Chapter 6: Competitive Markets

Chapter 6: Competitive Markets

Core Ideas

  • Firms aim to maximize profits.
  • Firms in competitive markets produce quantities that maximize gains from trade, leading to a Pareto efficient market outcome.

Outline of Chapter 6

  • Introduction
  • Demand and Supply
  • Competitive Equilibrium
  • Firms in Competitive Markets
  • Gains from Trade in Competitive Markets
  • Changes in Demand and Supply
  • Government Policies
  • Efficacy of the Model

1. Introduction

  • Competitive Markets:
    • Analysis of markets involving many buyers and sellers trading the same good (competitive markets).
    • Differentiates from markets with firms that possess market power (Chapter 5).
    • Intense competition characterizes markets with multiple sellers of the same good.

Questions in This Unit

  • How do firms in competitive markets decide on production and pricing?
  • Are market outcomes Pareto efficient?
  • Do market outcomes maximize gains from trade?

Approach in This Unit

  • Model decision-making of profit-maximizing firms devoid of market power.

2. Demand and Supply

Example: Demand for Second-Hand Textbooks

  • Demand arises from students beginning courses.
  • Willingness to Pay (WTP):
    • Varies among students based on work habits, book importance, and purchasing resources.
  • Demand curve is downward sloping: higher price leads to lower quantity demanded.

Supply of Second-Hand Textbooks

  • Supply sourced from students who have completed related courses.
  • Willingness to Accept (WTA):
    • Varies based on eagerness to sell the textbook.
  • Supply curve is upward sloping: higher price results in more textbooks supplied.

Market Definition

  • A market is composed of a group of buyers and sellers of a particular good or service.
    • Highly organized: specific times and places for trading.
    • Less organized: no specific meeting times or places.

Communication in the Market

  • Modern communication methods enhance advertising, allowing buyers to easily find offerings (e.g., Google, Amazon).
  • Traditional markets exist where physical inspection is feasible (e.g., city markets).

Dynamics of the Textbook Market

  • Buyers' price willingness ranges: $20 to $0.
  • Sellers' price acceptance ranges: $2 to $12.
  • The precise price and quantity sold depend on market dynamics.

3. Competitive Equilibrium

Market Pricing Mechanics

  • A market's clearing price is indicative of equilibrium price.
  • Market equilibrium occurs when quantity demanded equals quantity supplied.
  • Expectations are that most transactions will occur at near the equilibrium price of P^* = 8.

Excess Conditions

  • Excess Supply:
    • Occurs when sellers seek prices higher than $8, leading to unsold items.
  • Excess Demand:
    • Occurs with prices lower than $8, resulting in more inclined buyers than available sellers.

Testing the Model's Predictions

  • Competitive equilibrium relies on many sellers and identical goods, predicting a convergence at the market-clearing price.
  • Observational and experimental data necessary to verify accuracy of predictions.
  • Notable experiments (e.g., Vernon Smith) show convergence toward equilibrium with informed buyers and sellers.

4. Firms in Competitive Markets

Bakery Example

  • Conceptualize a city with numerous bakeries selling identical bread products.
  • Market demand curve for bread is downward sloping efficacy.

Pricing Decisions for a Bakery

  • As a bakery owner, pricing must align with the prevailing market price, here P = 2.35.
  • Sales quantity is responsive to this competitive price, with no ability to price above competitors' offerings.

Price Taking Behavior

  • In competitive markets, all buyers and sellers are considered price takers.
    • They do not set the market price but respond accordingly.
    • Firms lack market power, resulting in a perfectly elastic demand curve.

Production Decisions

  • Bakery production should hinge on marginal costs considering both fixed and variable costs.

Marginal Cost of Production

  • Marginal costs are categorized as a step function relating price to quantity produced.
  • The intersection of market price and marginal cost delineates optimal production level, maximizing profits.

Optimal Production Quantity

  • For competitive firms, the quantity where market price equals marginal cost is profit-maximizing.
  • The principle governing the relationship: if marginal revenue (price) exceeds marginal cost, production should increase until they equate.

Market Supply Dynamics

  • Aggregate supply curve constructed by totaling quantities supplied at each price by all firms.

5. Gains from Trade in Competitive Markets

Trade Efficiency

  • Buyers and sellers engage in trade due to mutual benefit, assessed via surpluses.
  • Surplus potential exists when buyers' WTP exceeds marginal production costs.

Competitive Equilibrium Notation

  • Gains from trade are maximized at the competitive equilibrium, making it Pareto efficient.
  • Efficiency is stripped in non-competitive markets leading to deadweight loss (DWL).

Conditions for Efficiency

  • Market characteristics pivotal in achieving a Pareto efficient competitive equilibrium include:
    • Many buyers/sellers of identical goods.
    • Absence of market power.
    • Equilibrium status in the market.
    • Absence of external trade effects.

Fairness Concerns

  • Pareto efficiency does not imply equity:
    • Example: Disparity in wealth and resource distribution (e.g., housing and food inequality).

Surplus Distribution

  • The distribution between consumer and producer surplus is dictated by demand and supply elasticities.

6. Changes in Demand and Supply

Market Adaptation Analysis

  • When events shift demand/supply, equilibrium must be reassessed.

Demand Shifts

  • Causes include variations in consumer behavior, influences of income, preferences, expectations, and substitute goods pricing.

Supply Shifts

  • Influential factors comprise input costs, technological advancements, expectations, and natural events.

Market Insights via Case Studies

  • Case studies (e.g., quinoa, hats, bread) explain equilibrium shifts via demand/supply dynamics.

7. Government Policies in Competitive Markets

Overview of Government Interventions

  1. Taxes
  2. Subsidies
  3. Price Controls

Taxes

  • Taxes serve multiple functions including revenue generation and behavior regulation.
  • Tax impact modeled through supply-demand relationships, shifting curves.

Subsidies

  • Subsidies encourage production/consumption by altering market dynamics, resulting in excess transactions at a cost to the government.

Price Controls

  • Price controls establish limits on market pricing, leading to unintended consequences like shortages (binding ceilings) or surpluses (binding floors).

Price Control Examples

  • Real-world examples spotlight policy effects on markets like rent controls and minimum wage laws.

8. Efficacy of the Demand and Supply Model

Applicability Evaluation

  • The competitive equilibrium model is a foundational analytical tool in economics, guiding the understanding of market behaviors.

Real-World Market Application

  • Real economies exhibit varied competitive characteristics but align with theoretical principles in numerous cases:
    • Agricultural products, slightly differentiated goods.

Model Limitations

  • Recognition of imperfectly competitive market realities highlights practical deviations from the model's assumptions.

Summary of Key Insights

  • Markets with many buyers/sellers equate supply and demand to define product pricing.
  • Competitive equilibrium achieves maximal trade without deadweight loss, contrasting with non-competitive market dynamics.
  • Government taxes/subsidies alter equilibria, creating inefficiencies or facilitating beneficial outcomes.