UNIT 8: SUPPLY & DEMAND - PRICE-TAKING AND COMPETITIVE MARKETS

Index:
Price taking firms
Demand and supply curve
Competitive equilibrium
Maximizing profits
Individual and aggregate supply function
Changes in equilibrium
Effects of taxes in equilibrium
Perfect competition

Firms with market power can set their own price, but the price-taking firms are those that take the
price that comes from the market without being able to modify it. as they cannot manipulate the
price they have to manipulate the quantity.

1. Competitive Equilibrium
The price that each individual firm takes as given is determined by the interaction of two market
forces, which are inverse to each other:
● Demand curve: measures the total quantity all consumers are willing to buy at any given
price, so it represents the WTP (willingness to pay) of buyers.
Demand is negatively related to prices.
● Supply curve: measures the total quantity all firms are willing to sell at any given price,
and represents the WTA(willingness to accept) of sellers.
Supply is positively related to prices
Different sellers may have different reservation prices. If the reservation price is above the market
price they will not participate in the market.
The equilibrium of the market is the intercept of both lines. When we are talking about this kind
of market, the products are supposed to be identical.
Price taking firms cannot try to sell to a higher price as products are identical in the competence.

● At the equilibrium (market-clearing)

price, P∗, supply = demand.
● Any other price is not a Nash
equilibrium, as there will be gains
from unilateral deviation (excess
supply or demand).
 2. Price-Taking Firms
Price-taking firms are stuck with the price
determined by the market, so they cannot
benefit from choosing a different price,
they cannot influence the price and if they
try to sell at a higher price they will sell
nothing.
This requires competition and identical
products(indifference to choose a seller).
The firm's problem is to choose the
quantity of production.

● If there is a Price-taking Firm, the feasible set (demand curve) for each individual would
be completely flat, with slope=0.
● And firms maximize profits when P=MC.
At this point, Slope of isoprofit(MRS)=slope of Demand(MRT)=0

● Slope of the iso-profit =

● But if the price is determined by the market: P=P∗; then the slope of the iso-profit tangent
to an horizontal demand is zero.

If we calculate analytically the equilibrium:

-If p> MC, increase your Q

-If p< MC, decrease your Q

Individual supply function

➔ For each possible price level, the firm will be willing to supply the amount that
maximizes its profits (MC=P).
➔ What each firm is willing to supply to the market is given by: S(Q)=MC(Q)
➔ Then, the price determined by the whole market will identify the equilibrium quantity
supplied by each firm
Aggregate supply function
Obtained by summing individual quantities at each price level:

Example: if the market has 50 firms with the same cost structure: S(Q)= 50 x S(Q)

3. Competitive equilibrium again

There is competitive equilibrium if all buyers and sellers are price takers, if contracts are
complete and if the transactions do not cause externalities.
We know that equilibrium in a competitive market is obtained by S=D.
➔ In this equilibrium all the gains from trade are exploited, so there is no DWL and the
Total surplus is at the maximum. This equilibrium is Pareto efficient, but that does not
imply fairness (CS and PS are not equal).
➔ The distribution of TS depends on the shape of D and S curves, and the shape of TS is
inversely related to elasticity.
As the firm has no power over the price, the total revenue is P.Q; it is no longer the revenue of the
function of the aggregated demand, as the company has no power over prices.
The optimal situation for the firm is to sell exactly the same as the MC.
For each possible price level that the firm can have, the amount of quantity that the firm sells
would vary.

● CS=WTP- market price

● PS=market price - WTA/MC
● TS=CS + PS

4. Changes in Equilibrium
Exogenous shocks can lead to shifts of the demand or supply curve. In such cases, buyers and
sellers adapt to a new equilibrium again.
 5. Taxation and Market distortions
Taxes are an important source of revenue for governments (redistribution)
➔ Taxes on suppliers/consumers shift the S/D curve (they increase P at each Q).
➔ Government imposes a sales tax (profit for them), the firms collect the tax and transfer it
to the government.
➔ The firms see the tax as an increase in their MC so S shifts to the left.
➔ IMPORTANT: compared to the initial (competitive market) equilibrium, the tax reduces
gains of the firms. It produces DWL.
The fall in total surplus is positively related to elasticity of demand (how sensitive consumers are
to price changes), because it not only affects sellers but also buyers.
Typically, the less elastic group bears more of the tax burden.
The creation of taxes can try to lead the consumer to have certain behavior, for example, the
climate related taxes or the taxes on certain products.
As the consumer and producer surplus are triangles, we calculate them as areas of triangles.

6. Perfect competition
A perfectly competitive market has the following properties:
● The good or services exchanged are homogenous
● Large number of potential buyers and sellers, who act independently
● No barriers to enter or leave the market
● Price information is easily available to buyers and sellers
As a result:
● Law of one price: all transactions take place at a single price. This clears the market
(D=S)
● Buyers and sellers are all price-takers
● All potential gains from trade are realized.
The perfect competitive markets are better than perfect markets.
The main difference between the discussed market structures: