THE FIRM AND ITS CUSTOMERS: PART 2 Unit 7 THE FIRM AND ITS CUSTOMERS: PART 2

OUTLINE Introduction Competitive equilibrium: Key concepts Factors that affect equilibrium Example: The world oil market

A. Introduction

The Context for This Unit Firms with market power can set their own price. Market outcomes are generally not Pareto-efficient. In reality, many firms are price-takers. How does their behaviour differ from price-setting firms? Can competition improve market outcomes? (Unit 7)

This Unit Model of interactions between price-taking firms and customers Perfect competition = special case of the model Similarities and differences between price-taking and price-setting firms

B. Competitive equilibrium: Key concepts

Demand curve Demand curve = total quantity that all consumers together want to buy at any given price. Represents the willingness to pay (WTP) of buyers. Example: Secondhand textbook market.

Supply curve Supply curve = total quantity that all firms together would produce at any given price. Represents the willingness to accept (WTA) of sellers. Sellers may have different reservation prices.

Equilibrium price At the equilibrium (market-clearing) price, supply equals demand. Any other price is not a Nash equilibrium e.g. if price was above P*, then there would be excess supply, so some sellers could benefit from charging a lower price. Assumes the products are identical, so buyers would be willing to buy from any seller.

Firm chooses quantity, not price Price-taking firms Price-taking firms cannot benefit from choosing a different price from the market price, and cannot influence the market price. Demand curve (feasible set) is completely flat Maximize profits when MC=P (slope of isoprofit = 0) Firm’s supply curve = MC curve Firm chooses quantity, not price

Price-taking firms: Market supply curve Market supply curve = the total amount produced by all firms at each price.

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

Competitive equilibrium: Characteristics All gains from trade are exploited in equilibrium (no deadweight loss). Equilibrium allocation is Pareto efficient, assuming: Participants are price-takers. Contracts are complete. Transaction only affects buyers and sellers (no external effects)

Competitive equilibrium: Caveats Allocation may not be Pareto efficient if assumptions do not hold. Fairness: The distribution of total surplus depends on the elasticities of demand and supply (share of total surplus inversely related to elasticity) Hard to find price-takers in real life.

C. Factors that affect equilibrium

Changes in supply and demand The entire supply or demand curve can shift due to exogenous shocks e.g. technological change, popularity Buyers and sellers adjust their behaviour so that the market clears. E.g. Improved baking technology 1. Supply of bread increases at every price (supply curve shifts) 2. Excess supply at the going market price (move along demand curve) 3. Price falls to a new equilibrium

Market entry The supply curve can also shift due to market entry/exit. If existing firms are earning economic rents and costs of entry are not too high, other firms may enter the market.

Price-setters vs. Price-takers Price-setters (Monopoly) Price-takers (Perfect Competition) MC < Price MC = Price Deadweight losses (Pareto inefficient) No deadweight losses (can be Pareto efficient) Owners receive economic rents in both long- and short-run No economic rents in the long-run Firms advertise their unique product Little advertising expenditure Firms invest in R&D, seek to prevent copying Little incentive for innovation

D. Example: The World Oil Market

Short-run supply and demand Short-run demand: → Steep (limited substitution possibilities) Short-run market supply curve: → Initially low and flat (the cost of extraction is low once well is drilled)… → and then turns upwards very steeply (capacity constraints) Crude oil is oligopolistic due to OPEC

2000 – 2008 oil price shock Shift in demand curve: Rapid economic growth in industrializing countries Demand for car ownership and tourist air travel grows relatively rapidly as the countries become wealthier Due to inelastic short-run supply curve, price increase is bigger compared to increase in oil consumption

Summary Model of price-taking firms Competitive equilibrium where demand = supply Firms maximize profits where MC = Price Perfect competition is a special case Comparison with price-setting firms 2. Used model to show how equilibrium can change Exogenous shocks to demand/supply or market entry Effect of taxation on surplus

In the next unit The labour market – how it functions differently from markets for goods Model of the labour market – how wages, employment, and distribution of income between owners and employees are determined Changes in supply and demand – the effect of unions and public policy on wages and employment