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 Week 4 lecture
Price-taking firms,
asset markets, market dynamics
ECN113
Dr. Eileen Tipoe
Outline
1. Market equilibrium for price-taking firms
How do price-taking firms choose the profit-maximizing quantity?
Changes in supply/demand
Short-run vs long-run equilibria (firm- and market-level)

2. Taxation
How do taxes affect market surplus and the distribution of surplus?

3. Price dynamics in asset markets (self-study material)

Modelling asset price bubbles; application to environmental processes
 Price-taking firms: Profit maximisation
The profit-maximizing point is where the demand curve is tangent to the highest
possible isoprofit curve.
1. Unlike price-setting firms, price-taking firms face a
flat demand curve (horizontal at the market price, P*).
Firms choose the quantity to produce, not the price.
3. At the profit-maximizing quantity (point A), P* = MC
(slope of isoprofit = zero)

C
A
Demand curve
B
2.The price that the firm
faces is determined by the
intersection of market Feasible set At B, firm can increase profits by
supply and market demand producing an additional unit.
curves. At C, firm can increase profits
by producing one unit less.
Price-taking firms: Supply curve
For a price-taking firm, the marginal cost curve is their supply curve.
(because the amount they choose to
produce is always where P = MC)
Price-taking firms: Market supply curve
Market supply is the total amount all firms will supply at each price.
From firm supply to market supply:
Suppose there are N identical price-taking
bakeries. At any given price, the market
supply is N x individual firm supply.

Suppose there are 50 identical

price-taking bakeries. At any
given price, the market supply is
50 x individual firm supply.

Multiply the horizontal axis labels by N

Market equilibrium
The equilibrium allocation (competitive equilibrium) maximises total surplus
(contrast with price-setting firm).
(It is not possible to make anyone person better off
without making someone else worse off;
All potential gains from trade are achieved.)

Competitive equilibrium is Pareto efficient if:

• Buyers and sellers are price-takers
Consumer surplus
• Contracts are complete
Producer surplus • Transactions have no external effects
Market equilibrium
Any change in external (exogenous) factors shifts the entire demand/supply curve
upwards or downwards.
The adjustment process is important!
1. Point A: Initial market equilibrium.

2. New demand curve: Bread becomes

more popular due to a recent government
B health campaign.
C 3. Point D: At the current price, there
D is excess demand for bread.
4. Sellers realise that they can make
New demand higher profits by raising the price and
producing more.

5. Point C: Prices and quantities increase

until a new equilibrium is reached.
 Market equilibrium: Changes in supply
Examples: Technological improvement, entry of new firms

1. Initially the market is in 2. Technological improvement decreases

equilibrium at point A. the marginal costs of production.

3. There is excess supply (B)

at the original price, so firms
would want to lower prices.
B
E 4. At the new equilibrium (E),
the price is lower and quantity
supplied is higher.
 Does the ‘invisible hand’ really work?
Economist Vernon Smith designed some experiments to see if ‘ordinary people’
(undergraduate students) could replicate this adjustment behaviour.
Equilibrium price predicted by theory Actual prices at which trades occurred

1. Students were assigned roles

(buyer or seller) and were only
told their own WTP/WTA. Over time, most trades
2. They were given a limited occurred at the price
time to find a willing predicted by theory as
buyer/seller in an open market. students learned about the
3. Once they successfully prices other students were
negotiated the price, they willing to pay/accept.
traded and left the market.
4. They played this game
several times.
Does the ‘invisible hand’ really work?
Demand shift: Variation of the experiment where the buyers were given a new WTP after
4 periods of trading.

Again, students eventually

learned about the prices other
students were willing to
pay/accept.

Read about it (optional reading): Smith, V. L. (1962). An experimental study of competitive market
behavior. Journal of Political Economy, 70(2), 111-137.
 Market equilibrium: Short-run vs Long-run
Short run = some factors e.g. number of firms are fixed/cannot change.
Long run = all factors are free to adjust. Short run: P = MC
Long run: P = MC = AC

1. The market is in short-run

equilibrium (A). Each firm is
making positive profits. New supply (MC)

Supply (MC) in long-

run equilibrium

B B 3. Firms enter until the price

C C
equals the average cost
2. Profits encourage new (long-run equilibrium at C).
firms to enter, shifting the
supply curve downwards.
Profits of each firm fall (B).
Market equilibrium: Short-run vs Long-run
Example: Consumers increase their demand for bread
Short run: P = MC
How does the market adjust to long-run equilibrium? Long run: P = MC = AC

Marginal cost curve Original

Original supply (MC)supply (MC)

Original demand

A A
Zero economic
profit (AC curve)

New demand

Original demand
Perfect competition
In a perfectly competitive market:
1. The law of one price holds.
2. The market clears.
3. Buyers and sellers are all price-takers.
4. All potential gains from trade are realized.

Do competitive equilibria exist?

Check whether conditions 1 and 3 hold.
 Imperfect competition: Product differentiation
Model of perfect competition can be a reasonable approximation if a product has
many close substitutes.

Adding up the marginal cost curves

Many close substitutes exist, of all firms gives an approximation
so the firm’s demand curve to the market supply curve.
is almost flat.

Each firm must set its price close

to the equilibrium price (B), a
The range of feasible prices similar price to its competitors.
is narrow.

The profit-maximizing price

(P*) is close to MC, so the MC
curve is a reasonable
approximation to the firm’s
supply curve.
Price-setting vs Price-taking firms
Price-setting firm/monopoly Price-taking firm
Takes market-determined price as given and
Sets price and quantity to maximize profits
chooses quantity to maximize profits
P > MC P = MC

Deadweight losses (Pareto inefficient) No deadweight losses for consumers and firms

Owners make economic profits in the long run No economic profits in the long run

Firms advertise their unique product Little/No advertising

Firms may spend money to influence elections,
Little/No expenditure
legislation and regulation

Firms invest in research and innovation Little/No incentives for innovation

Taxation and market surplus
Governments can use taxes to raise revenue, or reduce consumption of a harmful good.
How would the effect on surplus change
3. The new equilibrium quantity is if consumers were taxed instead?
at B. Consumers pay a higher price
2. The tax raises the marginal cost
and have lower surplus.
at each quantity produced.

Tax revenue 1. Before tax, the market

DWL
equilibrium is at point A.

4. Producers reduce quantity

5. Tax raises revenue but
produced and receive a lower price.
creates deadweight loss.
Producer surplus falls.
Tax incidence: Effective vs formal
What if we tax consumers instead of producers?

(Who is legally responsible for paying the tax?)

(How is the tax burden shared between consumers and firms?)

1. Effective incidence of a tax is the same, regardless of formal incidence.

2. More-inelastic side bears a greater proportion of the effective incidence.

 Example: Taxes on ‘junk food’
Governments can use taxes to try to reduce consumption of a harmful good.
Vietnam
Which country is the UK?
2.1
India 3.9
Japan 4.3
South Korea 4.7
China 6.2
Pakistan 8.6
Thailand 10
Seychelles 14
Malaysia 15.6
A
Denmark 19.7
Brazil 22.1
Spain 23.8
Venezuela 25.6
B
United Kingdom 27.8
Mexico 28.9
Australia 29
New CZealand 30.8
Turkey 32.1
DArabia
Saudi 35.4
United States 36.2
Tonga 48.2
Palau 55.3
Nauru 61

0 10 20 30 40 50 60 70
% of adult population (aged 18+) classified as obese
Source: Our World in Data, 2016
 Example: Taxes on ‘junk food’
UK (2018-Present): Tax on France (2012): Per-litre tax Norway (2018): 80% increase in tax per kg on
sugary drinks, depending on on sugary drinks. chocolate and sugar products.
sugar content. Denmark (2011-2012): Tax per kg
of saturated fats in a product.
Berkeley, US (2015-Present):
Tax on sugary drinks.
Hungary (2011-Present): Tax on
pre-packaged foods containing
high levels of salt or sugar.
Mexico (2013-Present):
Percentage tax on sweetened Kerala, India (2016-2017): Tax on ‘junk
drinks and calorie-dense foods food’ sold in branded restaurants.

Chile (2014-Present): Percentage tax

depending on sugar content of drinks.
Two types of taxes
E.g. Danish butter tax E.g. Sugary drinks taxes in Mexico and Chile
Per-unit (’specific duty’) Proportional (‘ad valorem’)
Supply (after-tax) = Supply + Tax (T) Supply (after-tax) = Supply x (1 + Tax)
Supply Supply
(after-tax) Before tax: (after-tax)
CS = A + B + C
Supply PS = D + E + F Supply
minus
After tax:
CS = A
Demand PS = F
Revenue = B + D
Demand
Quantity Quantity DWL = C + E
(after tax) (before tax)
Analysis is the same if the tax is on
consumers
Taxation: Problem-solving question
The diagram shows a market where all firms and consumers are price-takers, the
(inverse) supply curve is P = 2Q, and the (inverse) demand curve is P = 100 – ½Q. The
initial equilibrium is P = 80, Q = 40.
Suppose the government imposes a per-unit tax of $10 on suppliers. Calculate the
new equilibrium quantity, price paid by consumers, and price received by firms.
P ! = 2$ + 10
! = 2$
100

80 A

10
! = 100 − )*$

40 20 Q
Example: Taxes on ‘junk food’
What factors affect the effectiveness of a tax?
Example: Taxes on ‘junk food’
Governments can use taxes to raise revenue, or reduce consumption of a harmful good.
• Taxing a price-inelastic good can raise more revenue.
Example: Danish butter tax
However, tax was too costly to collect and was
abandoned after 15 months.

Successfully reduced consumption by 20%

Check your understanding
The figure shows the effect of a tax intended to reduce the consumption of butter.
The before-tax equilibrium is at A = (2.0 kg, 45 kr) and the after-tax equilibrium is at
B = (1.6 kg, 54 kr). The tax imposed is 10 kr per kg of butter.
Which of the following statements is correct?

A. The tax policy would be more effective if

the consumers were taxed instead of
producers.
B. The tax policy would be more effective if
the supply curve were more elastic.
C. The effective incidence of the tax falls more
on the producers than the consumers.
Summary
Model of perfect competition (P = MC) is a reasonable
approximation for firms that sell products with many
close substitutes. Under certain assumptions (price-
taking, complete contracts, no external effects),
competitive equilibrium is Pareto efficient.

Policymakers can use taxation to raise revenue

and/or change consumption behaviour. The
formal incidence and effective incidence of the
tax may differ, and depends on the relative
elasticity of demand (producers vs consumers).
Summary
Learning objectives Key concepts
• Understand how price-taking firms choose quantity to maximise • Price-taking firms
profits
• Competitive equilibrium
• Use a supply and demand diagram to illustrate the effects of
• Exogenous shocks
exogenous shocks on markets with price-taking firms
• Model of perfect competition
• Analyse how price-taking markets adjust to equilibrium in the
short run and in the long run. • Market equilibration through rent-seeking
• Define the characteristics of perfect competition • Long-run and short-run equilibria
• Understand how the behaviour of price-taking firms and price- • Taxation; Tax incidence (formal, effective)
setting firms differ
• Use a diagram to analyse the effects of taxation on surplus

Self-study material…
• Asset markets and price dynamics – how do asset price bubbles form?

In the next session…

• More about firms – mathematical problem-solving