Unit 8 - 'Supply and demand, price-taking
in competitive markets'. In this video I'm
going to talk about the competitive markets.
The approach that I'm taking is that to fully
understand the competitive market, we need to
compare it to a market that is non-competitive.
So I'm going to talk about, and compare and
contrast, a competitive market to a monopoly
market that we discussed during the previous
video. So let's start. So let me scroll down
and start analyzing a competitive market from
the perspective of one single firm. So we go
to 8.3 - 'Price-taking firms'. Let me remind
you we're looking at a competitive market from a
perspective of one single firm . Then I'm going
to talk about the aggregate level. Now let me
introduce the monopoly market that we studied in
Unit 7 on the right-hand side of our screen. So on
the right-hand side we have a monopoly market, on
the left-hand side we have a competitive market.
Let's compare and contrast the features of
these two markets. On the monopoly market if
you remember we had just one firm, Beautiful
Cars, selling a luxury car - a differentiated
product. Beautiful Cars were spending a lot of
money on advertisement in order to differentiate
its product. So Beautiful Cars is a monopoly -
it is not competing with other firms. But on the
left-hand side is the competitive market. We've
got a bakery - we 've got one bakery among many,
many, many bakeries, so our firm is competing
with many firms on the competitive market. Now
this bakery in the competitive market is selling
a standardized product - bread. I know that in
reality you've got differentiation in breads
- you've got olive bread, cheese burgers,
organic bread, but we can think of bread as
a good example, as an example which gets very
close to a standardized product. Now let's focus
on one key difference between these two markets.
On the monopoly side Beautiful Cars, the monopoly
firm, has to make a decision about two things:
first the quantity of cars that is going to
produce, second the price that is going to charge
for its cars. So the demand curve for Beautiful
Cars is this. This company has different pricing
options but the situation is different than
the competitive market where there are a lot
of bakeries and a lot of buyers so the price is
given to the bakery. The bakery is a price taker.
Now from a perspective one bakery the demand
line is flat: the price of bread is given to
the firm at €2.35. Now if that bakery decides
to sell above that price nobody's going to buy
bread from them. At the same time that bakery
does not have to sell below that price. Why?
Because they know that they'll have enough buyers
of their bread at €2.35. So the bakery does not
have to make any pricing decision: the price of
bread is given to them. The only decision that
they have to make is about quantity: how much
bread to produce at the market price of €2.35.
Let's go to our competitive market and put
ourselves in the shoes of that one bakery. We're
ready for production. We set up the machinery that
we paid for - the fixed cost. We just need to make
a decision about how many bread loaves to produce.
Let's assume we're starting from zero and we want
to make a decision about expanding our production
from zero to 1. Are we going to do that? Yes,
if the benefit of this expansion is higher than
the cost of this expansion. What's the benefit
of this expansion? We're going to produce our
first loaf of bread and we're going to sell it
at €2.35. What's the cost of this expansion?
The marginal cost of the first bread. So the
price is above marginal cost. We're going to
produce. Are we going to produce the second one?
Yes. Why? Because the price we can charge for the
second bread is higher than the marginal cost of
producing that, so we're going to keep expanding
our production until the marginal cost becomes the
same as the price. We're not going to go further
than here. Why? Because the cost of expansion
is higher than the benefit we get out of it,
so we're going to stop at 120. So we know that
in this situation our firm produces 120 loaves
of bread and makes a total profit of €80
per day. What does this tell us? It tells us that
in a competitive market the marginal cost becomes
the supply curve. Going back to our comparison
we spot an interesting difference between these
two markets. In a competitive firm we see that
firms keep on expanding until the marginal cost
becomes the same as the price given by the market,
but in the monopoly market we find a difference
between the price and the marginal cost.
Now, so far we talked about the competitive
market from a perspective of one single firm.
Now we're going to aggregate. We're going to
look at a competitive market at the aggregate
level. Section 8.4 goes from the firm level to
the market level, to the aggregate level. So let's
scroll down and focus on the supply curve from a
perspective of one firm - one bakery. The supply
curve answers the following hypothetical question:
let's assume the price of a loaf of bread is €1,
how much are you going to produce? Nothing.
Let's assume a price of a loaf of bread is
€2. How much are you going to produce? Around 90
loaves of bread. If the price of bread is €2.35,
we're going to produce 120 loaves of bread. So you
get the idea: a supply curve is the combination
of many scenarios. Which one of them may actually
materialize? In this case, because our bakery is
operating in a competitive environment, the supply
curve is the same as the marginal cost curve.
Now the next question is: how do we go
from the firm level to the aggregate level?
In this case, we are assuming that we have 50
identical bakeries. They have the same level of
competitiveness and cost structure, so therefore
in order to go from one bakery to the market level
we just need to multiply everything by 50. For
instance, let's assume the price of bread is €2.35
at the firm level, that one bakery is
going to produce 120 loaves of bread,
so we multiply this by 50 and we get 6,000 loaves
of bread at the market level. This is what we're
going to supply. The market is going to supply
if the price of bread is €2.35. Now let me scroll
down and add one more component to our aggregate
model and that's the demand side. As you can see,
our demand curve is no longer flat because we're
not analyzing the situation from a perspective
of one bakery. True, one bakery cannot influence
prices but if you put all the bakeries together
they can change prices. For instance, in this
case, if the bakers start to produce more and more
loaves of bread they start to drive
down prices at the aggregate level,
hence the downward sloping demand curve.
Now, eventually, the equilibrium market price
emerges here out of the interaction of
many, many sellers and many, many buyers
and this price emerges out of trial and error.
For instance, the bakers who are selling above
this price realise that nobody's buying bread from
them so they start to reduce their price and at
the same time bakers who are selling below this
price realise that if they increase their price,
none of their customers is going to
walk away. And they could, you know,
sell the same amount of bread as
before. So the equilibrium price emerges
out of the interaction of many, many sellers
and many, many buyers in the competitive market.