7

FIRMS AND MARKETS FOR

GOODS AND SERVICES

Factory warehouse storage

7.1 INTRODUCTION

• Technological and cost advantages of large-scale production favour large

firms.
• Firms producing differentiated products choose price and quantity to
maximize their profits, taking into account the product demand curve
and the cost function.
• Firms with fewer competitors have more power to set prices, and so
achieve higher profit margins.
• When consumers and firm owners interact in markets, the gains from
trade are shared, but when prices are set above marginal cost there is
market failure and deadweight loss.
• The responsiveness of consumers to a price change is measured by the
elasticity of demand.
• Economic policymakers use estimates of elasticities of demand to design
tax policies, and reduce firms’ market power through competition
policy.
• In some cases, competition can determine a market equilibrium in
which both buyers and sellers are price-takers. This is called a competit-
ive equilibrium, and it ensures that all possible gains from trade are
realized.
• Shifts in supply or demand, known as shocks, will cause a period of
adjustment in prices.

Ernst F. Schumacher’s Small is Beautiful, published in 1973, advocated Ernst F. Schumacher. 1973. Small is
small-scale production by individuals and groups in an economic system Beautiful: Economics as if People
designed to emphasize happiness rather than profits. In the year the book Mattered (https://tinyco.re/
was published, the firms Intel and FedEx each employed only a few 3749799). New York, NY:
thousand people in the US. Forty years later, Intel employed around HarperCollins.
108,000 people and FedEx more than 300,000.

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 7 FIRMS AND MARKETS FOR GOODS AND SERVICES

Most firms are much smaller than this, but in all high-income eco-
nomies, most people work for large firms. For example, in 2015, 53% of
US private-sector employees worked in firms with at least 500 employ-
ees. Firms grow because their owners can make more money if they
expand, and people with money to invest get higher returns from
owning stock in large firms. Employees in large firms are also paid more.
Figure 7.1 shows the growth measured by numbers of employees of
some highly successful US firms during the twentieth century. (Note that
Ford’s employment in the US peaked before 1980.)
Why are some firms more successful than others? And why do some
firms grow while others remain small or go out of business? Firms have
many decisions to make: for example, how to choose, design, and
advertise products that will attract customers; how to produce at lower
cost and at a higher quality than their competitors; or how to recruit and
retain employees who can make these things happen. In this unit, we
look at one of the most important of these decisions: how to choose the
price of a product, and therefore the quantity to produce. This depends
on demand—that is, the willingness of potential consumers to pay for
the product—and production costs. We also look at markets, in which
the decisions of firms and consumers come together to determine the
allocation of goods and services.

View this data at OWiD https://tinyco.re/ 2,500,000

8927352
Walmart

Erzo G. J. Luttmer. 2011. ‘On the 2,000,000

Number of employees

Mechanics of Firm Growth’. The Review

of Economic Studies 78 (3): pp. 1042–68.
1,500,000
Amazon

1,000,000
FedEx
McDonald's
500,000 Ford
Dell
Intel
Proctor and Gamble
0
1900

1910

1920

1930

1940

1950

1960

1970

1980

1990

2000

2010

2020

Year

Figure 7.1 Firm size in the US: Number of employees (1900–2021).

276 F OR I NS T R UC T O R S ' US E O N L Y . P L E A S E D O N O T S H A R E W IT H
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7.2 ECONOMIES OF SCALE AND THE COST ADVANTAGES OF LARGE-SCALE PRODUCTION

7.2 ECONOMIES OF SCALE AND THE COST

ADVANTAGES OF LARGE-SCALE PRODUCTION
Why have firms like Walmart, Intel, and FedEx grown so large? An import-
ant reason why a large firm may be more profitable than a small firm is that
the large firm produces its output at lower cost per unit. This may be
possible for two reasons:

• Technological advantages: Large-scale production often uses fewer inputs

per unit of output.
• Cost advantages: In larger firms, costs that don’t depend on number of
units produced (such as advertising or acquiring the necessary patents or
other intellectual property rights (IPR)), have a smaller effect on the cost
per unit.

Technological advantages
Economists use the term economies of scale or
increasing returns to describe the technological economies of scale These occur when doubling all of the
advantages of large-scale production. For inputs to a production process more than doubles the output.
example, if doubling the amount of every input The shape of a firm’s long-run average cost curve depends both
that the firm uses triples the firm’s output, then on returns to scale in production and the effect of scale on the
the firm exhibits increasing returns. prices it pays for its inputs. Also known as: increasing returns to
Economies of scale may result from scale. See also: diseconomies of scale.
specialization within the firm, which allows increasing returns to scale These occur when doubling all of
employees to do the task they do best and the inputs to a production process more than doubles the
minimizes training time by limiting the skill set output. The shape of a firm’s long-run average cost curve
that each worker needs. Economies of scale may depends both on returns to scale in production and the effect
also occur for purely engineering reasons. For of scale on the prices it pays for its inputs. Also known as: eco-
example, transporting more of a liquid requires a nomies of scale. See also: decreasing returns to scale, constant
larger pipe, but doubling the capacity of the pipe returns to scale.
increases its diameter (and the material necessary
to construct it) by much less than a factor of two.

Cost advantages
There is usually a fixed cost of production to a
firm. It does not depend on the number of units, fixed costs Costs of production that do not vary with the
and so would be the same whether the firm number of units produced.
produced one unit or many. Examples of fixed research and development Expenditures by a private or public
costs include: entity to create new methods of production, products, or other
economically relevant new knowledge.
• Marketing expenses: For example, advertising.
The cost of a 30-second advertisement during
the television coverage of the US Super Bowl football game in 2017
(https://tinyco.re/5012179) was $5.5 million, which would be justifiable
only if a large number of units would be sold as a result.
• Innovation: For example, research and development (R&D), product
design, acquiring a production licence, or obtaining a patent for a
particular technique.
• Lobbying: The cost of trying to influence government bodies, or of
contributions to election campaigns and public relations expenditures,
are more or less independent of the level of the firm’s output.

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 7 FIRMS AND MARKETS FOR GOODS AND SERVICES

These fixed costs mean that, even if there were decreasing returns to scale
decreasing returns to scale These
(also known as diseconomies of scale), cost per unit may still fall if the firm
occur when doubling all of the
increased its output.
inputs to a production process less
Large firms have more bargaining power than small firms when
than doubles the output. Also
negotiating with suppliers. This means they are also able to purchase their
known as: diseconomies of scale.
inputs on more favourable terms.
See also: increasing returns to
scale.
Demand advantages
network economies of scale These
Large size can also benefit a firm in selling its product, if people are more
exist when an increase in the
likely to buy a product or service that already has a lot of users. For
number of users of an output of a
example, a software application is more useful when everybody else uses a
firm implies an increase in the
compatible version. These demand-side benefits of scale are called
value of the output to each of
network economies of scale. There are many examples in technology-
them, because they are connected
related markets.
to each other.
diseconomies of scale These occur
Organizational disadvantages
when doubling all of the inputs to a
Production by a small group of people is therefore often too costly to
production process less than
compete with larger firms. But while small firms typically either grow or
doubles the output. Also known as:
die, there are limits to growth known as diseconomies of scale, or
decreasing returns to scale. See
decreasing returns.
also: economies of scale.
A larger firm needs more layers of management and supervision. Firms
typically organize themselves as hierarchies in which employees are
supervised by those at a higher level and, as the firm grows, the
organizational costs will grow as a proportion of the firm’s overall costs.

Outsourcing
Sometimes it is cheaper to outsource production of part of the product than
to manufacture it within the firm. For example, Apple would be even more
gigantic if its employees produced the touchscreens, chipsets, and other
components that make up the iPhone and iPad, rather than purchasing
these parts from Toshiba, Samsung, and other suppliers. Apple’s
outsourcing strategy limits the firm’s size and increases the size of Toshiba,
Samsung, and other firms that produce Apple’s components. In our
‘Economist in action’ video (https://tinyco.re/0965855) Richard Freeman,
an economist who specializes in labour markets, explains some of the
consequences of outsourcing.

QUESTION 7.1 CHOOSE THE CORRECT ANSWER(S)

Which of the following are factors that contribute to a firm’s
diseconomies of scale?

the firm needing to double the capacity of a pipe that transports its
fuel when the production level is doubled
Richard Freeman: You can’t
fixed costs such as lobbying
outsource responsibility
difficulty of monitoring workers’ effort as the number of employees
https://tinyco.re/0965855
increases
network effects of its output goods

278 F OR I NS T R UC T O R S ' US E O N L Y . P L E A S E D O N O T S H A R E W IT H
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 7.3 THE DEMAND CURVE AND WILLINGNESS TO PAY

7.3 THE DEMAND CURVE AND WILLINGNESS TO PAY

The story of the British retailer, Tesco, founded in 1919 by Jack Cohen,
suggests one pricing strategy for firms.
Jack Cohen began as a street market trader in the East End of London. The
traders would gather at dawn each day and, at a signal, race to their favourite
stall site, known as a pitch. Cohen perfected the technique of throwing his cap
to claim the most desirable pitch. He opened his first store in 1931. In the
1950s, Cohen began opening supermarkets on the US model, adapting quickly
to this new style of operation. Tesco became the UK market leader in 1995,
and now employs over 400,000 people in Europe and Asia.
Today, Tesco’s pricing strategy aims to appeal to all segments of the
market, labelling some of its own-brand products as Finest and others as
Value. The BBC Money Programme summarized the three Tesco
commandments as ‘be everywhere’, ‘sell everything’, and ‘sell to everyone’.
‘Pile it high and sell it cheap,’ was Jack Cohen’s motto. In 2017, Tesco was
ranked ninth by sales (https://tinyco.re/7943023) among the world’s retailers.
Keeping the price low, as Cohen recommended, is one possible strategy for a
firm seeking to maximize its profits. Even though the profit on each item is
small, the low price may attract so many customers that total profit is high.
Other firms adopt quite different strategies. Apple sets high prices for
iPhones and iPads, increasing its profits by charging a price premium rather
than lowering prices to reach more customers. For example, between April
2010 and March 2012, profit per unit on Apple iPhones was between 49%
and 58% of the price. During the same period, Tesco’s operating profit per
unit was between 6.0% and 6.5%.

The demand curve and differentiated products

To decide what price to charge and how much to produce, a firm needs
demand curve The curve that gives
information about demand—how much potential consumers are willing to
the quantity consumers will buy at
pay for its product. This information, as you know from the discussion of
each possible price.
the effect of taxes on sales of sugary drinks (in Unit 3), is summarized in a
demand curve.
Shoppers buying ready-to-eat breakfast cereals often face a bewildering
choice of dozens of varieties each with distinct attributes. The table below
gives some of the largest selling cereals in the US among brands targeted at
‘families’ (other categories are ‘kids’ and ‘adults’). As you can see, the prices vary
considerably. (Prices are stated per pound, and there are 2.2 pounds in 1 kg.)
In 1996, economist Jerry Hausman used data on weekly sales of
breakfast cereals to estimate how the weekly quantity of cereal that
customers in a typical city wished to buy would vary with its price per
pound. Figure 7.3 shows the demand curve for Apple Cinnamon Cheerios.
The demand curve provides an answer to the hypothetical question: ‘For
each possible price that might be charged, how many pounds of cereal would
be purchased?’ From the figure, we could pick some hypothetical price, say $3
per pound and ask: ‘If this price were charged, how many pounds would be
purchased?’ The answer is 25,000 pounds of Apple Cinnamon Cheerios. For
most products, the lower the price, the more customers wish to buy.

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 7 FIRMS AND MARKETS FOR GOODS AND SERVICES

Breakfast cereals are differentiated products. Each brand is produced

differentiated product A product
by just one firm and has some unique nutritional, taste, and other
produced by a single firm that has
characteristics that distinguish it from the brands sold by other firms.
some unique characteristics
Many other consumer goods and services are also differentiated
compared to similar products of
products. If you want to buy a car, a mobile phone, or a washing
other firms.
machine, it is not just the price that matters—you will want to find a
brand and model with characteristics that match your own preferences.
You might consider the design, the quality, or the service the
manufacturer offers, rather than always choosing the cheapest.
What this means is that even if there are many firms selling similar
products, each firm is alone as a seller of its particular type and brand. Only
one firm sells General Mills Apple Cinnamon Cheerios: General Mills.

Jerry A. Hausman. 1996. ‘Valuation of

Brand Company Average price ($) per pound
new goods under perfect and imperfect
competition’ (https://tinyco.re/595508). Cheerios General Mills 2.644
In The Economics of New Goods.
pp. 207–48. Chicago: University of Honey-Nut Cheerios General Mills 3.605
Chicago Press. Apple-Cinnamon Cheerios General Mills 3.480
Corn Flakes Kellogg 1.866
Raisin Bran Kellogg 3.214
Rice Krispies Kellogg 2.475
Frosted Mini-Wheats Kellogg 3.420
Frosted Wheat Squares Nabisco 3.262
Raisin Bran Post 3.046

Figure 7.2 Sales of major ready-to-eat breakfast cereals in the US (1992).

Adapted from Figure 5.2 in Jerry A. 8

Hausman. 1996. ‘Valuation of New
Goods under Perfect and Imperfect
Competition’ (https://tinyco.re/595508).
Price, P (dollars per pound)

In The Economics of New Goods, 6

pp. 207–48. Chicago, IL: University of
Chicago Press.

Demand curve

0
0 20,000 40,000 60,000 80,000
Quantity of Cheerios, Q (pounds)

Figure 7.3 Estimated demand for Apple Cinnamon Cheerios.

280 F OR I NS T R UC T O R S ' US E O N L Y . P L E A S E D O N O T S H A R E W IT H
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 7.3 THE DEMAND CURVE AND WILLINGNESS TO PAY

Willingness to pay and demand

From the point of view of the firm selling such a product, this means that it
faces a downward-sloping demand curve like the one for Apple Cinnamon
Cheerios. To see why the demand curve for a differentiated product slopes
downward, think about an imaginary firm, called Language Perfection (LP),
which offers lessons in English, Arabic, Mandarin, Spanish, and other
languages. LP provides tutors offering one-on-one training at a public
location of the learner’s choice (a coffee shop, library, or park, for example).
There are many other firms offering language lessons in LP’s city, some of
them in classroom settings, some online, and some, like LP, one-on-one.
The language lessons being offered by these firms differ in a great many
ways. (To get some sense of how language lessons are a differentiated
product, go online and search for lessons, and notice how many different
choices you will have, even after you have chosen the language you want to
learn.) Some will offer advanced courses, some accelerated teaching, others
specialize in learning technical, business, or medical terms, while others are
aimed at students or tourists. In some, you go to the tutor’s location; in
others, the tutor comes to you.
The potential language learners are even more different from one
another than the firms offering the teaching. For some, the kind of
course offered by LP might be exactly what they want, so they would buy
the course even if the price was high. Others might be seeking something
a little different from the LP course, and so would sign up with LP only
at a low price.
Consumers differ not only in what they are looking for, but also in how
much money they can afford to spend.
These differences are the basis of the demand curve. Think of all of
willingness to pay (WTP) An
the possible buyers and arrange them in order, starting with the person
indicator of how much a person
who would purchase LP’s Spanish-language course at the highest price.
values a good, measured by the
Next in order is the person who would be willing to pay almost the high-
maximum amount he or she would
est price but not quite, and so on, ending with the person who would
pay to acquire a unit of the good.
sign up for LP’s course only if the price were very low. The highest price
See also: willingness to accept.
a person would be willing to pay for the course is called the individual’s
willingness to pay (WTP).
A person will buy the course if the price is less than or equal to his or
her WTP. Suppose we line up the consumers in order of WTP, with the
highest first, and plot a graph to show how the WTP varies along the line
(Figure 7.4). You can see from the figure, for example, that at a price of
$700, nobody would buy the course; if the course were offered free, 100
people would sign up.
If we choose any price, say P = $255, the graph shows the number of
consumers whose WTP is greater than or equal to P. In this case, 60 con-
sumers are willing to pay $255 or more, so the demand for LP’s course at a
price of $255 is 60.
The points on and under the demand curve in Figure 7.4, shaded and
labelled as the ‘feasible set’, are all of the prices and quantities sold that are
feasible for the firm. The feasible point that we picked out is labelled as A.
But the firm could also set a price of $255 and admit just 50 students to
their course, even if more than that would be willing to pay the price. The
demand curve is the boundary of the feasible set and so it is another
example of the feasible frontier.

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 7 FIRMS AND MARKETS FOR GOODS AND SERVICES

The law of demand dates back to Because we have arranged the potential buyers in order of their
the seventeenth century and is willingness to pay, it follows that if P is lower, there is a larger number of
attributed to Gregory King consumers willing to buy, so the demand is higher. Demand curves are
(1648–1712) and Charles Davenant often drawn as straight lines, as in this example, although there is no reason
(1656–1714). King was a herald at to expect them to be straight in reality—the demand curve for Apple
the College of Arms in London, Cinnamon Cheerios is not straight. But we do expect demand curves to
who produced detailed estimates slope downward—as the price rises, the quantity demanded falls. In other
of the population and wealth of words, when the available quantity is low, the cereal can be sold at a high
England. Davenant, a politician, price. This relationship between price and quantity is sometimes known as
published the Davenant-King law the law of demand.
of demand in 1699, using King’s
data. It described how the price of Price discrimination
corn would change depending on If you were the owner of the firm, LP, how would you choose the price for
the size of the harvest. For the Spanish-language course?
example, he calculated that a The first thought the owner might have is that she should go to the
‘defect’, or shortfall, of one-tenth person with the greatest willingness to pay and offer the course at a price
(10%) would raise the price by slightly below that person’s WTP, ensuring that the person would buy.
30%. Then she would move on to the person with the next greatest WTP and
offer the course at a price just below that customer’s WTP, and so on.
This practice is called price discrimination. If the owner could do this,
price discrimination A selling
LP would make the most money possible from selling introductory
strategy in which different prices
Spanish instruction to this population.
for the same product are set for dif-
But price discrimination—at least, the type that is finely tuned so that
ferent buyers or groups of buyers,
each individual pays a different price just below that customer’s
or per-unit prices vary depending
willingness to pay—is generally impossible. The seller has no way of
on the number of units purchased.
determining the WTP of each potential buyer. The seller cannot find out
by simply asking, because the potential buyer would often lie, so as to be
able to buy the course at a lower price.
Another reason why price discrimination is not the rule is that a buyer
who purchased the course (or any good) at a low price could then resell it to
someone with a higher willingness to pay, ending up by making a profit.

700

600

500
Price, P: WTP

400
Feasible set Feasible frontier
300
A

200

100

0
0 10 20 30 40 50 60 70 80 90 100 110 120

Quantity of students enrolled per month, Q

Figure 7.4 The demand for LP’s Spanish-language courses.

282 F OR I NS T R UC T O R S ' US E O N L Y . P L E A S E D O N O T S H A R E W IT H
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 7.3 THE DEMAND CURVE AND WILLINGNESS TO PAY

Some firms are able to practice a less individualized form of price

discrimination—lower prices for customers whose willingness to pay might
be less due to lower income, for example. Lower prices charged for students
or the elderly are examples of price discrimination of this type. But for the
most part, the product is sold at a single price to all customers.
This price will be on the demand curve, because that maps out the feas-
ible frontier facing the firm: it shows the maximum quantity that is
demanded at any price the firm sets. The law of demand—the fact that the
feasible frontier facing the firm slopes downward—means that the firm
faces a trade-off. If it must sell its product at the same price to everyone,
then selling more means a lower price, and a higher price means selling less.
As in our other examples of feasible frontiers (page 159), the slope of the
demand curve is a marginal rate of transformation (MRT), in this case of
price into quantity.
Before finding out how the firm decides at which single price on the
demand curve to sell the Spanish-language course, we need to introduce the
concepts of costs and profits.

QUESTION 7.2 CHOOSE THE CORRECT ANSWER(S)

Figure 7.5 depicts two alternative demand curves, D and D′, for a
product. Based on this graph, which of the following are correct?

12, 000

10,000

8,000
Price, P (€)

6,000

4,000

2,000

D D′
0
0 10 20 30 40 50 60 70 80 90 100

Quantity of consumers, Q

Figure 7.5 Two demand curves.

On demand curve D, when the price is €5,000, the firm can sell 15
units of the product.
On demand curve D′, the firm can sell 70 units at a price of €3,000.
At price €1,000, the firm can sell 40 more units of the product on D′
than on D.
With an output of 30 units, the firm can charge €2,000 more on D′
than on D.

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 7 FIRMS AND MARKETS FOR GOODS AND SERVICES

7.4 PROFITS, COSTS, AND THE ISOPROFIT CURVE

Imagining that you are the owner of a firm, your profits are the difference
between sales revenue and production costs. So, before we can calculate
profits, we need to know the production costs.
Let’s assume that LP is a very simple firm with a single owner. The
owner employs tutors to teach a ten-hour Spanish course, with one tutor
for each student. Production costs to the owner, per student, would be:

• Providing printed materials to the students: These cost $30 per student.
• The tutor’s time: The tutor costs $30 an hour, for ten hours.
• The owner’s time: We value this at what she would earn if she were
employed elsewhere. We know that she could close her firm and get a
job as a manager of someone else’s language school, making $60 an hour.
She spends, on average, half an hour per student per course, so the
opportunity cost of her time, per student, per course, would be $30.

Therefore, the cost to the owner, per student, per course, would be:
30 + (30 × 10) + 30 = $360.
We assume that LP can simply hire more tutors and provide materials at
constant returns to scale These
the same costs, however many courses are offered (so the firm has constant
occur when doubling all of the
returns to scale). Unit costs are constant at $360 for any level of the firm’s
inputs to a production process
output (number of courses actually offered).
doubles the output. The shape of a
To maximize profit, the owner should produce exactly the quantity she
firm’s long-run average cost curve
expects to sell, and no more. Then revenue, costs, and profit are given by:
depends both on returns to scale in
production and the effect of scale
on the prices it pays for its inputs.
See also: increasing returns to
scale, decreasing returns to scale.
unit cost Total cost divided by
number of units produced.

So we have a formula for profit:

Using this formula, the owner can calculate the profit for any hypothetical
combination of price and quantity.
For example, if she sells 25 courses at $480, her profits are ($480 − $360)
× 25 = $3,000. Similarly, selling 60 courses at $410 would give profits of
($410 − $360) × 60 = $3,000. And selling 100 courses at $390 would also
give profits of ($390 − $360) × 100 = $3,000.
Work through the analysis of Figure 7.6 to see that there are many other
isoprofit curve A curve on which all
combinations of price and number of courses sold per month that would give
points yield the same profit.
the owner profits of $3,000. The curve joining up all the combinations giving
profits of $3,000 is called an isoprofit curve.
There will be an isoprofit curve where profits are zero—we have already
seen that it is the average cost curve and it will be a horizontal line in Figure
7.6 at P = C = $360.
Just as indifference curves join points in a diagram that give the same
level of utility, isoprofit curves join points that give the same level of
total profit. Because it is the owner who gets the profits, we can think of
the isoprofit curves as the owner’s indifference curves—the owner is

284 F OR I NS T R UC T O R S ' US E O N L Y . P L E A S E D O N O T S H A R E W IT H
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 7.4 PROFITS, COSTS, AND THE ISOPROFIT CURVE

indifferent between the hypothetical combinations of price and quantity

that would give her the same profit.

QUESTION 7.3 CHOOSE THE CORRECT ANSWER(S)

A firm’s cost of production is €12 per unit of output. If Point (Q, P) = (2,000, 20) is on the isoprofit curve
P is the price of the output good and Q is the number representing the profit level €20,000.
of units produced, which of the following statements Point (Q, P) = (2,000, 20) is on a lower isoprofit
are correct? curve than point (Q, P) = (1,200, 24).
Points (Q, P) = (2,000, 20) and (4,000, 16) are on the
same isoprofit curve.
Point (Q, P) = (5,000, 12) is not on any isoprofit
curve.

800 To explore all of the slides in this figure,

Isoprofit curve: $3,000 see the online version
Isoprofit curve: $700 at https://tinyco.re/8081383.
700
Isoprofit curve: $0

600
Price; Cost ($)

500 A (25, 480)

B (60, 410)
400 C (100, 390)

300

200

100

0
0 10 20 30 40 50 60 70 80 90 100 110 120

Quantity of students enrolled per month, Q

Figure 7.6 Isoprofit curves for the production of LP Spanish-language courses.

1. Profit of $3,000 3. Isoprofit curve—$3,000 5. Zero-profit isocost curve—the

If she could sell 25 courses at $480, her There are many other ways to make a average cost curve
profits would be ($480 − 360) × 25 = profit of $3,000. The isoprofit curve The horizontal line shows the choices
$3,000 (point A). here shows all the possible ways of of price and quantity where profit is
making a $3,000 profit. zero; if she sets a price of $360, she
2. Other ways to make the same profit would be selling each course for
She could make $3,000 profit, not only 4. Isoprofit curve—$700 exactly what it cost.
by selling 25 courses at $480 (point A), The $700 isoprofit curve shows all the
but also by selling 60 courses at $410 combinations of P and Q for which 6. Isoprofit curves
(point B), or 100 courses at a price of profit is equal to $700. The cost of each The graph shows a number of isoprofit
$390 (point C). course is $360, so profit = (P − 360) × Q. curves for LP Spanish-language
This means that isoprofit curves slope courses.
downward. To make a profit of $700, P
would have to be very high if Q was
less than 5. But if Q = 80, the owner
could make this profit with a low P.

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S T U D E NT S .
 7 FIRMS AND MARKETS FOR GOODS AND SERVICES

7.5 THE ISOPROFIT CURVES AND THE DEMAND CURVE

To achieve a high profit, the owner would like both price and quantity to be
as high as possible. She prefers points on higher isoprofit curves, but she is
constrained by the demand curve. If she chooses a high price, she will be
able to sell only a small quantity; if she wants to sell a large quantity, she
must choose a low price.
The demand curve determines what is feasible. Figure 7.7 shows the iso-
profit curves and demand curve together. The owner faces a similar problem
to Alexei, the student in Unit 4 (page 164), who wanted to choose the point in
his feasible set at which his utility was maximized. The owner should choose a
feasible price and quantity combination that will maximize her profit.

To explore all of the slides in this figure, 800

see the online version Isoprofit curve: $3,000
at https://tinyco.re/6556856. Isoprofit curve: $700
700
Unit cost (also, isoprofit curve: $0)
Demand curve
600

E
Price; Cost ($)

500

400

300

200

100

0
0 10 20 30 40 50 60 70 80 90 100 110 120

Quantity of students enrolled per month, Q

Figure 7.7 The profit-maximizing choice of price and quantity for LP

Spanish-language courses.

1. The profit-maximizing choice 3. Profit-maximizing choices 4. Maximizing profit at E

The owner would like to choose a com- The owner would choose a price and The owner reaches the highest possible
bination of P and Q on the highest quantity corresponding to a point on isoprofit curve while remaining in the
possible isoprofit curve in the feasible the demand curve. Any point below the feasible set by choosing point E, where
set. demand curve would be feasible, such the demand curve is tangent to an iso-
as selling 30 courses at a price of $200, profit curve. She should choose P =
2. Zero profits on the average cost but she would make more profit if she $510, selling Q = 20 courses.
curve raised the price.
The horizontal line shows the choices
of price and quantity at which profit is
zero; if the owner sets a price of $360,
she would be selling each course for
exactly what it cost.

286 F OR I NS T R UC T O R S ' US E O N L Y . P L E A S E D O N O T S H A R E W IT H
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 7.5 THE ISOPROFIT CURVES AND THE DEMAND CURVE

The owner’s best strategy is to choose point E in Figure 7.7—she should

produce 20 courses and sell the course at a price of $510, making $3,000
profit. Just as in the case of Alexei in Unit 4 (page 164), the optimal combin-
ation of price and quantity involves balancing two trade-offs:
marginal rate of substitution (MRS)
• The isoprofit curve is the owner’s indifference curve: Its slope at any point
The trade-off that a person is
represents the trade-off she is willing to make between P and Q—her
willing to make between two
MRS. She would be willing to substitute a high price for a lower
goods. At any point, this is the slope
quantity if she obtained the same profit.
of the indifference curve. See also:
• The slope of the demand curve is the trade-off she is constrained to make: It is
marginal rate of transformation.
her MRT, or the rate at which the demand curve allows her to
marginal rate of transformation
‘transform’ quantity into price. She cannot raise the price without
(MRT) A measure of the trade-offs
lowering the quantity, because fewer consumers will buy a more
a person faces in what is feasible.
expensive product.
Given the constraints (feasible
frontier) a person faces, the MRT is
These two trade-offs balance at the profit-maximizing choice of P and Q.
the quantity of some good that
The owner of Language Perfection (LP) may not have thought about the
must be sacrificed to acquire one
decision in this way.
additional unit of another good. At
Perhaps she remembered past experience in setting prices too low or too
any point, it is the slope of the feas-
high (trial and error), or did some market research. However she made the
ible frontier. See also: feasible
choice, we expect that a firm could discover a profit-maximizing price and
frontier, marginal rate of substitu-
quantity. The purpose of our economic analysis (page 172) is not to model
tion.
the owner’s thought process to get to this point, but to understand the out-
come, and its relationship to the firm’s cost and consumer’s demand.
However, the owner may have conducted a thought experiment that we To see a different way of finding
can relate to the model. Suppose she thinks first about how many courses the profit-maximizing price using
she could sell if she were to charge only what it costs to produce them. This the concept of marginal revenue,
is where the demand curve intersects the cost curve, and she would make go to Section 7.6 (https://tinyco.re/
zero profits. If instead she charged a price just above the cost of production, 3081654) in The Economy.
she would now be making a profit. Imagine what happens as she continues
moving leftwards along the demand curve. Initially, she will be crossing
higher and higher isoprofit curves, due to the effect of a slightly higher
price on her profits. But at a certain point, she will discover that if she
increases the price further, her profits would begin to fall—in other words,
she will start crossing ever-lower isoprofit curves. The point on the demand
curve that touches the highest possible isoprofit curve is the combination of
price and quantity on the demand curve at which profits are maximized. So,
that is the price she will set. Graphically, it is where the isoprofit curve is
tangent to the demand curve.
Like the cost curve, which is the isoprofit curve for zero profits, the
other isoprofit curves are independent of the demand curve. A shift in the
cost curve will shift the family of isoprofit curves with it. A shift in the
demand curve will not.

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 7 FIRMS AND MARKETS FOR GOODS AND SERVICES

QUESTION 7.4 CHOOSE THE CORRECT ANSWER(S)

The table represents market demand Q for a good at different prices P.

Q 100 200 300 400 500 600 700 800 900 1,000
P €270 €240 €210 €180 €150 €120 €90 €60 €30 €0

The firm’s unit cost of production is €60. Based on this information,

which of the following are correct?

At Q = 100, the firm’s profit is €20,000.

The profit-maximizing output is Q = 400.
The maximum profit that can be attained is €50,000.
The firm will make a loss at all outputs above 800.

QUESTION 7.5 CHOOSE THE CORRECT ANSWER(S)

Which of the following statements regarding the marginal rate of sub-
stitution (MRS) and the marginal rate of transformation (MRT) of a
profit-maximizing firm are correct?

The MRT is how much in price the consumers are willing to give up
for an incremental increase in the quantity consumed, keeping their
utility constant.
The MRS is how much in price the owner is willing to give up for an
incremental increase in the quantity, holding profits constant.
The MRT is the slope of the isoprofit curves.
If MRT > MRS, then firms can increase their profit by increasing
output.

EXERCISE 7.1 CHANGES IN THE MARKET

Draw diagrams to show how the curves in Figure 7.7 would change in each
of the following cases:

1. A rival company producing a similar Spanish-language course slashes

its prices.
2. The cost of hiring tutors for LP’s course rises to $35 per hour (instead of
$30).
3. LP introduces a local advertising campaign costing $20 per month.

In each case, explain what would happen to the price and the profit.

288 F OR I NS T R UC T O R S ' US E O N L Y . P L E A S E D O N O T S H A R E W IT H
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 7.6 GAINS FROM TRADE

7.6 GAINS FROM TRADE

economic rent A payment or other
Remember from Unit 5 (page 185) that, when people engage voluntarily in
benefit received above and beyond
an economic interaction, they do so because it makes them better off—they
what the individual would have
can obtain a surplus called economic rent, meaning the difference between
received in his or her next best
how much they gain by this interaction compared to not engaging in the
alternative (or reservation option).
interaction. The total surplus for the parties involved is a measure of the
See also: reservation option.
gains from exchange (also known as gains from trade).
total surplus The total gains from
We can analyse the outcome of the economic interactions between con-
trade received by all parties
sumers and a firm’s owner—just as we did for Angela and Bruno in Unit
involved in the exchange. It is
5 (page 185)—and calculate the total surplus and the way it is shared.
measured as the sum of the con-
We have assumed that the rules of the game for allocating language
sumer and producer surpluses. See:
courses to consumers are:
joint surplus.
gains from exchange The benefits
1. A firm’s owner decides how many items to produce: The owner sets a single
that each party gains from a
price at which admission to the course will be sold to all consumers.
transaction compared to how they
2. Then individual consumers decide whether to buy or not: No consumer buys
would have fared without the
more than one course.
exchange. Also known as: gains
from trade. See also: economic
In the interactions between a firm like Language Perfection and its con-
rent.
sumers, there are potential gains for both the owner and the students, as
long as LP is able to hire tutors to teach the course at a cost less than its
value to a consumer. (The tutors may also benefit from the pay they receive,
but we will not consider their benefits or costs in this example.)
Recall that the demand curve shows the WTP of each of the potential
consumers. A consumer whose WTP is greater than the price will buy the
good and receive a surplus, since the value of the course to that customer is
higher than the price.
And if the price paid by the customer is greater than what it costs the
firm to offer the course, the owner receives a surplus too. This surplus is
higher than the amount the owner would earn as a manager in another
language company, which we have included in the cost of producing the
course. Figure 7.8 shows how to find the total surplus for the firm and its
consumers, when LP sets the price to maximize its profits.
In Figure 7.8, the shaded area above P* measures the consumer
consumer surplus The consumer’s
surplus, and the shaded area below P* is the producer surplus. We see
willingness to pay for a good minus
from the relative size of the two areas in Figure 7.8 that, in this market, the
the price at which the consumer
firm obtains a greater share of the surplus.
bought the good, summed across
As in the voluntary contracts between Angela and Bruno in Unit 5 (page
all units sold.
185), both parties gain in the market for learning Spanish. The division of
producer surplus The price at
the gains is determined by bargaining power. In this case, the firm is the
which a firm sells a good minus the
only seller of this course, and can set a high price and obtain a high share of
minimum price at which it would
the gains, knowing that those who value the course highly have no
have been willing to sell the good,
alternative but to accept. The firm has many other potential customers, and
summed across all units sold.
so people have no power to bargain for a better deal.

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 7 FIRMS AND MARKETS FOR GOODS AND SERVICES

To explore all of the slides in this figure,

see the online version Isoprofit curve: $3,000
at https://tinyco.re/8752968. Demand curve
Unit cost (also, Isoprofit curve: $0)

E
P* = 510

Price; Cost ($)

360

12 Q* = 20

Quantity of students enrolled per month, Q

Figure 7.8 Gains from trade.

1. The firm set its profit-maximizing 3. What would the fifteenth customer 5. The producer surplus on a single
price have been willing to pay? lesson
P* = $510, and it sells Q* = 20 courses This consumer has WTP of $542 and Similarly, the firm makes a producer
per month, the 20th consumer, whose hence a surplus of $32. surplus of $150 on each course sold—
WTP is $510, is just indifferent between the difference between the price ($510)
buying and not buying a course, so that 4. The consumer surplus and the unit cost ($360). The vertical
particular buyer’s surplus is equal to To find the surplus obtained by con- line in the diagram shows the producer
zero. sumers, we add together the surplus of surplus on the twelfth course, but it is
each buyer. This is shown by the the same for every course sold—the
2. A higher WTP shaded triangle between the demand distance between P* and the unit cost
Other buyers were willing to pay more. curve and the line where price is P*. line.
The tenth consumer, whose WTP is This measure of the consumer’s gains
$574, makes a surplus of $64, shown by from trade is the consumer surplus. 6. The total producer surplus
the vertical line at the quantity 10. To find the producer surplus, we add
together the surplus on each course
offered—this is the purple-shaded
rectangle.

CONSUMER SURPLUS, PRODUCER SURPLUS, AND PROFIT • In general, the profit is equal to the producer surplus
• The consumer surplus is a measure of the benefits of minus the firm’s fixed costs. The firm LP would have fixed
participation in the market for consumers. costs if, for example, it paid for advertising for its courses.
• The producer surplus is closely related to the firm’s profit. • The total surplus arising from trade in this market, for the
In our example they are exactly the same thing, but that is firm and consumers together, is the sum of consumer and
because we have assumed that the firm doesn’t have any producer surplus.
fixed costs.

290 F OR I NS T R UC T O R S ' US E O N L Y . P L E A S E D O N O T S H A R E W IT H
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 7.6 GAINS FROM TRADE

Evaluating the outcome using the Pareto efficiency criterion

Is the allocation of Spanish-language courses in this market Pareto
Pareto efficient An allocation with
efficient? To answer this question, we need to know all the technically
the property that there is no
feasible outcomes. These are combinations of price and quantity on the
alternative technically feasible
demand curve, where the price is no lower than the cost of production. If
allocation in which at least one
there is another technically feasible outcome in which at least one person
person would be better off, and
(customer or owner) is better off and no one is worse off, then the
nobody worse off.
outcome is not Pareto efficient.
Beginning at the allocation E in Figure 7.8, and considering the
customers, it is clear that there are some consumers who do not purchase
the course at the firm’s chosen price, but who would nevertheless be willing
to pay more than it would cost the firm to produce the course, namely
$360.
But we also know that, at any price below $510 (the profit-maximizing
Pareto improvement A change that
price at point E), profits are lower (the owner would be on an isoprofit
benefits at least one person
curve with lower profits). It appears that a Pareto improvement is not
without making anyone else worse
possible because, although consumers would be better off, the owner
off. See also: Pareto dominant.
would be worse off.
But evaluating whether the outcome is Pareto efficient does not mean
the rules of the game must be kept unchanged. If there is a technically feas-
ible allocation in which at least one person is better off and nobody is worse
off, then E is not Pareto efficient.
If LP could practise price discrimination, it could offer one more
Spanish course and sell it to the 21st consumer at a price lower than $510
but higher than the production cost. (The other 20 customers would
continue to pay $510.) This would be a Pareto improvement—both the
firm and the 21st consumer would be better off; the other 20 would be no
worse off. The firm’s profit on the 21st course sold would be lower than
on the 20th but total profits would rise. Remember that the isoprofit
curve is drawn assuming that all customers pay the same price. We need
to add the profit on the 21st course to $3,000 to calculate the firm’s total
profits.
The 21st consumer benefits from being able to buy the language course.
This example shows that the potential gains from trade in the market for
this type of language course have not been exhausted at E.
The cost of producing one more unit of output is called the marginal
marginal cost The addition to total
cost. In practice, marginal costs may depend on the level of production. For
costs associated with producing
example, if the firm had to pay overtime rates to achieve higher levels of
one additional unit of output.
output, the marginal cost of a course might be higher at high levels of pro-
duction. But, in our simple model of LP Spanish courses, we have assumed
that every course costs $360 to produce, irrespective of the total number of
courses sold. In this case, the marginal cost of a course is the same as the
unit cost—it is $360, however many courses are produced.
In Figure 7.9 we have drawn the demand curve again, as well as the
marginal cost line, which is a horizontal line at $360. Look at point F,
where the two lines cross. You can see that the forty-third consumer has a
WTP that is equal to the marginal cost of a course. For the forty-second
consumer, the willingness to pay exceeds the cost, so not offering the
forty-second course would not be efficient. For the forty-fourth con-
sumer, the willingness to pay is less than the cost, so offering more than
43 courses would also not be efficient.

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 7 FIRMS AND MARKETS FOR GOODS AND SERVICES

Figure 7.9 shows that the total surplus, which we can think of as the pie
to be shared between the owner and LP’s customers, would be the highest
possible if the firm produced 43 courses and sold them for $360.
Since the firm chooses E rather than F, there is a loss of potential
deadweight loss A loss of total
surplus, known as the deadweight loss.
surplus relative to a Pareto-effi-
It might seem confusing that the firm chooses E when we said that, at
cient allocation.
this point, it would be possible for both the consumers and the owner to be
better off. That is true, but only if LP could practise price discrimination—
if courses could be sold to other consumers at a lower price than to the first
20 consumers. The owner chooses E because that is the best she can do
given the rules of the game (setting one price for all consumers). To sell 43
courses without price discrimination, she would have to set a price of $360,
so her profits would be zero.

To explore all of the slides in this figure,

see the online version Isoprofit curve: $3,000
at https://tinyco.re/4878922. Marginal cost
Demand curve

E
P* = 510
Price; Cost ($)

DWL
F
360

Q* = 20 Q0= 43

Quantity of students enrolled per month, Q

Figure 7.9 Deadweight loss.

1. The total surplus at F 2. Producing at F would be Pareto 3. The total surplus at E is smaller
If the firm offered 43 courses and sold efficient The total surplus is smaller at E than F.
them for $360, the shaded area shows If fewer than 43 courses were The difference is called the deadweight
the total surplus. produced, there would be unexploited loss. It is the white triangle between
gains—some consumers would be Q = 20, the demand curve and the mar-
willing to pay more for another course ginal cost line.
than it would cost to make. If more
than 43 courses were produced, they 4. The division of the surplus at E
could only be sold at a loss. Producing At E, the surplus is divided between the
and selling 43 courses would be Pareto consumers and the owner.
efficient.

292 F OR I NS T R UC T O R S ' US E O N L Y . P L E A S E D O N O T S H A R E W IT H
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 7.6 GAINS FROM TRADE

The allocation that results from price-setting by the producer of a dif-

ferentiated product like Language Perfection’s Spanish course is Pareto
inefficient. The owner uses the firm’s bargaining power to set a price that is
higher than the marginal cost of a course. The firm keeps the price high by
producing a quantity that is too low, relative to the Pareto-efficient allocation.
Exercise 7.2 below shows that, in an unlikely scenario in which the firm
could engage in price discrimination and charge different prices for each
buyer, it would be possible to achieve a Pareto-efficient allocation.

EXERCISE 7.2 CHANGING THE RULES OF THE GAME

1. Suppose that Language Perfection had sufficient information and
enough bargaining power to charge each individual consumer the
maximum they would be willing to pay. Draw the demand curve and
marginal cost line (as in Figure 7.9), and indicate on your diagram:
(a) the number of courses sold
(b) the highest price paid by any consumer
(c) the lowest price paid by any consumer
(d) the consumer and producer surplus.
2. Give examples of goods that are sold in this way.
3. Why is price discrimination not common practice? Explain your
reasons.
4. Some firms charge different prices to different groups of consumers, for
example, airlines may charge higher fares for last-minute travellers.
Why would they do this, and what effect would it have on the consumer
and producer surpluses?
5. Now suppose that price discrimination is impossible, and that it
becomes very easy for language firms to set up in the city in which LP
operates. How could this give consumers more bargaining power?
6. Under these rules, how many courses would be sold?
7. Under these rules, what would the producer and consumer surpluses
be?

QUESTION 7.6 CHOOSE THE CORRECT ANSWER(S)

Which of the following statements are correct?

Consumer surplus is the difference between the consumers’

willingness to pay and what they actually pay.
Producer surplus is always equal to the firm’s profit.
Deadweight loss is the loss that the producer incurs for not selling
more courses.
All possible gains from trade are achieved when the firm chooses its
profit-maximizing output and price.

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 7 FIRMS AND MARKETS FOR GOODS AND SERVICES

7.7 PRICE-SETTING, MARKET POWER, AND PUBLIC

POLICY
Augustin Cournot and Irving Our analysis of pricing applies to any firm producing and selling a
Fischer. (1838) 1971. Researches product that is in some way different from that of any other firm. In the
into the Mathematical Principles nineteenth century, Augustin Cournot, carried out a similar analysis
of the Theory of Wealth. New York, using the example of bottled water from ‘a mineral spring which has just
NY: A. M. Kelley. been found to possess salutary properties possessed by no other’. Cournot
referred to this as a case of monopoly—in a monopolized market, there
is only one seller. He showed, as we have done, that the firm would set a
price greater than the marginal cost.
A more common market structure is called monopolistic competition.
monopoly A firm that is the only
In this case each firm sells a unique product, like Cheerios, but there are
seller of a product without close
other firms selling products that, while unique, are very similar in the
substitutes. Also refers to a market
minds (or tastes) of consumers, like Cornflakes.
with only one seller. See also:
monopoly power, natural
monopoly. GREAT ECONOMISTS
monopolistic competition A Augustin Cournot
market in which each seller has a Augustin Cournot (1801–1877)
unique product but there is com- was a French economist, now most
petition among firms because firms famous for his model of oligopoly
sell products that are close (a market with a small number of
substitutes for one another. firms). Cournot’s 1838 book,
oligopoly A market with a small Recherches sur les Principes
number of sellers of the same Mathématiques de la Théorie des
good, giving each seller some Richesses (Research on the
market power. Mathematical Principles of the
market failure When markets Theory of Wealth), introduced a
allocate resources in a Pareto- new mathematical approach to
inefficient way. economics, although he feared it
profit margin The difference would ‘draw on me … the
between the price and the mar- condemnation of theorists of repute’. Cournot’s work influenced other
ginal cost. nineteenth-century economists, such as Marshall and Walras, and
price markup The price minus the established the basic principles we still use to think about the behaviour
marginal cost, divided by the price. of firms. Although he used algebra rather than diagrams, Cournot’s
It is inversely proportional to the analysis of demand and profit maximization was very similar to ours.
elasticity of demand for this good.

We saw in Section 7.3 (page 279) that, when the producer of a differentiated
good sets a price above the marginal cost of production, the market out-
come is not Pareto efficient. When trade in a market results in a Pareto-
inefficient allocation, we describe this as a case of market failure.
The deadweight loss gives us a measure of the unexploited gains from
trade. The deadweight loss is high when the gap between the price and the
marginal cost, which we call the firm’s profit margin, is high. More
precisely, what matters is the markup—the profit margin as a proportion
of the price.
What determines the markup chosen by the firm? To answer this
question, we need to think again about how consumers behave.
Markets with differentiated products reflect differences in the prefer-
ences of consumers as well as differences in their incomes. Like those
wishing to learn a language, people who want to buy a car, for example, are
looking for different combinations of characteristics. A consumer’s

294 F OR I NS T R UC T O R S ' US E O N L Y . P L E A S E D O N O T S H A R E W IT H
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 7.7 PRICE-SETTING, MARKET POWER, AND PUBLIC POLICY

willingness to pay for a particular model will depend not only on its
characteristics, but also on the characteristics and prices of similar types of
cars sold by other firms.
When consumers can choose between several similar cars, the demand
for each of these cars is likely to be quite responsive to prices. If the price of
the Ford Fiesta, for example, were to rise, demand would fall because
people would choose to buy one of the other brands instead. Conversely, if
the price of the Fiesta were to fall, demand would increase because con-
sumers would be attracted away from the other cars.
The more similar the other cars are to the Fiesta, the more responsive
consumers will be to price differences. Only those with the highest brand
loyalty to Ford, and those with a strong preference for a characteristic of
the Fiesta that other cars do not possess, would fail to respond. Therefore,
the firm will not be able to raise the price much without losing consumers.
To maximize its profits, it will choose a low markup.

Price elasticity of demand and market power

The responsiveness of consumers to price changes can be measured by
price elasticity of demand The
calculating the price elasticity of demand, which, as we saw in Unit
percentage change in demand that
3 (page 132), is defined as the percentage fall in the quantity demanded
would occur in response to a 1%
in response to a 1% rise in the price. If you think about the graph of a
increase in price. We express this as
demand curve—with quantity as the horizontal axis variable and price as
a positive number. Demand is
the vertical axis variable—you can see that the elasticity of demand for a
elastic if this is greater than 1, and
good will be high when its demand curve is relatively flat, and low when
inelastic if less than 1.
it slopes steeply downward.
monopoly rents A form of profits,
In contrast, the manufacturer of a very specialized type of car, quite dif-
which arise due to restricted com-
ferent from any other brand in the market, faces little competition and
petition in selling a firm’s product.
hence less elastic demand. It can set a price well above marginal cost
substitutes Two goods for which an
without losing customers. Such a firm is earning monopoly rents (profits
increase in the price of one leads to
over and above its production costs), arising from its position as the only
an increase in the quantity
supplier of this type of car.
demanded of the other. See also:
A firm will be in a strong position if there are few firms producing close
complements.
substitutes for its own brand, because it faces little competition. Its
market power An attribute of a
elasticity of demand will be relatively low. We say that such a firm has
firm that can sell its product at a
market power. It will have sufficient bargaining power in its relationship
range of feasible prices, so that it
with customers to set a high markup without losing them to competitors.
can benefit by acting as a price-
This was the case with LP, because it was the only firm selling one-on-one
setter (rather than a price-taker).
Spanish-language courses in its city.
Thus, the main difference between monopoly and monopolistic com-
petition is that the price elasticity of demand is low in the case of
monopoly, because there are no competing firms selling close substitutes
for the firm’s product. By contrast, a monopolistically competitive firm
faces a more elastic demand curve because, if it raises prices, consumers
will switch to other firms selling close substitutes. Joan Robinson
pioneered the economic theory of market competition among firms that
were neither monopolies nor the price-taking firms that are the basis of
the model of perfect competition.

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 7 FIRMS AND MARKETS FOR GOODS AND SERVICES

GREAT ECONOMISTS
Joan Robinson (1903–1983)
A letter to a female student in
1970, from Paul Samuelson,
perhaps the most influential
economist of the twentieth
century, concluded: ‘P.S. Do study
economics. Perhaps the best
economist in the world happens
also to be a woman ( Joan
Robinson).’
Robinson earned respect and
recognition in 1933 with her first
major work, The Economics of
Imperfect Competition. She
challenged the conventional
wisdom by developing an analysis
of what we now call monopolistic
competition. Facing a downward-
Joan Robinson. 1933. The Eco-
sloping demand curve, firms act as price-setters, not price-takers.
nomics of Imperfect Competition
She was a member of the small circle at the University of Cambridge
(https://tinyco.re/1766675).
that John Maynard Keynes drew upon to comment on and refine his
London: MacMillan & Co.
General Theory, published in 1936. In 1937 she published Introduction to
the Theory of Employment, which made Keynes’ work accessible to
students.
That Robinson’s much-lauded intellectual achievements were not
crowned with a Nobel prize has drawn much speculation. Was it because
of her relentless critique of what she called ‘mainstream’ economics
including, very pointedly, Samuelson’s ideas?
George R. Feiwel (ed.). 1989. Joan Her advice to teachers of economics was to ‘start from the beginning
Robinson and Modern Economic to discuss various types of economic system. Every society (except
Theory. New York: New York Uni- Robinson Crusoe) has to have some rules of the game for organizing
versity Press: p. 4. production and the distribution of the product.’ She also urged eco-
nomists to ‘displace the theory of the relative prices of commodities
from the centre of the picture.’

Competition policy
This discussion helps to explain why policymakers may be concerned about
firms that have few competitors. Market power allows the firms to set high
prices—and make high profits—at the expense of consumers. Potential con-
sumer surplus is lost both because few consumers buy, and because those
who buy pay a high price. The owners of the firm benefit, but overall there
is a deadweight loss.
A firm selling a niche product catering for the preferences of a small
number of consumers (such as a luxury car brand like a Lamborghini) is
unlikely to attract the attention of policymakers, despite the loss of con-
sumer surplus. But if one firm is becoming dominant in a large market,
governments may intervene to promote competition. In 2000, the
European Commission prevented the proposed merger of Volvo and
Scania, on the grounds that the merged firm would have a dominant
position in the heavy-trucks market in Ireland and the Nordic countries.

296 F OR I NS T R UC T O R S ' US E O N L Y . P L E A S E D O N O T S H A R E W IT H
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 7.7 PRICE-SETTING, MARKET POWER, AND PUBLIC POLICY

In Sweden the combined market share of the two firms was 90%. The
merged firm would almost have been a monopoly—the extreme case of a
firm that has no competitors at all.
When there are only a few firms in a market, they may form a cartel—a
cartel A group of firms that collude
group of firms that colludes to keep the price high. By working together
in order to increase their joint
and behaving as a monopoly rather than competing, the firms can increase
profits.
profits. A well-known example is OPEC, an association of oil-producing
competition policy Government
countries. OPEC members jointly agree to set production levels to control
policy and laws to limit monopoly
the global price of oil. Following sharp increase in oil prices in 1973 and
power and prevent cartels. Also
again in 1979, the OPEC cartel played a major role in sustaining these high
known as: antitrust policy.
oil prices at a global level.
antitrust policy Government policy
While cartels between private firms are illegal in many countries, firms
and laws to limit monopoly power
often find ways to cooperate in the setting of prices so as to maximize
and prevent cartels. Also known as:
profits. Policy to limit market power and prevent cartels is known as com-
competition policy.
petition policy, or antitrust policy in the US.
Dominant firms may exploit their position by strategies other than high
prices. In a famous antitrust case at the end of the twentieth century, the US Richard J. Gilbert and Michael L.
Department of Justice accused Microsoft of behaving anticompetitively by Katz. 2001. ‘An Economist’s Guide
‘bundling’ its own web browser, Internet Explorer, with its Windows to US v. Microsoft’
operating system. In the 1920s, an international group of companies (https://tinyco.re/7683758). Journal
making electric light bulbs—including Philips, Osram, and General of Economic Perspectives 15 (2):
Electric—formed a cartel that agreed to a policy of ‘planned obsolescence’ pp. 25–44.
to reduce the lifetime of their bulbs to 1,000 hours, so that consumers
would have to replace them more quickly. Markus Krajewski. 2014. ‘The Great
Lightbulb Conspiracy’
(https://tinyco.re/3479245). IEEE
EXERCISE 7.3 MULTINATIONALS OR INDEPENDENT RETAILERS?
Spectrum. Updated 25 September
Imagine that you are a politician in a town in which a multinational
2014.
retailer is planning to build a new superstore. A local campaign is
protesting that it will drive small independent retailers out of business,
thereby reducing consumer choice and changing the character of the area.
Supporters of the plan argue, in turn, that this will only happen if con-
sumers prefer the supermarket.
Which side are you on? Explain the reasons for your choice.

QUESTION 7.7 CHOOSE THE CORRECT ANSWER(S)

Which of the following statements regarding the film industry are
correct?

Industry regulators should cap the price of a DVD at its marginal

cost.
The marginal cost of producing additional copies of a film is high.
The quantity sold in the film industry is inefficient.
The price is above marginal cost due to lack of substitutes.

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S T U D E NT S .
 7 FIRMS AND MARKETS FOR GOODS AND SERVICES

QUESTION 7.8 CHOOSE THE CORRECT ANSWER(S)

Suppose that a multinational retailer is planning to build a new
superstore in a small town. Which of the following arguments could be
correct?

The local protesters argue that the close substitutability of some of

the goods sold between the new retailer and existing ones means
that the new retailer faces inelastic demand for those goods, giving
it excessive market power.
The new retailer argues that the close substitutability of some of
the goods implies a high elasticity of demand, leading to healthy
competition and lower prices for consumers.
The local protesters argue that, once the local retailers are driven
out, there will be no competition, giving the multinational retailer
more market power and driving up prices.
The new retailer argues that most of the goods sold by local
retailers are sufficiently differentiated from its own goods that their
elasticity of demand will be high enough to protect the local
retailers’ profits.

7.8 PRODUCT SELECTION, INNOVATION, AND

ADVERTISING
John Kay. ‘The Structure of The profits that the owners of a firm can achieve depend on the demand
Strategy’ (reprinted from Business curve for its product, which in turn depends on the preferences of con-
Strategy Review 1993) sumers and competition from other firms. But the firm may be able to
(https://tinyco.re/7663497). move the demand curve to increase profits by changing its selection of
products, or through advertising.
Parker Brothers first marketed a property-trading board game under the
name Monopoly in 1935. In a series of court cases in the 1970s, Parker
Brothers attempted to prevent Ralph Anspach, an economics professor,
from selling a game called Anti-Monopoly. Anspach claimed that Parker
Brothers did not have exclusive rights to sell Monopoly, since the company
had not originally invented it.
After the court ruled in favour of Anspach, many competing versions of
Monopoly appeared on the market. After a change in the law, Parker
Brothers established the right to the Monopoly trademark in 1984, so
Monopoly is now a monopoly again.
When deciding what goods to produce, the firm would ideally like to
find a product that is both attractive to consumers and has different
characteristics from the products sold by other firms. In this case,
demand would be high (many consumers would wish to buy it at each
price) and the elasticity low. Of course, this is not likely to be easy. A
firm wishing to make a new type of sportswear, or type of car, knows
that there are already many brands on the market. But technological
innovation may provide opportunities to get ahead of competitors. In
1997, Toyota developed the first mass-produced hybrid car, the Prius.
For many years afterwards, other manufacturers produced few similar
cars, and Toyota effectively monopolized the hybrid market. By 2013,
there were several competing brands, but the Prius remained the market
leader, with more than 50% of hybrid sales.

298 F OR I NS T R UC T O R S ' US E O N L Y . P L E A S E D O N O T S H A R E W IT H
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If a firm has invented or created a new product, it may be able to prevent

competition altogether by claiming exclusive rights to produce it, using
patent or copyright laws. For example, Parker Brothers spent years in court
fighting to keep their monopoly of Monopoly. This kind of legal protection
of monopoly may help to provide incentives for research and development
of new products, but at the same time limits the gains from trade.
Advertising is another strategy that firms can use to influence demand.
It is widely used by both car manufacturers and breakfast cereal producers.
When products are differentiated, the firm can use advertising to inform
consumers about the existence and characteristics of its product, attract
them away from its competitors, and create brand loyalty.
According to Schonfeld and Associates, a firm of market analysts,
advertising of breakfast cereals in the US is about 5.5% of total sales
revenue—about 3.5 times higher than the average for manufactured
products. The data in Figure 7.10 is for the highest-selling 35 breakfast
cereal brands sold in the Chicago area in 1991 and 1992. The graph
shows the relationship between market share and quarterly expenditure
on advertising.
If you investigated the breakfast cereals market more closely, you would Matthew Shum. 2004. ‘Does
see that market share is not closely related to price. But it is clear from Advertising Overcome Brand
Figure 7.10 that the brands with the highest share are also the ones that Loyalty? Evidence from the
spend the most on advertising. Matthew Shum, an economist, analysed Breakfast-Cereals Market’
cereal purchases in Chicago using this dataset, and showed that advertising (https://tinyco.re/3909324). Journal
was more effective than price discounts in stimulating demand for a brand. of Economics & Management
Since the best-known brands were also the ones spending most on Strategy 13 (2): pp. 241–72.
advertising, he concluded that the main function of advertising was not to
inform consumers about the product, but rather to increase brand loyalty
and encourage consumers of other cereals to switch.

6 Figure 1 in Matthew Shum. 2004. ‘Does

Cornflakes
Advertising Overcome Brand Loyalty?
5 Evidence from the Breakfast-Cereals
Market’ (https://tinyco.re/3909324).
Cheerios
Journal of Economics & Management
Market share (%)

4
Frosted Flakes Strategy 13 (2): pp. 241–72.

Quaker Oats Grape Nuts

2
Raisin Bran
1

0
0 2 4 6 8
Quarterly national advertising expenditure ($, millions)

Figure 7.10 Advertising expenditure and market share of breakfast cereals in

Chicago (1991–1992).

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 7 FIRMS AND MARKETS FOR GOODS AND SERVICES

7.9 BUYING AND SELLING: DEMAND AND SUPPLY IN A

COMPETITIVE MARKET
WTP is a useful concept for buyers So far, we have considered the case of a differentiated product sold by just
in online auctions, such as eBay. If one firm. In the market for such a product there is one seller with many
you want to bid for an item, one buyers. Now we look at markets in which many buyers and sellers interact,
way to do it is to set a maximum and show how the market price is determined by both the preferences of
bid equal to your WTP, which will consumers and the costs of suppliers.
be kept secret from other bidders. For a simple model of a market with many buyers and sellers, think
For how to do this on eBay, see about the potential for trade in second-hand copies of a recommended
their online customer service textbook for a university economics course. Demand for the book comes
centre (https://tinyco.re/0107311). from students who are about to begin the course, and they will differ in
eBay will place bids automatically their willingness to pay. No one will pay more than the price of a new copy
on your behalf until you are the in the campus bookshop. Below that, students’ WTP may depend on how
highest bidder, or until your hard they work, how important they think the book is, and on their avail-
maximum is reached. You will win able resources for buying books.
the auction if, and only if, the high- Figure 7.11 shows the demand curve. As we did for Language Perfection,
est bid is less than or equal to your we line up all the consumers in order of willingness to pay, highest first.
WTP. The first student is willing to pay $20, the 20th is willing to pay $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.
willingness to accept (WTA) The
The demand curve represents the WTP of buyers. Similarly, supply
reservation price of a potential
depends on the sellers’ willingness to accept (WTA) money in return
seller, who will be willing to sell a
for books.
unit only for a price at least this
The supply of second-hand books comes from students who have
high. See also: reservation price,
previously completed the course, who will differ in the amount they are
willingness to pay.
willing to accept—that is, their reservation price. Recall from Unit 5 (page
reservation price The lowest price
209) that Angela was willing to enter into a contract with Bruno only if it
at which someone is willing to sell
gave her at least as much utility as her reservation option (no work and
a good (keeping the good is the
survival rations). Here, the reservation price of a potential seller represents
potential seller’s reservation
the value to her of keeping the book, and she will only be willing to sell for
option). See also: reservation
a price at least that high. Poorer students (who are keen to sell so that they
option.
can afford other books) and those no longer studying economics may have
lower reservation prices.

20

15
Price, P (WTP, $)

10

Demand curve

0
0 5 10 15 20 25 30 35 40 45
Quantity of books, Q (number of buyers)

Figure 7.11 The market demand curve for books.

300 F OR I NS T R UC T O R S ' US E O N L Y . P L E A S E D O N O T S H A R E W IT H
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 7.9 BUYING AND SELLING: DEMAND AND SUPPLY IN A COMPETITIVE MARKET

We can draw a supply curve by lining up the

Online auctions like eBay allow sellers to specify their WTA. If
sellers in order of their reservation prices (their
you sell an item on eBay you can set a reserve price, which will
WTAs). Figure 7.12 is an example of a supply
not be disclosed to the bidders. See eBay’s online customer
curve. To do this, we put the sellers who are most
service centre (https://tinyco.re/9324100) for how to set a
willing to sell—those who have the lowest reserva-
reserve price on their platform. You are telling eBay that the
tion prices—first, so the graph of reservation
item should not be sold unless there is a bid at (or above) that
prices slopes upward.
price. Therefore, the reserve price should correspond to your
For any price, the supply curve shows the
WTA. If no one bids your WTA, the item will not be sold.
number of students willing to sell at that price—
that is, the number of books that will be supplied
to the market. We have drawn the supply and
supply curve The curve that shows the number of units of
demand curves as straight lines for simplicity. In
output that would be produced at any given price. For a
practice, they are more likely to be curves, with
market, it shows the total quantity that all firms together would
the exact shape depending on how valuations of
produce at any given price.
the book vary among the students.

14 To explore all of the slides in this figure,

Price, P (sellers' reservation prices) ($)

see the online version

12 at https://tinyco.re/1096561.

10

4
Supply curve
2

0
0 5 10 15 20 25 30 35 40 45
Quantity of books, Q (number of sellers)

Figure 7.12 The supply curve for books.

1. Reservation price 3. Seller 40 4. Supply curves slope upward

The first seller has a reservation price The fortieth seller’s reservation price is If you choose a particular price, say
of $2 and will sell at any price above $12. $10, the graph shows how many books
that. would be supplied (Q) at that price—in
this case, it is 32. The supply curve
2. Seller 20 slopes upward: the higher the price, the
The 20th seller will accept $7. more students will be willing to sell.

FOR IN STR U C T OR S ' U S E ONLY. P L E A S E D O N O T S H A R E W I T H 301

S T U D E NT S .
 7 FIRMS AND MARKETS FOR GOODS AND SERVICES

QUESTION 7.9 CHOOSE THE CORRECT ANSWER(S)

As a student representative, one of your roles is to organize a second-
hand textbook market between the current and former first-year
students. After a survey, you estimate the demand and supply curves.
For example, you estimate that pricing the book at $7 would lead to a
supply of 20 books and a demand of 26 books. Which of the following
statements are correct?

A rumour that the textbook may be required again in Year 2 would

change the supply curve, shifting it upwards.
Doubling the price to $14 would double the supply.
A rumour that the textbook may no longer be on the reading list for
the first-year students would change the demand curve, shifting it
upwards.
Demand would double if the price were reduced sufficiently.

EXERCISE 7.4 SELLING STRATEGIES AND RESERVATION PRICES

Consider three possible methods to sell a car that you own:

• advertise it in the local newspaper

• take it to a car auction
• offer it to a second-hand car dealer.

1. Would your reservation price be the same in each case? Why?

2. If you used the first method, would you advertise it at your reservation
price?
3. Which method do you think would result in the highest sale price?
4. Which method would you choose? Give reasons for your choice.

The equilibrium price

What will happen in the market for this textbook? That will depend on the
market institutions that bring buyers and sellers together. If students need
to rely on word of mouth, then when a buyer finds 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 a high willingness to pay. Before concluding a deal
with one trading partner, both parties would like to know about other
trading opportunities.
Traditional market institutions often brought many buyers and sellers
together in one place. Many of the world’s great cities grew up around
marketplaces and bazaars along ancient trading routes such as the Silk
Road between China and the Mediterranean. In the Grand Bazaar of
Istanbul, one of the largest and oldest covered markets in the world, shops
selling carpets, gold, leather, and textiles cluster together in different areas.
With modern communications and online marketplaces, sellers can
advertise their goods and buyers can more easily find out what is available
and where to buy it. But in some cases, it is still convenient for many buyers
and sellers to meet. Large cities have markets for meat, fish, vegetables, or
flowers, where buyers can inspect the produce and compare prices.

302 F OR I NS T R UC T O R S ' US E O N L Y . P L E A S E D O N O T S H A R E W IT H
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 7.9 BUYING AND SELLING: DEMAND AND SUPPLY IN A COMPETITIVE MARKET

At the end of the nineteenth century, the economist Alfred Marshall Alfred Marshall. 1920. Principles of
introduced his model of supply and demand using a similar example to our Economics (https://tinyco.re/
case of second-hand books. Most English towns had a corn exchange—also 0560708). 8th ed. London:
known as a grain exchange—a building in which farmers met with merchants MacMillan & Co.
to sell their grain. In Principles of Economics: Book Five: General Relations of
Demand, Supply, and Value, Marshall described how the supply curve of grain
would be determined by the prices that farmers would be willing to accept,
and the demand curve by the willingness to pay of merchants. Then he
argued that, although the price ‘may be tossed hither and thither like a
shuttlecock’ in the ‘higgling and bargaining’ of the market, it would never be
very far from the particular price at which the quantity demanded by
merchants was equal to the quantity the farmers would supply.
Marshall called the price that equated supply and demand the equilib-
excess supply A situation in which
rium price. If the price was above the equilibrium, farmers would want to
the quantity of a good supplied is
sell large quantities of grain, but few merchants would want to buy—there
greater than the quantity
would be excess supply. Then, even the merchants who were willing to pay
demanded at the current price. See
that much would realize that farmers would soon have to lower their prices
also: excess demand.
and would wait until they did. Similarly, if the price was below the equilib-
Nash equilibrium A set of
rium, sellers would prefer to wait rather than sell at that price. If, at the
strategies, one for each player in
going price, the amount supplied did not equal the amount demanded,
the game, such that each player’s
Marshall reasoned that some sellers or buyers could benefit by charging
strategy is a best response to the
some other price. In modern terminology, we would say that the going
strategies chosen by everyone else.
price was not a Nash equilibrium. The price would tend to settle at an
equilibrium A model outcome that
equilibrium level, where demand and supply were equated.
does not change unless an outside
Marshall’s supply and demand model can be applied to markets in which all
or external force is introduced that
sellers are selling identical (not differentiated) goods, so buyers are equally
alters the model’s description of
willing to buy from any seller.
the situation.
marginal utility The additional
GREAT ECONOMISTS utility resulting from a one-unit
Alfred Marshall increase of a given variable.
Alfred Marshall (1842–1924) was
a founder—with Léon Walras—of Alfred Marshall. 1920. Principles of
what is termed the neoclassical Economics (https://tinyco.re/
school of economics. His 0560708). 8th ed. London:
Principles of Economics, first MacMillan & Co.
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 to express key concepts such as
marginal costs and marginal utility. The concepts of consumer and
producer surplus are also attributed 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.

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 7 FIRMS AND MARKETS FOR GOODS AND SERVICES

Sadly, much of the wisdom in Marshall’s text has rarely been taught
by his followers. Marshall paid attention to facts—and to ethics. 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. And he insisted that:

Ethical forces are among those of which the economist must 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 Eco-
nomics, 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.
A. C. Pigou (editor). 1966. 6. If you can’t succeed in 4, burn 3. This last I did often.
Memorials of Alfred Marshall. New
York, A. M. Kelley. pp. 427–28. 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.
Nevertheless, 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?

304 F OR I NS T R UC T O R S ' US E O N L Y . P L E A S E D O N O T S H A R E W IT H
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 7.9 BUYING AND SELLING: DEMAND AND SUPPLY IN A COMPETITIVE MARKET

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. We would expect most
trades to occur at similar prices. Buyers and sellers could 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; 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 prices.
We can find the equilibrium price by drawing the supply and demand
curves on one diagram, as in Figure 7.13. 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 market-clearing price is $8—that is, supply is equal to demand at
market-clearing price At this price
this price—all buyers who want to buy, and all sellers who want to sell, can
there is no excess supply or excess
do so. The market is in equilibrium. In everyday language, something is in
demand. See also: equilibrium.
equilibrium if the forces acting on it are in balance, so that it remains still.
We say that a market is in equilibrium if the actions of buyers and sellers
have no tendency to change the price or the quantities bought and sold,
until there is a change in market conditions. At the equilibrium price for
textbooks, all those who wish to buy or sell are able to do so, so there is no
tendency for change.

To explore all of the slides in this figure,

20
see the online version
at https://tinyco.re/8602647.

15 Supply curve
Price, P ($)

10
A
P*

Demand curve

0
0 5 10 15 20 Q* 25 30 35 40 45
Quantity of books, Q

Figure 7.13 Equilibrium in the market for second-hand books.

1. Supply and demand 3. A price above the equilibrium price— 4. A price below the equilibrium
We find the equilibrium by drawing the excess supply price—excess demand
supply and demand curves in the same At a price greater than $8 more At a price less than $8, there would be
diagram. students would wish to sell, but not all more buyers than sellers—excess
of them would find buyers. There would demand—so sellers could raise their
2. The market-clearing price be excess supply, so these sellers would prices. Only at $8 is there no tendency
At a price P* = $8, the quantity supplied want to lower their price. for change.
is equal to the quantity demanded: Q* =
24. The market is in equilibrium. We say
that the market clears at a price of $8.

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 7 FIRMS AND MARKETS FOR GOODS AND SERVICES

Price-taking
Not all online markets for books are in competitive equilib-
Will a market always be in equilibrium? No—
rium. Michael Eisen, a biologist, noticed that an out-of-print
when conditions change, it will take time for the
text, The Making of a Fly, was listed for sale on Amazon by two
market participants to adjust; while that
reputable sellers, with prices starting at $1,730,045.91 (+$3.99
happens, goods may be bought and sold at non-
shipping). Over the next week prices rose rapidly, peaking at
equilibrium prices. But, as Marshall argued,
$23,698,655.93, before dropping to $106.23. Eisen explains why
people would want to change their prices if there
in his blog (https://tinyco.re/0044329).
was excess supply or demand and would expect
these changes to eventually move the economy
toward a market equilibrium.
price-taker Characteristic of producers and consumers who
In the textbook market that we have described,
cannot benefit by offering or asking any price other than the
individual students accept the prevailing equilib-
market price in the equilibrium of a competitive market. They
rium price determined by the supply and demand
have no power to influence the market price.
curves. This is because they could not benefit by
excess demand A situation in which the quantity of a good
offering to buy or sell at a price different from the
demanded is greater than the quantity supplied at the current
equilibrium price. No one would trade with a
price. See also: excess supply.
seller asking a higher price or a buyer offering a
competitive equilibrium A market outcome in which all buyers
lower one, because anyone could find an
and sellers are price-takers, and at the prevailing market price,
alternative seller or buyer with a better price.
the quantity supplied is equal to the quantity demanded.
The participants in this market equilibrium
are price-takers, because there is sufficient
competition from other buyers and sellers that the best they can do is to
trade at the same price. They are free to choose other prices, but in
contrast to the case when there is either excess supply or excess demand,
when the market is in equilibrium they cannot benefit by doing so.
On both sides of the market, competition eliminates bargaining
power. We describe the equilibrium in such a market as a competitive
equilibrium. A competitive equilibrium is a Nash equilibrium because,
given what all other actors are doing (trading at the equilibrium price),
no actor can do better than to continue what they are doing (also trading
at the equilibrium price).
In contrast, the seller of a differentiated product can set its price,
because there are no close competitors. But the buyers are price-takers. In
the example of Language Perfection, there are many consumers wanting to
buy a Spanish-language course, so individual consumers have no power to
negotiate a more advantageous deal—they have to accept the price that
other consumers are paying.

EXERCISE 7.5 PRICE-TAKERS

Think about some of the goods you buy: perhaps different kinds of food,
clothes, transport tickets, or electronic goods.

1. Are there many sellers of these goods?

2. Do you try to find the lowest price in each case?
3. If not, why not?
4. For which goods would price be your main criterion?
5. Use your answers to help you decide if the sellers of these goods are
price-takers. Are there goods for which you, as a buyer, are not a price-
taker?

306 F OR I NS T R UC T O R S ' US E O N L Y . P L E A S E D O N O T S H A R E W IT H
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 7.10 DEMAND AND SUPPLY IN A COMPETITIVE MARKET: BAKERIES

QUESTION 7.10 CHOOSE THE CORRECT ANSWER(S)

Figure 7.14 shows the demand and the supply curves for a textbook.
The curves intersect at (Q, P) = (24, 8). Which of the following state-
ments are correct?

20

15 Supply curve
Price, P ($)

10
A
P*

Demand curve

0
0 5 10 15 20 Q* 25 30 35 40 45
Quantity of books, Q

Figure 7.14 Supply and demand for textbooks.

At price $10, there is an excess demand for the textbook.

At $8, some of the sellers have an incentive to increase their selling
price to $9.
At $8, the market clears.
Forty books will be sold in total.

7.10 DEMAND AND SUPPLY IN A COMPETITIVE

MARKET: BAKERIES
In the second-hand textbook example, both buyers and sellers are indi-
vidual consumers. Now we look at an example in which the sellers are firms
producing output. We know how the firm sets the price and quantity of a
differentiated product, and that the price depends on whether there is com-
petition from firms selling quite similar products—if there is competition,
demand will be elastic, and the firm will be unable to set a high price
because that would cause consumers to switch to other similar brands.
If there are many firms producing identical products, and consumers
can easily switch from one firm to another, then firms will be price-takers
in equilibrium. They will be unable to benefit from attempting to trade at a
price different from the prevailing price.
To understand how price-taking firms behave, consider a city in which
many small bakeries produce bread and sell it directly to consumers. Figure
7.15 shows what the market demand curve (the total daily demand for
bread of all consumers in the city) might look like. It is downward-sloping
as usual because, at higher prices, fewer consumers will be willing to buy.
Suppose that you are the owner of one small bakery. You have to decide
what price to charge and how many loaves to produce each morning.
Suppose that neighbouring bakeries are selling loaves identical to yours at
€2.35. The loaf is a large baguette. This is the prevailing market price; you
will not be able to sell loaves at a higher price than other bakeries, because
no one would buy—you are a price-taker.

FOR IN STR U C T OR S ' U S E ONLY. P L E A S E D O N O T S H A R E W I T H 307

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 7 FIRMS AND MARKETS FOR GOODS AND SERVICES

What you should do depends on your costs of production—and, in

particular, on your marginal costs. You may have some fixed costs, for
example, the rent you pay on your premises—but you have to pay these
irrespective of the number of loaves you produce. It is the additional costs
of actually making each loaf of bread—the cost of the ingredients, and what
you have to pay your employees for the time it takes to bake a loaf—that
determine whether you should produce 30, 50 or 100 loaves per day.
Having installed mixers, ovens, and other equipment, the marginal cost of
each extra loaf may be relatively low, as long as you don’t exceed the
capacity of your equipment.
Figure 7.16 illustrates this situation. Your bakery has the capacity to
produce up to 120 loaves per day. Below that level, the marginal cost of a
loaf is €1.50. The horizontal line at P* = €2.35 represents the demand for
bread from your bakery—because you are a price-taker, each loaf you
produce can be sold for €2.35.
In this example, it is easy to find the profit-maximizing price and
quantity without drawing isoprofit curves. Work through the analysis of
Figure 7.16 to see how this is done.
Your optimal choice is P* = €2.35 and Q* = 120; since your marginal
cost is less than the market price, you maximize profit by making as many
loaves as possible. Your profit will be the total surplus on 120 loaves minus
your fixed costs.
What would you do if the market price changed? As long as it remains
above €1.50, your profit-maximizing choice remains the same. But if the
price fell below €1.50, you should immediately stop making bread. In that
case, you would make a loss on any loaf produced.
Even if the market price were a little above €1.50, you might make a loss
overall if your fixed costs were high. In this case, you still do the best you
can by producing 120 loaves—at least the surplus will help you to cover
part of the fixed costs. But in the longer term you would need to consider
whether it is worth continuing in business. If you expect market conditions
to remain bad, it might be best to sell up and leave the market—you could
obtain a better return on your capital elsewhere.

3
Price, P (€)

Demand curve

0
0 1,000 2,000 3,000 4,000 5,000 6,000 7,000 8,000 9,000 10,000
Quantity of loaves, Q

Figure 7.15 The market demand curve for bread.

308 F OR I NS T R UC T O R S ' US E O N L Y . P L E A S E D O N O T S H A R E W IT H
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 7.10 DEMAND AND SUPPLY IN A COMPETITIVE MARKET: BAKERIES

The market supply curve

The market for bread in the city has many consumers and many bakeries.
Let’s suppose initially there are 20 bakeries, differing in their marginal costs
and their production capacity. Costs differ across bakeries because they
specialize in producing different kinds of bread. Those that specialize in
making large baguettes have the lowest marginal costs; for other bakeries to
supply this type of bread, they need to switch employees who are more
skilled in other types of bread production to baguette baking and their costs
are higher. Similarly, the equipment of the non-specialist bakeries is less
suited to producing baguettes, which is another reason their marginal costs
are higher. As bakeries less and less suited to produced large baguettes
supply the market, marginal costs rise, as shown in Figure 7.17.

To explore all of the slides in this figure,

5
see the online version
at https://tinyco.re/2377985.
4
Price, P; Cost (€)

3
Market price
P*
2
Producer surplus
Marginal cost of a loaf

0
0 20 40 60 80 100 Q* = 120 140 160 180 200

Quantity of loaves, Q

Figure 7.16 The profit-maximizing price and quantity.

1. The marginal cost of a loaf 3. Price-taking 5. The profit-maximizing quantity

Whatever quantity of loaves you decide The bakery is a price-taker. The market On every loaf you produce up to 120,
to produce between 0 and 120, the cost price is P* = €2.35. If you choose a you can make a surplus of €2.35 −
of making one more loaf—that is, the higher price, customers will go to other €1.50=€0.85. You can increase your
marginal cost—is €1.50. bakeries. Your feasible set of prices and profit by making as many as possible.
quantities is the shaded area below the Your profit-maximizing quantity is Q* =
2. The maximum level of production horizontal line at P*, where the price is 120.
Given the capacity of your bakery, you less than or equal to €2.35, and the
cannot produce more than 120 loaves. quantity is less than or equal to 120. 6. Producer surplus
Your surplus is the shaded area below
4. The profit-maximizing price the line at P* above the marginal cost.
However many loaves you produce, Surplus = (2.35 − 1.50) × 120 = €102.
you should sell them at €2.35 each. A
higher price is not feasible, and a lower
price would bring less profit.

FOR IN STR U C T OR S ' U S E ONLY. P L E A S E D O N O T S H A R E W I T H 309

S T U D E NT S .
 7 FIRMS AND MARKETS FOR GOODS AND SERVICES

Each bakery will decide how many loaves to produce in the same way:

• When the market price is above its marginal cost: It will produce and sell its
maximum output.
• When the market price is below its marginal cost: It will make none of this
kind of bread.

We can work out how much each bakery will supply at any given market
price. To find the market supply curve, we just add up the total amount that
all the bakeries will supply at each price.
We can do this in the same way as for second-hand textbooks. Figure
7.17 shows how to find the market supply by lining the 20 bakeries up in
order of their marginal costs.

To explore all of the slides in this figure, 5

see the online version
at https://tinyco.re/5854244.
4
Price, P (€)

0
0 1,000 2,000 3,000 4,000

Quantity of loaves, Q

Figure 7.17 The market supply curve: 20 firms.

1. The market supply curve 3. The next bakery 5. Market supply when the price is P*
To draw the market supply, we line up The next one has marginal cost €1.10 If the price is P*, only the bakeries with
the 20 bakeries in order of their mar- and can make 240 loaves per day. marginal cost less than or equal to P*
ginal costs—lowest first—and plot the will produce bread. If the price was €3,
marginal cost of each one, up to the 4. The capacity of the market the graph shows that total market
maximum number of loaves it can If all the bakeries produce at full supply would be 3,140 loaves.
produce. capacity, they can produce 4,000 loaves
altogether.
2. The bakery with the lowest cost
The first bakery has marginal cost €1
and can make 360 loaves per day.

310 F OR I NS T R UC T O R S ' US E O N L Y . P L E A S E D O N O T S H A R E W IT H
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 7.10 DEMAND AND SUPPLY IN A COMPETITIVE MARKET: BAKERIES

If there were many more bakeries in the city, more bread would be
produced and there would be many more ‘steps’ on the supply curve. Rather
than drawing them all, it is easier to approximate market supply with a
smooth curve. Figure 7.18 shows an approximate market supply curve
when there are many firms.
Notice that the supply curve tells us two different things. If we choose
any price, it tells us how many loaves, in total, the bakeries would produce.
But remember that, to construct it, we plotted the marginal cost of each loaf
of bread in increasing order of marginal costs. So, if we choose a particular
quantity (7,000, say) and use the curve to find the corresponding value on
the vertical axis (€2.74), this tells us that the marginal cost of the 7,000th
loaf is €2.74. In other words, the market supply curve is the marginal cost
curve for all the bread produced in the city.

Competitive equilibrium
Now we know both the demand curve (Figure 7.15 (page 308)) and the
supply curve (Figure 7.18) for the bread market as a whole. Figure 7.19
shows that the competitive 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
Supply (marginal cost)
Price, P (€); cost

0
0 1,000 2,000 3,000 4,000 5,000 6,000 7,000 8,000 9,000 10,000

Quantity of loaves, Q

Figure 7.18 The market supply curve: Many bakeries.

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S T U D E NT S .
 7 FIRMS AND MARKETS FOR GOODS AND SERVICES

4
Supply (marginal cost)

Price, P (€)
A
2

Demand
1

0
0 1,000 2,000 3,000 4,000 5,000 6,000 7,000 8,000 9,000 10,000

Quantity of loaves, Q

Figure 7.19 Equilibrium in the market for bread.

Since the equilibrium is the point where the demand curve crosses the mar-
ginal cost curve, we know that—in equilibrium—both the willingness to pay
of the 5,000th consumer, and the marginal cost of the 5,000th loaf, are
equal to the market price.

7.11 COMPETITIVE EQUILIBRIUM: GAINS FROM TRADE,

ALLOCATION, AND DISTRIBUTION
Buyers and sellers of bread voluntarily engage in trade because both
benefit. Their mutual benefits from the equilibrium allocation can be
measured by the consumer and producer surpluses introduced in Section
7.7 (page 294). Any buyer whose willingness to pay for a good is higher
than the market price, receives a surplus—the difference between the
WTP and the price paid. Similarly, if the marginal cost of producing an
item is below the market price, the producer receives a surplus. Figure
7.20 shows how to calculate the total surplus (the gains from trade) at the
competitive equilibrium in the market for bread, in the same way as we
did for the market for language courses (monopolistic competition).
When the market for bread is in equilibrium with the quantity of loaves
supplied equal to the quantity demanded, the total surplus is the area below
the demand curve and above the supply curve.
Notice how the equilibrium allocation in this market differs from the
allocation of a differentiated product, such as LP’s Spanish course. The
equilibrium quantity of bread is at the point where the market supply curve
(which is also the marginal cost curve) crosses the demand curve; the total
surplus is the whole of the area between the two curves. Figure 7.16 (page
309) showed that the owner of LP chose to produce a quantity below the
point where the marginal cost curve meets the demand curve, reducing the
total surplus.
The competitive equilibrium allocation of bread has the property that
the total surplus is maximized. The surplus would be smaller if fewer than
5,000 loaves were produced; if more than 5,000 loaves were produced, the

312 F OR I NS T R UC T O R S ' US E O N L Y . P L E A S E D O N O T S H A R E W IT H
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7.11 COMPETITIVE EQUILIBRIUM: GAINS FROM TRADE, ALLOCATION, AND DISTRIBUTION

surplus on the extra loaves would be negative—they would cost more to

make than consumers were willing to pay.
At the equilibrium, all the potential gains from trade are exploited, Joel Waldfogel, an economist,
which means there is no deadweight loss. This property—that the gave his chosen discipline a bad
combined consumer and producer surplus is maximized at the point where name by suggesting that gift-giving
supply equals demand—holds in general. If both buyers and sellers are at Christmas may result in a
price-takers, the competitive equilibrium allocation maximizes the sum of deadweight loss (https://tinyco.re/
the gains achieved by trading in the market. 7728778). If you receive a gift that
is worth less to you than it cost the
Pareto efficiency giver, he argued that the surplus
At the competitive equilibrium allocation of bread, it is not possible to from the transaction is negative
make any of the consumers or firms better off (that is, to increase the (https://tinyco.re/0182759). Do you
surplus of any individual) without making at least one of them worse off. agree?
Provided that what happens in this market does not affect anyone other
than the participating buyers and sellers, we can say that the equilibrium
allocation is Pareto efficient.
Pareto efficiency follows from three assumptions we have made about
the bread market.

4.5 To explore all of the slides in this figure,

see the online version
4.0 at https://tinyco.re/4382391.
Supply (marginal cost)

3.5

3.0
Price, P (€)

2.5 Consumer surplus

A
2.0
Producer surplus
1.5
Demand
1.0

0.5

0.0
0 1,000 2,000 3,000 4,000 5,000 6,000 7,000 8,000 9,000 10,000

Quantity of loaves, Q

Figure 7.20 Equilibrium in the bread market: Gains from trade.

1. The consumer surplus 3. The producer surplus 4. Total surplus

At the equilibrium price of €2.00 in the Remember that the producer’s surplus The shaded area below €2.00 is the
bread market, a consumer who is on a unit of output is the difference sum of the bakeries’ surpluses on every
willing to pay €3.50 obtains a surplus of between the price at which it is sold loaf that they produce. The whole
€1.50. and the marginal cost of producing it. shaded area shows the sum of all gains
The marginal cost of the 2,000th loaf is from trade in this market, known as the
2. Total consumer surplus €1.25; since it is sold for €2.00, the total surplus.
The shaded area above €2.00 shows producer obtains a surplus of €0.75.
total consumer surplus—the sum of all
the buyers’ gains from trade.

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 7 FIRMS AND MARKETS FOR GOODS AND SERVICES

Price-taking
The participants are price-takers. They have no market power. When a
particular buyer trades with a particular seller, each of them knows that the
other can find an alternative trading partner willing to trade at the market
price. Competition prevents sellers from raising the price in the way that
the producer of a differentiated good would do.

A complete contract
The exchange of a loaf of bread for money is governed by a complete con-
tract between buyer and seller. If you find there is no loaf of bread in the
bag marked ‘Bread’ when you get home, you can get your money back.
Compare this with the incomplete employment contract in Unit 6 (page
244), in which the firm can buy the worker’s time, but cannot be sure how
much effort the worker will put in. We will see in Unit 8 that this leads to a
Pareto-inefficient allocation in the labour market.

No effects on others
We have implicitly assumed that what happens in this market affects no one
except the buyers and sellers. To assess Pareto efficiency, we need to con-
sider everyone affected by the allocation. If, for example, the early morning
activities of bakeries disrupt the sleep of local residents, then there are addi-
tional costs of bread production and we ought to take the costs to the
bakeries’ neighbours into account too. Then, we may conclude that the
equilibrium allocation is not Pareto efficient after all. We will investigate
this type of problem in Unit 11.

Fairness and efficiency

Remember from Unit 5 (page 185) that there are two criteria for assessing
an allocation—efficiency and fairness. Even if we think that the market
allocation is Pareto efficient, we should not conclude that it is necessarily a
desirable one. What can we say about fairness in the case of the bread
market? We could examine the distribution of the gains from trade between
producers and consumers. Figure 7.20 shows that both consumers and
firms obtain a surplus; in this example consumer surplus is slightly higher
than producer surplus. You can see that this happens because the demand
curve is relatively steep (inelastic) compared with the supply curve.
We might also want to consider the market participants’ standard of
living. For example, if a poor student buys a book from a rich student, we
might think that an outcome in which the buyer paid less than the market
price (closer to the seller’s reservation price) would be better, because it
would be fairer. Or, if the consumers in the bread market were
exceptionally poor, we might decide to pass a law setting a maximum
bread price lower than €2.00 to achieve a fairer (although Pareto-
inefficient) outcome.
Maurice Stucke, an antitrust The Pareto efficiency of a competitive equilibrium allocation is often
lawyer, asks if competition in a interpreted as a powerful argument in favour of markets as a means of
market economy is always good allocating resources. But we need to be careful not to exaggerate the value
(https://tinyco.re/8720076). of this result:

• The allocation may not be Pareto efficient: We might not have taken
everything into account.
• There are other important considerations: Fairness, for example.

314 F OR I NS T R UC T O R S ' US E O N L Y . P L E A S E D O N O T S H A R E W IT H
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7.11 COMPETITIVE EQUILIBRIUM: GAINS FROM TRADE, ALLOCATION, AND DISTRIBUTION

• Price-takers are hard to find in real life: It is not as easy as you might think
to find markets where all participants are price-takers. Goods (including
bread) are rarely identical, and participants don’t always know what
prices are available.

Watch ‘Economist in action’, Kathryn Graddy explain how she collected

data on the price of whiting from the Fulton Fish Market in New York and
what she found out about the model of perfect competition.

EXERCISE 7.6 SURPLUS AND DEADWEIGHT LOSS

1. Sketch a diagram to illustrate the competitive market for bread,
showing the equilibrium where 5,000 loaves are sold at a price of €2.00.
2. Suppose that the bakeries get together to form a cartel. They agree to
raise the price to €2.70, and jointly cut production to supply the
number of loaves that consumers demand at that price. Shade the
Kathryn Graddy: Fishing for perfect
areas on your diagram to show the consumer surplus, producer surplus,
competition https://tinyco.re/
and deadweight loss caused by the cartel.
9632056
3. For what kinds of goods would you expect the supply curve to be highly
elastic?
4. Draw diagrams to illustrate how the share of the gains from trade
obtained by producers depends on the elasticity of the supply curve.

QUESTION 7.11 CHOOSE THE CORRECT ANSWER(S)

Which of the following statements about a competitive equilibrium
allocation are correct?

It is the best possible allocation.

No buyer’s surplus or seller’s surplus can be increased without
reducing someone else’s surplus.
The allocation must be Pareto efficient.
The total surplus from trade is maximized.

QUESTION 7.12 CHOOSE THE CORRECT ANSWER(S)

Figure 7.20 (page 313) shows the demand and supply curves in the
bread market and the distribution of surplus in competitive equilib-
rium. Ceteris paribus, which of the following would affect the
distribution of gains from trade between consumers and producers?

legislation that sets the price above or below P*

relative elasticities of demand and supply
total quantity traded
the slope of the firms’ marginal cost curve

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 7 FIRMS AND MARKETS FOR GOODS AND SERVICES

7.12 CHANGES IN SUPPLY AND DEMAND

Quinoa is a cereal crop grown on the Altiplano, a high barren plateau in the
Andes of South America. It is a traditional staple food in Peru and Bolivia.
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. Figures 7.21a–c show how the market
changed. You can see in Figures 7.21a and 7.21b that, between 2001 and
2011, the price of quinoa trebled and production almost doubled. Figure
7.21c indicates the strength of the increase in demand—in real terms,
spending on imports of quinoa rose from just $2.4 million to over $40
million over 10 years. Note that the increase in spending on quinoa reflects
the increase in the price shown in Figure 7.21b as well as the purchase of
higher quantities of the grain.
For the producer countries, these changes are a mixed blessing. While
their staple food has become expensive for poor consumers, farmers—who
are amongst the poorest—are benefiting from the boom in export sales.
Other countries are now investigating whether quinoa can be grown in dif-
ferent climates, and France and the US have become substantial producers.
How can we explain the rapid increase in the price of quinoa? In this
section, we look at the effects of changes in demand and supply, illustrating
our model by the real-world case of quinoa.

The supply of quinoa

At the beginning of the current century, there was ample land for growing
quinoa on the Altiplano, and farmers producing other crops could easily
switch to quinoa as the price rose. As a result, the initial increase in produc-
tion between 2001 and 2007 to meet rising demand did not raise costs. This
means that the supply curve was virtually flat. But in order to allow the
continued output of quinoa after 2007, land less suited for the crop had to
be brought into use, and the new farmers taking up the crop were giving up
the production of other crops on which they had been making adequate
incomes. As a result, costs rose. To represent this, we show the supply curve
in Figure 7.23 (page 319) becoming increasingly steep as production rose.

Jose Daniel Reyes and Julia Oliver. 90

Production of quinoa (thousands of tonnes)

‘Quinoa: The Little Cereal That Could’ Ecuador

(https://tinyco.re/9266629). The Trade 80 Peru
Post. 22 November 2013. Underlying 70
Bolivia

data from Food and Agriculture

Organization of the United Nations. 60
FAOSTAT Database (https://tinyco.re/
4368803). 50

40

30

20

10

0
2001 2003 2005 2007 2009 2011
Year

Figure 7.21a The production of quinoa.

316 F OR I NS T R UC T O R S ' US E O N L Y . P L E A S E D O N O T S H A R E W IT H
S T UD E N T S .
 7.12 CHANGES IN SUPPLY AND DEMAND

An increase in demand
As in the case of demand for language courses or Apple Cinnamon Cheerios,
the demand curve for quinoa sloped downwards, as is shown by D2001 in
Figure 7.23 (page 319). The original equilibrium was at point A.
The new fashion among North American and European consumers for
eating quinoa meant that for any given price of the crop, the tonnes of quinoa
purchased rose. In other words, the demand curve for quinoa shifted to the
right. You could also say that it shifted up, meaning that the price that was
sufficient to allow the sales of any given quantity of quinoa had now increased.
This is shown in Figure 7.23 (see the new demand curve labelled ‘2008’).
The increase in demand destroys the old equilibrium (the supply and
demand curves no longer cross at A). With the new demand curve and initially
with no change in sales of quinoa or in the price, there were a great many
potential consumers whose willingness to pay for quinoa exceeded the price.

1,400 Jose Daniel Reyes and Julia Oliver.

Bolivia ‘Quinoa: The Little Cereal That Could’
1,200 (https://tinyco.re/9266629). The Trade
Post. 22 November 2013. Underlying
Peru data from Food and Agriculture
Price of quinoa ($/tonne)

1,000 Organization of the United Nations.

FAOSTAT Database (https://tinyco.re/
800 4368803).

600

400

200

0
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
Year

Figure 7.21b Quinoa real producer prices in Peru.

50 Jose Daniel Reyes and Julia Oliver.

All other countries ‘Quinoa: The Little Cereal That Could’
Import demand for quinoa ($ millions)

United States
(https://tinyco.re/9266629). The Trade
Canada
40 Post. 22 November 2013. Underlying
EU-27
data from Food and Agriculture
Organization of the United Nations.
30 FAOSTAT Database (https://tinyco.re/
4368803).

20

10

0
2001 2003 2005 2007 2009 2011
Year

Figure 7.21c Global import demand for quinoa.

FOR IN STR U C T OR S ' U S E ONLY. P L E A S E D O N O T S H A R E W I T H 317

S T U D E NT S .
 7 FIRMS AND MARKETS FOR GOODS AND SERVICES

Market disequilibrium and adjustment to a new equilibrium

Thus, point A was no longer a Nash equilibrium because at least some of
disequilibrium A situation in which
the producers would have realized that they could raise their prices without
at least one of the actors can bene-
reducing their sales. The original price and quantity are termed a
fit by altering his or her actions and
disequilibrium because, at point A, someone can benefit by changing the
therefore changing the situation,
price. The reason is that at the initial price, there is excess demand. The
given what everybody else is doing.
increase in demand set off the sequence of events shown in Figure 7.22.
Figure 7.22 describes what economists call a disequilibrium adjustment
process, which is simply how market actors react when the existing situ-
ation is not an equilibrium. How long will this process go on? It will
continue until the combination of higher prices and greater production has
eliminated the excess demand, shown in Figure 7.23 (page 319) as point C.
When we refer to ‘increase in demand’, it’s important to be careful about
what exactly we mean. Figure 7.24 uses the example of quinoa to explain.
This change is a movement along the supply curve. But the supply curve
price elasticity of supply The
has not shifted! The amount supplied increased in response to the change in
percentage change in supply that
price. A shift in the supply curve would take place if, for example, an
would occur in response to a 1%
improved method of cultivating quinoa was invented so that for any given
increase in price. Supply is elastic if
price, more would be supplied.
this is greater than 1, and inelastic
After an increase in demand, the equilibrium quantity rises. The price
if less than 1.
change depends on the steepness of the supply curve, which captures how
responsive supply is to prices. We know that the price elasticity of demand
measures how much demand falls when prices rise. Similarly, the price
elasticity of supply is defined as the percentage increase in supply when
prices rise by one percent.
You can see in Figure 7.23 that the steeper (more inelastic) the supply
shock An exogenous change in
curve, the higher the price will rise and the less the quantity will increase.
some of the fundamental data or
Initially, the supply curve was flat (elastic), so in the equilibrium at point B,
variables used in a model.
the price was the same as at point A and the quantity sold was fully
responsive to the demand shock.

An increase in the willingness to pay for quinoa

The demand curve shifts out

The original price and quantity are now not a Nash equilibrium

Some producers raise their prices, increasing their profits

⇩ ⇩

New producers start quinoa production Existing farmers produce more

Figure 7.22 Disequilibrium in demand for quinoa.

318 F OR I NS T R UC T O R S ' US E O N L Y . P L E A S E D O N O T S H A R E W IT H
S T UD E N T S .
 7.12 CHANGES IN SUPPLY AND DEMAND

1,000 To explore all of the slides in this figure,

S see the online version
900 at https://tinyco.re/3630822.
800
C
700
D′′2009
600
Price ($)

500

400 B
A
300
Excess demand
200

100
D2001 D′2008
0
0 2 4 6 8 10 12 14 16 18 20

Quantity of quinoa (thousands of tonnes)

Figure 7.23 An increase in the demand for quinoa.

1. The initial equilibrium point 3. Excess demand when the price is 5. A further increase in demand
At the original levels of demand and $340 Worldwide demand for quinoa
supply, the equilibrium is at point A. If the price remained at $340, there continues to rise and the demand curve
The price is $305 per tonne, and 2.4 would be excess demand for quinoa, shifts out again to the one labelled
thousand tonnes of quinoa are sold. that is, more buyers than sellers. Some 2009. There is excess demand. The land
producers raise the price and their well suited to quinoa has all been used
2. An increase in demand profits increase. The market is in so the supply curve slopes upward.
Demand for quinoa in Europe and disequilibrium.
North America increases between 2001 6. A new equilibrium point with a
and 2008. There would be more con- 4. A new equilibrium point higher price and larger quantity
sumers wanting to buy quinoa at each The excess demand encourages more supplied
possible price. The demand curve shifts farmers to grow quinoa. The expansion Some producers raise the price in
to the right. of production eliminates the excess response to the higher demand.
demand. There is a new equilibrium at Producers who have higher costs of
point B with the price at $380 and a big production now find it profitable to
increase in the quantity of quinoa sold. switch to producing quinoa. At the new
equilibrium at C, both price and
quantity are higher.

Demand is higher at each possible price (the demand curve has shifted)

There is a change in the price

There is an increase in the quantity supplied

Figure 7.24 An increase in demand for quinoa.

FOR IN STR U C T OR S ' U S E ONLY. P L E A S E D O N O T S H A R E W I T H 319

S T U D E NT S .
 7 FIRMS AND MARKETS FOR GOODS AND SERVICES

When either the supply curve or the demand curve shifts, an adjustment of
exogenous Coming from outside
prices is needed to bring the market into equilibrium. Such shifts in supply
the model rather than being
and demand are often referred to as shocks in economic analysis. We start by
produced by the workings of the
specifying an economic model and find the equilibrium. Then we look at how
model itself. See also: endogenous.
the equilibrium changes when something changes—the model receives a
shock. The shock is called exogenous because the model doesn’t explain why
it happened—it shows the consequences of the shock, not the causes.
In the next section, we will examine another example in the world
market for oil. Both the supply of and the demand for oil are more elastic in
the long run, because producers can eventually build new oil wells and con-
sumers can switch to different fuels for cars or heating. What we mean by
the short run in this case is the period during which firms are limited by the
capacity of existing wells, and consumers are limited by the cars and
heating appliances they currently own.

EXERCISE 7.7 THE MARKET FOR QUINOA

Consider again the market for quinoa studied in Figures 7.21a–c (page 316).

1. Would you expect the price to fall eventually to its original level?
2. Use the same model to show the effects on price and quantity of a
significant improvement in the methods for producing quinoa, resulting
in lower costs for farmers.

EXERCISE 7.8 PRICES, SHOCKS, AND REVOLUTIONS

Helge Berger and Mark Spoerer. Historians usually attribute the wave of revolutions in Europe in 1848 to
2001. ‘Economic Crises and the long-term socioeconomic factors and a surge of radical ideas. But a poor
European Revolutions of 1848’. The wheat harvest in 1845 lead to food shortages and sharp price rises, which
Journal of Economic History 61 (2): may have contributed to these sudden changes.
pp. 293–326. Figure 7.25 shows the average and peak prices of wheat from 1838 to
1845, relative to silver. There are three groups of countries: those in which
violent revolutions took place; those in which constitutional change took
place without widespread violence; and those in which no revolution
occurred.

1. Explain, using supply and demand curves, how a poor wheat harvest
could lead to price rises and food shortages.
2. Using Excel or other data analysis programs, find a way to present the
data to show that the size of the price shock, rather than the price
level, is associated with the likelihood of revolution.
3. Do you think this is a plausible explanation for the revolutions that
occurred?
4. A journalist suggests that similar factors played a part in the Arab
Spring in 2010 (https://tinyco.re/8936018). Read the post. What do you
think of this hypothesis?

320 F OR I NS T R UC T O R S ' US E O N L Y . P L E A S E D O N O T S H A R E W IT H
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 7.12 CHANGES IN SUPPLY AND DEMAND

Helge Berger and Mark Spoerer. 2001.

Average Price Maximum Price
‘Economic Crises and the European
1838–45 1845–48 Revolutions of 1848.’ The Journal of Eco-
Austria 52.9 104.0 nomic History 61 (2): pp. 293–326.

Baden 77.0 136.6

Bavaria 70.0 127.3
Bohemia 61.5 101.2
France 93.8 149.2
Hamburg 67.1 108.7
Hesse- 76.7 119.7
Darmstadt
Violent revolution 1848 Hungary 39.0 92.3
Lombardy 88.3 119.1
Mecklenburg- 72.9 110.9
Schwerin
Papal States 74.0 105.1
Prussia 71.2 110.7
Saxony 73.3 125.2
Switzerland 87.9 146.7
Württemberg 75.9 128.7
Average Price Maximum Price
1838–45 1845–48
Belgium 93.8 140.1
Bremen 76.1 109.5

Immediate constitutional Brunswick 62.3 100.3

change 1848 Denmark 66.3 81.5
Netherlands 82.6 136.0
Oldenburg 52.1 79.3
Average Price Average Price
1838–45 1845–48
England 115.3 134.7
Finland 73.6 73.7
Norway 89.3 119.7
No revolution 1848
Russia 50.7 44.1
Spain 105.3 141.3
Sweden 75.8 81.4

Figure 7.25 Average and peak prices of wheat in Europe, 1838–1845.

FOR IN STR U C T OR S ' U S E ONLY. P L E A S E D O N O T S H A R E W I T H 321

S T U D E NT S .
 7 FIRMS AND MARKETS FOR GOODS AND SERVICES

QUESTION 7.13 CHOOSE THE CORRECT ANSWER(S)

Look again at Figure 7.19 (page 312), which shows the equilibrium of
the bread market to be 5,000 loaves per day at price €2. A year later,
we find that the market equilibrium price has fallen to €1.50. What can
we definitely conclude?

The fall in the price must have been caused by a downward shift in
the demand curve.
The fall in the price must have been caused by a downward shift in
the supply curve.
The fall in price could have been caused by a shift in either curve.
At a price of €1.50, there will be an excess demand for bread.

QUESTION 7.14 CHOOSE THE CORRECT ANSWER(S)

Which of the following statements are correct?

A fall in the mortgage interest rate would shift up the demand curve
for new houses.
The launch of a new Sony smartphone would shift up the demand
curve for existing iPhones.
A fall in the oil price would shift up the demand curve for oil.
A fall in the oil price would shift down the supply curve for plastics.

7.13 THE WORLD OIL MARKET

Figure 7.26 plots the real price of oil in world markets (in constant 2014
US dollars) and the total quantity consumed globally from 1865 to 2020.
To understand what drives the large fluctuations in the oil price, we can
use our supply and demand model, distinguishing between the short run
and the long run.

BP. (2021) BP Statistical Review of World

2008 Start of global
Energy 2021. 1979–80 financial crisis
Oil consumption (ratio scale: thousands of barrels)
Second oil shock
140 120,000

1990
120
Price per barrel, P ($ 2014 per barrel)

1973–74 Dissolution
1918 1945
First oil of the Soviet
End of WWI End of WWII
shock Union
100

80
1929 Start of Great 60,000
Depression
60

40

20

0 30,000
1861 1871 1881 1891 1901 1911 1921 1931 1941 1951 1961 1971 1981 1991 2001 2011 2021

Year

Figure 7.26 World oil prices in constant prices (1861–2020) and global oil
consumption (1965–2020).

322 F OR I NS T R UC T O R S ' US E O N L Y . P L E A S E D O N O T S H A R E W IT H
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 7.13 THE WORLD OIL MARKET

Prices reflect scarcity. If a good becomes scarcer or costlier to produce,

scarcity A good that is valued, and
then the supply will fall and the price will tend to rise. For more than 60
for which there is an opportunity
years, oil industry analysts have been predicting that demand would soon
cost of acquiring more.
outstrip supply—production would reach a peak and prices would then rise
as world reserves declined. ‘Peak oil’ is not evident in Figure 7.26. One
reason is that rising prices provide incentives for further exploration.
Between 1981 and 2014, more than 1,000 billion barrels were extracted and
consumed, yet world reserves of oil more than doubled from roughly 680
billion barrels to 1,700 billion barrels.
Prices have risen strongly in the twenty-first century and an increasing R. G. Miller and S. R. Sorrell. 2013.
number of analysts are predicting that conventional oil, at least, has reached ‘The Future of Oil Supply’
a peak. But unconventional resources such as shale oil are now being (https://tinyco.re/6167443).
exploited. Perhaps it will be climate change policies, rather than resource Philosophical Transactions of the
depletion, that eventually curb oil consumption. Royal Society A: Mathematical,
The oil price data in Figure 7.26 is difficult to interpret because of the Physical and Engineering Sciences
sharp swings from high to low and back again over short periods of time. 372 (2006) (December).
These fluctuations cannot be explained by looking at oil reserves,
because they reflect short-run scarcity. Both supply and demand are Nick A. Owen, Oliver R. Inderwildi,
inelastic in the short run. and David A. King. 2010. ‘The
Status of Conventional World Oil
Short-run supply and demand Reserves—Hype or Cause for
On the demand side, the main use of oil products is in transport services (air, Concern?’ (https://tinyco.re/
road, and sea). Demand is inelastic in the short run because of the limited 8978100) Energy Policy 38 (8):
substitution possibilities. For example, even if petrol prices rise substantially, pp. 4743–49.
in the short run most commuters will continue to use their existing cars to
travel to work because of the limited alternatives immediately available to
them. Therefore, the short-run demand curve is steep.
Traditional oil extraction technology is characterized by a large up-front
oligopoly A market with a small
investment in expensive oil wells that can take many months or longer to
number of sellers of the same
construct, and once in place, can keep pumping until the well is depleted or
good, giving each seller some
oil can no longer be profitably extracted. Once the well is drilled, the cost of
market power.
extracting the oil is relatively low, but the rate at which the oil is pumped
faces capacity constraints—producers can get only so many barrels per day
from a well. This means that, taking existing capacity as fixed in the short
run, we should draw a short-run market supply curve that is initially low
and flat, and then turns upwards very steeply as capacity constraints are hit.
We also need to allow for the oligopolistic structure of the world market
for crude oil. The Organization of Petroleum Exporting Countries (OPEC)
is a cartel with a dozen member countries that currently accounts for about
40% of world oil production. OPEC sets output quotas for its members. We
can represent this in our supply and demand diagram by a flat marginal
cost line that stops at the total OPEC production quota. At that point, the
line becomes vertical. This is not because of capacity constraints, but
because OPEC producers will not sell any more oil.

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S T U D E NT S .
 7 FIRMS AND MARKETS FOR GOODS AND SERVICES

Figure 7.27 assembles the market supply curve by adding the OPEC pro-
duction quota to the supply from non-OPEC countries (remember that we
obtain market supply curves by adding the amounts supplied by each
producer at each price) and combines it with the demand curve to
determine the world oil price.

To explore all of the slides in this figure, SWORLD

SOPEC
see the online version SNON-OPEC
at https://tinyco.re/5419253.

P0
Non-OPEC
OPEC profits
profits
c
Price, P

Demand

QOPEC QNON-OPEC

Q0
Quantity, Q

Figure 7.27 The world market for oil.

1. OPEC supply 3. World supply curve 5. Profit

OPEC’s members can increase produc- Total world supply is the sum of pro- OPEC’s profit is (P0 − c) × QOPEC, the
tion easily within their current capacity, duction by OPEC and other countries at area of the rectangle below P0. Non-
without increasing their marginal cost each price. OPEC profit is the rest of the shaded
c. OPEC quotas limit their total produc- area below P0.
tion to QOPEC. 4. The equilibrium oil price
The demand curve is steep—world
2. The non-OPEC supply demand is inelastic in the short run. In
Non-OPEC countries can produce oil at equilibrium, the price is P0 and total oil
the same marginal cost c until they get consumption Q0 is equal to QOPEC +
close to capacity, when their marginal Qnon-OPEC.
costs rise steeply.

324 F OR I NS T R UC T O R S ' US E O N L Y . P L E A S E D O N O T S H A R E W IT H
S T UD E N T S .
 7.13 THE WORLD OIL MARKET

The 1970s oil price shocks

In 1973 and 1974, OPEC countries imposed a partial oil embargo in
response to the Middle East war. In 1979 and 1980, oil production by Iran
and Iraq fell because of the supply disruptions following the Iranian
Revolution and the outbreak of the Iran–Iraq war. These are represented in
Figure 7.28 by a leftward shift of the world supply curve Sworld, driven by a
reduction in the volume of OPEC production to Q′OPEC. Total production
and consumption falls, but because demand is very price inelastic, the
percentage increase in price is much larger than the percentage decrease in
quantity. This is what we see in the data in Figure 7.28. The oil price (in
2014 US dollars) goes from $18 per barrel in 1973 to $56 in 1974, and then
to $106 in 1980, but the declines in world oil consumption after these price
shocks are small by comparison (−2% between 1973 and 1975, and −10%
between 1979 and 1983).
income elasticity of demand The
The 2000–2008 oil price shocks
percentage change in demand that
The years 2000 to 2008 were a period of rapid economic growth in indus-
would occur in response to a 1%
trializing countries, especially China and India. The income elasticity of
increase in the individual’s income.
demand for oil and oil products is higher in these countries than in
developed market economies, and demand for car ownership and tourist air
travel is growing relatively rapidly as the countries become wealthier. This
increase in income moves the demand curve to the right, as shown in
Figure 7.28. In this case, it is the inelastic short-run supply curve for oil that
accounts for the big increase in price and only a modest increase in world
oil consumption. The sharp price decrease in 2009 has the same
explanation, but in reverse—the financial crisis of 2008–2009 was a neg-
ative demand shock that moved the demand curve to the left, so world
consumption fell by about 3%, and the price of crude fell from over $100
per barrel in the summer of 2008 to $40–50 in early 2009.

S′WORLD SWORLD

P1

P0

c
Price, P

Demand

0 Quantity, Q
Q1 Q0
QOPEC

Q′OPEC

Figure 7.28 The OPEC oil price shocks of the 1970s: OPEC decreases output.

FOR IN STR U C T OR S ' U S E ONLY. P L E A S E D O N O T S H A R E W I T H 325

S T U D E NT S .
 7 FIRMS AND MARKETS FOR GOODS AND SERVICES

EXERCISE 7.9 THE WORLD MARKET FOR OIL 4. How would the diagram, and the response to shocks,
Using a supply and demand diagram: be different if there were:
(a) a competitive market composed of many
1. Illustrate what happens when economic growth producers?
boosts world demand (b) a single monopoly oil producer?
(a) in the short run (c) an OPEC cartel controlling 100% of world oil pro-
(b) in the long run as producers invest in new oil duction and seeking to maximize the combined
wells profits of its members?
(c) in the long run as consumers find substitutes for 5. Why would individual OPEC member countries have
oil an incentive to produce more than the quota
2. Similarly, describe the short- and long-run assigned to them?
consequences of a negative supply shock similar to 6. Does this logic carry over to the situation in the real
the 1970s shock. world where there are also non-OPEC producers?
3. If you observed an oil price rise, how in principle
could you tell whether it was driven by supply-side
or demand-side developments?

EXERCISE 7.10 THE SHALE OIL REVOLUTION Dale, group chief economist at oil producer BP PLC,
An important development in the past 10 years has explained how shale oil production differs from
been the re-emergence of the US as a major oil traditional extraction.
producer via the ‘shale oil revolution’. Shale oil is
extracted using the technology of hydraulic fracturing 1. According to Dale, how has the shale oil revolution
or ‘fracking’—injecting fluid into ground at high affected the world market for oil?
pressure to fracture the rock and allow extraction. In a 2. How will the world oil market be different in future?
speech called ‘The New Economics of Oil’ 3. Explain how our supply and demand diagram should
(https://tinyco.re/9345243) in October 2015, Spencer be changed if his analysis is correct.

SWORLD

P1

P0
Price, P

c
Demand′

Demand

0
Q0 Q1
QOPEC

Quantity, Q

Figure 7.29 The oil price shocks of 2000–2008: Economic growth increases world
demand.

326 F OR I NS T R UC T O R S ' US E O N L Y . P L E A S E D O N O T S H A R E W IT H
S T UD E N T S .
 7.14 CONCLUSION

7.14 CONCLUSION
This unit has looked at how the firm, as an actor in the economy, decides
what prices to set and how much to produce. This decision depends on
both the willingness to pay (WTP) of its customers (as summarized by the
demand curve and the price elasticity), and on the firm’s cost structure.
One advantage of large-scale production is lower unit costs due to
increased bargaining power with suppliers, or a high initial fixed cost. But
firms cannot benefit from economies of scale indefinitely.
To our economic toolkit we have added two models of firm behaviour,
each relying on different assumptions regarding the nature of the product
and the market structure.

Price-setting firm (monopolistic competitor) Price-taking firm

Setting and The firm has few competitors as it produces a Competition from other firms producing identical products
assumptions differentiated product. It faces a downward- means that firms have no power to set their own prices.
sloping product demand curve. The firm sets They each face a flat demand curve for their product. Given
price to maximize profits (price-setter). There is the market price, the firm chooses the quantity to produce
no price discrimination, so the chosen price is the to maximize profits (price-taker).
same for all customers.
Economic Constrained optimization problem Supply and demand analysis
toolkit
The firm chooses the highest isoprofit curve The supply curve depends on suppliers’ willingness to
possible, given the product demand curve as a accept (their reservation prices). Its shape depends on the
constraint. The profit-maximizing choice is where marginal cost curve.
the curves are tangent. This is where MRS (slope
of isoprofit) equals MRT (slope of demand). The market-clearing price is determined by the intersection
of market supply and market demand curves.
Main result Price is greater than marginal cost, and owners Price is equal to marginal cost. In this competitive
receive economic rents. There exist deadweight equilibrium, total surplus is maximized and the outcome is
losses, meaning there are unexploited gains from Pareto efficient, assuming only buyers and sellers are
trade. The outcome is Pareto inefficient. affected. Owners can only receive dynamic rents when
markets are in disequilibrium following an exogenous
shock.

A firm’s market power determines the markup it can set, which is

inversely related to the price elasticity of demand. Competition policy
aims to prevent abuses of market power that may result from the formation
of cartels. The model of perfect competition provides a useful benchmark
against which to evaluate economic outcomes.
Price-setting firms face a multitude of decisions every day, and their
success depends on more than just ‘getting the price right’. As summarized
in Figure 7.30, a firm can actively influence both consumer demand and
costs in various ways, including innovation, advertising, wage-setting and
influencing taxes and environmental regulation.

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 7 FIRMS AND MARKETS FOR GOODS AND SERVICES

Expenditure
on innovation

Expenditure Sets the

on advertising wage

What to How to
produce produce

Demand Cost
curve curve
Expenditure to influence
taxes and other public policies

Sets the
price

Quantity
sold

Profit Hiring

Figure 7.30 The price- and wage-setting firm’s decisions.

7.15 DOING ECONOMICS: SUPPLY AND DEMAND

In this unit, we used demand and supply curves to find market equilibrium.
But how do we know what the supply and demand curves look like in the real
world? Unlike the models in this unit, we cannot ask consumers for their
willingness to pay at different prices or ask firms to tell us their profit-
maximizing decisions. Instead, usually the best data available are prices and
quantities over a number of periods (both of the product we are interested in
and of other products), and information about policies and other events that
happened in those periods.
In Doing Economics Empirical Project 7 we will be using a ‘real-world’
example (the US market for watermelons in 1930–1951) to learn how to
model demand and supply using available data and interpret the results.

Learning objectives
In this project you will:

• convert values from natural logarithms to base 10 logarithms

• draw graphs based on equations
• give an economic interpretation of coefficients in supply and
demand equations
• distinguish between exogenous and endogenous shocks
• explain how we can use exogenous supply/demand shocks to
identify the demand/supply curve.

328 F OR I NS T R UC T O R S ' US E O N L Y . P L E A S E D O N O T S H A R E W IT H
S T UD E N T S .
 7.16 REFERENCES

Go to Doing Economics Empirical Project 7 (https://tinyco.re/4242717) to

work on this project.

7.16 REFERENCES
Consult CORE’s Fact checker for a detailed list of sources.
Berger, Helge, and Mark Spoerer. 2001. ‘Economic Crises and the
European Revolutions of 1848’. The Journal of Economic History 61 (2):
pp. 293–326.
Cournot, Augustin, and Irving Fischer. (1838) 1971. Researches into the
Mathematical Principles of the Theory of Wealth. New York, NY: A.
M. Kelley.
Eisen, Michael. 2011. ‘Amazon’s $23,698,655.93 book about flies’. It is NOT
junk. (https://tinyco.re/0044329). Updated 22 April 2011.
Feiwel, George R. (ed.). 1989. Joan Robinson and Modern Economic Theory.
New York: New York University Press: p. 4.
Giberson, Michael. 2010. ‘I Cringe When I See Hayek’s Knowledge Problem
Wielded as a Rhetorical Club’ (https://tinyco.re/9189202).
Knowledge Problem. Updated 5 April.
Gilbert, Richard J., and Michael L. Katz. 2001. ‘An Economist’s Guide to US
v. Microsoft’ (https://tinyco.re/7683758). Journal of Economic
Perspectives 15 (2): pp. 25–44.
Hayek, Friedrich A. 1994. The Road to Serfdom (https://tinyco.re/0683881).
Chicago, Il: University of Chicago Press.
Kay, John. ‘The Structure of Strategy’ (https://tinyco.re/7663497).
Reprinted from Business Strategy Review 1993.
Krajewski, Markus. 2014. ‘The Great Lightbulb Conspiracy’
(https://tinyco.re/3479245). IEEE Spectrum. Updated 25 September
2014.
Marshall, Alfred. 1920. Principles of Economics (https://tinyco.re/0560708).
8th ed. London: MacMillan & Co.
Miller, R. G., and S. R. Sorrell. 2013. ‘The Future of Oil Supply’
(https://tinyco.re/6167443). Philosophical Transactions of the Royal
Society A: Mathematical, Physical and Engineering Sciences 372 (2006)
(December).
Owen, Nick A., Oliver R. Inderwildi, and David A. King. 2010. ‘The Status
of Conventional World Oil Reserves—Hype or Cause for Concern?’
(https://tinyco.re/8978100) Energy Policy 38 (8): pp. 4743–49.
Pigou, A. C. (editor). 1966. Memorials of Alfred Marshall. New York, A. M.
Kelley. pp.427–28.
Reyes, Jose Daniel, and Julia Oliver. 2013. ‘Quinoa: The Little Cereal That
Could’ (https://tinyco.re/9266629). The Trade Post. 22 November
2013.
Robinson, Joan. 1933. The Economics of Imperfect Competition
(https://tinyco.re/1766675). London: MacMillan & Co.
Schumacher, Ernst F. 1973. Small is Beautiful: Economics as if People Mattered
(https://tinyco.re/3749799). New York, NY: HarperCollins.
Seabright, Paul. 2010. The Company of Strangers: A Natural History of Eco-
nomic Life (Revised Edition). Princeton, NJ: Princeton University
Press.
Shum, Matthew. 2004. ‘Does Advertising Overcome Brand Loyalty?
Evidence from the Breakfast-Cereals Market’ (https://tinyco.re/
3909324). Journal of Economics & Management Strategy 13 (2):
pp. 241–72.

FOR IN STR U C T OR S ' U S E ONLY. P L E A S E D O N O T S H A R E W I T H 329

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 7 FIRMS AND MARKETS FOR GOODS AND SERVICES

The Economist. 2001. ‘Is Santa a Deadweight Loss?’ (https://tinyco.re/

7728778) Updated 20 December 2001.
The Economist. 2014. Keynes and Hayek: Prophets for Today
(https://tinyco.re/0417474). Updated 14 March 2014.

330 F OR I NS T R UC T O R S ' US E O N L Y . P L E A S E D O N O T S H A R E W IT H
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