Unit 8 Flashcards
How can we draw supply and demand diagrams and find the market equilibrium?
The demand curve can be drawn by arranging all consumers in descending order of WTP.
The supply curve can be drawn by arranging all sellers in ascending order of WTA/reservation price.
Where the demand and supply curves intersect is the market equilibrium - where the market clears.
What is excess supply and demand?
If sellers set a price above the market equilibrium price, there would be an extension in supply and contraction in demand, and so quantity of supply>quantity of demand - excess supply.
If sellers set a price below the market equilibrium price, there would be an extension in demand and contraction in supply, and so quantity demanded>quantity supplied - excess demand.
In both cases buyers or sellers could do better by trading at different prices.
What is a highly competitive market?
A market where there are man y buyers and sellers and goods are identical, meaning neither buyers nor sellers have market power and act as price takers.
Buyers and sellers therefore trade at the market price, as no seller would accept a lower price as there would find a buyer with a WTP equal to the market price, and no buyer would pay more than the market price as they would find a seller with a WTA equal to the market price.
In a highly competitive market, how do sellers decide how much to produce at the market equilibrium price?
At the market equilibrium price, sellers can sell as much as they can make. How much they make depends on marginal costs.
Assuming constant marginal cost, the firm’s feasible set is the area under the market price as selling at a higher price is not feasible.
The firm’s profit maximising quantity is where price = marginal cost.
When price>marginal cost, the firm makes a profit on each additional unit of output and when marginal cost>price, the firm makes a loss on each additional unit of output.
How would a firm’s profit-maximising quantity be affected by a change in the market price?
If the market price falls below the firm’s marginal costs, the firm should stop production as they would make a loss on each unit of output.
As long as the market price is greater than or equal to the marginal cost, the firm’s profit maximising quantity stays the same.
If marginal cost is not constant and rather an increasing function, how can we determine the profit maximising quantity?
Let a firm’s cost function be C(Q) so that marginal costs is C’(Q). The marginal costs curve is upward sloping, therefore convex so C’’(Q)>0. This means the average cost and isoprofit curves are U-shaped and the MC curve passes through the minimum point of each one.
Let the profit function: Π(Q)=PQ-C(Q)
Differentiating: dΠ/dQ= P-C’(Q)=0 so, to maximise profit, P=C’(Q), therefore P=MC like when marginal costs is constant.
So P=MC is always the profit maximising condition for a firm.
What is consumer and producer surplus?
Consumer surplus is calculated as WTP-price, it is the difference between what consumers are willing to pay and the actual price they pay.
Producer surplus is calculated as price-MC (MC=WTA), it is the difference between the price they receive and the price they are willing to accept.
What is total surplus and why is it maximised at the competitive equilibrium?
The total surplus from trade = consumer surplus + producer surplus.
Total surplus is maximised at the competitive equilibrium.
If fewer units of output were produced, there would be unexploited gains from trade as some consumers without the product would be willing to pay for more than the cost of producing an extra unit.
If more units of output were produced, total surplus would decrease as they would cost more than consumers are willing to pay.
What are exogenous shocks and how do markets respond to them?
Exogenous shocks are shifts in demand or supply in which the supply and demand model cannot explain why they happen and only explains the consequences.
Eg If demand were to shift right, there would be excess demand if the equilibrium remained constant. Sellers realise they can charge higher prices and produce more output and so supply extends, forming a new equilibrium at a higher price and output level.
What is a cartel and why would firms want to join one?
A cartel is a group of firms (or countries in the case of OPEC) who are in the same market producing identical goods and collude toset agreements on prices and/or quantities of output.
Using game theory, we can assess why a firm would want to join a cartel.
Imagine a market where firm A and B produce identical goods which cost £1 to produce.
Both firms can charge a high price of £4 and sell 30 units each or charge a low price of £2 and sell 36 units each.
At the high price, both firms make a profit of £90 and at the low price they make £36 profit.
If one where it charge a low price whilst the other remains high, the entire market would switch to the lower priced firm, who makes a profit of £72 (1x72). This is lower than the profit of both selling a high price, and so the best response is to both set a high price, resulting in a Nash equilibrium.
A cartel is formed a both firms agree to charge the high price of £4 and will be sustained as neither benefit from dropping out.
How does competition destroy cartels?
If there is a cartel in a market, ie between firms A and B, and a new firm, C, joins the market selling an identical product, the situation changes.
If all three firms set a high price of £4, they all make £60 profit. If all set a low price of £1, they each make £24 profit.
Agreeing to set a high price is clearly preferred to agreeing to set a low price.
But if one firm undercuts the deal and sets a low price whilst the other two set a high price, that firm receives £72 profit leaving the other two with £0 as the entire market switches to that firm.
With this information, all firms would choose to set a low price in fear if being undercut and left with nothing, thus destroying the cartel.
The added competition has therefore transformed the game from a coordination game to a prisoner’s dilemma where the dominant strategy is to set a low price.
What are the conditions for a market to be in competitive equilibrium?
If the following conditions hold, the market will be in competitive equilibrium and competition between buyers ad sellers will ensure no one will trade at any other price.
- there are many buyers and sellers acting independently
- goods are homogenous
- all buyers and sellers have equal information
- buyers and sellers seek the best price available (ie seek to utility/profit maximise)
What are some evaluations of perfect competition/competitive equilibrium?
- Perfect competition is rare in actuality as in most markets, products are somewhat differentiated, reducing the intensity of competition.
- Even in markets like oil which is a homogenous good, there are not enough buyers and sellers to prevent a large group of countries to gain market power by forming a cartel
- Buyers do not normally have perfect information and are not immediately responsive to prices.
What is the effect on market equilibrium of imposing a tax on a good?
Suppose that initially the market equilibrium is at PQ and a tax of x% is imposed on suppliers, effectively raising marginal costs by x%.
The supply curve shifts upwards, intersect the demand curve at a higher price and lower quantity. The new equilibrium forms at P1Q1.
The supplier receives a price of P0 (where Q1 intersects the old supply curve). The difference between P1 and P0 is the extent of the tax and what is received by the government.
What is the effect on consumers, producers and the government of a tax?
Consumer surplus falls as they pay a higher price of P1 and buy a lower quantity.
Producer surplus falls as producers supply less and receive a lower net price of P0.
The government receive the tax revenue = (P1-P0)Q1
Total surplus is lower as there is a deadweight loss from the units of output that are no longer traded.
Explain the effect of a price control in the form of a price ceiling.
Price ceilings are used by the government in markets such as rent to prevent sellers from charging a price deemed too high.
Initially the market trades at PQ. If a price ceiling is established under the market price at P1, there will be excess demand because sellers with a WTA higher than this price will leave the market, and more consumers who have a WTP lower than the market price will enter the market.
