Unit 8 - Supply and demand: Markets with many buyers and sellers
8.1 - How the American Civil War rocked global cotton prices
The defeat of the southern Confederate states in the American Civil War ended slavery in the production of cotton and other crops in that region
The tiny quantities reaching England through the blockade were a dramatic reduction in supply, causing large excess demand
Excess demand: A situation in which the quantity of a good demanded is greater than the quantity supplied at the current price
→ some sellers realised they could profit by raising the price
Some firms switched to India for an alternative, increasing demand there - different kind of cotton, a new machinery was developed for it
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
Friedrich Hayek
Central planning: In a centrally-planned economy, decisions about what to produce and how are taken by the government, rather than by firms responding to market prices.
8.2 - Buying and selling: Demand, supply, and the market-clearing price
Willingness to pay (WTP): An indicator of how much a person values a good, measured by the maximum amount they would pay to acquire a unit of the good
Willingness to accept (WTA): An indicator of how much a person values a good, measured by the minimum amount of money they would accept in exchange for a unit of the good (that is, their reservation price)
Reservation price: The lowest price at which someone is willing to sell a good
Markets and market clearing
Before concluding a deal with one trading partner, both parties would like to know about other trading opportunities.
In medieval towns and cities it was common for makers and sellers to set up shops close to others selling the same good, so customers knew where to find them
With modern communications, sellers can advertise widely; buyers can more easily find out what is available and where
Market-clearing price: The price at which the amount of the good demanded is equal to the amount supplied
Alfred Marshall
8.3 - Competitive equilibrium and price-taking
Marshall called the market-clearing price the equilibrium price - the market is in equilibrium
Excess demand: A situation in which the quantity of a good demanded is greater than the quantity supplied at the current price
Excess supply: A situation in which the quantity of a good supplied is greater than the quantity demanded at the current price
Competitive equilibrium
Marshall’s supply and demand model can be applied to markets with many buyers and sellers of identical goods
In equilibrium, no individual has the power to influence the market price
Competitive equilibrium: A market is in competitive equilibrium if the quantity supplied is equal to the quantity demanded at the prevailing price, and all buyers and sellers are price-takers, so that no-one can benefit from attempting to trade at a different price
A competitive equilibrium is a Nash equilibrium
Price-taker: A buyer or seller acts as a price-taker if they cannot benefit from attempting to trade at any other price than the prevailing market price. A price-taker has no power to influence the market price, but can buy or sell as many items as they wish at that price
In general, we expect buyers to be price-takers if there are many other buyers, and sellers to be price-takers if there are many sellers selling an identical product
Do markets with many buyers and sellers reach competitive equilibrium
If supply and demand were not equal, buyers and sellers would adjust their prices until the equilibrium was reached
8.4 - Firms in competitive equilibrium
If products are identical and consumers can easily switch from one firm to another, the choice of price is extremely restricted: firms will be price-takers in equilibrium
The firm’s supply curve
A firm in a competitive market equilibrium does not choose a price - accepts the market price, and chooses a quantity that depends on its marginal cost
Supply curve: A supply curve shows the number of units of output that would be supplied to the market at any given price. The firm’s supply curve shows the units supplied by an individual firm, and the market (or industry) supply curve shows the total number of units supplied by all sellers in the market (or firms in the industry)
8.5 - Gains from trade in competitive equilibrium: Allocation and distribution
Buyers and sellers of bread voluntarily engage in trade because both benefit
There is a potential surplus whenever a buyer will pay more for the good than the marginal cost of producing it
All potential gains from trade are exhausted at the competitive equilibrium—in other words, the total surplus is maximized
Pareto efficiency
The equilibrium allocation is Pareto efficient
Often interpreted as a powerful argument in favour of markets as a means of allocating resources
Conditions:
In a market with many buyers and sellers of identical goods
At the equilibrium, when all participants are price-takers
When trade in the market has no external effects
Where there is a complete contract between each buyer and seller
The distribution of the gains from trade
There are two criteria for assessing an allocation: efficiency and fairness
We can assess how the monetary gains are distributed between the producers and the consumers, by comparing the consumer and producer surplus
8.6 - Changes in supply and demand
An increase in demand
Moves the equilibrium
Demand is higher at each possible price, so the demand curve has shifted
In response to this shift, there is a change in the equilibrium price. At the current price, sellers find that they can sell more hats than before
Sellers respond to this price message by increasing the quantity supplied, along the supply curve
But the supply curve itself has not shifted (the marginal costs of hat sellers have not changed): instead the equilibrium quantity supplied has increased because of the price change
Shifts in demand (or supply) are often referred to as exogenous shocks
Exogenous shock: An exogenous shock (for example a demand shock or a supply shock) is a change in one or more of the exogenous variables in a model—that is, variables that are othewise held constant by the modeller
Market equilibration through rent-seeking
When demand shifts, some of the buyers or sellers will realise that they can benefit by being a price-maker, and decide to offer or charge a different price from the others
When a market is not in equilibrium, both buyers and sellers can act as price-makers, transacting at prices different from the previous equilibrium price and earning disequilibrium rents
Disequilibrium rent: The economic rent that arises when a market is not in equilibrium, for example when there is excess demand or excess supply in a market for some good or service. In contrast, rents that arise in equilibrium are called equilibrium rents
An increase in supply due to improved productivity
When marginal costs fall, the supply curve shifts down (to the right)
8.7 - Short-run and long-run equilibria
Short-run: The term does not refer to a specific length of time, but instead to what happens while some things (such as prices, wages, capital stock, technology, or institutions) are assumed to be held constant (they are assumed to be fixed, or exogenous). For example, the firm’s stock of capital goods may be fixed in the short run, but in the longer run the firm could vary it (by selling some, or buying more).
Long-run: The term does not refer to a specific length of time, but instead to what is held constant and what can vary within a model. The long run refers to what happens when these variables are allowed to vary and be determined by the model (they become endogenous). A long-run cost curve, for example, refers to costs when the firm can fully adjust all of the inputs including its capital goods
If and when the market reaches a long-run equilibrium, rent-seeking and competition will have eliminated both the less-efficient firms and the rents
Firms that remain will be producing at low average cost, and since the market price will have fallen close to their average cost, they will be making normal profits
Opportunity cost of capital: The amount of income an investor could have received, per unit of investment spending, by investing elsewhere
Costs of entry: Startup costs that are incurred when a seller enters a market or an industry. These would usually include the cost of acquiring and equipping new premises, research and development, the necessary patents, and initial costs of finding staff
Short run and long run elasticies
When demand for a good increases, the increase in the quantity sold depends on the elasticity of the market supply curve
Because of the possibility of changes in capacity, the supply is more elastic in the long run
8.8 - Application: Market dynamics in the oil market
Cartel: A group of firms that collude (work together) to set output and/or prices in order to raise their joint profits
8.9 - How competition works: Transforming a cartel coordination game into a competitive prisoners’ dilemma
How can competition work to destroy a cartel
If a single company acts like a competitor and charges a low price to capture a larger share of the market → the cartel will fall apart, leading to lower prices for consumers
The firms could benefit from working together as a cartel, agreeing on a high market price - does not necessarily mean that the cartel can be sustained
Charging high and low prices are both a Nash equilibrium - neither would benefit from dropping out
The firms would prefer a cartel, where all agree to set the high price, to the outcome where they all set a low price - the cartel cannot be sustained
A cartel cannot succeed, because each member would rather violate the price-setting agreement and cut prices
The additional firm reduces the profits available from the cartel, making defection from the cartel a more profitable strategy
Barriers to entry: Anything making it difficult for new firms to enter a market, such as intellectual property rights or economies of scale in production
8.10 - Supply, demand, and competitive equilibrium: Is this a good model?
Conditions for competitive equilibrium
The theoretical requirements for a market to be in competitive equilibrium are as follows:
many buyers and sellers, all acting independently
identical (homogeneous) goods
all the buyers and sellers are aware of the prices at which others are trading
buyers and sellers always seek the best price available
Perfectly competitive: A market may be described as perfectly competitive if (i) there are many buyers and many sellers of identical goods, all acting independently, who are aware of prices and always choose the best price they can get, and (ii) the market is in competitive equilibrium, with supply equal to demand and all buyers and sellers acting as price-takers
Competitive equilibrium as a useful benchmark
Perfect competition: Perfect competition is the type of interaction between buyers and sellers that takes place in the equilibrium of a market when (i) there are many buyers and sellers of identical goods, and (ii) supply equals demand and all participants act as price-takers
The conditions for competitive equilibrium point us towards market characteristics that we would expect to favour competition and lead to beneficial outcomes
Where the model of competitive equilibrium can be applied
Where there are small differences in the quality or characteristics of goods—there may be enough competition that firms’ demand curves are elastic and the range of feasible prices is narrow
Walras, Hayek, and the debate about competitive equilibrium
Léon Walras built a mathematical model of a whole economy in which buyers and sellers are price-takers, which has been influential in how many economists think about markets
In Hayek’s view, the concept of a competitive equilibrium with price-taking did not capture what was important about competition
In practice, economies are a mixture of more and less competitive markets
8.11 - Application: Why information about prices matters
By gaining access to real-time market information on prices, the sellers could adjust their pattern of production and distribution (the market they visit) to secure the highest returns
Real-time market information allowed the sellers to get more information about prices, and become very effective rent-seekers
Law of One Price
8.12 - The effect of a tax
Using taxes to raise revenue: The case of salt
For centuries, salt has been used as a preservative, allowing food to be stored, transported, and traded
The ancient Chinese advocated taxing salt to raise revenue
Salt taxes were used by ruling elites
Tax incidence: The effect of a tax on the surplus of buyers, sellers, or both
An important feature of taxes: it is not necessarily the taxpayer who feels its main effect
Compared to the situation before the tax, some of the surplus has been transferred from consumers and producers to the government, but also the total surplus is lower - deadweight loss
8.13 - Price controls
Rent ceiling: The maximum legal price a landlord can charge for a rent.