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

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

3. A. Introduction

4. 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)

5. 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

6. B. Competitive equilibrium: Key concepts

7. 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.

8. 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.

9. 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.

10. 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

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

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

13. 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)

14. 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.

15. C. Factors that affect equilibrium

16. 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

17. 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.

18. 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

19. D. Example: The World Oil Market

20. 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

21. 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

22. 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

23. 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