If you were to ask another economist to predict the effects of an economic recession on purchases of automobiles, he would imagine a demand curve shifting to the left and thus predict lower prices and lower output. Based on this model, she will predict higher prices and lower consumption. The mental model she will use is almost certainly to imagine a supply curve for oil shifting to the left. Yet suppose you ask an economist to predict the likely effect of a worsening conflict in the Middle East on oil prices. In fact-strictly speaking-there is no such thing as a supply curve when a firm has market power.Įconomists understand this very well. A firm with market power does not take the price as given and then determine a quantity to supply. We explain how firms set these prices in Chapter 6 "Where Do Prices Come From?". It sets a price as a markup over marginal cost and then produces enough to meet demand at that price. A firm with market power chooses a point on the demand curve that it faces. You might think this greatly weakens the usefulness of the supply-and-demand framework. In most markets, firms possess some market power, meaning that the demand curve they face is not perfectly elastic. Such examples notwithstanding, the vast majority of markets are not perfectly competitive. Markets for certain financial assets are another. Markets for commodities, such as wheat or gold, are one example. There are certainly some markets that fit these criteria. Each buyer and seller must be “small” relative to the market, meaning that they cannot influence market price. There also must be a large number of buyers. For a market to be perfectly competitive, there must be a large number of sellers of an identical product. Yet the conditions for perfect competition are quite stringent.
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