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preferences back and Kodak has no choice but to lower its price. As we argued in consumer theory, for Kodak to have
market traction while avoiding a price war it would have to choose a new price such that: Kodak needs to charge a slightly lower price than Fuji because it has a lower quality than Fuji.
Price rivalry due to large numbers arising from no or low barriers to entry: From 1938 – 1978, the airline industry was
regulated by the government which capped fares and restricted entry. In 1979, the U.S. airline industry was deregulated,
and almost immediately was flooded by a wave of new entrants, triggering price rivalry, and lowering fares:
U.S. Airline Industry: Average Fare and Number of Carriers from 1979 – 2010
Average Fare (in constant 2000 dollars) Number of Carriers
Sources: Own calculations compiled from Airlines.org Annual Round-Trip Fares
and Fees: Domestic, RITA @ Bureau of Transportation Statistics, and US
Department of Commerce, US Statistical Abstracts.
While competition is defined as “price taking behavior” and not “large number of sellers”, one can argue in this case that
the “large” number of carriers has given rise to price taking behavior, a process facilitated by the fact that air travel is for
all practical purposes a “homogeneous good” so that price is most important dimension in which carriers compete with
each other. 3
ECO 204 Chapter 15: Competitive Firms and Markets (this version 2012-2013) University of Toronto, Department of Economics (STG). ECO 204, S. Ajaz Hussain. Do not distribute. From ECO 100 recall that in perfect competition, the price is determined as the market clearing price at which the
market is in “equilibrium”, i.e. where total quantity demanded equals total quantity supplied: Sum of individual
Curve Price taking consumers Price taking firms Market
Curve Sum of individual
curves. In the rest of this chapter we will: Derive the market (aggregate) demand curve from individual consumers’ demand curves, which in turn are
derived from each individual consumer’s Utility Maximization Problem (UMP). Derive the market (aggregate) supply curve from individual firms’ supply curves which in turn, as we will see, are
derived from each individual firm’s Cost Minimization Problem (CMP). Derive the equilibrium market price and quantity. Analyze a real life business case and derive a “real life” supply model which can be used to trade commodities. Throughout this chapter we will almost always analyze competitive firms in the short run.
2. The Competitive Market: Market Demand Curve
Consider a “good” (product/service) sold in a competitive market with price taking firms, where “price taking” behavior
may arise with a “few” firms. Start by assuming that the “market” consists of “price taking” rational consumers with
exogenously given incomes2. In ECO 204 we assumed that a rational consumer’s preferences can be modeled by a
continuous, though not necessarily differentiable, utility function. Given prices and income, each consumer is assumed
to have solved her UMP and derived her individual demand function for this good sold in the competitive market. Let:
Given price quantity demanded by an individual price taking consumer this is total “market” quantity demanded by all consumers in the market ∑ 2 Note to self: starting with 204 summer 2013, differentiate between partial and equilibrium models and introduce the already
written chapter on buyers and sellers.
ECO 204 Chapter 15: Competitive Firms and Markets (this version 2012-2013) University of Toronto, Department of Economics (STG). ECO 204, S. Ajaz Hussain. Do not distribute. Since
∑ we can derive the market demand function as the sum of individual demand functions, and from this
derive the market demand curve. Let’s do some examples:
Example: Suppose “good 1” is the commodity being analyzed and “Good 2” is “all other goods”. Suppose there are
consumers (A, B, C) with identical Cobb-Douglas utility functions, and individual-specific incomes
respectively. We can solve each consumer’s UMP (do it!) and derive their individual demand functions for good 1
(remember that in consumer theory we assumed that consumers were price takers): From this we can derive the market demand function for good as:
∑ (⏟ )
∑ ∑ This expression is as if we had solved a Cobb-Douglas UMP for a consumer with the utility function
income level ∑ . That is, three consumers’ total demand for good 1 is as if these three consumers behave as one single
price taking “repre...
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This document was uploaded on 01/19/2014.
- Fall '14