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Competitive Markets
Economics 110
Introduction to Economic Theory
Professor Tanya Rosenblat
1
Experiment (Session 1). Widget Market (48
participants)
Type of Agent
Number of
Agents
Cost
Value
Low-Cost
Supplier
16
10
High-Cost
Supplier
8
30
High-Value
Demander
8
40
Low-Value
Demander
16
20
2
Supply Schedule
Price Range
P<10
Amount Supplied
0
10<P<30
16
P>30
24
3
Demand Schedule
Price Range
Amount Demanded
P>40
0
20<P<40
8
P<20
24
4
Session 1: Supply and Demand for Widgets
P 40
R
I
30
C
E 20
10
8
16
24
5
Number of Bushels
Experimental Data
• Round 1 – Average Price 18.3
(19.5)
Round 1 Prices
40
Price
30
20
10
0
0
10
20
30
Transactions
6
Experimental Data
• Round 2 – Average Price 17.4
(17.3)
Price
Round 2 Prices
35
30
25
20
15
10
5
0
0
5
10
15
20
Transactions
7
A Demand Curve Can Be Thought of as a Schedule
of Buyers’ Maximum Willingnesses to Pay
$5.75
$2.25
$ per unit
Highest price
Potential at which individual
is willing to buy
Buyer
#1
$ 6.00
#2
$ 5.50
#3
$ 5.00
#4
$ 4.50
#5
$ 4.00
#6
$ 3.50
#7
$ 3.00
#8
$ 2.50
#9
$ 2.00
#10
$ 1.50
#11
$ 1.00
#12
$ 0.50
• Only one buyer has a maximum willingness
to pay greater than $5.75
• Thus: at a price of $5.75, only one potential buyer (#1)
would buy.
• Quantity demanded at $5.75 = 1
$6.50
$6.00
$5.50
$5.00
$4.50
$4.00
$3.50
$3.00
$2.50
• At a price of $2.25, eight potential buyers
would buy (#1 - #8).
• Quantity demanded at $2.25 = 8.
$2.00
$1.50
$1.00
Demand Curve
$0.50
Quantity
$-
0
1
2
3
4
5
6
7
8
9
10
11
12
Notice that the demand curve also describes the maximum willingness to pay of all
potential buyers in the market!
8
A Supply Curve Can Be Thought of as a Schedule of
Seller’s Minimum Willingnesses to Sell
$5.75
$ per unit
•
$6.50
•
Supply Curve
The price of $5.75 is greater than the
minimum willingness to sell for 11 potential sellers
Thus: quantity supplied at $5.75 = 11
$6.00
Lowest price
Potential at which seller
is willing to sell*
Seller
#1
$ 0.50
#2
$ 1.00
#3
$ 1.50
#4
$ 2.00
#5
$ 2.50
#6
$ 3.00
#7
$ 3.50
#8
$ 4.00
#9
$ 4.50
#10
$ 5.00
#11
$ 5.50
#12
$ 6.00
$5.50
$5.00
$4.50
$4.00
$3.50
$3.00
$2.25
$2.50
$2.00
$1.50
$1.00
$0.50
Quantity
$-
0
1
2
3
4
5
6
7
8
9
10
11
12
9
Is There An Equilibrium in Our Market? Yes!
Supply Curve
$ per unit
•
$6.50
$6.00
•
$5.50
$5.00
$4.50
•
$4.00
$3.50
equilibrium price “band”
At any price above $3.00
but below $3.50, exactly
6 potential buyers are
willing to buy
At a price above $3.00
but below $3.50, exactly
6 potential sellers are
willing to sell.
For any price in this
band, quantity supplied
equals quantity
demanded at this price.
$3.00
$2.50
$2.00
$1.50
$1.00
Demand Curve
$0.50
Quantity
$-
0
1
2
3
4
5
6
7
8
9
10
11
12
10
How Much Do Buyers Gain at the Market
Equilibrium?
Buyer #1:
winning to pay as much as: $6.00
actually pays:
$3.25
net gain (consumer surplus): $2.75 (area A)
$ per unit
$6.50
Buyer #2:
winning to pay as much as: $5.50
actually pays:
$3.25
net gain (consumer surplus): $2.25 (area B)
$6.00
$5.50
$5.00
Buyer #6:
winning to pay as much as: $3.50
actually pays:
$3.25
net gain (consumer surplus): $0.25 (area F)
A
$4.50
B
$4.00
$3.50
F
$3.25
$3.00
Highest price
Potential at which individual
is willing to buy
Buyer
#1
$ 6.00
#2
$ 5.50
#3
$ 5.00
#4
$ 4.50
#5
$ 4.00
#6
$ 3.50
#7
$ 3.00
#8
$ 2.50
#9
$ 2.00
#10
$ 1.50
#11
$ 1.00
#12
$ 0.50
$2.50
$2.00
$1.50
$1.00
These buyers do not buy
Their consumer surplus is zero!
$0.50
Demand Curve
Quantity
$-
0
1
2
3
4
5
6
7
8
9
10
11
12
11
Consumer Surplus
• Consumer surplus: the aggregate net gain to
$ per unit
consumers from purchasing at a given market price.
• Equal to: the area underneath the demand curve
above the market price
• In our picture: consumer surplus at a market price
of $3.25 equals area A+B+C+D+E+F.
• This number, which equals $9.00, is the aggregate
difference between what consumers are willing to
pay and what they actually pay.
$6.50
$6.00
$5.50
$5.00
A
$4.50
B
C
$4.00
D
E
$3.50
F
$3.25
$3.00
$2.50
$2.00
Consumer Surplus:
Willingness to pay - Actual payment
$1.50
$1.00
Demand Curve
$0.50
Quantity
$-
0
1
2
3
4
5
6
7
8
9
10
11
12
12
The Concept of Consumer Surplus Also Applies to
“Smooth” Demand Curves
P ($ per liter)
• Consumers demand 4000 liters at $6 per unit.
• Consumers surplus = difference between
total willingness to pay and
actual amount paid = area A
= $8,000.
$10
$6
A
MARKET
DEMAND CURVE
Q (liters per year)
4000
13
How Much Do Sellers Gain at the Market
Equilibrium?
Supply Curve
$ per unit
Seller #1:
actually receives:
$3.25
must receive at least:
$0.50
net gain (producer surplus): $2.75 (area A)
$6.50
$6.00
$5.50
Lowest price
Potential at which seller
is willing to sell*
Seller
#1
$ 0.50
#2
$ 1.00
#3
$ 1.50
#4
$ 2.00
#5
$ 2.50
#6
$ 3.00
#7
$ 3.50
#8
$ 4.00
#9
$ 4.50
#10
$ 5.00
#11
$ 5.50
#12
$ 6.00
Seller #2:
actually receives:
$3.25
must receive at least:
$1.00
net gain (producer surplus): $2.25 (area B)
$5.00
$4.50
$4.00
$3.50
$3.25
F
$3.00
$2.50
B
$2.00
Seller #6:
actually receives:
$3.25
must receive at least:
$3.00
net gain (producer surplus): $0.25 (area F)
A
$1.50
$1.00
$0.50
Quantity
$-
0
1
2
3
4
5
6
7
8
9
10
11
12
14
Producer Surplus
Supply Curve
$ per unit
Producer Surplus:
Actual payment - required payment
$6.50
$6.00
$5.50
$5.00
$4.50
$4.00
• Producer surplus: the aggregate net gain to sellers
from selling at a given market price.
• Equal to: the area underneath the market price
above the supply curve.
• In our picture: producer surplus at a market price of
$3.25 equals area A+B+C+D+E+F.
• This number, which equals $9.00, is the aggregate
difference between what sellers actually receive
and the smallest amount they need to receive.
$3.50
$3.25
$3.00
F
E
D
$2.50
C
B
$2.00
A
$1.50
$1.00
$0.50
Quantity
$-
0
1
2
3
4
5
6
7
8
9
10
11
12
15
Producer Surplus Also Applies to “Smooth” Supply
Curves
P ($ per liter)
Market Supply Curve
$6
A
• Firms supply 4000 liters at $6 per liter.
• Producer surplus is area A in the diagram = $8,000.
$2
Q (liters per year)
4000
16
Total Economic Value Created in a Market =
Consumer Surplus + Producer Surplus
Supply Curve
$ per unit
$6.50
$6.00
$5.50
$5.00
$4.50
• Total economic value created when
market price is $3.25
= Consumer surplus at $ 3.25
+ Producer surplus at $3.25
= $9.00 + 9.00
= $18.00
$4.00
$3.50
$3.25
$3.00
$2.50
$2.00
$1.50
$1.00
Demand Curve
$0.50
Quantity
$-
0
1
2
3
4
5
6
7
8
9
10
11
12
17
If The Market is Prevented From Reaching
Equilibrium, Economic Surplus is Not Realized
Supply Curve
$ per unit
$6.50
$6.00
$5.50
$5.00
• If, for some reason, potential buyers #3,4,5
and potential sellers #3,4,5 were prevented
from participating in the market,
consumer and producer surplus would
be lost.
• Gains from exchange would not be realized!
• We say there is a deadweight loss: unrealized
economic benefits.
• How could this happen?
Government interventions!
$4.50
$4.00
$3.50
$3.00
$2.50
$2.00
$1.50
$1.00
Demand Curve
$0.50
Quantity
$-
0
1
2
3
4
5
6
7
8
9
10
11
12
18
The Economics of Price Controls
Price
($ per unit)
Free
market
(no price
control)
Price
controls
Difference
due to price
controls
Producer
surplus
F + C+ E
F
- C-E
Consumer
surplus
A+B+D
A+B+C
C–D
Total
surplus
A+B+C
+D+E+F
A+B+C
+F
-E-D
A
B
S
D
$2,000
E
C
$1,400
F
D
QS
Q*
QD
Quantity (units per period)
E + D = Deadweight loss
19
Elasticity
• Where is the Demand Curve coming from? How do we measure
its slope?
• The Demand Curve tells us how much consumers will buy for
different prices of the good
• From Consumer Behavior, we know how to deduce from tastes
how much an individual consumer will buy at a given price.
Summing over consumers, we get the Demand Curve
• The Demand Curve is (assumed to be) decreasing (The “Law of
Demand”): The higher the price, the lower the consumption
20
How to measure elasticity?
• It is important to measure how sensitive Demand is to changes in Prices
• Preferably, this measure should not depend on units: are we counting in
dollars, cents, or euros? Pounds, Kilograms or Tons?
• The price elasticity of demand provides such a measure:
Q / Q
Ep 
P / P
D
D
In words, it is the % change in quantity for (or divided by) a given % change in
prices
(sometimes, the elasticity is defined as the opposite number: the precise convention
does not matter, as long as one realizes that the law of demand applies)
21
The Importance of Elasticity
•
The Concept of Elasticity is used for other concepts:
- Income elasticity of Demand:
Q D / Q D
EI 
I / I
- Price Elasticity of Supply:
Q S / Q S
ES 
P / P
•
What affects the Slope? When is it steep? It is steep when
22
there is no good substitute
Using Calculus
% change in quantity demanded dQ / Q P dQ


x
% change in price
dP / P Q dP
% change in quantity demanded dQ / Q I dQ


% change in income
dI / I
Q dI
23
Examples
• Linear Demand
• Q = a – bP
• Elasticity =
dQ / Q
P dQ
P
bP


(b) 
dP / P
Q dP
Q
bP  a
24
Elasticity
• Elastic – responsive to price changes
• Inelastic – not responsive to price changes
Examples:
- An unconscious bleeding man is brought to the hospital
emergency room.
- Among hospital patients whose insurance will pay all charges,
what would the demand be like for nurse-administered
propoxyphene (Darvon), a pain-killer?
- Now suppose that the patients are in managed care plans that
pressure physicians to use lower-price drugs. What might demand
for the Darvon be?
- A patient is given a presciption for a drug to control high blood
pressure. The patient's insurance doesn't cover drugs, so the
25
patient must pay out of pocket.
Elasticity
• Demand is more elastic
if the decision-maker has an incentive to save
money
and
if there is an adequate substitute for the product
or service.
26
What Shifts Demand Curves?
•
•
•
•
•
•
•
•
Change in income
Change in a price of a substitute
Change in a price of a complement
Change in composition of population
Change in tastes
Change in information
Change in availability of credit
Change in expectations
27
What Shifts Supply Curve?
•
•
•
•
•
Change in price of inputs
Change in technology
Change in natural environment
Change in availability of credit
Change in expectations
28