills of Lancashire in England came to a virtual halt, eliminating
three-quarters of the supply of this critical raw material. Sailing at night, a
few blockade-running ships evaded Lincoln’s patrols, but 1,500 were
destroyed or captured.
Vegetable market, Da Lat, Vietnam
313
excess demand A situation in
which the quantity of a good
demanded is greater than the
quantity supplied at the current
price. See also: excess supply.
We will see in this unit that the market price of a good, such as cotton, is
determined by the interaction of supply and demand. In the case of raw
cotton, the tiny quantities reaching England through the blockade were a
dramatic reduction in supply. There was large excess demand—that is to
say, at the prevailing price, the quantity of raw cotton demanded exceeded
the available supply. As a result, some sellers realized they could profit by
raising the price. Eventually, cotton was sold at prices six times higher than
before the war, keeping the lucky blockade-runners in business. Consump-
tion of cotton fell to half the prewar level, throwing hundreds of thousands
of people who worked in cotton mills out of work.
Mill owners responded. For them, the price rise was an increase in their
costs. Some firms failed and left the industry due to the reduction in their
profits. Mill owners looked to India to find an alternative to US cotton,
greatly increasing the demand for cotton there. The excess demand in the
markets for Indian cotton gave some sellers an opportunity to profit by
raising prices, resulting in increases in the prices of Indian cotton, which
quickly rose almost to match the price of US cotton.
Responding to the higher income now obtainable from growing cotton,
Indian farmers abandoned other crops and grew cotton instead. The same
occurred wherever cotton could be grown, including Brazil. In Egypt, farm-
ers who rushed to expand the production of cotton in response to the
higher prices began employing slaves, captured (like the American slaves
that Lincoln was fighting to free) in sub-Saharan Africa.
There was a problem. The only source of cotton that could come close to
making up the shortfall from the US was in India. But Indian cotton
differed from American cotton, and required an entirely different kind of
processing. Within months of the shift to Indian cotton, new machinery
was developed to process it.
As the demand for this new equipment soared, firms like Dobson and
Barlow, who made textile machinery, saw profits take-off. We know about
this firm, because detailed sales records have survived. It responded by
increasing production of these new machines and other equipment. No mill
could afford to be left behind in the rush to retool, because if it didn’t, it
could not use the new raw materials. The result was, in the words of
Douglas Farnie, a historian who specialized in the history of cotton produc-
tion, ‘such an extensive investment of capital that it amounted almost to the
creation of a new industry.’
The lesson for economists: Lincoln ordered the blockade, but in what
followed, the farmers and sellers who increased the price of cotton were not
responding to orders. Neither were the mill owners who cut back the
output of textiles and laid off the mill workers, nor were the mill owners
desperately searching for new sources of raw material. By ordering new
machinery, the mill owners set off a boom in investment and new jobs.
All of these decisions took place over a matter of months, by millions of
people, most of whom were total strangers to one another, each seeking to
make the best of a totally new economic situation. American cotton was
now scarcer, and people responded, from the cotton fields of Maharashtra
in India to the Nile delta, to Brazil, and the Lancashire mills.
To understand how the change in the price of cotton transformed the
world cotton and textile production system, think about the prices
determined by markets as messages. The increase in the price of US cotton
shouted: ‘find other sources, and find new technologies appropriate for
their use.’ Similarly, when the price of petrol rises, the message to the car
UNIT 8 SUPPLY AND DEMAND: PRICE-TAKING AND COMPETITIVE MARKETS
314
willingness to pay (WTP) An
indicator of how much a person
values a good, measured by the
maximum amount he or she would
pay to acquire a unit of the good.
See also: willingness to accept.
willingness to accept (WTA) The
reservation price of a potential
seller, who will be willing to sell a
unit only for a price at least this
high. See also: willingness to pay.
driver is: ‘take the train’, which is passed on to the railway operator: ‘there
are profits to be made by running more train services’. When the price of
electricity goes up, the firm or the family is being told: ‘think about
installing photovoltaic cells on the roof.’
In many cases—like the chain of events that began at Lincoln’s desk on
12 April 1861—the messages make sense not only for individual firms and
families but also for society: if something has become more expensive then
it is likely that more people are demanding it, or the cost of producing it has
risen, or both. By finding an alternative, the individual is saving money and
conserving society’s resources. This is because, in some conditions, prices
provide an accurate measure of the scarcity of a good or service.
In planned economies, which operated in the Soviet Union and other
central and eastern European countries before the 1990s (discussed in Unit
1), messages about how things would be produced are sent deliberately by
government experts. They decide what will be produced and at what price it
will be sold. The same is true, as we saw in Unit 6, inside large firms like
General Motors, where managers (and not prices) determine who does what.
The amazing thing about prices determined by markets is that indi-
viduals do not send the messages, but rather the anonymous interaction of
sometimes millions of people. And when conditions change—a cheaper way
of producing bread, for example—nobody has to change the message (‘put
bread instead of potatoes on the table tonight’). A price change results from
a change in firms’ costs. The reduced price of bread says it all.
8.1 BUYING AND SELLING: DEMAND AND SUPPLY
In Unit 7 we considered the case of a good produced and sold by just one
firm. There was one seller with many buyers in the market for that product.
In this unit, we look at markets where many buyers and sellers interact, and
show how the competitive market price is determined by both the prefer-
ences of consumers and the costs of suppliers. When there are many firms
producing the same product, each firm’s decisions are affected by the
behaviour of competing firms, as well as consumers.
For a simple model of a market with many
buyers and sellers, think about the potential for
trade in second-hand copies of a recommended
textbook for a university economics course.
Demand for the book comes from students who
are about to begin the course, and they will differ
in their willingness to pay (WTP). No one will
pay more than the price of a new copy in the
campus bookshop. Below that, students’ WTP may
depend on how hard they work, how important
they think the book is, and on their available
resources for buying books.
Figure 8.1 shows the demand curve. As in Unit
7, we line up all the consumers in order of
willingness to pay, highest first. The first student is willing to pay $20, the
20th $10, and so on. For any price, P, the graph tells you how many students
would be willing to buy: it is the number whose WTP is at or above P.
The demand curve represents the WTP of buyers; similarly, supply
depends on the sellers’ willingness to accept (WTA) money in return for
books.
This is explained in more detail in
‘Who’s in Charge?’
(https://tinyco.re/9867111),
Chapter 1 of Paul Seabright’s book
on how market economies manage
to organize complex trades among
strangers (follow the link to access
Chapter 1 as a pdf). Paul Seabright.
2010. The Company of Strangers: A
Natural History of Economic Life
(Revised Edition). Princeton, NJ:
Princeton University Press.
Often when you buy something you don’t need to think about
your exact willingness to pay. You just decide whether to pay
the asking price. But WTP is a useful concept for buyers in
online auctions, such as eBay.
If you want to bid for an item, one way to do it is to set a
maximum bid equal to your WTP, which will be kept secret
from other bidders: this article explains how to do it on eBay
(https://tinyco.re/0107311). eBay will place bids automatically
on your behalf until you are the highest bidder, or until your
maximum is reached. You will win the auction if, and only if,
the highest bid is less than or equal to your WTP.
8.1 BUYING AND SELLING: DEMAND AND SUPPLY
315
reservation price The lowest price at which someone is willing
to sell a good (keeping the good is the potential seller’s reser-
vation option). See also: reservation option.
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.
The supply of second-hand books comes from
students who have previously completed the
course, who will differ in the amount they are
willing to accept—that is, their reservation price.
Recall from Unit 5 that Angela was willing to
enter into a contract with Bruno only if it gave her
at least as much utility as her reservation option
(no work and survival rations); here the reserva-
tion price of a potential seller represents the value
to her of keeping the book, and she will only be
willing to sell for a price at least that high. Poorer
students (who are keen to sell so that they can
afford other books) and those no longer studying
economics may have lower reservation prices. Again, online auctions like
eBay allow sellers to specify their WTA.
We can draw a supply curve by lining up the sellers in order of their
reservation prices (their WTAs): see Figure 8.2. We put the sellers who are
most willing to sell—those who have the lowest reservation prices—first, so
the graph of reservation prices slopes upward.
For any price, the supply curve shows the number of students willing to
sell at that price—that is, the number of books that will be supplied to the
market. Notice that we have drawn the supply and demand curves as
straight lines for simplicity. In practice they are more likely to be curves,
with the exact shape depending on how valuations of the book vary among
the students.
If you sell an item on eBay you can set a reserve price, which
will not be disclosed to the bidders. This article explains eBay
reserve prices (https://tinyco.re/9324100). You are telling eBay
that the item should not be sold unless there is a bid at (or
above) that price. So the reserve price should correspond to
your WTA. If no one bids your WTA, the item will not be sold.
Pr
ic
e,
P
(W
TP
, $
)
0
5
10
15
20
Quantity of books, Q (number of buyers)
0 5 10 15 20 25 30 35 40 45
Demand curve
Figure 8.1 The market demand curve for books.
UNIT 8 SUPPLY AND DEMAND: PRICE-TAKING AND COMPETITIVE MARKETS
316
QUESTION 8.1 CHOOSE THE CORRECT ANSWER(S)
As a student representative, one of your roles is to organize a second-
hand textbook market between the current and former first-year
students. After a survey, you estimate the demand and supply curves to
be the ones shown in Figures 8.1 and 8.2. For example, you estimate
that pricing the book at $7 would lead to a supply of 20 books and a
demand of 26 books. Which of the following statements is correct?
A rumour that the textbook may be required again in Year 2 would
change the supply curve, shifting it upwards.
Doubling the price to $14 would double the supply.
A rumour that the textbook may no longer be on the reading list for
the first-year students would change the demand curve, shifting it
upwards.
Demand would double if the price were reduced sufficiently.
Supply curve
0 5 10 15 20 25 30 35 40 45
0
2
4
6
8
14
12
10
Quantity of books, Q (number of sellers)
Pr
ic
e,
P
(s
el
le
rs
' r
es
er
va
tio
n
pr
ic
es
) (
$)
Pr
ic
e,
P
(s
el
le
rs
' r
es
er
va
tio
n
pr
ic
es
) (
$)
Figure 8.2 The supply curve for books.
1. Reservation price
The first seller has a reservation price
of $2, and will sell at any price above
that.
2. The 20th seller
The 20th seller will accept $7 …
3. The 40th seller
… and the 40th seller’s reservation price
is $12.
4. Supply curves slope upward
If you choose a particular price, say
$10, the graph shows how many books
would be supplied (Q) at that price: in
this case, it is 32. The supply curve
slopes upward: the higher the price, the
more students will be willing to sell.
8.1 BUYING AND SELLING: DEMAND AND SUPPLY
317
EXERCISE 8.1 SELLING STRATEGIES AND RESERVATION PRICES
Consider three possible methods to sell a car that you own:
• Advertise it in the local newspaper.
• Take it to a car auction.
• Offer it to a second-hand car dealer.
1. Would your reservation price be the same in each case? Why?
2. If you used the first method, would you advertise it at your reservation
price?
3. Which method do you think would result in the highest sale price?
4. Which method would you choose?
8.2 THE MARKET AND THE EQUILIBRIUM PRICE
What would you expect to happen in the market for this textbook? That
will depend on the market institutions that bring buyers and sellers
together. If students have to rely on word-of-mouth, then when a buyer
finds a seller they can try to negotiate a deal that suits both of them. But
each buyer would like to be able to find a seller with a low reservation price,
and each seller would like to find a buyer with a high willingness to pay.
Before concluding a deal with one trading partner, both parties would like
to know about other trading opportunities.
Traditional market institutions often brought many buyers and sellers
together in one place. Many of the world’s great cities grew up around
marketplaces and bazaars along ancient trading routes such as the Silk
Road between China and the Mediterranean. In the Grand Bazaar of
Istanbul, one of the largest and oldest covered markets in the world, shops
selling carpets, gold, leather, and textiles cluster together in different areas.
In medieval towns and cities it was common for makers and sellers of a
specific type of good to set up shops close to each other, so customers knew
where to find them. The city of London is now a financial centre, but
evidence of trades once carried out there can be found in surviving street
names: Pudding Lane, Bread Street, Milk Street, Threadneedle Street,
Ropemaker Street, Poultry Street, and Silk Street.
With modern communications, sellers can advertise their goods and
buyers can more easily find out what is available, and where to buy it. But
in some cases it is still convenient for many buyers and sellers to meet each
other. Large cities have markets for meat, fish, vegetables or flowers, where
buyers can inspect and compare the quality of the produce. In the past,
markets for second-hand goods often involved specialist dealers, but
nowadays sellers can contact buyers directly through online marketplaces
such as eBay. Websites now help students sell textbooks to others in their
university.
At the end of the nineteenth century, the economist Alfred Marshall
introduced his model of supply and demand using a similar example to our
case of second-hand books. Most English towns had a corn exchange (also
known as a grain exchange)—a building where farmers met with merchants
to sell their grain. Marshall described how the supply curve of grain would
be determined by the prices that farmers would be willing to accept, and
the demand curve by the willingness to pay of merchants. Then he argued
that, although the price ‘may be tossed hither and thither like a shuttlecock’
UNIT 8 SUPPLY AND DEMAND: PRICE-TAKING AND COMPETITIVE MARKETS
318
Alfred Marshall. 1920. Principles of
Economics (https://tinyco.re/
0560708), 8th ed. London:
MacMillan & Co.
excess supply A situation in which the quantity of a good
supplied is greater than the quantity demanded at the current
price. See also: excess demand.
Nash equilibrium A set of strategies, one for each player in the
game, such that each player’s strategy is a best response to the
strategies chosen by everyone else.
equilibrium (of a market) A state of a market in which there is
no tendency for the quantities bought and sold, or the market
price, to change, unless there is some change in the underlying
costs, preferences, or other determinants of the behaviour of
market actors.
marginal cost The effect on total
cost of producing one additional
unit of output. It corresponds to the
slope of the total cost function at
each point.
marginal utility The additional
utility resulting from a one-unit
increase of a given variable.
in the ‘higgling and bargaining’ of the market, it would never be very far
from the particular price at which the quantity demanded by merchants
was equal to the quantity the farmers would supply.
Marshall called the price that equated supply
and demand the equilibrium price. If the price was
above the equilibrium, farmers would want to sell
large quantities of grain. But few merchants
would want to buy—there would be excess
supply. Then, even the merchants who were
willing to pay that much would realize that farm-
ers would soon have to lower their prices and
would wait until they did. Similarly, if the price
was below the equilibrium, sellers would prefer to
wait rather than sell at that price. If, at the going
price, the amount supplied did not equal the
amount demanded, Marshall reasoned that some
sellers or buyers could benefit by charging some
other price (in modern terminology, we would say that the going price was
not a Nash equilibrium). So the price would tend to settle at an equilib-
rium level, where demand and supply were equated.
Marshall’s argument was based on the assumption that all the grain was
of the same quality. His supply and demand model can be applied to
markets in which all sellers are selling identical goods, so buyers are equally
willing to buy from any seller. If the farmers all had grain of different
qualities, they would be more like the sellers of differentiated products in
Unit 7.
GREAT ECONOMISTS
Alfred Marshall
Alfred Marshall (1842–1924) was
a founder—with Léon Walras—of
what is termed the neoclassical
school of economics. His Principles
of Economics, first published in
1890, was the standard
introductory textbook for English
speaking students for 50 years. An
excellent mathematician, Marshall
provided new foundations for the
analysis of supply and demand by
using calculus to formulate the
workings of markets and firms,
and express key concepts such as marginal costs and marginal utility.
The concepts of consumer and producer surplus are also due to
Marshall. His conception of economics as an attempt to ‘understand the
influences exerted on the quality and tone of a man’s life by the manner
in which he earns his livelihood …’ is close to our own definition of the
field.
Sadly, much of the wisdom in Marshall’s text has rarely been taught
by his followers. Marshall paid attention to facts. His observation that
large firms could produce at lower unit costs than small firms was
8.2 THE MARKET AND THE EQUILIBRIUM PRICE
319
Ethical forces are among those of which the economist has to take
account. Attempts have indeed been made to construct an abstract
science with regard to the actions of an economic man who is
under no ethical influences and who pursues pecuniary gain …
selfishly. But they have not been successful. (Principles of Eco-
nomics, 1890)
Now at last we are setting ourselves seriously to inquire whether it
is necessary that there should be any so called lower classes at all:
that is whether there need be large numbers of people doomed
from their birth to hard work in order to provide for others the
requisites of a refined and cultured life, while they themselves are
prevented by their poverty and toil from having any share or part
in that life. … The answer depends in a great measure upon facts
and inferences, which are within the province of economics; and
this is it which gives to economic studies their chief and their
highest interest. (Principles of Economics, 1890)
integral to his thinking, but it never found a place in the neoclassical
school. This may be because if the average cost curve is downward-
sloping even when firms are very large, there will be a kind of winner-
takes-all competition in which a few large firms emerge as winners with
the power to set prices, rather than taking the going price as a given. We
return to this problem in Unit 12 and Unit 21.
Marshall would also have been distressed that homo economicus
(whose existence we questioned in Unit 4) became the main actor in
textbooks written by the followers of the neoclassical school. He insisted
that:
While advancing the use of mathematics in economics, he also cautioned
against its misuse. In a letter to A. L. Bowley, a fellow mathematically
inclined economist, he explained his own ‘rules’ as follows:
1. Use mathematics as a shorthand language, rather than as an engine of
inquiry
2. Keep to them [that is, stick to the maths] till you have done
3. Translate into English
4. Then illustrate by examples that are important in real life
5. Burn the mathematics
6. If you can’t succeed in 4, burn 3: ‘This I do often.’
Marshall was Professor of Political Economy at the University of
Cambridge between 1885 and 1908. In 1896 he circulated a pamphlet to
the University Senate objecting to a proposal to allow women to be
granted degrees. Marshall prevailed and women would wait until 1948
before being granted academic standing at Cambridge on a par with
men.
But his work was motivated by a desire to improve the material con-
ditions of working people:
Would Marshall now be satisfied with the contribution that modern
economics has made to creating a more just economy?
UNIT 8 SUPPLY AND DEMAND: PRICE-TAKING AND COMPETITIVE MARKETS
320
market-clearing price At this price
there is no excess supply or excess
demand. See also: equilibrium.
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.
To apply the supply and demand model to the textbook market, we assume
that all the books are identical (although in practice some may be in better
condition than others) and that a potential seller can advertise a book for
sale by announcing its price on a local website. As at the Corn Exchange, we
would expect that most trades would occur at similar prices. Buyers and
sellers can easily observe all the advertised prices, so if some books were
advertised at $10 and others at $5, buyers would be queuing to pay $5, and
these sellers would quickly realize that they could charge more, while no
one would want to pay $10 so these sellers would have to lower their price.
We can find the equilibrium price by drawing the supply and demand
curves on one diagram, as in Figure 8.3. At a price P* = $8, the supply of
books is equal to demand: 24 buyers are willing to pay $8, and 24 sellers are
willing to sell. The equilibrium quantity is Q* = 24.
The market-clearing price is $8—that is, supply is equal to demand at
this price, so all buyers who want to buy and all sellers who want to sell can
do so. The market is in equilibrium. In everyday language, something is in
equilibrium if the forces acting on it are in balance, so that it remains still.
Remember Fisher’s hydraulic model of price determination from Unit 2:
changes in the economy caused water to flow through the apparatus until it
reached an equilibrium, with no further tendency for prices to change. We
say that a market is in equilibrium if the actions of buyers and sellers have
no tendency to change the price or the quantities bought and sold, unless
Demand curve
Supply curve
A
Quantity of books, Q
0 5 10 15 20 25 30 35 40 45
Pr
ic
e,
P
($
)
0
5
10
15
20
Q*
P*
Figure 8.3 Equilibrium in the market for second-hand books.
1. Supply and demand
We find the equilibrium by drawing the
supply and demand curves in the same
diagram.
2. 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.
3. A price above the equilibrium price
At a price greater than $8 more
students would wish to sell, but not all
of them would find buyers. There would
be excess supply, so these sellers would
want to lower their price.
4. A price below the equilibrium price
At a price less than $8, there would be
more buyers than sellers—excess
demand—so sellers could raise their
prices. Only at $8 is there no tendency
for change.
8.2 THE MARKET AND THE EQUILIBRIUM PRICE
321
price-taker Characteristic of
producers and consumers who
cannot benefit by offering or asking
any price other than the market
price in the equilibrium of a com-
petitive market. They have no
power to influence the market
price.
competitive equilibrium A market
outcome in which all buyers and
sellers are price-takers, and at the
prevailing market price, the
quantity supplied is equal to the
quantity demanded.
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 are able to do so, so
there is no tendency for change.
Price-taking
Will the market always be in equilibrium? As we have seen, Marshall argued
that prices would not deviate far from the equilibrium level, because people
would want to change their prices if there were excess supply or demand. In
this unit, we study competitive market equilibria. In Unit 11 we will look at
when and how prices change when the market is not in equilibrium.
In the textbook market that we have described, individual students have
to accept the prevailing equilibrium price in the market, determined by the
supply and demand curves. No one would trade with a student asking a
higher price or offering a lower one, because anyone could find an
alternative seller or buyer with a better price. The participants in this
market are price-takers, because there is sufficient competition from other
buyers and sellers so the best they can do is to trade at the same price. Any
buyer or seller is of course free to choose a different price, but they cannot
benefit by doing so.
We have seen examples where market participants do not behave as
price-takers: the producer of a differentiated product can set its own price
because it has no close competitors. Notice, however, that although the
sellers of differentiated products are price-setters, the buyers in Unit 7 were
price-takers. Since there are so many consumers wanting to buy breakfast
cereals, an individual consumer has no power to negotiate a more
advantageous deal, but simply has to accept the price that all other con-
sumers are paying.
In this unit, we study market equilibria where both buyers and sellers
are price-takers. We expect to see price-taking on both sides of the market
where there are many sellers selling the identical goods, and many buyers
wishing to purchase them. Sellers are forced to be price-takers by the
presence of other sellers, as well as buyers who always choose the seller
with the lowest price. If a seller tried to set a higher price, buyers would
simply go elsewhere.
Similarly buyers are price-takers when there are plenty of other buyers,
and sellers willing to sell to whoever will pay the highest price. On both
sides of the market, competition eliminates bargaining power. We will
describe the equilibrium in such a market as a competitive equilibrium.
A competitive market equilibrium is a Nash equilibrium, because given
what all other actors are doing (trading at the equilibrium price), no actor
can do better than to continue what he or she is doing (also trading at the
equilibrium price).
Not all online markets for books
are in competitive equilibrium. In
one case when the conditions for
equilibrium were not met,
automatic price-setting algorithms
raised the price of a book to $23
million! Michael Eisen, a biologist,
noticed a classic but out-of-print
text, The Making of a Fly, was
listed for sale on Amazon by two
reputable sellers, with prices
starting at $1,730,045.91 (+$3.99
shipping). He watched over the
next week as the prices rose
rapidly, eventually peaking at
$23,698,655.93, before dropping to
$106.23. Eisen explains why in his
blog (https://tinyco.re/0044329).
UNIT 8 SUPPLY AND DEMAND: PRICE-TAKING AND COMPETITIVE MARKETS
322
EXERCISE 8.2 PRICE-TAKERS
Think about some of the goods you buy: perhaps different kinds of food,
clothes, transport tickets, or electronic goods.
1. Are there many sellers of these goods?
2. Do you try to find the lowest price in each case?
3. If not, why not?
4. For which goods would price be your main criterion?
5. Use your answers to help you decide whether the sellers of these goods
are price-takers. Are there goods for which you, as a buyer, are not a
price-taker?
QUESTION 8.2 CHOOSE THE CORRECT ANSWER(S)
The diagram shows the demand and the supply curves for a textbook.
The curves intersect at (Q, P) = (24, 8). Which of the following is
correct?
Demand curve
Supply curve
A
Quantity of books, Q
0 5 10 15 20 25 30 35 40 45
Pr
ic
e,
P
($
)
0
5
10
15
20
Q*
P*
At price $10, there is an excess demand for the textbook.
At $8, some of the sellers have an incentive to increase their selling
price to $9.
At $8, the market clears.
40 books will be sold in total.
8.3 PRICE-TAKING FIRMS
In the second-hand textbook example, both buyers and sellers are indi-
vidual consumers. Now we look at markets where the sellers are firms. We
know from Unit 7 how firms choose their price and quantity when produc-
ing differentiated goods, and we saw that if other firms made similar
products, their choice of price would be restricted (the demand curve for
their own product would be almost flat) because raising the price would
cause consumers to switch to other similar brands.
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.
8.3 PRICE-TAKING FIRMS
323
To see how price-taking firms behave, consider a city where many small
bakeries produce bread and sell it direct to consumers. Figure 8.4 shows
what the market demand curve (the total daily demand for bread of all con-
sumers in the city) might look like. It is downward-sloping as usual because
at higher prices, fewer consumers will be willing to buy.
Suppose that you are the owner of one small bakery. You have to decide
what price to charge and how many loaves to produce each morning.
Suppose that neighbouring bakeries are selling loaves identical to yours at
€2.35. This is the prevailing market price, and you will not be able to sell
loaves at a higher price than other bakeries, because no one would buy—
you are a price-taker.
Your marginal costs increase with your output of bread. When the
quantity is small, the marginal cost is low, close to €1: having installed
mixers, ovens and other equipment, and employed a baker, the additional
cost to produce a loaf of bread is relatively small, but the average cost of a
loaf is high. As the number of loaves per day increases, the average cost falls,
but marginal costs begin to rise gradually because you have to employ extra
staff and use equipment more intensively. At higher quantities the marginal
cost is above the average cost; then average costs rise again.
The marginal and average cost curves are drawn in Figure 8.5. As in Unit
7, costs include the opportunity cost of capital. If price were equal to
average cost (P = AC), your economic profit would be zero. You, the owner,
would obtain a normal return on your capital. So the average cost curve
(the leftmost curve in Figure 8.5) is the zero-economic-profit curve. The
isoprofit curves show price and quantity combinations at which you would
receive higher levels of profit. As we explained in Unit 7, isoprofit curves
slope downwards where price is above marginal cost, and upwards where
price is below marginal cost, so the marginal cost curve passes through the
lowest point on each isoprofit curve. If price is above marginal cost, total
profits can remain unchanged only if a larger quantity is sold for a lower
price. Similarly, if price is below marginal cost, total profits can remain
unchanged only if a larger quantity is sold for a higher price.
Figure 8.5 demonstrates how to make your decision. Like the firms in
Unit 7, you face a constrained optimization problem. You want to find the
point of maximum profit in your feasible set.
Pr
ic
e,
P
(€
)
0
1
2
3
5
Quantity of loaves, Q
0 1,000 2,000 3,000 4,000 5,000 6,000 7,000 8,000 9,000 10,000
Demand curve
4
Figure 8.4 The market demand curve for bread.
UNIT 8 SUPPLY AND DEMAND: PRICE-TAKING AND COMPETITIVE MARKETS
324
Because you are a price-taker, the feasible set is all points where price is
less than or equal to €2.35, the market price. Your optimal choice is
P* = €2.35 and Q* = 120, where the isoprofit curve is tangent to the feas-
ible set. The problem looks similar to the one for Beautiful Cars in Unit 7,
except that for a price-taker, the demand curve is completely flat. For your
bakery, it is not the market demand curve in Figure 8.4 that affects your
own demand, it is the price charged by your competitors. This is why the
horizontal line at P* in Figure 8.5 is labelled as the firm’s demand curve. If
you charge more than P*, your demand will be zero, but at P* or less you
can sell as many loaves as you like.
Figure 8.5 illustrates a very important characteristic of price-taking
firms. They choose to produce a quantity at which the marginal cost is
equal to the market price (MC = P*). This is always true. For a price-taking
firm, the demand curve for its own output is a horizontal line at the market
price, so maximum profit is achieved at a point on the demand curve where
Feasible set
A
Marginal cost
curve
Firm’s demand
curve
Isoprofit curve:
€200
Zero-economic-
profit curve
(AC curve)
Isoprofit curve:
€80
Quantity of loaves, Q
0 20 40 60 80 100 120 140 160 180 200
Pr
ic
e,
P
(€
);
co
st
0
2
4
6
8
P*
Figure 8.5 The profit-maximizing price and quantity for a bakery.
1. Marginal cost and isoprofit curves
The bakery has an increasing MC curve.
On the AC curve, profit is zero. When
MC > AC, the AC curve slopes upward.
The other isoprofit curves represent
higher levels of profit, and MC passes
through the lowest points of all the iso-
profit curves.
2. Price-taking
The bakery is a price-taker. The market
price is P* = €2.35. If you choose a
higher price, customers will go to other
bakeries. Your feasible set of prices and
quantities is the area below the hori-
zontal line at P*.
3. The profit-maximizing price
The point of highest profit in the feas-
ible set is point A, where the €80
isoprofit curve is tangent to the feasible
set. You should make 120 loaves per
day, and sell them at the market price,
€2.35 each. You will make €80 of profit
per day in addition to normal profits.
4. The profit-maximizing quantity
Your profit-maximizing quantity,
Q* = 120, is found at the point where
P* = MC: the marginal cost of the 120th
loaf is equal to the market price.
8.3 PRICE-TAKING FIRMS
325
PRICE-TAKING FIRM
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*.
the isoprofit curve is horizontal. And we know from Unit 7 that where iso-
profit curves are horizontal, the price is equal to the marginal cost.
Another way to understand why a price-taking firm produces at the
level of output where MC = P* is to think about what would happen to its
profits if it deviated from this point. If the firm were to increase output to a
level where MC > P*, the last unit would cost more than P* to make, so the
firm would make a loss on this unit and could make higher profits by
reducing output. If it were to produce where MC < P*, it could produce at
least one more unit and sell it at a profit. Therefore it should raise output as
far as the point where MC = P*. This is where profits are maximized.
This is an important result that you should remember, but you need to
be careful with it. When we make statements like ‘for a price-taking firm,
price equals marginal cost’, we do not mean that the firm chooses a price
equal to its marginal cost. Instead, we mean the opposite: the firm accepts
the market price, and chooses its quantity so that the marginal cost is equal
to that price.
Put yourself in the position of the bakery owner again. What would you
do if the market price changed? Figure 8.6 demonstrates that as prices
change you would choose different points on the marginal cost curve.
Marginal cost
curve
Isoprofit curve:
€200
Zero-economic-
profit curve
(AC curve)
Supply curve
Quantity of loaves, Q Quantity of loaves, Q
0 200120 16040 80
0
2
4
6
7
5
3
1
0 200120 16040 80
0
2
4
6
7
5
3
1
Pr
ic
e,
P
(€
);
co
st
Pr
ic
e,
P
(€
);
co
st
Isoprofit curve:
€80
Figure 8.6 The firm’s supply curve.
1. A change in price
When the market price is €2.35, you
supply 120 loaves. What would you do
if the price changed?
2. If the price rises
If P* were to rise to €3.20, you could
reach a higher isoprofit curve. To
maximize profit you should produce
163 loaves per day.
3. If the price falls
If the price falls to €1.52 you could
reach only the lightest blue curve. Your
best choice would be 66 loaves, and
your economic profit would be zero.
4. The marginal cost curve is the supply
curve
In each case, you choose the point on
your marginal cost curve where
MC = market price. Your marginal cost
curve is your supply curve.
UNIT 8 SUPPLY AND DEMAND: PRICE-TAKING AND COMPETITIVE MARKETS
326
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.
Notice, however, that if the price fell below €1.52 you would be making
a loss. The supply curve shows how many loaves you should produce to
maximize profit, but when the price is this low, the economic profit is
nevertheless negative. On the supply curve, you would be minimizing your
loss. If this happened, you would have to decide whether it was worth
continuing to produce bread. Your decision depends on what you expect to
happen in the future:
• If you expect market conditions to remain bad, it might be best to sell up
and leave the market—you could obtain a better return on your capital
elsewhere.
• If you expect the price to rise soon, you might be willing to incur some
short-term losses, and it might be worth continuing to produce bread if
the revenue helped you to cover the costs of maintaining your premises
and retaining staff.
QUESTION 8.3 CHOOSE THE CORRECT ANSWER(S)
Figure 8.5 (page 325) shows a price-taking bakery’s marginal and
average cost curves, and its isoprofit curves. The market price for
bread is P*= €2.35. Which of the following statements is correct?
The firm’s supply curve is horizontal.
At the market price of €2.35, the firm will supply 62 loaves, at the
point where the firm makes zero profit.
At any market price, the firm’s supply is given by the corresponding
point on the average cost curve.
The marginal cost curve is the firm’s supply curve.
8.4 MARKET SUPPLY AND EQUILIBRIUM
The market for bread in the city has many consumers and many bakeries.
Let’s suppose there are 50 bakeries. Each one has a supply curve
corresponding to its own marginal cost curve, so we know how much it
will supply at any given market price. To find the market supply curve, we
just add up the total amount that all the bakeries will supply at each price.
Figure 8.7 shows how this works if all the bakeries have the same cost
functions. We work out how much one bakery would supply at a given
price, then multiply by 50 to find total market supply at that price.
The market supply curve shows the total quantity that all the bakeries
together would produce at any given price. It also represents the marginal
cost of producing a loaf, just as the firm’s supply curve does. For example, if
the market price is €2.75, total market supply is 7,000. For every bakery,
the marginal cost—the cost of producing one more loaf—is €2.75. And that
means that the cost of producing the 7,001st loaf in the market is €2.75,
whichever firm produces it. So the market supply curve is the market’s mar-
ginal cost curve.
Now we know both the demand curve (Figure 8.4) and the supply curve
(Figure 8.7) for the bread market as a whole. Figure 8.8 shows that the equi-
librium price is exactly €2.00. At this price, the market clears: consumers
demand 5,000 loaves per day, and firms supply 5,000 loaves per day.
Leibniz: Market supply curve
(https://tinyco.re/L080401)
8.4 MARKET SUPPLY AND EQUILIBRIUM
327
Firm supply
(marginal cost)
Market supply
(marginal cost)
Quantity of loaves, Q
0 200120 16040 80
Quantity of loaves, Q
0 10,0006,000 8,0002,000 4,000
0
2
4
5
3
1
0
2
4
5
3
1
Pr
ic
e,
P
(€
);
co
st
Pr
ic
e,
P
(€
);
co
st
Figure 8.7 The firm and market supply curves.
Pr
ic
e,
P
(€
)
Quantity of loaves, Q
0 1,000 2,000 3,000 4,000 5,000 6,000 7,000 8,000 9,000 10,000
Supply (marginal cost)
Demand
A
4.5
4.0
3.5
3.0
2.5
2.0
1.5
1.0
0.5
0.0
Figure 8.8 Equilibrium in the market for bread.
1. The firm’s supply curve
There are 50 bakeries, all with the
same cost functions. If the market price
is €2.35, each bakery will produce 120
loaves.
2. The market supply curve
When P = €2.35, each bakery supplies
120 loaves, and the market supply is
50 × 120 = 6,000 loaves.
3. Firm and market supply curves look
similar
At a price of €1.52 they each supply 66
loaves, and market supply is 3,300. The
market supply curve looks like the
firm’s supply curve, but the scale on the
horizontal axis is different.
4. What if different firms had different
costs?
If the bakeries had different cost func-
tions, then at a price of €2.35 some
bakeries would produce more loaves
than others, but we could still add them
together to find market supply.
UNIT 8 SUPPLY AND DEMAND: PRICE-TAKING AND COMPETITIVE MARKETS
328
In the market equilibrium, each bakery is producing on its marginal cost
curve, at the point where its marginal cost is €2.00. If you look back to the
isoprofit curves in Figure 8.6, you will see that the firm is above its average
cost curve, the isoprofit curve where economic profits are zero. So the
owners of the bakeries are receiving economic rents (profit in excess of
normal profit). Whenever there are economic rents, there is an opportunity
for someone to benefit by taking an action. In this case, we might expect the
economic rents to attract other bakeries into the market. We will see
presently how this would affect the market equilibrium.
QUESTION 8.4 CHOOSE THE CORRECT ANSWER(S)
There are two different types of producers of a good in an industry
where firms are price-takers. The marginal cost curves of the two types
are given below:
0
0
1
2
3
Type A
5 10 15 20 25 30 35 0
0
1
2
3
Pr
ic
e,
P
; m
ar
gi
na
l c
os
t
Pr
ic
e,
P
; m
ar
gi
na
l c
os
t
Type B
5 10 15 20 25 30 35
Output Output
Type A is more efficient than Type B: for example, as shown, at the
output of 20 units, the Type A firms have a marginal cost of $2, as
opposed to a marginal cost of $3 for the Type B firms. There are 10
Type A firms and 8 Type B firms in the market. Which of the following
statements is correct?
At price $2, the market supply is 450 units.
The market will supply 510 units at price $3.
At price $2, the market’s marginal cost of supplying one extra unit
of the good will depend on the type of the firm that produces it.
With different types of firms, we cannot determine the marginal
cost curve for the market.
Leibniz: Market equilibrium
(https://tinyco.re/L080402)
8.4 MARKET SUPPLY AND EQUILIBRIUM
329
8.5 COMPETITIVE EQUILIBRIUM: GAINS FROM TRADE,
ALLOCATION, AND DISTRIBUTION
Buyers and sellers of bread voluntarily engage in trade because both bene-
fit. Their mutual benefits from the equilibrium allocation can be measured
by the consumer and producer surpluses introduced in Unit 7. Any buyer
whose willingness to pay for a good is higher than the market price receives
a surplus: the difference between the WTP and the price paid. Similarly, if
the marginal cost of producing a good is below the market price, the
producer receives a surplus. Figure 8.9a shows how to calculate the total
surplus (the gains from trade) at the competitive equilibrium in the market
for bread, in the same way as we did for the markets in Unit 7.
When the market for bread is in equilibrium with the quantity of loaves
supplied equal to the quantity demanded, the total surplus is the area below
the demand curve and above the supply curve.
Notice how the equilibrium allocation in this market differs from the
allocation of a differentiated product, Beautiful Cars, in Unit 7. The equilib-
rium quantity of bread is at the point where the market supply curve, which
is also the marginal cost curve, crosses the demand curve, and the total
surplus is the whole of the area between the two curves. Figure 7.13 showed
that in the market for Beautiful Cars, the manufacturer chooses to produce
Supply (marginal cost)
Producer surplus
Consumer surplus
Demand
A
Quantity of loaves, Q
0 1,000 2,000 3,000 4,000 5,000 6,000 7,000 8,000 9,000 10,000
Pr
ic
e,
P
(€
)
4.5
4.0
3.5
3.0
2.5
2.0
1.5
1.0
0.5
0.0
Figure 8.9a Equilibrium in the bread market: Gains from trade.
1. The consumer surplus
At the equilibrium price of €2 in the
bread market, a consumer who is
willing to pay €3.50 obtains a surplus of
€1.50.
2. Total consumer surplus
The shaded area above €2 shows total
consumer surplus—the sum of all the
buyers’ gains from trade.
3. The producer surplus
Remember from Unit 7 that the
producer’s surplus on a unit of output is
the difference between the price at
which it is sold, and the marginal cost
of producing it. The marginal cost of
the 2,000th loaf is €1.25; since it is sold
for €2, the producer obtains a surplus
of €0.75.
4. Total producer surplus
The shaded area below €2 is the sum of
the bakeries’ surpluses on every loaf
that they produce. The whole shaded
area shows the sum of all gains from
trade in this market, known as the total
surplus.
UNIT 8 SUPPLY AND DEMAND: PRICE-TAKING AND COMPETITIVE MARKETS
330
deadweight loss A loss of total
surplus relative to a Pareto-effi-
cient allocation.
a quantity below the point where the marginal cost curve meets the demand
curve, and the total surplus is lower than it would be at that point.
The competitive equilibrium allocation of bread has the property that
the total surplus is maximized. Figure 8.9b shows that the surplus would be
smaller if fewer than 5,000 loaves were produced. There would be con-
sumers without bread who would be willing to pay more than the cost of
producing another loaf, so there would be unexploited gains from trade.
The total gains from trade in the market would be lower. We say there
would be a deadweight loss equal to the triangle-shaped area. Producers
would be missing out on potential profits, and some consumers would be
unable to obtain the bread they were willing to pay for.
And if more than 5,000 loaves were produced,
the surplus on the extra loaves would be negative:
they would cost more to make than consumers
were willing to pay.
At the equilibrium, all the potential gains from
trade are exploited, which means there is no
deadweight loss. This property—that the
combined consumer and producer surplus is
maximized at the point where supply equals
demand—holds in general: if both buyers and
sellers are price-takers, the equilibrium allocation
maximizes the sum of the gains achieved by
trading in the market, relative to the original
allocation. We demonstrate this result in our Einstein at the end of this
section.
Leibniz: Gains from trade
(https://tinyco.re/L080501)
Joel Waldfogel, an economist, gave his chosen discipline a bad
name by suggesting that gift-giving at Christmas may result in
a deadweight loss. If you receive a gift that is worth less to you
than it cost the giver, you could argue that the surplus from
the transaction is negative. Do you agree?
Joel Waldfogel. 1993. ‘The Deadweight Loss of Christmas’
(https://tinyco.re/0182759). American Economic Review 83 (5).
‘Is Santa a Deadweight Loss?’ (https://tinyco.re/7728778). The
Economist. Updated 20 December 2001.
Pr
ic
e,
P
(€
)
4.5
Quantity of loaves, Q
0 1,000 2,000 3,000 4,000 5,000 6,000 7,000 8,000 9,000 10,000
Supply (marginal cost)
Total surplus
Demand
4.0
3.5
3.0
2.5
2.0
1.5
1.0
0.5
0.0
A
DWL
Figure 8.9b Deadweight loss.
8.5 COMPETITIVE EQUILIBRIUM
331
Pareto efficient An allocation with
the property that there is no
alternative technically feasible
allocation in which at least one
person would be better off, and
nobody worse off.
Pareto efficiency
At the competitive equilibrium allocation in the bread market, it is not
possible to make any of the consumers or firms better off (that is, to
increase the surplus of any individual) without making at least one of them
worse off. Provided that what happens in this market does not affect
anyone other than the participating buyers and sellers, we can say that the
equilibrium allocation is Pareto efficient.
Pareto efficiency follows from three assumptions we have made about
the bread market.
Price-taking
The participants are price-takers. They have no market power. When a
particular buyer trades with a particular seller, each of them knows that the
other can find an alternative trading partner willing to trade at the market
price. Sellers can’t raise the price because of competition from other sellers,
and competition from other buyers prevents buyers from lowering it.
Hence the suppliers will choose their output so that the marginal cost (the
cost of the last unit produced) is equal to the market price.
In contrast, the producer of a differentiated good has bargaining power
because it faces less competition: no one else produces an identical good.
The firm uses its power to keep the price high, raising its own share of the
surplus but lowering total surplus. The price is above marginal cost, so the
allocation is Pareto inefficient.
A complete contract
The exchange of a loaf of bread for money is governed by a complete con-
tract between buyer and seller. If you find there is no loaf of bread in the
bag marked ‘bread’ when you get home, you can get your money back.
Compare this with the incomplete employment contract in Unit 6, in which
the firm can buy the worker’s time, but cannot be sure how much effort the
worker will put in. We will see in Unit 9 that this leads to a Pareto-
inefficient allocation in the labour market.
No effects on others
We have implicitly assumed that what happens in this market affects no one
except the buyers and sellers. To assess Pareto efficiency, we need to con-
sider everyone affected by the allocation. If, for example, the early morning
activities of bakeries disrupt the sleep of local residents, then there are addi-
tional costs of bread production and we ought to take the costs to the
bakeries’ neighbours into account too. Then, we may conclude that the
equilibrium allocation is not Pareto efficient after all. We will investigate
this type of problem in Unit 12.
UNIT 8 SUPPLY AND DEMAND: PRICE-TAKING AND COMPETITIVE MARKETS
332
Fairness
Remember from Unit 5 that there are two criteria for assessing an alloca-
tion: efficiency and fairness. Even if we think that the market allocation is
Pareto efficient, we should not conclude that it is necessarily a desirable
one. What can we say about fairness in the case of the bread market? We
could examine the distribution of the gains from trade between producers
and consumers: Figure 8.9a showed that both consumers and firms obtain a
surplus, and in this example consumer surplus is slightly higher than
producer surplus. You can see that this happens because the demand curve
is relatively steep compared with the supply curve. Recall also from Unit 7
that a steep demand curve corresponds to a low elasticity of demand.
Similarly, the slope of the supply curve corresponds to the elasticity of
supply: in Figure 8.9a, demand is less elastic than supply.
In general, the distribution of the total surplus between consumers and
producers depends on the relative elasticities of demand and supply.
We might also want to take into account the market participants’
standard of living. For example, if a poor student buys a book from a rich
student, we might think that an outcome in which the buyer paid less than
the market price (closer to the seller’s reservation price) would be better,
because it would be fairer. Or, if the consumers in the bread market were
exceptionally poor, we might decide that it would be better to pass a law
setting a maximum bread price lower than €2.00 to achieve a fairer
(although Pareto-inefficient) outcome. In Unit 11, we will look at the effect
of regulating markets in this way.
The Pareto efficiency of a competitive equilibrium allocation is often
interpreted as a powerful argument in favour of markets as a means of
allocating resources. But we need to be careful not to exaggerate the value
of this result:
• The allocation may not be Pareto efficient: We might not have taken
everything into account.
• There are other important considerations: Fairness, for example.
• Price-takers are hard to find in real life: It is not as easy as you might think
to find behaviour consistent with our simple model of the bread market
(as we will see in Section 8.9).
Maurice Stucke. 2013. ‘Is Competi-
tion Always Good?’
(https://tinyco.re/8720076).
OUPblog.
8.5 COMPETITIVE EQUILIBRIUM
333
willingness to pay (WTP) An
indicator of how much a person
values a good, measured by the
maximum amount he or she would
pay to acquire a unit of the good.
See also: willingness to accept.
willingness to accept (WTA) The
reservation price of a potential
seller, who will be willing to sell a
unit only for a price at least this
high. See also: willingness to pay.
EXERCISE 8.3 MAXIMIZING THE SURPLUS
Consider a market for the tickets to a football match. Six supporters of the
Blue team would like to buy tickets; their valuations of a ticket (their WTP)
are 8, 7, 6, 5, 4, and 3. The diagram below shows the demand ‘curve’. Six
supporters of the Red team already have tickets, for which their reserva-
tion prices (WTA) are 2, 3, 4, 5, 6, and 7.
0
0
2
4
6
8
10
WTP
Number of supporters
1 2 3 4 5 6
1. Draw the supply and demand ‘curves’ on a single diagram (Hint: the
supply curve is also a step function, like the demand curve).
Suppose all trades are to take place at a single price as in a competitive
market where buyers and sellers are price takers.
2. Show that four trades take place in equilibrium.
3. What is the equilibrium price?
4. Calculate the consumer (buyer) surplus by adding up the surpluses of
the four buyers who trade.
5. Similarly calculate the producer (or seller) surplus.
6. Hence, find the total surplus in equilibrium.
7. Now suppose that the market operates through bargaining between
individual buyers and sellers. Find a way of matching the buyers and
sellers so that more than four trades occur. (Hint: suppose the highest
WTP buyer buys from the highest WTA seller.)
8. In this case, work out the surplus from each trade.
9. How does the total surplus in this case compare with the equilibrium
surplus?
10. Starting from the allocation of tickets you obtained through bargaining,
in which at least five tickets are owned by Blue supporters, is there a
way through further trade to make one of the supporters better off
without making anyone worse off?
UNIT 8 SUPPLY AND DEMAND: PRICE-TAKING AND COMPETITIVE MARKETS
334
EXERCISE 8.4 SURPLUS AND DEADWEIGHT LOSS
1. Sketch a diagram to illustrate the competitive market for bread,
showing the equilibrium where 5,000 loaves are sold at a price of €2.00.
2. Suppose that the bakeries get together to form a cartel. They agree to
raise the price to €2.70, and jointly cut production to supply the
number of loaves that consumers demand at that price. Shade the
areas on your diagram to show the consumer surplus, producer surplus,
and deadweight loss caused by the cartel.
3. For what kinds of goods would you expect the supply curve to be highly
elastic?
4. Draw diagrams to illustrate how the share of the gains from trade
obtained by producers depends on the elasticity of the supply curve.
QUESTION 8.5 CHOOSE THE CORRECT ANSWER(S)
In Figure 8.9a (page 330), the market equilibrium output and price of
the bread market is shown to be at (Q*, P*) = (5,000, €2). Suppose that
the mayor decrees that bakeries must sell as much bread as consumers
want, at a price of €1.50. Which of the following statements are
correct?
The consumer and producer surpluses both increase.
The producer surplus increases but the consumer surplus decreases.
The consumer surplus increases but the producer surplus decreases.
The total surplus is lower than at the market equilibrium.
QUESTION 8.6 CHOOSE THE CORRECT ANSWER(S)
Which of the following statements about a competitive equilibrium
allocation are correct?
It is the best possible allocation.
No buyer’s or seller’s surplus can be increased without reducing
someone else’s surplus.
The allocation must be Pareto efficient.
The total surplus from trade is maximized.
8.5 COMPETITIVE EQUILIBRIUM
335
EINSTEIN
Total surplus and WTP
However the market works, and whatever prices are paid, we can
calculate the consumer surplus by adding together the differences
between WTP and price paid for all the people who buy, and the
producer surplus by adding together the difference between price
received and marginal cost of every unit of output:
Then when we calculate the total surplus, the prices paid and received
cancel out:
When buyers and sellers are price-takers, and the price equalizes supply
and demand, the total surplus is as high as possible, because the con-
sumers with the highest WTPs buy the product and the units of output
with the lowest marginal costs are sold. Every trade involves a buyer
with a higher WTP than the seller’s reservation value, so the surplus
would go down if we omitted any of them. And if we tried to include any
more units of output in this calculation, the surplus would also go down
because the WTPs would be lower than the MCs.
•8.6 CHANGES IN SUPPLY AND DEMAND
Quinoa is a cereal crop grown on the Altiplano, a high barren plateau in the
Andes of South America. It is a traditional staple food in Peru and Bolivia.
In recent years, as its nutritional properties have become known, there has
been a huge increase in demand from richer, health-conscious consumers
in Europe and North America. Figures 8.10a–c show how the market
changed. You can see in Figures 8.10a and 8.10b that between 2001 and
2011, the price of quinoa trebled and production almost doubled. Figure
8.10c indicates the strength of the increase in demand: spending on imports
of quinoa rose from just $2.4 million to $43.7 million in 10 years.
For the producer countries these changes are a mixed blessing. While
their staple food has become expensive for poor consumers, farmers—who
are amongst the poorest—are benefiting from the boom in export sales.
Other countries are now investigating whether quinoa can be grown in dif-
ferent climates, and France and the US have become substantial producers.
How can we explain the rapid increase in the price of quinoa? In this
section, we look at the effects of changes in demand and supply in our
simple examples of books and bread. At the end of this section you can
apply the analysis to the real-world case of quinoa.
UNIT 8 SUPPLY AND DEMAND: PRICE-TAKING AND COMPETITIVE MARKETS
336
An increase in demand
In the market for second-hand textbooks, demand comes from new
students enrolling on the course, and supply comes from students who took
the course in the previous year. In Figure 8.11 we have plotted supply and
demand for textbooks when the number of students enrolling remains
stable at 40 per year. The equilibrium price is $8 and 24 books are sold, as
shown by point A. Suppose that in one year the course became more
popular. Figure 8.11 shows what would happen.
The increase in demand leads to a new equilibrium, in which 32 books
are sold for $10 each. At the original price, there would be excess demand
and sellers would want to raise their prices. At the new equilibrium, both
price and quantity are higher. Some students who would not have sold their
books at $8 will now sell at a higher price. Notice, however, that although
demand has increased, not all the students who would have bought at $8
0
10
20
30
40
50
60
70
80
90
2001 2003 2005 2007 2009 2011
Year
Pr
od
uc
tio
n
of
qu
in
oa
(t
ho
us
an
ds
of
to
nn
es
)
Ecuador
Peru
Bolivia
Figure 8.10a The production of quinoa.
Jose Daniel Reyes and Julia Oliver.
‘Quinoa: The Little Cereal That Could’
(https://tinyco.re/9266629). The Trade
Post. 22 November 2013. Underlying
data from Food and Agriculture
Organization of the United
Nations. FAOSTAT Database
(https://tinyco.re/4368803).
Bolivia
Peru
0
200
400
600
800
1,000
1,200
1,400
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
Year
Pr
ic
e
of
qu
in
oa
($
/t
on
ne
)
Figure 8.10b Quinoa producer prices.
8.6 CHANGES IN SUPPLY AND DEMAND
337
010
20
30
40
50
2001 2003 2005 2007 2009 2011
Year
Im
po
rt
de
m
an
d
fo
rq
ui
no
a
($
m
ill
io
ns
) All other countries
United States
Canada
EU-27
Figure 8.10c Global import demand for quinoa.
Supply
Excess demand
New demand
Original demand
A
B
Quantity of books
0 5 10 15 20 25 30 35 40 45 50 55 60
0
5
25
10
15
20
Pr
ic
e
($
)
Figure 8.11 An increase in the demand for books.
1. The initial equilibrium point
At the original levels of demand and
supply, the equilibrium is at point A.
The price is $8, and 24 books are sold.
2. An increase in demand
If there were more students enrolling in
one year, there would be more students
wanting to buy the book at each
possible price. The demand curve shifts
to the right.
3. Excess demand when the price is $8
If the price remained at $8, there would
be excess demand for books, that is,
more buyers than sellers.
4. A new equilibrium point
There is a new equilibrium at point B
with a price of $10, at which 32 books
are sold. The increase in demand has
led to a rise in the equilibrium quantity
and price.
UNIT 8 SUPPLY AND DEMAND: PRICE-TAKING AND COMPETITIVE MARKETS
338
shock An exogenous change in
some of the fundamental data used
in a model.
exogenous Coming from outside
the model rather than being
produced by the workings of the
model itself. See also: endogenous.
will purchase the book at the new equilibrium: those with WTP between $8
and $10 no longer want to buy.
When we say ‘increase in demand’, it’s important to be careful about
exactly what we mean:
• Demand is higher at each possible price, so the demand curve has shifted.
• In response to this shift there is a change in the price.
• This leads to an increase in the quantity supplied.
• This change is a movement along the supply curve.
• But the supply curve itself has not shifted (the number of sellers and their
reserve prices have not changed), so we do not call this ‘an increase in
supply’.
After an increase in demand, the equilibrium quantity rises, but so does the
price. You can see in Figure 8.11 that the steeper (more inelastic) the supply
curve, the higher the price will rise and the lower the quantity will increase.
If the supply curve is quite flat (elastic), then the price rise will be smaller
and the quantity sold will be more responsive to the demand shock.
An increase in supply due to improved productivity
In contrast, as an example of an increase in supply, think again about the
market for bread in one city. Remember that the supply curve represents
the marginal cost of producing bread. Suppose that bakeries discover a new
technique that allows each worker to make bread more quickly. This will
lead to a fall in the marginal cost of a loaf at each level of output. In other
words, the marginal cost curve of each bakery shifts down.
Figure 8.12 shows the original supply and demand curves for the
bakeries. When the MC curve of each bakery shifts down, so does the
market supply curve for bread. Look at Figure 8.12 to see what happens
next.
The improvement in the technology of breadmaking leads to:
• an increase in supply
• a fall in the price of bread
• a rise in the quantity sold
As in the 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 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 because our model doesn’t explain
why it happened: the model shows the consequences, not the causes.
An increase in supply: More bakeries enter the market
Another reason for a change in market supply is the entry of more firms or
the exit of existing firms. We analysed the equilibrium of the bread market
in the case when there were 50 bakeries in the city. Remember from Section
8.4 that at the equilibrium price of €2, each bakery is on an isoprofit curve
above the average cost curve. If economic profits are greater than zero,
firms are receiving an economic rent, so other firms might want to invest in
the baking business.
Leibniz: Shifts in demand and
supply (https://tinyco.re/L080601)
8.6 CHANGES IN SUPPLY AND DEMAND
339
costs of entry Startup costs that
would be incurred when a seller
enters a market or an industry.
These would usually include the
cost of acquiring and equipping
new premises, research and
development, the necessary
patents, and the cost of finding and
hiring staff.
Since there is an opportunity for making greater than normal profit by
selling bread in the city, new bakeries may decide to enter the market.
There will be some costs of entry, for example, acquiring and equipping
the premises, but provided these are not too high (or if premises and
equipment can be easily sold if the venture doesn’t work out) it will be
worthwhile to do so.
Remember that we find the market supply curve by adding up the
amounts of bread supplied by each firm, at each price. When more bakeries
have entered, more bread will be supplied at each price level. Although the
reason for the supply increase is different from the previous one, the effect
on the market equilibrium is the same: a fall in price and a rise in bread
sales. Figure 8.13 shows the effects on equilibrium. The bakeries once again
start off at point A, selling 5,000 loaves of bread for €2. The entry of new
firms shifts the supply curve outwards. There is more bread for sale at each
price, so at the original price there would be excess supply. The new equi-
librium is at point B with a lower price and higher bread sales.
0 1,000 2,000 3,000 4,000 5,000 6,000 7,000 8,000 9,000 10,000
Excess supply New supply (MC)
Demand
A
B
4.5
4.0
3.5
3.0
2.5
2.0
1.5
1.0
0.5
0.0
Quantity of loaves, Q
Pr
ic
e,
P
(€
)
Original supply
Figure 8.12 An increase in the supply of bread: A fall in MC.
1. The initial equilibrium point
The city’s bakeries start out at point A,
producing 5,000 loaves and selling
them for €2 each.
2. A fall in marginal costs
The market supply curve then shifts
because of the fall in the bakeries’ mar-
ginal costs. The supply curve shifts
down, because at each level of output,
the marginal cost and therefore the
price at which they are willing to
supply bread is lower.
3. An increase in supply
The supply curve has shifted down. But
another way to think of this change in
supply is to say that the supply curve
has shifted to the right. Since costs
have fallen, the amount that bakeries
will supply at each price is greater—an
increase in supply.
4. Excess supply when the price is €2
The effect of the fall in marginal cost is
an increase in market supply. At the
original price, there is more bread than
buyers want (excess supply). The
bakeries would want to lower their
prices.
5. The new equilibrium point
The new market equilibrium is at point
B, where more bread is sold and the
price is lower. The demand curve has
not shifted, but the fall in price has led
to an increase in the quantity of bread
demanded, along the demand curve.
UNIT 8 SUPPLY AND DEMAND: PRICE-TAKING AND COMPETITIVE MARKETS
340
The entry of new firms is unlikely to be welcomed by the existing
bakeries. Their costs have not changed, but the market price has fallen to
€1.75, so they must be making less profit than before. As we will see in
Unit 11, the entry of new firms may eventually drive economic profits to
zero, eliminating rents altogether.
EXERCISE 8.5 THE MARKET FOR QUINOA
Consider again the market for quinoa. The changes shown in Figures
8.10a–c (page 337) can be analysed as shifts in demand and supply.
1. Suppose there was an unexpected increase in demand for quinoa in the
early 2000s (a shift in the demand curve). What would you expect to
happen to the price and quantity initially?
2. Assuming that demand continued to rise over the next few years, how
do you think farmers responded?
3. Why did the price stay constant until 2007?
4. How could you account for the rapid price rise in 2008 and 2009?
5. Would you expect the price to fall eventually to its original level?
Pr
ic
e,
P
(€
)
Quantity of loaves, Q
0 1,000 2,000 3,000 4,000 5,000 6,000 7,000 8,000 9,000 10,000
Original supply (MC)
New supply (MC)
Demand
A
B
4.5
4.0
3.5
3.0
2.5
2.0
1.5
1.0
0.5
0.0
Figure 8.13 An increase in the supply of bread: More firms enter.
8.6 CHANGES IN SUPPLY AND DEMAND
341
EXERCISE 8.6 PRICES, SHOCKS, AND REVOLUTIONS
Historians usually attribute the wave of revolutions in
Europe in 1848 to long-term socioeconomic factors and
a surge of radical ideas. But a poor wheat harvest in
1845 lead to food shortages and sharp price rises, which
may have contributed to these sudden changes.
The table shows the average and peak prices of
wheat from 1838 to 1845, relative to silver. There are
three groups of countries: those where violent revolu-
tions took place, those where constitutional change
took place without widespread violence, and those
where no revolution occurred.
1. Explain, using supply and demand curves, how a
poor wheat harvest could lead to price rises and
food shortages.
2. Find a way to present the data to show that the size
of the price shock, rather than the price level, is
associated with the likelihood of revolution.
3. Do you think this is a plausible explanation for the
revolutions that occurred?
4. A journalist suggests that similar factors played a
part in the Arab Spring in 2010 (https://tinyco.re/
8936018). Read the post. What do you think of this
hypothesis?
Avg. price 1838–45 Max. price 1845–48
Austria 52.9 104.0
Baden 77.0 136.6
Bavaria 70.0 127.3
Bohemia 61.5 101.2
France 93.8 149.2
Hamburg 67.1 108.7
Hessedarmstadt 76.7 119.7
Hungary 39.0 92.3
Lombardy 88.3 119.9
Mecklenburgschwerin 72.9 110.9
Papal states 74.0 105.1
Prussia 71.2 110.7
Saxony 73.3 125.2
Switzerland 87.9 146.7
Violent revolution 1848
Württemberg 75.9 128.7
Belguim 93.8 140.1
Bremen 76.1 109.5
Brunswick 62.3 100.3
Denmark 66.3 81.5
Netherlands 82.6 136.0
Immediate constitutional change 1848
Oldenburg 52.1 79.3
England 115.3 134.7
Finland 73.6 73.7
Norway 89.3 119.7
Russia 50.7 44.1
Spain 105.3 141.3
No revolution 1848
Sweden 75.8 81.4
Berger, Helge, and Mark Spoerer. 2001. ‘Economic Crises and the European Revolutions of
1848.’ The Journal of Economic History 61 (2): pp. 293–326.
UNIT 8 SUPPLY AND DEMAND: PRICE-TAKING AND COMPETITIVE MARKETS
342
QUESTION 8.7 CHOOSE THE CORRECT ANSWER(S)
Figure 8.8 (page 328) shows the equilibrium of the bread market to be
5,000 loaves per day at price €2. A year later, we find that the market
equilibrium price has fallen to €1.50. What can we conclude?
The fall in the price must have been caused by a downward shift in
the demand curve.
The fall in the price must have been caused by a downward shift in
the supply curve.
The fall in price could have been caused by a shift in either curve.
At a price of €1.50, there will be an excess demand for bread.
QUESTION 8.8 CHOOSE THE CORRECT ANSWER(S)
Which of the following statements are correct?
A fall in the mortgage interest rate would shift up the demand curve
for new houses.
The launch of a new Sony smartphone would shift up the demand
curve for existing iPhones.
A fall in the oil price would shift up the demand curve for oil.
A fall in the oil price would shift down the supply curve for plastics.
•8.7 THE EFFECTS OF TAXES
Governments can use taxation to raise revenue (to finance government
spending, or redistribute resources) or to affect the allocation of goods and
services in other ways, perhaps because the government considers a
particular good to be harmful. The supply and demand model is a useful
tool for analysing the effects of taxation.
Using taxes to raise revenue
Raising revenue through taxation has a long history (see Unit 22). Take the
taxation of salt, for example. For most of history, salt was used all over the
world as a preservative, allowing food to be stored, transported, and traded.
The ancient Chinese advocated taxing salt, since people needed it, however
high the price. Salt taxes were an effective but often resented tool used by
ruling elites in ancient India and medieval kings. Resentment of high salt
taxes played an important part in the French Revolution, and Gandhi led
protests against the salt tax imposed by the British in India.
Figure 8.14 illustrates how a salt tax might work. Initially the market
equilibrium is at point A: the price is P* and the quantity of salt traded is
Q*. Suppose that a sales tax of 30% is imposed on the price of salt, to be
paid to the government by the suppliers. If suppliers have to pay a 30% tax,
their marginal cost of supplying each unit of salt increases by 30%. So the
supply curve shifts: the price is 30% higher at each quantity.
The new equilibrium is at point B, where a lower quantity of salt is
traded. Although the consumer price has risen, note that it is not 30%
higher than before. The price paid by consumers, P1, is 30% higher than the
price received by the suppliers (net of the tax), which is P0. Suppliers receive
a lower price than before, they produce less, and their profits will be lower.
This illustrates an important feature of taxes: it is not necessarily the
8.7 THE EFFECTS OF TAXES
343
tax incidence The effect of a tax on
the welfare of buyers, sellers, or
both.
taxpayer who feels its main effect. In this case, although the suppliers pay
the tax, the tax incidence falls partly on consumers and partly on
producers.
Figure 8.15 shows the effect of the tax on consumer and producer
surplus:
• Consumer surplus falls: Consumers pay a higher price, and buy less salt.
• Producer surplus falls: They produce less and receive a lower net price.
• Total surplus is lower: Even taking account of the tax revenue received by
the government, the tax causes a deadweight loss.
When the salt tax is imposed, the total surplus from trade in the salt
market is given by:
Since the quantity of salt traded is no longer at the level that maximizes
gains from trade, the tax has led to a deadweight loss.
Market supply
Market supply
with tax
Demand
B
A
Pr
ic
e
of
s
al
t
Quantity of salt
P0
P1
Q1
P*
Q*
Figure 8.14 The effect of a 30% salt tax.
1. The initial equilibrium
Initially the market equilibrium is at
point A. The price is P* and the quantity
of salt sold is Q*.
2. A 30% tax
A 30% tax is imposed on suppliers.
Their marginal costs are effectively
30% higher at each quantity. The
supply curve shifts.
3. The new equilibrium
The new equilibrium is at B. The price
paid by consumers has risen to P1 and
the quantity has fallen to Q1.
4. The tax paid to the government
The price received by suppliers (after
they have paid the tax) is P0. The
double-headed arrow shows the tax
paid to the government on each unit of
salt sold.
UNIT 8 SUPPLY AND DEMAND: PRICE-TAKING AND COMPETITIVE MARKETS
344
Market supply
Market supply
with tax
Market
demand
B
A
Pr
ic
e
of
s
al
t
Quantity of salt
P0
P*
Q*
P1
Q1
Market supply
Market supply
with tax
Market
demand
B
A
Pr
ic
e
of
s
al
t
Quantity of salt
P0
P*
Q*
P1
Q1
DWL
Figure 8.15 Taxation and deadweight loss.
1. Maximized gains from trade
Before the tax is imposed, the equilib-
rium allocation at A maximizes the
gains from trade. In the upper panel
the red triangle is the consumer surplus
and the blue triangle is the producer
surplus.
2. A tax reduces consumer surplus
The tax reduces the quantity traded to
Q1, and raises the consumer price from
P* to P1. The consumer surplus falls.
3. A tax reduces producer surplus
The suppliers sell a lower quantity, and
the price they receive falls from P* to
P0. The producer surplus falls.
4. The tax revenue and deadweight loss
A tax equal to (P1 – P0) is paid on each
of the Q1 units of salt that are sold. The
green rectangular area is the total tax
revenue. There is a deadweight loss
equal to the area of the white triangle.
8.7 THE EFFECTS OF TAXES
345
In general, taxes change prices, and prices change buyers’ and sellers’
decisions, which can cause deadweight loss. To raise as much revenue as
possible, the government would prefer to tax a good for which demand is
not very responsive to price, so that the fall in quantity traded is quite
small—that is to say, a good with a low elasticity of demand. That is why the
ancient Chinese recommended taxing salt.
We can think of the total surplus as a measure of the welfare of society as
a whole (provided that the tax revenue is used for the benefit of society). So
there is a second reason for a government that cares about welfare to prefer
taxing goods with low elasticity of demand—the loss of total surplus will be
lower. The overall effect of the tax depends on what the government does
with the revenues that it collects:
• The government spends the revenue on goods and services that enhance the
wellbeing of the population: Then the tax and resulting expenditure may
enhance public welfare—even though it reduces the surplus in the
particular market that is taxed.
• The government spends the revenues on an activity that does not contribute to
wellbeing: Then the lost consumer surplus is just a reduction in the living
standards of the population.
Therefore, taxes can improve or reduce overall welfare. The most that we
can say is that taxing a good whose demand is inelastic is an efficient way to
transfer the surplus from consumers to the government.
The government’s power to levy taxes is a bit like the price-setting
power of a firm that sells a differentiated good. It uses its power to raise the
price and collect revenue, while reducing the quantity sold. Its ability to
levy taxes depends on the institutions it can use to enforce and collect them.
One reason for the use of salt taxes in earlier times was that it was
relatively easy for a powerful ruler to take full control of salt production, in
some cases as a monopolist. In the notorious case of the French salt tax, the
monarchy not only controlled all salt production; it also forced its subjects
to buy up to 7 kg of salt each per year.
In March and April 1930, the artificially high price of salt in British
colonial India provoked one of the defining moments of the Indian
independence movement: Mahatma Gandhi’s salt march to acquire salt
from the Indian ocean. Similarly, in what came to be called the Boston tea
party, in 1773 American colonists objecting to a British colonial tax on tea
dumped a cargo of tea into the Boston harbour.
Resistance to taxes on inelastic goods arises for the very reason they are
imposed: they are difficult to escape!
In many modern economies the institutions for tax collection are well-
established, usually with democratic consent. Provided that citizens believe
taxes have been implemented fairly, using them to raise revenue is accepted
as a necessary part of social and economic policy. We will now look at
another reason why governments may decide to levy taxes.
UNIT 8 SUPPLY AND DEMAND: PRICE-TAKING AND COMPETITIVE MARKETS
346
Using taxes to change behaviour
Policymakers in many countries are interested in the idea of using taxes to
deter consumption of unhealthy foods with the objective of improving
public health and tackling the obesity epidemic. In Unit 7, we looked at
some data and estimates of demand elasticities for food products in the US,
which help to predict how higher prices might affect people’s diets there.
Some countries have already introduced food taxes. Several, including
France, Norway, Mexico, Samoa, and Fiji, tax sweetened drinks. Hungary’s
‘chips tax’ is aimed at products carrying proven health risks, particularly
those with high sugar or salt content. In 2011, the Danish government
introduced a tax on products with high saturated fat content.
The level of the Danish tax was 16 Danish kroner (kr) per kilogram of
saturated fat, corresponding to 10.4 kr per kg of butter. Note that this was a
specific tax, levied as a fixed amount per unit of butter. A tax like the one we
analysed for salt, levied as a percentage of the price, is known as an ad
valorem tax. According to a study of the Danish fat tax, it corresponded to
about 22% of the average butter price in the year before the tax. The study
found that it reduced the consumption of butter and related products
(butter blends, margarine, and oil) by between 15% and 20%. We can
illustrate the effects in the same way as we did for the salt tax, using the
supply and demand model (we are assuming here that butter retailers are
price-takers).
Figure 8.16 shows a demand curve for butter, measured in kilograms per
person per year. The numbers correspond approximately to Denmark’s
experience. We have drawn the supply curve for butter as almost flat, on the
assumption that the marginal cost of butter for retailers does not change
very much as quantity varies. The initial equilibrium is at point A, where
the price of butter is 45 kr per kg, and each person consumes 2 kg of butter
per year.
A tax of 10 kr per kg shifts the supply curve upwards and leads to a rise
in price to 54 kr, and a fall in consumption to 1.6 kg. The consumer price
rises by 9 kr—almost the full amount of the tax—and the suppliers’ net
revenue per kg of butter falls to 44 kr. In this case, although suppliers pay
the tax, the tax incidence is felt mainly by consumers. Of the 10 kr tax per
kg, the consumer effectively pays 9 kr, while the supplier or producer pays
1 kr. So the price received by the retailers, net of tax, is only 1 kr lower.
Figure 8.17 shows what happens to consumer and producer surplus as a
result of the fat tax.
Again, both consumer and producer surpluses fall. The area of the green
rectangle represents the tax revenue: with a tax of 10 kr per kg and equilib-
rium sales of 1.6 kg per person, tax revenue is 10 × 1.6 = 16 kr per person
per year.
How effective was the fat tax policy? For a full evaluation of the effect on
health we should look at all the foods taxed, and take into account the
cross-price effects—the changes in consumption of other foods caused by
the tax. The study of the Danish tax also allowed for the possibility that
some retailers are not price-takers. Nevertheless, Figures 8.16 and 8.17
illustrate some important implications of the tax:
• Consumption of butter products fell: In this case by 20%. You can see this in
Figure 8.16. In this respect, the policy was successful.
• There was a large fall in surplus, especially consumer surplus: You can see
this in Figure 8.17. But recall that the government’s aim when it
Jørgen Dejgård Jensen and Sinne
Smed. 2013. ‘The Danish Tax on
Saturated Fat: Short Run Effects on
Consumption, Substitution
Patterns and Consumer Prices of
Fats’. Food Policy 42: 18–31.
8.7 THE EFFECTS OF TAXES
347
implemented the fat tax policy was not to raise revenue, but rather to
reduce quantity. So the fall in consumer surplus was inevitable. The loss
of surplus caused by a tax is a deadweight loss, which sounds negative.
But in this case the policymaker might see it as a gain if the ‘good’, butter,
is considered ‘bad’ for consumers.
B
A
Demand curve
Supply curve
After tax
supply curve
Tax
Pr
ic
e,
P
(k
r p
er
k
g)
0
90
100
Quantity of butter, Q (kg per person per year)
0.0 1.0 2.0 3.0 4.0
80
70
60
50
40
30
20
10
0.5 1.5 2.5 3.5
Figure 8.16 The effect of a fat tax on the retail market for butter.
Pr
ic
e,
P
(k
r p
er
k
g)
0
90
100
Quantity of butter, Q (kg per person per year)
0.0 1.0 2.0 3.0 4.0
80
70
60
50
40
30
20
10
0.5 1.5 2.5 3.5
B
A
Demand curve
Supply curve
After tax
supply curve
Tax
Consumer surplus
Figure 8.17 The effect of a fat tax on the consumer and producer surplus for butter.
1. Equilibrium in the market for butter
Initially the market for butter is in equi-
librium. The price of butter is 45 kr per
kg, and consumption of butter in
Denmark is 2 kg per person per year.
2. The effect of a tax
A tax of 10 kr per kg levied on suppliers
raises their marginal costs by 10 kr at
every quantity. The supply curve shifts
upwards by 10 kr.
3. A new equilibrium
The new equilibrium is at point B. The
price has risen to 54 kr. Each person’s
annual consumption of butter has
fallen to 1.6 kg.
UNIT 8 SUPPLY AND DEMAND: PRICE-TAKING AND COMPETITIVE MARKETS
348
One aspect of taxation not illustrated in our supply and demand analysis is
the cost of collecting it. Although the Danish fat tax successfully reduced fat
consumption, the government abolished it after only 15 months because of
the administrative burden it placed on firms. Any taxation system requires
effective mechanisms for tax collection, and designing taxes that are simple
to administer (and difficult to avoid) is an important goal of tax policy.
Policymakers who want to introduce food taxes will need to find ways of
minimizing administrative costs. But since the costs cannot be eliminated,
they will also need to consider whether the health gain (and reduction of
costs of bad health) will be sufficient to offset them.
EXERCISE 8.7 THE DEADWEIGHT LOSS OF THE BUTTER TAX
Food taxes such as the ones discussed here and in Unit 7 are often
intended to shift consumption towards a healthier diet, but give rise to
deadweight loss.
Why do you think a policymaker and a consumer might interpret this
deadweight loss differently?
QUESTION 8.9 CHOOSE THE CORRECT ANSWER(S)
Figure 8.14 (page 344) shows the demand and supply curves for salt,
and the shift in the supply curve due to the implementation of a 30%
tax on the price of salt. Which of the following statements are correct?
In the post-tax equilibrium, the consumers pay P1 and the producers
receive P*.
The government’s tax revenue is given by (P* – P0)Q1.
The deadweight loss is given by (1/2)(P1 – P0)(Q* – Q1).
As a result of the tax, the consumer surplus is reduced by (1/2)(Q1 +
Q*)(P1 – P*).
QUESTION 8.10 CHOOSE THE CORRECT ANSWER(S)
Figure 8.17 (page 348) shows the effect of a tax intended to reduce the
consumption of butter. The before-tax equilibrium is at A = (2.0 kg, 45
kr) and the after-tax equilibrium is at B = (1.6 kg, 54 kr). The tax
imposed is 10 kr per kg of butter. Which of the following statements is
correct?
The producers receive 45 kr per kg of butter.
The tax policy would be more effective if the supply curve were less
elastic.
The very elastic supply curve implies that the incidence of the tax
falls mainly on consumers.
The loss of consumer surplus due to tax is (1/2) × 10 × (2.0 – 1.6) =
2.0.
8.7 THE EFFECTS OF TAXES
349
PERFECT COMPETITION
A hypothetical market in which:
• The good or service being
exchanged is homogeneous (it
does not differ from one seller
to another).
• There are large numbers of
potential buyers and sellers of
the good, each acting
independently of the others.
• Buyers and sellers can readily
know the prices at which other
buyers and sellers are
exchanging the good.
perfectly competitive equilibrium Such an equilibrium occurs
in a model in which all buyers and sellers are price-takers. In
this equilibrium, all transactions take place at a single price.
This is known as the law of one price. At that price, the amount
supplied equals the amount demanded: the market clears. No
buyer or seller can benefit by altering the price they are
demanding or offering. They are both price-takers. All potential
gains from trade are realized. See also: law of one price.
law of one price Holds when a good is traded at the same price
across all buyers and sellers. If a good were sold at different
prices in different places, a trader could buy it cheaply in one
place and sell it at a higher price in another. See also:
arbitrage.
gains from exchange The benefits that each party gains from a
transaction compared to how they would have fared without
the exchange. Also known as: gains from trade. See also: eco-
nomic rent.
8.8 THE MODEL OF PERFECT COMPETITION
To apply the model of supply and demand, we have assumed throughout
this unit that buyers and sellers are price-takers. In what kinds of markets
would we expect to see price-taking on both sides? To generate competition
between sellers, and force sellers to act as price-takers, we need:
• Many undifferentiated sellers: As Marshall discussed, there must be many
sellers, all selling identical goods. If their goods were differentiated, then
each one would have some market power.
• Sellers must act independently: If they act as a cartel, for example, they are
not price-takers—they can jointly choose the price.
• Many buyers all wanting to buy the good: Each of them will choose
whichever seller has the lowest price.
• Buyers know the sellers’ prices: If they do not, they cannot choose the
lowest one.
Similarly, buyers must force each other to be price-takers:
• There must be many buyers, competing with each other: Then sellers have no
reason to sell to someone who would pay less than everyone else.
A market with all of these properties is described
as perfectly competitive. We can predict that the
equilibrium in such a market will be a competitive
equilibrium—so it will have the following
characteristics:
• All transactions take place at a single price: This is
known as the law of one price.
• At that price, the amount supplied equals the amount
demanded: the market clears.
• No buyer or seller can benefit by altering the price
they are demanding or offering. They are all
price-takers.
• All potential gains from trade are realized.
Léon Walras, a ninteenth-century French
economist, built a mathematical model of an eco-
nomy in which all buyers and sellers are price-
takers, which has been influential in how many
economists think about markets.
UNIT 8 SUPPLY AND DEMAND: PRICE-TAKING AND COMPETITIVE MARKETS
350
Leon Walras. (1874) 2014.
Elements of Theoretical Eco-
nomics: Or the Theory of Social
Wealth. Cambridge: Cambridge
University Press.
GREAT ECONOMISTS
Léon Walras
Léon Walras (1834–1910) was a
founder of the neoclassical school
of economics. He was an
indifferent student, and twice
failed the entrance exam to the
École Polytechnique in Paris, one
of the most prestigious
universities in his native France.
He studied engineering at the
School of Mines instead.
Eventually his father, an
economist, convinced him to take
up the challenge of making eco-
nomics into a science.
The pure economic science to which he aspired was the study of rela-
tionships among things, not people, and he had notable success in
eliminating human relationships from his modelling. ‘The pure theory of
economics,’ he wrote, ‘resembles the physico-mathematical sciences in
every respect.’
His device for simplifying the economy so that it could be expressed
mathematically was to represent interactions among economic agents as
if they were relationships among inputs and outputs, and to focus
entirely on the economy in equilibrium. In the process the entrepreneur,
a key actor in wealth creation from the Industrial Revolution to today,
simply disappeared from Walrasian economics:
Walras represented basic economic relationships as equations, which he
used to study the workings of an entire economy composed of many
interlinked markets. Prior to Walras, most economists had considered
these markets in isolation: they would have studied, for example, how
the price of textiles is determined on the cloth market, or land rents on
the land market.
A century before Walras, a group of French economists called the
physiocrats had studied the circulation of goods throughout the eco-
nomy, as if the flow of goods from one sector to another in the economy
was comparable to the circulation of blood in the human body (one of
the leading physiocrats was a medical doctor). But the physiocrats’
model was little more than a metaphor that drew attention to the
interconnectedness of markets.
Walras used mathematics, rather than medical analogies, to create
what is now called general equilibrium theory, a mathematical model of
an entire economy in which all buyers and sellers act as price-takers and
supply equals demand in all markets. Walras’ work was the basis of the
proof, much later, of the invisible hand theorem, giving the conditions
Assuming equilibrium, we may even go so far as to abstract
from entrepreneurs and simply consider the productive
services as being, in a certain sense, exchanged directly for
one another … (Elements of Theoretical Economics, 1874)
8.8 THE MODEL OF PERFECT COMPETITION
351
under which such an equilibrium is Pareto efficient. The invisible hand
game in Unit 4 is an example of the conditions in which the pursuit of
self-interest can benefit everyone.
Walras had defended the right to private property, but to help the
working poor he also advocated the nationalization of land and the
elimination of taxes on wages.
Seven years after his death, the general equilibrium model was to play
an important role in the debate about the feasibility and desirability of
centralized economic planning compared to a market economy. In 1917,
the Bolshevik Revolution in Russia put the economics of socialism and
central planning on the agenda of many economists, but surprisingly, it
was the defenders of central planning, not the advocates of the market,
who used Walras’ insights to make their points.
Friedrich Hayek, and other defenders of capitalism, criticized the
Walrasian general equilibrium model. Their argument: by deliberately
ignoring the fact that a capitalist economy is constantly changing, and
therefore not taking into account the contribution of entrepreneurship
and creativity in market competition, Walras had missed the true virtues
of the market.
The model of perfect competition describes an idealized market structure in
which we can be confident that the assumption of price-taking that underlies
our model of supply and demand will hold. Markets for agricultural products
such as wheat, rice, coffee, or tomatoes look rather like this, although goods
are not truly identical, and it is unlikely that everyone is aware of all the prices
at which trade takes place. But it is nevertheless clear that they have very little,
if any, power to affect the price at which they trade.
In other cases—for example, markets where there are some differences
in the quality of goods—there may still be enough competition that we can
assume price-taking, in order to obtain a simple model of how the market
works. A simplified model can provide useful predictions when the
assumptions underlying it are only approximately true. Judging whether or
not it is appropriate to draw conclusions about the real world from a
simplified model is an important skill of economic analysis.
For example, we know that markets are not perfectly competitive when
products are differentiated. Consumers’ preferences differ, and we saw in
Unit 7 that firms have an incentive to differentiate their product, if they can,
rather than to supply a product similar or identical to others. Nevertheless,
the model of supply and demand can be a useful approximation to help us to
understand how some markets for non-identical products behave.
Figure 8.18 shows the market for an imaginary product called Choccos,
for which there are close substitutes, as many similar products compete in
the wider market for chocolate bars. Due to competition from other
chocolate bars, the demand curve is almost flat. The range of feasible prices
for Choccos is narrow, and the firm chooses a price and quantity where the
marginal cost is close to the price. So this firm is in a similar situation to a
firm in a perfectly competitive market. It is the equilibrium price in the
larger market for chocolate bars that determines the feasible prices for
Choccos—they have to be sold at a similar price to other chocolate bars.
The narrow range of feasible prices for this firm is determined by the
behaviour of its competitors. So the main influence on the price of Choccos
is not the firm, but the market for chocolate bars as a whole. Since all the
UNIT 8 SUPPLY AND DEMAND: PRICE-TAKING AND COMPETITIVE MARKETS
352
firms will be producing at similar prices, which will be close to their mar-
ginal costs, we lose little by ignoring the differences between them and
assuming that each firm’s supply curve is its marginal cost curve, then
finding the equilibrium in the wider market for chocolate bars.
We have already taken this approach when we analysed the Danish butter
market. In practice, it is likely that some retailers who sell butter have some
power to set prices. A local shop may be able to set a price that is higher than
the price of butter elsewhere, knowing that some shoppers will find it
convenient to buy rather than searching for a lower price. However, it is
reasonable to assume that they don’t have much wiggle room to set prices,
and are strongly influenced by the prevailing market price. So price-taking is
a good approximation for this market—good enough, at least, that the supply
and demand model can help us to understand the impact of a fat tax.
Pr
ic
e
P*
0
Quantity of Choccos
Q*
Marginal cost
of Choccos
Isoprofit
curve
Demand
curve
A
Pr
ic
e
0
Total quantity of chocolate bars
Market supply
(MC)
Demand for
chocolate bars
B
Figure 8.18 The market for Choccos and chocolate bars.
1. The market for Choccos
The left hand panel shows the market
for Choccos, produced by one firm.
There are many close substitutes in the
wider market for chocolate bars.
2. The demand curve for Choccos
Due to competition from similar
chocolate bars, the demand curve for
Choccos is almost flat. The range of
feasible prices is narrow.
3. The price of Choccos
The firm chooses a price P* similar to
its competitors, and a quantity where
MC is close to P*. Whatever the price of
its competitors, it would produce close
to its marginal cost curve. So the firm’s
MC curve is approximately its supply
curve.
4. The market supply curve for
chocolate bars
We can construct the market supply
curve for chocolate bars in the right
hand panel by adding the quantities
from the marginal cost curves of all the
chocolate bar producers.
5. The market demand curve for
chocolate bars
If most consumers do not have strong
preferences for one firm’s product, we
can draw a market demand curve for
chocolate bars.
6. The demand curve for Choccos
The equilibrium price in the chocolate
bar market (right-hand panel)
determines the narrow range of prices
from which the Chocco firm can choose
(left-hand panel)—it will have to set a
price quite close to that of other
chocolate bars.
8.8 THE MODEL OF PERFECT COMPETITION
353
EXERCISE 8.8 PRICE-FIXING
We have used chocolate bars as a hypothetical example of an
approximately competitive market. But in recent years, producers of best-
selling chocolate bars worldwide have been accused of colluding with
each other to keep prices high. Use the information in this article
(https://tinyco.re/9016236) to explain:
1. In what ways does the market for chocolate bars fail to satisfy the con-
ditions for perfect competition?
2. Each brand of chocolate bar faces competition from many other similar
brands. Why, despite this, do some producers have considerable market
power?
3. In what market conditions do you think price-fixing is most likely to
occur, and why?
QUESTION 8.11 CHOOSE THE CORRECT ANSWER(S)
Look again at Figure 8.18 (page 353), which shows the market for
Choccos and for all chocolate bars. Based on the two diagrams, which
of the following statements is correct?
The firm that makes Choccos chooses to produce at the bottom of
the U-shaped isoprofit curve.
All chocolate bars will be sold at the same price P*.
The existence of many competitors means that the firm is a price-
taker.
The market marginal cost (MC) curve is approximately the sum of
the MC curves of all the producers of the chocolate bars.
8.9 LOOKING FOR COMPETITIVE EQUILIBRIA
If we look at a market in which conditions seem to favour perfect competi-
tion—many buyers and sellers of identical goods, acting independently—
how can we tell whether it satisfies the conditions for a competitive equilib-
rium? Economists have used two tests:
1. Do all trades take place at the same price?
2. Are firms selling goods at a price equal to marginal cost?
The difficulty with the second test is that it is often difficult to measure mar-
ginal cost. But Lawrence Ausubel, an economist, was able to do this for the
US bank credit card market in the 1980s. At this time 4,000 banks were
selling an identical product: credit card loans. The cards were mostly Visa or
Mastercard, but the individual banks decided the price of their loans—that
is, the interest rate. The banks’ cost of funds—the opportunity cost of the
money loaned to credit card holders—could be deduced from other interest
rates in financial markets. Although there were other components of mar-
ginal cost, the cost of funds was the only one that varied substantially over
time. So if the credit card market were competitive, we would expect to see
the interest rate on credit card loans rise and fall with the cost of funds.
UNIT 8 SUPPLY AND DEMAND: PRICE-TAKING AND COMPETITIVE MARKETS
354
By comparing the credit card interest rate with the cost of funds over a
period of eight years, Ausubel found that this didn’t happen. When the cost
of funds fell from 15% to below 7%, there seemed to be almost no effect on
the price of credit card loans.
Why do the banks not cut their interest rates when their costs fall? He
suggested two different possibilities:
• It may be difficult for consumers to change credit card provider: In that case,
the banks are not forced to compete with each other, so they keep prices
high when costs fall.
• Banks might not be able to decide which of their customers are bad risks: That
would be a problem in this market, because the bad risks are most
sensitive to prices. The banks do not want to lower their prices for fear
of attracting the wrong kind of customer.
Perfect competition requires that consumers are sufficiently sensitive to
prices to force firms to compete, and this may not be the case in any market
where consumers have to search for products. If it takes time and effort to
check prices and inspect products, they may decide to buy as soon as they
find something suitable, rather than continue the search for the cheapest.
When the Internet made online shopping feasible, many economists
hypothesized that this would make retail markets more competitive: con-
sumers would easily be able to check the prices of many suppliers before
deciding to buy.
But often consumers are not very sensitive to prices, even in this envir-
onment. You can test the law of one price in online retail competition for
yourself, by checking the prices of a particular product that should be the
same wherever you buy it—a book or household appliance, for example—
and comparing them. Figure 8.19 shows the prices of UK online retailers
for a particular DVD in March 2014. The range of prices is high: the most
expensive seller is charging 66% more than the cheapest.
From the early nineteenth century, the catches of Atlantic fisherman
landed in the port of New York were sold at the Fulton Fish Market in
Manhattan (in 2005, it relocated to the Bronx) to restaurants and retailers.
It is still the largest market for fresh fish in the US, although fish are now
brought in by road or air. Dealers do not display prices. Instead, customers
can inspect the fish and ask for a price before making their decision,
making it an institution that appears to encourage competition.
Kathryn Graddy, an economist who specializes in how prices are set,
studied the Fulton Fish Market. There were about 35 dealers, with stalls
close to each other, so customers could easily observe the quantity and
quality of fish available and ask several dealers for a price. She used details
of 3,357 sales of whiting by one dealer, including price, quantity, and
quality of fish, and characteristics of the buyers.
Of course, prices were not the same for every transaction: quality varied,
and fish supplies changed from day to day. But her surprising observation
was that on average Asian buyers paid about 7% less per pound than white
buyers (all of the dealers were white). There seemed to be no differences
between the transactions with white and Asian buyers that could explain
the different prices.
How could this happen? If one dealer was setting high prices for white
buyers, why did other dealers not try to attract them to their own stalls by
offering a better deal? Watch our interview with Graddy to find out how
Lawrence M. Ausubel. 1991. ‘The
Failure of Competition in the
Credit Card Market’. American Eco-
nomic Review 81 (1): pp. 50–81.
Glenn Ellison and Sara Fisher
Ellison. 2005. ‘Lessons About
Markets from the Internet’
(https://tinyco.re/4419622). Journal
of Economic Perspectives 19 (2)
(June): p. 139.
Kathryn Graddy. 2006. ‘Markets:
The Fulton Fish Market’
(https://tinyco.re/4300778). Journal
of Economic Perspectives 20 (2):
pp. 207–220.
Kathryn Graddy. 1995. ‘Testing for
Imperfect Competition at the
Fulton Fish Market’
(https://tinyco.re/8279962). The
RAND Journal of Economics 26 (1):
pp. 75–92.
8.9 LOOKING FOR COMPETITIVE EQUILIBRIA
355
Kathryn Graddy: Fishing for perfect
competition https://tinyco.re/
1029500
she collected her data, and what she discovered about the model of perfect
competition.
Graddy observed that dealers knew that, in practice, white buyers were
willing to take higher prices than Asian buyers. The dealers knew this
without having to collude in setting their prices.
The examples in this section show that it is hard to find evidence of
perfect competition. Nevertheless, we have seen that the model can be a
useful approximation. Even if the conditions for perfect competition are
not all satisfied, the model of supply and demand is a valuable tool for eco-
nomic analysis, applicable when there is enough competition that
individuals have little influence on prices.
EXERCISE 8.9 PRICE DISPERSION
Choose any published textbook that you have been using in your course.
Go on to the web and find the price you can buy this book for from a
number of different suppliers (Amazon, eBay, your local bookstore, and so
on).
Is there dispersion in prices, and if so, how can you explain it?
EXERCISE 8.10 THE FULTON FISH MARKET
Watch Kathryn Graddy’s video (https://tinyco.re/1029500).
1. How does she explain her evidence that the law of one price did not
hold in the fish market?
2. Why did buyers and sellers not look for better deals?
3. Why did new dealers not enter the market in pursuit of economic rents?
In theory, the easy access to price
information across the market
should have allowed all buyers to
quickly find very similar prices. But
in practice, Graddy observed that
bargaining occurred rarely, and
then only with buyers of large
quantities.
The Hobbit: An Unexpected Journey
Supplier Price including postage (£)
Game 14.99
Amazon UK 15.00
Tesco 15.00
Asda 15.00
Base.com 16.99
Play.com 17.79
Savvi 17.95
The HUT 18.25
I want one of those 18.25
Hive.com 21.11
MovieMail.com 21.49
Blackwell 24.99
Figure 8.19 Differing prices for the same DVD, from UK online retailers (March
2014).
UNIT 8 SUPPLY AND DEMAND: PRICE-TAKING AND COMPETITIVE MARKETS
356
public good A good for which use
by one person does not reduce its
availability to others. Also known
as: non-rival good. See also: non-
excludable public good, artificially
scarce good.
•8.10 PRICE-SETTING AND PRICE-TAKING FIRMS
We now have two different models of how firms behave. In the Unit 7
model, the firm produces a product that is different from the products of
other firms, giving it market power—the power to set its own price. This
model applies to the extreme case of a monopolist, who has no competitors
at all, such as water supply companies, and national airlines with exclusive
rights granted by the government to operate domestic flights. The Unit 7
model also applies to a firm producing differentiated products such as
breakfast cereals, cars, or chocolate bars—similar, but not identical, to those
of its competitors. In such cases, the firm still has the power to set its own
price. But if it has close competitors, demand will be quite elastic and the
range of feasible prices will be narrow.
In the supply-and-demand model developed in this unit, firms are price-
takers. Competition from other firms producing identical products means
that they have no power to set their own prices. This model can be useful as
an approximate description of a market in which there are many firms
selling very similar products, even if the idealized conditions for a perfectly
competitive market do not hold.
In practice, economies are a mixture of more and less competitive
markets. In some respects, firms act the same whether they are the single
seller of a good or one of a great many competitors: all firms decide how
much to produce, which technologies to use, how many people to hire, and
how much to pay them so as to maximize their profits.
But there are important differences. Look back at the decisions made by
price-setting firms to maximize profits (Figure 7.2). Firms in more compet-
itive markets lack either the incentive or the opportunity to do some of
these things.
A firm with a unique product will advertise (Buy Nike!) to shift the
demand curve for its product to the right. But why would a single competit-
ive firm advertise (Drink milk!)? This would shift the demand curve for all
of the firms in the industry. Advertising in a competitive market is a public
good: the benefits go to all of the firms in the industry. If you see a message
like ‘Drink milk!’ it is probably paid for by an association of dairies, not by a
particular one.
The same is true of expenditures to influence public policy. If a large firm
with market power is successful, for example, in relaxing environmental
regulations, then it will benefit directly. But activities like lobbying or contri-
buting money to electoral campaigns will be unattractive to the competitive
firm because the result (a more profit-friendly policy) is a public good.
Similarly, investment in developing new technologies is likely to be
undertaken by firms facing little competition, because if they are successful
in finding a profitable innovation, the benefits will not be lost to
competitors also adopting it. However, one way that successful large firms
can emerge is by breaking away from the competition and innovating with
a new product. The UK’s largest organic dairy, Yeo Valley, was once an
ordinary farm selling milk, just like thousands of others. In 1994 it
established an organic brand, creating new products for which it could
charge premium prices. With the help of imaginative marketing campaigns
it has grown into a company with 1,800 employees and 65% of the UK
organic market.
The table in Figure 8.20 summarizes the differences between price-
setting and price-taking firms.
8.10 PRICE-SETTING AND PRICE-TAKING FIRMS
357
Price-setting firm or
monopoly
Firm in a perfectly competitive market
Sets price and quantity to
maximize profits (‘price-
maker’)
Takes market determined price as given and chooses
quantity to maximize profits (‘price-taker’)
Chooses an output level
at which marginal cost is
less than price
Chooses an output level at which marginal cost
equals price
Deadweight losses
(Pareto inefficient)
No deadweight losses for consumers and firms (can
be Pareto efficient if no one else in the economy is
affected)
Owners receive economic
rents (profits greater than
normal profits)
If the owners receive economic rents, the rents are
likely to disappear as more firms enter the market
Firms advertise their
unique product
Little advertising: it costs the firm, but benefits all
firms (it’s a public good)
Firms may spend money
to influence elections,
legislation and regulation
Little expenditure by individual firms on this (same as
advertising)
Firms invest in research
and innovation; seek to
prevent copying
Little incentive for innovation; others will copy (unless
the firm can succeed in differentiating its product and
escaping from the competitive market)
Figure 8.20 Price-setting and price-taking firms.
8.11 CONCLUSION
Buyers or sellers who have little influence on market prices, due to compet-
ition, are called price-takers. A market is in competitive equilibrium if all
buyers and sellers are price-takers, and at the prevailing market price, the
quantity supplied is equal to the quantity demanded (the market clears).
Price-taking firms choose their quantity so that the marginal cost is
equal to the market price. The equilibrium allocation exploits all possible
gains from trade.
The model of perfect competition describes a set of idealized market
conditions in which we would expect a competitive equilibrium to occur.
Markets for real goods don’t conform exactly to the model. But price-
taking can be a useful approximation, enabling us to use supply and
demand curves as a tool for understanding market outcomes, for example,
the effects of a tax, or a demand shock.
Concepts introduced in Unit 8
Before you move on, review these definitions:
• Price-taking firms
• Competitive equilibrium
• Exogenous shocks
• Taxation
• Model of perfect competition
UNIT 8 SUPPLY AND DEMAND: PRICE-TAKING AND COMPETITIVE MARKETS
358
8.12 REFERENCES
Consult CORE’s Fact checker for a detailed list of sources.
Ausubel, Lawrence M. 1991. ‘The Failure of Competition in the Credit
Card Market’. American Economic Review 81 (1): pp. 50–81.
Berger, Helge, and Mark Spoerer. 2001. ‘Economic Crises and the
European Revolutions of 1848’. The Journal of Economic History 61 (2):
pp. 293–326.
Eisen, Michael. 2011. ‘Amazon’s $23,698,655.93 book about flies’
(https://tinyco.re/0044329). It is NOT junk. Updated 22 April 2011.
Ellison, Glenn, and Sara Fisher Ellison. 2005. ‘Lessons About Markets from
the Internet’ (https://tinyco.re/4419622). Journal of Economic
Perspectives 19 (2) ( June): p. 139–158.
Graddy, Kathryn. 1995. ‘Testing for Imperfect Competition at the Fulton
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nomics 26 (1): pp. 75–92.
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