The tables below show the reservation values of buyers and sellers in the market for used iphones.

Vegetable market, Da Lat, Vietnam

History, instability, and growthGlobal economy

How markets operate when all buyers and sellers are price-takers

  • Competition can constrain buyers and sellers to be price-takers.
  • The interaction of supply and demand determines a market equilibrium in which both buyers and sellers are price-takers, called a competitive equilibrium.
  • Prices and quantities in competitive equilibrium change in response to supply and demand shocks.
  • Price-taking behaviour ensures that all gains from trade in the market are exhausted at a competitive equilibrium.
  • The model of perfect competition describes idealized conditions under which all buyers and sellers are price-takers.
  • Real-world markets are typically not perfectly competitive, but some policy problems can be analysed using this demand and supply model.
  • There are important similarities and differences between price-taking and price-setting firms.

Students of American history learn that 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. There is also an economics lesson in this story.

At the war’s outbreak on 12 April 1861, President Abraham Lincoln ordered the US Navy to blockade the ports of the Confederate states. These states had declared themselves independent of the US to preserve the institution of slavery.

As a result of the naval blockade, the export of US-grown raw cotton to the textile mills of Lancashire in England came to a virtual halt, eliminating three-quarters of the supply of this critical raw material. Sailing at night, a few blockade-running ships evaded Lincoln’s patrols, but 1,500 were destroyed or captured.

excess demandA situation in which the quantity of a good demanded is greater than the quantity supplied at the current price. See also: excess supply.

We will see in this unit that the market price of a good, such as cotton, is determined by the interaction of supply and demand. In the case of raw cotton, the tiny quantities reaching England through the blockade were a dramatic reduction in supply. There was large excess demand—that is to say, at the prevailing price, the quantity of raw cotton demanded exceeded the available supply. As a result, some sellers realized they could profit by raising the price. Eventually, cotton was sold at prices six times higher than before the war, keeping the lucky blockade-runners in business. Consumption of cotton fell to half the prewar level, throwing hundreds of thousands of people who worked in cotton mills out of work.

Mill owners responded. For them, the price rise was an increase in their costs. Some firms failed and left the industry due to the reduction in their profits. Mill owners looked to India to find an alternative to US cotton, greatly increasing the demand for cotton there. The excess demand in the markets for Indian cotton gave some sellers an opportunity to profit by raising prices, resulting in increases in the prices of Indian cotton, which quickly rose almost to match the price of US cotton.

Responding to the higher income now obtainable from growing cotton, Indian farmers abandoned other crops and grew cotton instead. The same occurred wherever cotton could be grown, including Brazil. In Egypt, farmers who rushed to expand the production of cotton in response to the higher prices began employing slaves, captured (like the American slaves that Lincoln was fighting to free) in sub-Saharan Africa.

There was a problem. The only source of cotton that could come close to making up the shortfall from the US was in India. But Indian cotton differed from American cotton, and required an entirely different kind of processing. Within months of the shift to Indian cotton, new machinery was developed to process it.

As the demand for this new equipment soared, firms like Dobson and Barlow, who made textile machinery, saw profits take-off. We know about this firm, because detailed sales records have survived. It responded by increasing production of these new machines and other equipment. No mill could afford to be left behind in the rush to retool, because if it didn’t, it could not use the new raw materials. The result was, in the words of Douglas Farnie, a historian who specialized in the history of cotton production, ‘such an extensive investment of capital that it amounted almost to the creation of a new industry.’

The lesson for economists: Lincoln ordered the blockade, but in what followed, the farmers and sellers who increased the price of cotton were not responding to orders. Neither were the mill owners who cut back the output of textiles and laid off the mill workers, nor were the mill owners desperately searching for new sources of raw material. By ordering new machinery, the mill owners set off a boom in investment and new jobs.

All of these decisions took place over a matter of months, by millions of people, most of whom were total strangers to one another, each seeking to make the best of a totally new economic situation. American cotton was now scarcer, and people responded, from the cotton fields of Maharashtra in India to the Nile delta, to Brazil, and the Lancashire mills.

To understand how the change in the price of cotton transformed the world cotton and textile production system, think about the prices determined by markets as messages. The increase in the price of US cotton shouted: ‘find other sources, and find new technologies appropriate for their use.’ Similarly, when the price of petrol rises, the message to the car driver is: ‘take the train’, which is passed on to the railway operator: ‘there are profits to be made by running more train services’. When the price of electricity goes up, the firm or the family is being told: ‘think about installing photovoltaic cells on the roof.’

In many cases—like the chain of events that began at Lincoln’s desk on 12 April 1861—the messages make sense not only for individual firms and families but also for society: 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. By finding an alternative, the individual is saving money and conserving society’s resources. This is because, in some conditions, prices provide an accurate measure of the scarcity of a good or service.1

In planned economies, which operated in the Soviet Union and other central and eastern European countries before the 1990s (discussed in Unit 1), messages about how things would be produced are sent deliberately by government experts. They decide what will be produced and at what price it will be sold. The same is true, as we saw in Unit 6, inside large firms like General Motors, where managers (and not prices) determine who does what.

The amazing thing about prices determined by markets is that individuals do not send the messages, but rather the anonymous interaction of sometimes millions of people. And when conditions change—a cheaper way of producing bread, for example—nobody has to change the message (‘put bread instead of potatoes on the table tonight’). A price change results from a change in firms’ costs. The reduced price of bread says it all.

8.1 Buying and selling: Demand and supply

willingness to pay (WTP)An indicator of how much a person values a good, measured by the maximum amount he or she would pay to acquire a unit of the good. See also: willingness to accept.

In Unit 7 we considered the case of a good produced and sold by just one firm. There was one seller with many buyers in the market for that product. In this unit, we look at markets where many buyers and sellers interact, and show how the competitive market price is determined by both the preferences of consumers and the costs of suppliers. When there are many firms producing the same product, each firm’s decisions are affected by the behaviour of competing firms, as well as consumers.

For a simple model of a market with many buyers and sellers, think about the potential for trade in second-hand copies of a recommended textbook for a university economics course. Demand for the book comes from students who are about to begin the course, and they will differ in their willingness to pay (WTP). No one will pay more than the price of a new copy in the campus bookshop. Below that, students’ WTP may depend on how hard they work, how important they think the book is, and on their available resources for buying books.

Often when you buy something you don’t need to think about your exact willingness to pay. You just decide whether to pay the asking price. But WTP is a useful concept for buyers in online auctions, such as eBay.

If you want to bid for an item, one way to do it is to set a maximum bid equal to your WTP, which will be kept secret from other bidders: this article explains how to do it on eBay. eBay will place bids automatically on your behalf until you are the highest bidder, or until your maximum is reached. You will win the auction if, and only if, the highest bid is less than or equal to your WTP.

willingness to accept (WTA)The reservation price of a potential seller, who will be willing to sell a unit only for a price at least this high. See also: willingness to pay.

Figure 8.1 shows the demand curve. As in Unit 7, we line up all the consumers in order of willingness to pay, highest first. The first student is willing to pay $20, the 20th $10, and so on. For any price, P, the graph tells you how many students would be willing to buy: it is the number whose WTP is at or above P.

The tables below show the reservation values of buyers and sellers in the market for used iphones.
Alfred Marshall (1842–1924) was a founder—with Léon Walras—of what is termed the neoclassical school of economics. His Principles of Economics, first published in 1890, was the standard introductory textbook for English speaking students for 50 years. An excellent mathematician, Marshall provided new foundations for the analysis of supply and demand by using calculus to formulate the workings of markets and firms, and express key concepts such as marginal costs and marginal utility. The concepts of consumer and producer surplus are also due to Marshall. His conception of economics as an attempt to ‘understand the influences exerted on the quality and tone of a man’s life by the manner in which he earns his livelihood …’ is close to our own definition of the field.2

Sadly, much of the wisdom in Marshall’s text has rarely been taught by his followers. Marshall paid attention to facts. His observation that large firms could produce at lower unit costs than small firms was integral to his thinking, but it never found a place in the neoclassical school. This may be because if the average cost curve is downward-sloping even when firms are very large, there will be a kind of winner-takes-all competition in which a few large firms emerge as winners with the power to set prices, rather than taking the going price as a given. We return to this problem in Unit 12 and Unit 21.

Marshall would also have been distressed that homo economicus (whose existence we questioned in Unit 4) became the main actor in textbooks written by the followers of the neoclassical school. He insisted that:

Ethical forces are among those of which the economist has to take account. Attempts have indeed been made to construct an abstract science with regard to the actions of an economic man who is under no ethical influences and who pursues pecuniary gain … selfishly. But they have not been successful. (Principles of Economics, 1890)

While advancing the use of mathematics in economics, he also cautioned against its misuse. In a letter to A. L. Bowley, a fellow mathematically inclined economist, he explained his own ‘rules’ as follows:

  1. Use mathematics as a shorthand language, rather than as an engine of inquiry
  2. Keep to them [that is, stick to the maths] till you have done
  3. Translate into English
  4. Then illustrate by examples that are important in real life
  5. Burn the mathematics
  6. If you can’t succeed in 4, burn 3: ‘This I do often.’

Marshall was Professor of Political Economy at the University of Cambridge between 1885 and 1908. In 1896 he circulated a pamphlet to the University Senate objecting to a proposal to allow women to be granted degrees. Marshall prevailed and women would wait until 1948 before being granted academic standing at Cambridge on a par with men.

But his work was motivated by a desire to improve the material conditions of working people:

Now at last we are setting ourselves seriously to inquire whether it is necessary that there should be any so called lower classes at all: that is whether there need be large numbers of people doomed from their birth to hard work in order to provide for others the requisites of a refined and cultured life, while they themselves are prevented by their poverty and toil from having any share or part in that life. … The answer depends in a great measure upon facts and inferences, which are within the province of economics; and this is it which gives to economic studies their chief and their highest interest. (Principles of Economics, 1890)

Would Marshall now be satisfied with the contribution that modern economics has made to creating a more just economy?

To apply the supply and demand model to the textbook market, we assume that all the books are identical (although in practice some may be in better condition than others) and that a potential seller can advertise a book for sale by announcing its price on a local website. As at the Corn Exchange, we would expect that most trades would occur at similar prices. Buyers and sellers can easily observe all the advertised prices, so if some books were advertised at $10 and others at $5, buyers would be queuing to pay $5, and these sellers would quickly realize that they could charge more, while no one would want to pay $10 so these sellers would have to lower their price.

market-clearing priceAt this price there is no excess supply or excess demand. See also: equilibrium.equilibriumA model outcome that is self-perpetuating. In this case, something of interest does not change unless an outside or external force is introduced that alters the model’s description of the situation.

We can find the equilibrium price by drawing the supply and demand curves on one diagram, as in Figure 8.3. At a price P* = $8, the supply of books is equal to demand: 24 buyers are willing to pay $8, and 24 sellers are willing to sell. The equilibrium quantity is Q* = 24.

The tables below show the reservation values of buyers and sellers in the market for used iphones.
Léon Walras (1834–1910) was a founder of the neoclassical school of economics. He was an indifferent student, and twice failed the entrance exam to the École Polytechnique in Paris, one of the most prestigious universities in his native France. He studied engineering at the School of Mines instead. Eventually his father, an economist, convinced him to take up the challenge of making economics into a science.

The pure economic science to which he aspired was the study of relationships among things, not people, and he had notable success in eliminating human relationships from his modelling. ‘The pure theory of economics,’ he wrote, ‘resembles the physico-mathematical sciences in every respect.’

His device for simplifying the economy so that it could be expressed mathematically was to represent interactions among economic agents as if they were relationships among inputs and outputs, and to focus entirely on the economy in equilibrium. In the process the entrepreneur, a key actor in wealth creation from the Industrial Revolution to today, simply disappeared from Walrasian economics:

Assuming equilibrium, we may even go so far as to abstract from entrepreneurs and simply consider the productive services as being, in a certain sense, exchanged directly for one another … (Elements of Theoretical Economics, 1874)8

Walras represented basic economic relationships as equations, which he used to study the workings of an entire economy composed of many interlinked markets. Prior to Walras, most economists had considered these markets in isolation: they would have studied, for example, how the price of textiles is determined on the cloth market, or land rents on the land market.

A century before Walras, a group of French economists called the physiocrats had studied the circulation of goods throughout the economy, as if the flow of goods from one sector to another in the economy was comparable to the circulation of blood in the human body (one of the leading physiocrats was a medical doctor). But the physiocrats’ model was little more than a metaphor that drew attention to the interconnectedness of markets.

Walras used mathematics, rather than medical analogies, to create what is now called general equilibrium theory, a mathematical model of an entire economy in which all buyers and sellers act as price-takers and supply equals demand in all markets. Walras’ work was the basis of the proof, much later, of the invisible hand theorem, giving the conditions under which such an equilibrium is Pareto efficient. The invisible hand game in Unit 4 is an example of the conditions in which the pursuit of self-interest can benefit everyone.

Walras had defended the right to private property, but to help the working poor he also advocated the nationalization of land and the elimination of taxes on wages.

Seven years after his death, the general equilibrium model was to play an important role in the debate about the feasibility and desirability of centralized economic planning compared to a market economy. In 1917, the Bolshevik Revolution in Russia put the economics of socialism and central planning on the agenda of many economists, but surprisingly, it was the defenders of central planning, not the advocates of the market, who used Walras’ insights to make their points.

Friedrich Hayek, and other defenders of capitalism, criticized the Walrasian general equilibrium model. Their argument: by deliberately ignoring the fact that a capitalist economy is constantly changing, and therefore not taking into account the contribution of entrepreneurship and creativity in market competition, Walras had missed the true virtues of the market.

The model of perfect competition describes an idealized market structure in which we can be confident that the assumption of price-taking that underlies our model of supply and demand will hold. Markets for agricultural products such as wheat, rice, coffee, or tomatoes look rather like this, although goods are not truly identical, and it is unlikely that everyone is aware of all the prices at which trade takes place. But it is nevertheless clear that they have very little, if any, power to affect the price at which they trade.

In other cases—for example, markets where there are some differences in the quality of goods—there may still be enough competition that we can assume price-taking, in order to obtain a simple model of how the market works. A simplified model can provide useful predictions when the assumptions underlying it are only approximately true. Judging whether or not it is appropriate to draw conclusions about the real world from a simplified model is an important skill of economic analysis.

For example, we know that markets are not perfectly competitive when products are differentiated. Consumers’ preferences differ, and we saw in Unit 7 that firms have an incentive to differentiate their product, if they can, rather than to supply a product similar or identical to others. Nevertheless, the model of supply and demand can be a useful approximation to help us to understand how some markets for non-identical products behave.

Figure 8.18 shows the market for an imaginary product called Choccos, for which there are close substitutes, as many similar products compete in the wider market for chocolate bars. Due to competition from other chocolate bars, the demand curve is almost flat. The range of feasible prices for Choccos is narrow, and the firm chooses a price and quantity where the marginal cost is close to the price. So this firm is in a similar situation to a firm in a perfectly competitive market. It is the equilibrium price in the larger market for chocolate bars that determines the feasible prices for Choccos—they have to be sold at a similar price to other chocolate bars.

The market for Choccos
: In this diagram, the horizontal axis shows the quantity of Choccos and the vertical axis shows the price. A downward-sloping line is labelled Demand curve. A downward-sloping convex curve is labelled Isoprofit curve and is tangent to the Demand curve. An upward-sloping line is lablled Marginal cost of Choccos and intersects the isoprofit curve at the point where it is tangent to the Demand curve.

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The market for Choccos

The left hand panel shows the market for Choccos, produced by one firm. There are many close substitutes in the wider market for chocolate bars.

The demand curve for Choccos
: In this diagram, the horizontal axis shows the quantity of Choccos and the vertical axis shows the price. A downward-sloping line is labelled Demand curve. It has a shallow slope, indicating a narrow range of feasible prices. A downward-sloping convex curve is labelled Isoprofit curve and is tangent to the Demand curve. An upward-sloping line is lablled Marginal cost of Choccos and intersects the isoprofit curve at the point where it is tangent to the Demand curve.

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The demand curve for Choccos

Due to competition from similar chocolate bars, the demand curve for Choccos is almost flat. The range of feasible prices is narrow.

The price of Choccos
: In this diagram, the horizontal axis shows the quantity of Choccos and the vertical axis shows the price. Coordinates are (quantity, price). A downward-sloping line is labelled Demand curve. It has a shallow slope, indicating a narrow range of feasible prices. A downward-sloping convex curve is labelled Isoprofit curve and is tangent to the Demand curve. An upward-sloping line is lablled Marginal cost of Choccos and intersects the isoprofit curve at the point where it is tangent to the Demand curve. The firm chooses to produce at point A with coordinates (q-star, p-star), which is at a lower quantity and higher price than the point of tangency.

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The price of Choccos

The firm chooses a price P* similar to its competitors, and a quantity where MC is close to P*. Whatever the price of its competitors, it would produce close to its marginal cost curve. So the firm’s MC curve is approximately its supply curve.

The market supply curve for chocolate bars
: There are two diagrams. In Diagram 1, the horizontal axis shows the quantity of Choccos and the vertical axis shows the price. Coordinates are (quantity, price). A downward-sloping line is labelled Demand curve. It has a shallow slope, indicating a narrow range of feasible prices. A downward-sloping convex curve is labelled Isoprofit curve and is tangent to the Demand curve. An upward-sloping line is lablled Marginal cost of Choccos and intersects the isoprofit curve at the point where it is tangent to the Demand curve. The firm chooses to produce at point A with coordinates (q-star, p-star), which is at a lower quantity and higher price than the point of tangency. In Diagram 2, the horizontal axis shows the total quantity of chocolate bars and the vertical axis shows the price. An upward-sloping line is labelled Market supply (MC).

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The market supply curve for chocolate bars

We can construct the market supply curve for chocolate bars in the right hand panel by adding the quantities from the marginal cost curves of all the chocolate bar producers.

The market demand curve for chocolate bars
: There are two diagrams. In Diagram 1, the horizontal axis shows the quantity of Choccos and the vertical axis shows the price. Coordinates are (quantity, price). A downward-sloping line is labelled Demand curve. It has a shallow slope, indicating a narrow range of feasible prices. A downward-sloping convex curve is labelled Isoprofit curve and is tangent to the Demand curve. An upward-sloping line is lablled Marginal cost of Choccos and intersects the isoprofit curve at the point where it is tangent to the Demand curve. The firm chooses to produce at point A with coordinates (q-star, p-star), which is at a lower quantity and higher price than the point of tangency. In Diagram 2, the horizontal axis shows the total quantity of chocolate bars and the vertical axis shows the price. An upward-sloping line is labelled Market supply (MC). A downward-sloping line intersects the Market supply curve and is labelled Demand for chocolate bars.

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The market demand curve for chocolate bars

If most consumers do not have strong preferences for one firm’s product, we can draw a market demand curve for chocolate bars.

The demand curve for Choccos
: There are two diagrams. In Diagram 1, the horizontal axis shows the quantity of Choccos and the vertical axis shows the price. Coordinates are (quantity, price). A downward-sloping line is labelled Demand curve. It has a shallow slope, indicating a narrow range of feasible prices. A downward-sloping convex curve is labelled Isoprofit curve and is tangent to the Demand curve. An upward-sloping line is lablled Marginal cost of Choccos and intersects the isoprofit curve at the point where it is tangent to the Demand curve. The firm chooses to produce at point A with coordinates (q-star, p-star), which is at a lower quantity and higher price than the point of tangency. In Diagram 2, the horizontal axis shows the total quantity of chocolate bars and the vertical axis shows the price. An upward-sloping line is labelled Market supply (MC). A downward-sloping line intersects the Market supply curve and is labelled Demand for chocolate bars. The point of intersection is labelled B.

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The demand curve for Choccos

The equilibrium price in the chocolate bar market (right-hand panel) determines the narrow range of prices from which the Chocco firm can choose (left-hand panel)—it will have to set a price quite close to that of other chocolate bars.

The narrow range of feasible prices for this firm is determined by the behaviour of its competitors. So the main influence on the price of Choccos is not the firm, but the market for chocolate bars as a whole. Since all the firms will be producing at similar prices, which will be close to their marginal costs, we lose little by ignoring the differences between them and assuming that each firm’s supply curve is its marginal cost curve, then finding the equilibrium in the wider market for chocolate bars.

We have already taken this approach when we analysed the Danish butter market. In practice, it is likely that some retailers who sell butter have some power to set prices. A local shop may be able to set a price that is higher than the price of butter elsewhere, knowing that some shoppers will find it convenient to buy rather than searching for a lower price. However, it is reasonable to assume that they don’t have much wiggle room to set prices, and are strongly influenced by the prevailing market price. So price-taking is a good approximation for this market—good enough, at least, that the supply and demand model can help us to understand the impact of a fat tax.

We have used chocolate bars as a hypothetical example of an approximately competitive market. But in recent years, producers of best-selling chocolate bars worldwide have been accused of colluding with each other to keep prices high. Use the information in this article to explain:

  1. In what ways does the market for chocolate bars fail to satisfy the conditions for perfect competition?
  2. Each brand of chocolate bar faces competition from many other similar brands. Why, despite this, do some producers have considerable market power?
  3. In what market conditions do you think price-fixing is most likely to occur, and why?

Look again at Figure 8.18, which shows the market for Choccos and for all chocolate bars. Based on the two diagrams, which of the following statements is correct?

  • The firm that makes Choccos chooses to produce at the bottom of the U-shaped isoprofit curve.
  • All chocolate bars will be sold at the same price P*.
  • The existence of many competitors means that the firm is a price-taker.
  • The market marginal cost (MC) curve is approximately the sum of the MC curves of all the producers of the chocolate bars.
  • The firm chooses to produce where the isoprofit curve is tangent to the firm’s demand curve. As the demand curve is not quite horizontal, this point will be close to, but not at, the bottom of the U-shape.
  • The chocolate bars are not perfect substitutes. They will be sold at similar but not exactly the same prices.
  • The left-hand diagram shows that the firm has a downward-sloping demand curve, so it can choose from a narrow range of prices.
  • Each firm produces close to its MC curve, so the MC curve is approximately the firm’s supply curve, and so market supply is approximately the sum of the firms’ MC curves.

8.9 Looking for competitive equilibria

If we look at a market in which conditions seem to favour perfect competition—many buyers and sellers of identical goods, acting independently—how can we tell whether it satisfies the conditions for a competitive equilibrium? Economists have used two tests:

  1. Do all trades take place at the same price?
  2. Are firms selling goods at a price equal to marginal cost?

The difficulty with the second test is that it is often difficult to measure marginal cost. But Lawrence Ausubel, an economist, was able to do this for the US bank credit card market in the 1980s. At this time 4,000 banks were selling an identical product: credit card loans. The cards were mostly Visa or Mastercard, but the individual banks decided the price of their loans—that is, the interest rate. The banks’ cost of funds—the opportunity cost of the money loaned to credit card holders—could be deduced from other interest rates in financial markets. Although there were other components of marginal cost, the cost of funds was the only one that varied substantially over time. So if the credit card market were competitive, we would expect to see the interest rate on credit card loans rise and fall with the cost of funds.

By comparing the credit card interest rate with the cost of funds over a period of eight years, Ausubel found that this didn’t happen. When the cost of funds fell from 15% to below 7%, there seemed to be almost no effect on the price of credit card loans.9

Why do the banks not cut their interest rates when their costs fall? He suggested two different possibilities:

  • It may be difficult for consumers to change credit card provider: In that case, the banks are not forced to compete with each other, so they keep prices high when costs fall.
  • Banks might not be able to decide which of their customers are bad risks: That would be a problem in this market, because the bad risks are most sensitive to prices. The banks do not want to lower their prices for fear of attracting the wrong kind of customer.

Perfect competition requires that consumers are sufficiently sensitive to prices to force firms to compete, and this may not be the case in any market where consumers have to search for products. If it takes time and effort to check prices and inspect products, they may decide to buy as soon as they find something suitable, rather than continue the search for the cheapest. When the Internet made online shopping feasible, many economists hypothesized that this would make retail markets more competitive: consumers would easily be able to check the prices of many suppliers before deciding to buy.

But often consumers are not very sensitive to prices, even in this environment.10 You can test the law of one price in online retail competition for yourself, by checking the prices of a particular product that should be the same wherever you buy it—a book or household appliance, for example—and comparing them. Figure 8.19 shows the prices of UK online retailers for a particular DVD in March 2014. The range of prices is high: the most expensive seller is charging 66% more than the cheapest.

The Hobbit: An Unexpected Journey
Supplier Price including postage (£)
Game 14.99
Amazon UK 15.00
Tesco 15.00
Asda 15.00
Base.com 16.99
Play.com 17.79
Savvi 17.95
The HUT 18.25
I want one of those 18.25
Hive.com 21.11
MovieMail.com 21.49
Blackwell 24.99

Differing prices for the same DVD, from UK online retailers (March 2014).

Figure 8.19 Differing prices for the same DVD, from UK online retailers (March 2014).

From the early nineteenth century, the catches of Atlantic fisherman landed in the port of New York were sold at the Fulton Fish Market in Manhattan (in 2005, it relocated to the Bronx) to restaurants and retailers. It is still the largest market for fresh fish in the US, although fish are now brought in by road or air. Dealers do not display prices. Instead, customers can inspect the fish and ask for a price before making their decision, making it an institution that appears to encourage competition.

Kathryn Graddy, an economist who specializes in how prices are set, studied the Fulton Fish Market. There were about 35 dealers, with stalls close to each other, so customers could easily observe the quantity and quality of fish available and ask several dealers for a price. She used details of 3,357 sales of whiting by one dealer, including price, quantity, and quality of fish, and characteristics of the buyers.11 12

Of course, prices were not the same for every transaction: quality varied, and fish supplies changed from day to day. But her surprising observation was that on average Asian buyers paid about 7% less per pound than white buyers (all of the dealers were white). There seemed to be no differences between the transactions with white and Asian buyers that could explain the different prices.

How could this happen? If one dealer was setting high prices for white buyers, why did other dealers not try to attract them to their own stalls by offering a better deal? Watch our interview with Graddy to find out how she collected her data, and what she discovered about the model of perfect competition.

In theory, the easy access to price information across the market should have allowed all buyers to quickly find very similar prices. But in practice, Graddy observed that bargaining occurred rarely, and then only with buyers of large quantities.

Graddy observed that dealers knew that, in practice, white buyers were willing to take higher prices than Asian buyers. The dealers knew this without having to collude in setting their prices.

The examples in this section show that it is hard to find evidence of perfect competition. Nevertheless, we have seen that the model can be a useful approximation. Even if the conditions for perfect competition are not all satisfied, the model of supply and demand is a valuable tool for economic analysis, applicable when there is enough competition that individuals have little influence on prices.

Choose any published textbook that you have been using in your course. Go on to the web and find the price you can buy this book for from a number of different suppliers (Amazon, eBay, your local bookstore, and so on).

Is there dispersion in prices, and if so, how can you explain it?

Watch Kathryn Graddy’s video.

  1. How does she explain her evidence that the law of one price did not hold in the fish market?
  2. Why did buyers and sellers not look for better deals?
  3. Why did new dealers not enter the market in pursuit of economic rents?

8.10 Price-setting and price-taking firms

We now have two different models of how firms behave. In the Unit 7 model, the firm produces a product that is different from the products of other firms, giving it market power—the power to set its own price. This model applies to the extreme case of a monopolist, who has no competitors at all, such as water supply companies, and national airlines with exclusive rights granted by the government to operate domestic flights. The Unit 7 model also applies to a firm producing differentiated products such as breakfast cereals, cars, or chocolate bars—similar, but not identical, to those of its competitors. In such cases, the firm still has the power to set its own price. But if it has close competitors, demand will be quite elastic and the range of feasible prices will be narrow.

In the supply-and-demand model developed in this unit, firms are price-takers. Competition from other firms producing identical products means that they have no power to set their own prices. This model can be useful as an approximate description of a market in which there are many firms selling very similar products, even if the idealized conditions for a perfectly competitive market do not hold.

In practice, economies are a mixture of more and less competitive markets. In some respects, firms act the same whether they are the single seller of a good or one of a great many competitors: all firms decide how much to produce, which technologies to use, how many people to hire, and how much to pay them so as to maximize their profits.

But there are important differences. Look back at the decisions made by price-setting firms to maximize profits (Figure 7.2). Firms in more competitive markets lack either the incentive or the opportunity to do some of these things.

public goodA good for which use by one person does not reduce its availability to others. Also known as: non-rival good. See also: non-excludable public good, artificially scarce good.

A firm with a unique product will advertise (Buy Nike!) to shift the demand curve for its product to the right. But why would a single competitive firm advertise (Drink milk!)? This would shift the demand curve for all of the firms in the industry. Advertising in a competitive market is a public good: the benefits go to all of the firms in the industry. If you see a message like ‘Drink milk!’ it is probably paid for by an association of dairies, not by a particular one.

The same is true of expenditures to influence public policy. If a large firm with market power is successful, for example, in relaxing environmental regulations, then it will benefit directly. But activities like lobbying or contri­buting money to electoral campaigns will be unattractive to the competitive firm because the result (a more profit-friendly policy) is a public good.

Similarly, investment in developing new technologies is likely to be undertaken by firms facing little competition, because if they are successful in finding a profitable innovation, the benefits will not be lost to competitors also adopting it. However, one way that successful large firms can emerge is by breaking away from the competition and innovating with a new product. The UK’s largest organic dairy, Yeo Valley, was once an ordinary farm selling milk, just like thousands of others. In 1994 it established an organic brand, creating new products for which it could charge premium prices. With the help of imaginative marketing campaigns it has grown into a company with 1,800 employees and 65% of the UK organic market.

The table in Figure 8.20 summarizes the differences between price-setting and price-taking firms.

Price-setting firm or monopoly Firm in a perfectly competitive market
Sets price and quantity to maximize profits (‘price-maker’) Takes market determined price as given and chooses quantity to maximize profits (‘price-taker’)
Chooses an output level at which marginal cost is less than price Chooses an output level at which marginal cost equals price
Deadweight losses (Pareto inefficient) No deadweight losses for consumers and firms (can be Pareto efficient if no one else in the economy is affected)
Owners receive economic rents (profits greater than normal profits) If the owners receive economic rents, the rents are likely to disappear as more firms enter the market
Firms advertise their unique product Little advertising: it costs the firm, but benefits all firms (it’s a public good)
Firms may spend money to influence elections, legislation and regulation Little expenditure by individual firms on this (same as advertising)
Firms invest in research and innovation; seek to prevent copying Little incentive for innovation; others will copy (unless the firm can succeed in differentiating its product and escaping from the competitive market)

Price-setting and price-taking firms.

Figure 8.20 Price-setting and price-taking firms.

8.11 Conclusion

Buyers or sellers who have little influence on market prices, due to competition, are called price-takers. A market is in competitive equilibrium if all buyers and sellers are price-takers, and at the prevailing market price, the quantity supplied is equal to the quantity demanded (the market clears).

Price-taking firms choose their quantity so that the marginal cost is equal to the market price. The equilibrium allocation exploits all possible gains from trade.

The model of perfect competition describes a set of idealized market conditions in which we would expect a competitive equilibrium to occur. Markets for real goods don’t conform exactly to the model. But price-taking can be a useful approximation, enabling us to use supply and demand curves as a tool for understanding market outcomes, for example, the effects of a tax, or a demand shock.

Before you move on, review these definitions:

8.12 References

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