Chapter 8 (1)

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Unit 1

Unit 2

Unit 3

Unit 5

The market price of a good 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 at the prevailing price, the quantity of raw cotton demanded exceeded the available supply, some sellers realized they could profit by raising the price. Consumption of cotton fell to half the prewar level, throwing hundreds of thousands of people who worked in cotton mills out of work

The interaction of supply and demand determines a market equilibrium in which both buyers and sellers are price-takers, called a competitive equilibrium

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.

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 prices

We can find the equilibrium price by drawing the supply and demand curves on one diagram

To apply the supply and demand model to the textbook market, we assume that all the books are identical and that a potential seller can advertise a book for sale by announcing its price on a local website

Marshell 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 farmers would soon have to lower their prices and would wait until they did. 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, Marshell reasoned that some sellers or buyers would benefit by charging some other price, the going price was not a Nash Equilibrium. So the price would tend to settle at an equilibrium level, where demand and supply were equated

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 the neighboring 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

To see how price taking firms behave, consider a city where many small bakeries produce bread and sell it directly to consumers

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

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

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

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. If the marginal cost of producing a good is below the market price, the producer receive a surplus

Their mutual benefits from the equilibrium allocation can be measured by the consumer and producer surpluses introduced.

The competitive equilibrium allocation of bread has the property that the total surplus is maximized.

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

We look at markets where many buyers and sellers interact, and show how the competitive market price is determined by both the preferences of consumers and the costs of suppliers.

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

The demand curve represents the WTP of buyers, similarly, the supply depends on the sellers willingness to accept (WTA). money in return for books

The first student is willing to pay $20, the 20th $10 and so on

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

We draw a supply curve by lining up the sellers in order to their reservation prices (their WTAs)

The reservation 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

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

Unit 4

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.

To find the market supply curve we just add up the total amount that all the bakeries will supply at each 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 firms supply curve does

Lets suppose there are 50 bakeries

So the market supply curve is the markets marginal cost curve

We put sellers who are most willing to sell - those who have the lowest reservation prices - first so the graph pf reservation prices slopes upward

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, 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.

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 there is a change in market conditions such as the numbers of potential buyers and sellers and how much they value the good

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

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

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

Buyers are price-takers when there are plenty of other buyers, and sellers are willing to sell to whoever pays the highest price. On both sides of the market, competition eliminates bargaining power. 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, no actor can do better than to continue what he or she is doing

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 feasible set.

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. If price is below marginal cost, total profits can remain unchanged only if a larger quantity is sold for a higher price

If price were equal to average cost (P = AC) your economic profit would be zero. The owner would obtain a normal return on capital. So the average cost curve is the zero-economic-profit curve

Demand curve is completely flat: If yoou change more than P your demand will be zero but at P or less you can sell as many loaves as you like.

Price taking firms. They choose to produce a quantity at which the marginal cost is equal to the market price (MC = P*) 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 the isoprofit curve is horizontal. The price is equal to the marginal cost

When we make statements like "for a price-taking from, price equals marginal cost" we do not mean that the firm chooses a price equal to its marginal cost, instead we mean: the firm accepts the market price, and chooses its quantity so that the marginal cost is equal to that price

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. You would have to decide whether it was worth continuing to produce bread.

For a price-taking firm, the marginal cost curve is the supply curve

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.
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 retain staff

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. Whenever there are economic rents, there is an opportunity for someone to benefit by taking an action

The equilibrium price is exactly $2. At this price the market clears: consumers demand 5000 loaves per day

At the competitive equilibrium allocation in the bread market, it is not possible to make any of the consumers or firms better off without making at least one of them worse off. We can say that the equilibrium allocation is Pareto efficient.

The surplus would be smaller if fewer than 5000 loaves were produced. There would be consumers without bread who would be willing to pay more than the cost of producing another loaf, so there would be unexploited gains from trade.

If more than 5000 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. 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

There would be a deadweight loss equal to the triangle-shaped area

Pareto efficiency follows from three assumptions:

Price taking - the participants are price takers. They have no market power. Sellers cant 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 is equal to the market price
A complete contract - The exchange of a loaf of bread for money is governed by a complete contract between the buyer and seller
No effects on others - What happens in this market affects no one except the buyers and sellers

There are two criteria for assessing an allocation: 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. Graph 9 showed that both consumers and firms obtain a surplus and in this example consumer surplus is slightly higher than producer surplus. This happens because the demand curve is relatively steep compared with the supply curve. Demand is less elastic than supply