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COMPETITIVE
GOODS MARKETS
The effect of competition on the ability of individual buyers or sellers to influence prices.
The similarities and differences between firms in competitive markets and firms with
monopoly power.
See www.core-econ.org for the full interactive version of The Economy by The CORE Project.
Guide yourself through key concepts with clickable figures, test your understanding with multiple choice
questions, look up key terms in the glossary, read full mathematical derivations in the Leibniz supplements,
watch economists explain their work in Economists in Action and much more.
Funded by the Institute for New Economic Thinking with additional funding from Azim Premji University and Sciences Po
as an example 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 the
available resources for buying books.
Figure 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.
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Demand curve
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Supply curve
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INTERACT
Follow figures click-by-click in the full interactive version at www.core-econ.org.
Now, if you choose a particular price, say $10, the graph shows how many books
would be supplied (Q) at that price: in this case, it is 32. The supply curve slopes
upward: the higher the price, the more students will be willing to sell.
Notice that we have drawn the supply and demand curves as straight lines for
simplicity. In practice they are more likely to be curves, with shapes depending on
how valuations of the book vary amongst the students.
what would you expect to happen in the market for this textbook? That will
depend on the market institutions that bring buyers and sellers together. If students
have to rely on word-of-mouth, then when a buyer happens to find a seller they can
try to negotiate a deal that suits both of them. But each buyer would like to be able
to find a seller with a low reservation price, and each seller would like to find a buyer
with high willingness to pay. Before concluding a deal with one trading partner they
would like to know about other trading opportunities.
Traditional market institutions often brought many buyers and sellers together
in one place. Many of the worlds great cities grew up around marketplaces and
bazaars along ancient trading routes such as the Silk Road between China and the
PAST ECONOMISTS
ALFRED MARSHALL
Alfred Marshall (1842-1924) was Professor
of Political Economy at the University of
Cambridge between 1885-1908. His work
was motivated by a desire to improve the
material conditions of working people.
Countering the prevailing pessimism, he
realised that wages would rise if labour
productivity could be improved. His
Principles of Economics, published in 1890,
laid out the supply and demand framework,
and emphasised the importance of marginal
quantities. Other economists were working
on similar ideas, but it was Marshall who
developed them fully over a period of 20
years before publishing them. John Maynard
Keynes paid tribute to Marshalls achievement by comparing it with the lessdeveloped work of Stanley Jevons, considered one of the greatest economists of the
1870s: Jevons saw the kettle boil and cried out with the delighted voice of a child;
Marshall too had seen the kettle boil and sat down silently to build an engine.
By drawing the supply and demand curves on one diagram, as in Figure 3, we can
find the equilibrium price in this market. 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 as shown by point A in Figure 3.
At the equilibrium price, all those who wish to buy or sell are able to do so. If the
price were higher than $8, more students would wish to sell, but not all of them
would find buyers, so the sellers would want to lower the price. If it were lower, there
would be more buyers than sellers, and the sellers would realise that they could raise
the price. There no tendency for change only at exactly $8.
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Price, P
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Supply curve
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P*
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Demand curve
0
10
20
Q*
30
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Quantity, Q, of books
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4.0
Supply
3.6
3.2
2.8
2.0
1.6
Period 5
Demand
Period 4
0.4
Period 3
0.8
Period 2
1.2
Period 1
Price ($)
2.4
0 1 2 3 4 5 6 7 8 9 10 11 12
01234512345123451234567123456
Quantity
Results like these suggest that the perfect competition model provides a good
prediction of what will happen in a market where goods are identical, and there
are enough buyers and sellers, who are well-informed about trading by others, to
generate competition. The outcome was close to equilibrium even in the first period,
and converged quickly towards it subsequently as the participants learned more
about supply and demand, just as Marshall argued that it would do.
But although prices may adjust to equalise demand and supply in controlled
laboratory conditions, we shouldnt necessarily expect this to happen in real markets
for all kinds of goods. We will look later in this unit at evidence suggesting that the
effects of competition on prices may be weak, and in Unit 9 at some examples where
prices do not clear markets.
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in the second-hand textbook example, both buyers and sellers are individual
consumers. Now we look at markets where the sellers are firms. In Unit 7 we analysed
the decisions of a firm producing a differentiated good, and saw that if other firms
made similar products the demand curve would be almost flat. The firms choice of
price would be restricted, because raising its price would cause consumers to switch
to other, similar, brands.
What would happen if there were many firms producing identical products? If
consumers were well-informed about the suppliers of the product, and could easily
switch from one firm to another, then we would have a perfectly competitive market.
Firms would be price-takers, with no discretion over price at all.
To see how competition affects the behaviour of firms, consider a city where many
small bakeries produce bread and sell it direct to consumers. Figure 5 shows what
the market demand curvethe total daily demand for bread of all consumers in the
citymight look like. It is downward-sloping as usual because, at higher prices,
fewer consumers will be willing to pay.
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4.5
4.0
3.5
Price, P ()
3.0
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2.0
1.5
1.0
Demand curve
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2,000
3,000
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5,000
6,000
7,000
8,000
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10,000
Price, P; Cost ()
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5
Marginal cost curve
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P*
2
Isoprofit curve: 80
Zero-economic-profit
curve (AC curve)
Feasible set
1
0
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40
60
80
100
120
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160
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Figure 6. Isoprofit curves and marginal cost curve for the bakery.
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Isoprofit curve: 80
Zero economic profits
MC
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Price, P; Cost ()
Price, P; Cost ()
Supply curve
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3
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160
200
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the market for bread in the city is competitive: there are many consumers and
many bakeries. Lets suppose there are 50 bakeries in the city. Each one has a supply
curve corresponding to its own marginal cost curve, so we know how much it will
supply at any given market price. To find the market supply curve, we just add up the
total amount that all the bakeries, together, will supply at each price.
Figure 8 shows how this works if all the bakeries have the same cost functions. In
this case we know, for example, that if the price is 2.35, each bakery will produce
120 loaves, and we can say that the market supply at 2.35 is 50 x 120 = 6,000 loaves.
At a price of 1.52 they each supply 66 loaves, and market supply is 3,300.The market
supply curve looks like the firms supply curve, except that the scale on the horizontal
axis is different. If the bakeries have different cost functions, then at a price of
2.35 some bakeries will produce more loaves than others, but we can still add them
together to find market supply.
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Firm supply (marginal cost)
Price, P ()
Price, P ()
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2,000
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LEIBNIZ
For mathematical derivations of key concepts, download the Leibniz boxes from
www.core-econ.org.
Now we know both the demand curve (Figure 5), and the supply curve (Figure 8) for
the bread market as a whole. Figure 9 shows that the equilibrium price is exactly
2.00. At this price, the market clears: consumers demand 5,000 loaves per day, and
firms supply 5,000 loaves per day.
4.5
Supply
(marginal cost)
4.0
3.5
Price, P ()
3.0
2.5
A
2.0
1.5
1.0
Demand
0.5
0
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2,000
3,000
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8,000
9,000 10,000
we can calculate the gains from trade in a competitive market, as we did for
the markets in Unit 7. At the equilibrium price of 2 in the bread market, shown in
Figure 10, a consumer who is willing to pay 3.50 obtains a surplus of 1.50. The red
shaded area shows total consumer surplusthe sum of all the buyers gains from
trade. Remember from Unit 7 that the producers surplus on a unit of output is the
difference between the price at which it is sold, and the marginal cost of producing
it. The marginal cost of the 2,000th loaf, for example, is 1.25; since it is sold for 2,
the surplus is 0.75. The purple-shaded area is the sum of the bakeries surpluses on
every loaf that they produce. The whole shaded area shows the sum of all gains from
trade in this market, known as the total surplus.
4.5
Supply
(marginal cost)
4.0
3.5
3.0
Price, P ()
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Consumer
surplus
2.5
2.0
Producer
surplus
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1.0
Demand
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0
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EINSTEIN 1
However the market works, and whatever prices are paid, we can calculate the
consumer surplus by adding together the difference between WTP and price paid of
all the people who buy, and the producer surplus by adding together the difference
between price received and marginal cost of every unit of output:
Consumer surplus = sum of WTPs sum of prices paid
Producer surplus = sum of prices received sum of MCs of each unit
Then when we calculate the total surplus, the prices paid and received cancel out:
Total surplus = sum of WTPs of consumers sum of MCs of producers
The equilibrium allocation in the competitive market makes this as high as possible
by including the consumers with the highest WTPs, and the units of output with the
lowest marginal costs. Every trade involves a buyer with higher WTP than the sellers
reservation value, so the surplus would go down if we omitted any of them. And if we
tried to include any more units of output in this calculation, the surplus would also
go down because the WTPs would be lower than the MCs.
In other words, it is not possible to make any of the consumers or firms better off
(that is, to increase the surplus of any individual) without making at least one of
them worse off. Provided that what happens in this market does not affect anyone
other than the participating buyers and sellers, we can say the equilibrium allocation
is Pareto efficient (We will consider below a case where this is not true, when noise
from the bakeries disturbs their neighbours). To find out how to calculate the total
surplus of a Pareto-efficient allocation using calculus, see LEIBNIZ 17.
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4.5
Supply
(marginal cost)
4.0
3.5
Price, P ()
3.0
Consumer
surplus
2.5
DWL
2.0
Producer
surplus
1.5
1.0
Demand
0.5
0
1,000
2,000
3,000
4,000
5,000
6,000
7,000
8,000
9,000 10,000
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Cost of funds
5
0
1982
1983
1984
1985
1986
1987
1988
1989
PRICE INCLUDING
POSTAGE ($)
Game
14.99
Amazon UK
15.00
Tesco
15.00
Asda
15.00
Base.com
16.99
Play.com
17.79
Zavvi
17.95
The HUT
18.25
18.25
Hive.com
21.11
MovieMail.com
21.49
Blackwell
24.99
Figure 12. Differing prices for the same DVD, from UK online retailers, March 2014.
Source: Bitcoincharts.com, accessed 14 January 2014.
The economist Katy Graddy studied the Fulton Fish Market in Manhattan, an
institution that appeared to encourage competition. There were about 35 dealers,
with stalls close to each other; customers could easily observe the quantity and
quality of fish available and ask several dealers for a price. She recorded details of
2,868 sales of whiting by one dealer, including price, quantity and quality of fish, and
characteristics of the buyers.
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the evidence in the previous section suggests that many real markets do not
conform to the model of perfect competition. So how should we assess the model? Is
it still useful? Why dont we see more cases of perfectly competitive markets?
We have encountered some reasons already. For example, buyers or sellers may
not be well-informed about the prices at which others are trading, as in the case
of the Fulton fish market. Another reason that the market for a product may not
be perfectly competitive is if the market demand function and the production cost
function, together, are not compatible with perfect competition.
To understand how this can happen, remember that in the face of competition from
other firms, the best a firm can do is to produce where its marginal cost is equal to
the market price. If you look back at the isoprofit curves and the marginal cost curve
for the bakery in Figure 7 you will see that it must sell at least 66 loaves at a price
of at least 1.52, if it is to make normal profits. It must operate at a scale where its
marginal cost is at least as high at its average cost. In a small town there may not be
enough demand for bread to sustain a market with many firms. For example, if the
market demand for bread was 80 at a price of 1.52 there wouldnt even be enough
demand to support two bakeries. One bakery could survive, but then the market
would no longer be competitive and the bakery could choose its own price.
This may seem to be an extreme example. But it is true, in general, that a firm in a
competitive market can only make normal profits if it can operate at a scale where its
marginal cost is greater than or equal to its average costthat is, where its average
cost is rising. If the cost function for a product is such that the average cost is high
at low levels of output and the marginal cost rises slowly, if at all, then perfect
competition may be impossible.
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Isoprofit
curve
P*
A
Demand
for Choccos
Market
supply (MC)
Price, P ($)
Price, P ($)
Marginal cost
of Choccos
Demand for
chocolate bars
Q*
Quantity of Choccos
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 firms supply curve is its
marginal cost curve. Then we can construct the market supply curve in Figure 13b by
finding the total number of chocolate bars produced at each price. Similarly, if most
consumers do not have strong preferences for one manufacturers product, we can
draw a market demand curve for chocolate bars. Then, looking back at Figure 13a,
we can see that it is the equilibrium price for chocolate bars at B that determines the
decisions of the producer of Choccos.
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8.9 CONCLUSION
looking back over Units 7 and 8 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 powerthe power to set its own price.
This model applies to the case of a monopolist, who has no competitors; common
examples are water supply companies, and national airlines with exclusive rights
granted by the government to operate domestic flights.
The price-setting model also applies to firm producing differentiated products such
as breakfast cereals, cars, or chocolate barssimilar, but not identical, to those
of their competitors. In this case the firm still has the power to set its own price,
although if it has close competitors demand will be quite elastic and the range of
feasible prices narrow.
In the model of a perfectly competitive market, 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. We have seen that this model can be
useful as an approximate description of a market in which there are firms producing
very similar products, even if they are not identical.
In practice economies are a mixture of more competitive markets, and less
competitive ones in which firms have more power to set pricesmonopoly power.
But in some respects firms act the same whether they are the single seller of a good
or one of a great many competitors. Most important among their similarities, 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 maximise their profits.
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1. In a market with many buyers and sellers, individuals and firms have little influence
on prices, due to competition. They are called price-takers.
2. When a perfectly competitive market is in equilibrium, all trade takes place at the
equilibrium price, and the market clears.
3. A perfectly competitive market would exploit all possible gains from trade,
eliminating all deadweight losses to consumers and firms. Most markets for real goods
dont conform exactly to the model of perfect competition, but it can be a useful
approximation.
4. Firms in competitive and single firm markets alike seek to maximise profits but the
former are restricted in the ways they can pursue this objective.
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