Unit 8 notes - core economy textbook PDF

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UNIT 8- SUPPLY AND DEMAND- PRICE-TAKING AND COMPETITIVE MARKETS:How markets operate when all buyers and sellers are price-takers:Interacion of supply and demand determines a market equilibrium in which both buyers and sellers are price-takers, this is called a compeiive equilibrium.8: Buying and sel...

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UNIT 8- SUPPLY AND DEMAND- PRICE-TAKING AND COMPETITIVE MARKETS: How markets operate when all buyers and sellers are price-takers: Interaction of supply and demand determines a market equilibrium in which both buyers and sellers are price-takers, this is called a competitive equilibrium. 8.1: Buying and selling: Demand and supply: 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 preferences of consumers and costs of suppliers. When there are many firms producing the same product, each firms’ decisions are affected by behaviour of competing firms and consumers. An example, is the demand for second hand university textbooks. Demand 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. Below that students WTP may depends on how hard they work, how important they think the book is, and on their available resources (affordability). The diagram shows the demand curve for the books. The demand curve represents the WTP of buyers; similarly, supply depends on the seller’s willingness to accept (WTA) money in return for books. The supply of the books comes from students who have previously completed the course, who will in differ in amount how much they are willing to accept – this is called their reservation price. (reservation price represents the value to the seller of keeping the book, to be willing to sell it, value must be therefore higher than this) The diagram shows supply curve of books. Notice that for simplicity, both the demand and supply curve have been drawn as straight lines (linear). 8.2: The market and equilibrium price: With modern communications, sellers can advertise their goods and buyers can more easily find out what is available – but in some cases it is more convenient to meet. The economist Alfred Marshall introduced his model of supply and demand using a similar example. He called the price that equated supply and demand -the equilibrium price.   

If the price was above the equilibrium, more products would be supplied, demand would decrease as less would be willing to pay. So, there would be excess supply. If price was below the equilibrium, sellers would prefer to sell less or wait. Therefore, price would tend to an equilibrium level.

Marshalls assumed that all the grain was of the same quality. His argument can be applied to all sellers that are selling identical goods. Equilibrium price is also the market-clearing price. Price-taking: In the textbook market example, individual students have to accept the equilibrium price. No one would trade with a student asking a higher price or offering a lower one, because they can find substitutes and other sellers/buyers offering better prices. The participants in the market are therefore price-takers, because there is sufficient

competition from other buyers and sellers. They are free to choose another price, but won’t gain any additional benefit. On both sides of the market, competition eliminates bargaining power. This is described as a competitive equilibrium known as a Nash equilibrium, because no actor can do better than they are doing at equilibrium price. 8.3: Price-taking firms: Suppose you are the owner of a bakery. You decide what price to charge. Your neighbouring bakeries are selling loaves for £2.35; this is the prevailing market price; you are not able to sell at a higher price because no-one would buy- you are a price-taker. Your marginal cost increases with output of bread. When quantity is small, marginal cost is low; having installed equipment such as ovens already, so the additional cost to produce a loaf of bread is relatively small, BUT average cost is high. A number of loaves increases, average cost falls, but marginal costs begin to rise gradually as you have to employ more staff and use more equipment, etc. At higher quantities the marginal cost is above the average cost, then average costs rise again. 

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If P=AC your economic profit would be zero. So, the average cost curve is the zeroeconomic profit curve. The isoprofit curves show price and quantity combinations at which you would receive higher levels of profit. Isoprofit curves slope downwards where price is above marginal cost, and upwards where price is below marginal cost, so marginal cost curve passes through the lowest point on each isoprofit curve.

In the diagram, bakery is a price-taker. Market price is 2.35, any higher and customers will go elsewhere. The point of highest profit in the feasible set is Point A, where P=MC. P=MC is the optimising point because if firms increased output where MC>P, the last unit would cost more than P to make, so firm makes a loss on this unit and can make higher profits by reducing output. If it were producing where MC...