Econ6049 Economic Analysis, S1 2021: Week 6: Unit 8 - Supply and Demand: Price-Taking and Competitive Markets (Part II)

ECON6049 ECONOMIC ANALYSIS, S1 2021
Week 6: Unit 8 – Supply And Demand: Price-taking and

Competitive Markets (Part II)
OUTLINE
E. Factors that affect equilibrium
F. The effect of taxes and subsidies
G. The model of Perfect competition
E. FACTORS THAT AFFECT EQUILIBRIUM
CHANGES IN SUPPLY AND DEMAND
Quinoa is a cereal crop grown on the
Altiplano, a high barren plateau in
the Andes of South America.
In recent years, as its nutritional
properties have become known,
there has been a huge increase in
demand from richer, health-
conscious consumers in Europe and
North America.
CHANGES IN
SUPPLY AND
DEMAND
Consumer sentiment impact

their demand and spending.
Is the COVID-19 Pandemic a
Supply or a Demand Shock?
Change in Demand Change in Supply
due to change in: due to change in:
Consumers’ income Input prices
Prices of substitute or complement Prices of substitutes or complement
goods goods
Consumer sentiment, confidence, Technology or improved productivity
taste/preferences
Population or immigration policy The number of firms
External shocks such as Covid-19 Natural disaster (flood or drought,
pandemic hurricanes)
AN INCREASE IN DEMAND
• The initial equilibrium point: at
point A, P = $8, Q = 24 books.
• An increase in demand: If there
were more students enrolling,
there would be more students
wanting to buy the book at each
possible price  The demand
curve shifts to the right.
• Excess demand when the
price is $8, due to more
buyers than sellers.
• A new equilibrium point: at
point B with P = $10 and Q =
32 books.
• The increase in demand has
led to a rise in the equilibrium
quantity and price.
When we say ‘increase in demand’, it’s important to be careful about
exactly what we mean:
• Demand is higher at each possible price, so the demand curve has shifted.
• In response to this shift there is a change in the price.
• This leads to an increase in the quantity supplied.
• This change is a movement along the supply curve.
• But the supply curve itself has not shifted (the number of sellers and their
reserve prices have not changed), so we do NOT call this ‘an increase in
supply’, rather, it is an “increase in quantity supplied”.
A DECREASE IN DEMAND
https://www.bbc.com/news/business-52350082
AN INCREASE IN SUPPLY
• The initial equilibrium point: at
point A, Q = 5,000 loaves and P =
€2 each.
• Improved baking technology
 a fall in marginal costs
 The market supply curve shifts
down to the right.
AN INCREASE IN SUPPLY
• At the original price €2, there is more
bread than buyers want excess
supply.
• The bakeries would want to lower their
prices.
• The new equilibrium point: at point B,
where more bread is sold and the price
is lower.
• The demand curve has not shifted, but the fall in price has led to an increase
in the quantity of bread demanded, represented by a movement along the
demand curve.
A DECREASE IN SUPPLY: SOARING ONION PRICE IN INDIA
A CHANGE IN SUPPLY DUE TO MARKET ENTRY/EXIT
• If existing firms are earning economic rents and costs of entry are
not too high, other firms may enter the market.
A CHANGE IN SUPPLY and DEMAND at the same time
A CHANGE IN SUPPLY and DEMAND at the same time
F. THE EFFECT OF TAXES AND SUBSIDIES
TAXES
Governments can use taxation to raise revenue to:
• Finance government spending
• Redistribute resources
• Affect the allocation of goods and services in other ways (e.g. if a
government considers a particular good to be harmful)
The supply and demand model is a useful tool for analysing the
effects of taxation.
Taxes on suppliers/consumers shift the supply/demand curve
because the price is higher at each quantity.
SALT TAX
The initial equilibrium: at point A (P*, Q*)
30% tax is imposed on suppliers: Their
marginal costs are effectively 30% higher
at each quantity. The supply curve shifts.
The new equilibrium: at B, the price paid
by consumers has risen to P1 and the
quantity has fallen to Q1.
The tax paid to the government
= (P1 - P0) per unit of salt sold
TAX INCIDENCE
• The previous example illustrates an important feature of taxes: it
is not necessarily the taxpayer (i.e., the sellers in our example)
who feels its main effect.
• In this case, although the suppliers pay the tax, the tax incidence
falls partly on consumers and partly on producers.
• Tax incidence depends on relative elasticity of consumers and
producers. The less elastic group bears more of the tax burden.
TAX INCIDENCE
TAXES: WELFARE EFFECTS
TAXES: WELFARE EFFECTS
Before tax With Tax Change

Consumer surplus a+b+c a - (b+c)
Producer surplus d+e+f f - (d+e)
Gov tax collection 0 b+e + (b+e)
Total surplus a+b+c+d+e+f a+b+e+f - (c+d)
DWL 0 c+d + (c+d)
IMPLICATIONS OF TAXES
• To raise as much revenue as possible, the government would prefer to
tax a good for which demand is not very responsive to price (i.e, low
elasticity of demand), so that the fall in quantity traded is quite small.
• To use taxes to alter consumers’ behaviour, such as reducing
consumption of soft drink, the government would prefer to tax a good
with high elasticity of demand.
• The overall effect of the tax depends on what the government does
with the revenues that it collects.
SUBSIDIES
Government support for agricultural producers
Notes: Support measures as a share of gross farm receipts.

PRODUCTION SUBSIDY
With No With Impact of
Subsidy Subsidy Subsidy
Consumer A+B A+B+E+ E+G+K
Surplus G+K
Producer E+F B+C+E+ B+C
Surplus F
Impact on Zero - B - C - E - -B-C-E-G-K-
Gov Budget G-K-J J
Net A+B+E+ A+B+E+ -J

Benefits F F–J
Deadweight Zero J J
Loss
28
G. THE MODEL OF PERFECT COMPETITION
 A perfectly competitive market has the following properties:
• The good or service being exchanged is homogeneous
• Very large number of potential buyers and sellers
• Buyers and sellers all act independently of one another
• Price information easily available to buyers and sellers
 At the competitive equilibrium: the market clears at a single price;
all price takers, maximum gain from trade.
 Perfect competition may not hold completely in reality, but can be
a good approximation to actual firm behaviour.
EVIDENCE OF PERFECT COMPETITION?
• Economists have used two tests for competitive equilibrium:
i. Do all trades take place at the same price?
ii. Are firms selling goods at a price equal to marginal cost?
• It is hard to find examples of perfect competition:
• Even when consumers can easily check the price of products
(online shopping sites), prices of the same product differ.
• Fulton Fish Market study – within the same market, prices
of the same fish product differed for different customer
types.
PRICE-SETTERS VS. PRICE-TAKERS
Price-setters (Monopoly) Price-takers (Perfect Competition)
MC < Price MC = Price
Deadweight losses (Pareto No deadweight losses (can be Pareto
inefficient) efficient)
Owners receive economic rents in No economic rents in the long-run
both long- and short-run
Firms advertise their unique product Little advertising expenditure
Firms invest in R&D, seek to prevent Little incentive for innovation
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ECON6049 ECONOMIC ANALYSIS, S1 2021

Week 6: Unit 8 – Supply And Demand: Price-taking and

Consumer sentiment impact

Before tax With Tax Change

Notes: Support measures as a share of gross farm receipts.

Net A+B+E+ A+B+E+ -J

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