Aram Grigoryan Econ 100B, Spring 2023

Part IV

Competitive Equilibrium, Taxes, and Welfare

So far we have learnt how a single consumer or a single firm behaves in a market. We will now
study the market as a whole; that is, the interaction of many consumers and firms. Lecture Notes
Part 4 will cover a single market / a single industry. In Part 5 (the last part) we will study the
general equilibrium model, where multiple products are traded simultaneously.

Competitive Markets (for a single good) (IMVH E1.a,b)

We study a market where many firms produce an identical good. This is the model of a perfectly
competitive market, or simply, the competitive market. The characteristics (assumptions) of this
model are the following:

• identical good,

• many firms,

• free entry and exit,

• perfect information,

• no transaction costs.

In reality no market may perfectly satisfy all these properties. However, the model is useful
to analyze markets that share these characteristics to some degree. For other markets, the theory
may not be too informative; other classic models (covered in 100C) may be more appropriate to
analyze those markets (examples: monopoly, oligopoly).

Market Demand, Market Supply, and Equilibrium

In competitive markets, the market demand and the market supply are the driving forces that
determine the market price and quantity.

Market Demand: We learnt about consumer demand in Econ 100A. The (Marshalian) demand
xj (p) of a consumer denotes the amount of the good that j consumes for a given price p. If we
aggregate the demand of all consumers j = 1, 2, . . . , N , we get the the market demand function

N
X
D
Q (p) = xj (p).
j=1

In Econ 100B, we take market demand as given, typically assuming that it is a linear function of
the form QD (p) = a bp, for some positive number a and b.

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Market Supply: The market supply shows the relation between the price of the good, and the
aggregate quantity produced by all active firms in the industry. Later in these notes, we will be
deriving the market supply by just looking at the individual firm’s cost functions. For now, let us
think of a market supply as some increasing function QS (p).

Equilibrium: One of the most powerful analysis tools of the neoclassical economics model is that
the price and quantity of the good will be determined solely by the market demand and the market
supply. Namely, the equilibrium price and quantity is the point where the demand and the supply
curves intersect.

The equilibrium price p⇤ solves

QD (p⇤ ) = QS (p⇤ )

and the equilibrium quantity is Q⇤ = QD (p⇤ ) = QS (p⇤ ).

p
QS

p⇤

QD
Q
Q⇤

Question: Why should we expect to have the price p⇤ in the competitive market?
Answer: Only when the price is p⇤ the market is in ‘equilibrium’ (no consumer or firm wants to
change the status quo). For example, suppose the price is p̄ > p⇤ . In that case, QS (p̄) > QD (p̄),
which means that firms are producing more than the consumers demand. Then, some of the firms
end up not selling their products. Then, these firms would o↵er the consumers a lower price than p̄
so that they do not purchase from other firms, and purchase from them instead. Hence, if the price
is larger than p⇤ , the market will put a downward pressure on it until it reaches the equilibrium
price p⇤ . Now suppose that the price is p < p⇤ . In that case, QS (p) < QD (p), which means that
some consumers who demand a product are not able to get one at that low price. Then, these
consumers would o↵er the firms a higher price than p so that they do not sell the products to other
consumers, and sell those to them instead. Hence, if the price is smaller than p⇤ , the market will
put an upward pressure on it until it reaches the equilibrium price p⇤ .

We will study equilibrium in two time horizons: the short-run and the long-run.

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Short-Run Equilibrium (IMVH E1.c)

In the short-run the number of active firms in the market is fixed. To study short-run equilibrium,
we need to derive the short-run market supply, which is the sum of all active firms’ supply curves.

Let si (p) denote the supply function for firm i = 1, 2, . . . , N . Then, the short-run market
supply is
XN
S
Q (p) = si (p).
i=1

Numerical Example: Derivation of Short-Run Market Supply. There are three active
firms in the market with the following short-run cost functions:

• Firm 1. c(q) = q 3 + 2q,

• Firm 2. c(q) = q 2 + q,

• Firm 3. c(q) = q 2 + q.

We first compute the short-run supply functions for each of the firms.
Firm 1: AV C(q) = q 2 + 2, min AV 2 ⇤
qC = 2, and M C(q) = 3q + 2. To find q (p) we solve for q in
p 2
3q 2 + 2 = p, which gives q ⇤ (p) = 3 . Therefore, the supply function of Firm 1 is
8
<0 if p < 2
s1 (p) = q
: p 2
if p 2
3

Firm 2 and Firm 3: AV C(q) = q + 1, min AV C = 1, and M C(q) = 2q + 1. To find q ⇤ (p) we solve
for q in 2q + 1 = p, which gives q ⇤ (p) = p 2 1 . Therefore, the supply function of Firm 1 is
8
<0 if p < 1
s2 (p) = s3 (p)
:p 1
if p 1
2

The market supply function is

8
>
> 0 if p < 1
>
<
QS (p) = s1 (p) + s2 (p) + s3 (p) = 0+ p 1 p 1
2 + 2 if 1  p < 2
>
> q
>
: p 2 p 1 p 1
3 + 2 + 2 if p 2

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Simplifying the expression, we get that

8
>
>0 if p < 1
>
<
S
Q (p) = p 1 if 1  p < 2
>
> q
>
: p 2 +p
3 1 if p 2

In the next numerical example we compute both the market supply and the short-run equilibrium.

Numerical Example: Short-Run Equilibrium. There are 8 firms in the market, each with
the cost function
c(q) = q 2 + 4q + 25

The market demand is

QD (p) = 34 p

We want to solve for the short-run equilibrium price p⇤ and quantity Q⇤ .

As a first step, we derive the supply function for each firm, and then aggregate them to obtain
the short-run market supply QS (p). Since the 8 firms are identical, it suffices to derive the short-
run supply function for only one of them. AV C(q) = q + 4, min AV C = 4, and M C(q) = 2q + 4.
From 2q + 4 = p, we get that q ⇤ (p) = p 2 4 . Hence, a firms’ supply function is
8
<0 if p < 4
s(p) =
:p 4
if p 4
2

The market supply would equal to 8 times s(p), that is,

8
<0 if p < 4
QS (p) =
:4p 16 if p 4

To find the equilibrium price p⇤ , we solve for QS (p⇤ ) = QD (p⇤ ). Assuming p⇤ 4, the relevant
section of the supply curve is 4p 16:

4p 16 = 34 p () 5p = 50 () p⇤ = 10

The equilibrium quantity (supplied and demanded) is

Q⇤ = QS (10) = QD (10) = 24

Each of the firms produces s(10) = 3 units.

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Aram Grigoryan Econ 100B, Spring 2023

Long-Run Equilibrium (IMVH E1.d, Perlo↵ 9.1)

In the long-run the number of firms is not fixed, but it is endogenously determined given the firms’
(optimal) decisions to enter and exit. Consider the last numerical example in the previous section.
With 8 firms in the market, the short-run equilibrium price will be p⇤ = 10, and each of the firms
will produce 3 units. In this short-run, the firms are earning negative profit:

⇡(10) = 10 · 3 c(3) = 30 32 4·3 25 = 16.

Since the firms are earning negative profit, some of them will exit the market until the profit is
no longer negative. If too many firms exit, the profit may become positive, in which case new
firms would like to enter the market. Therefore, the only scenario that ‘survives’ in the (long-run)
equilibrium is when the profit is zero. For example, consider the case when there are only 4 firms. In
that case, the market supply is 4 · s(p) (which is 2p 8 for prices larger than 4), and the equilibrium
price can be computed as follows:

2p 8 = 34 p () 3p = 42 () p⇤ = 14.

The equilibrium quantity is

Q⇤ = QD (14) = 20,

and each of the 4 firms produces s(14) = 5 units. The profit of each firm is zero:

⇡(14) = 14 · 5 c(5) = 70 52 4·5 25 = 0.

Since the profits are zero, none of the active firms strongly prefers to exit the industry, and none
of the non-active firms strongly prefers to enter the industry. This is the long-run equilibrium. To
summarize:

Long-run equilibrium price is determined by the zero profit condition, which is equivalent to

p⇤ = min AC

When solving numerical examples for the long-run equilibrium, the first step is to identify the
equilibrium price as the minimum of the average costs. In our example, c(q) = q 2 + 4q + 25, which
means that

25
AC(q) = q + 4 + , the minimizer q̂ of the AC is 5, and min AC = AC(5) = 14
q

(we can find the AC minimizer q̂ using the FOC: 1 25 q2

= 0).
Then, we plug in the equilibrium price into the demand function to get the equilibrium quantity

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Aram Grigoryan Econ 100B, Spring 2023

QD (14) = 34 14 = 20. Finally, to get the number of active firms in the long-run nLR , we divide
the equilibrium quantity by the number of units produced by each firm s(14) = 5. That is,

20
nLR = =4
5

p⇤ QS

Q
q̂ = s(p⇤ ) Q⇤

When the firms are identical, the long run equilibrium price is always equal to the minimum of
the average costs of the representative firm. Therefore, the long-run market supply curve is
horizontal at level min AC. This is illustrated at the graph above

Welfare in the Competitive Markets (IMVH E1.f,g, Perlo↵ 9.2, 9.3)

Consumer Surplus: Market demand shows how many units consumers are willing to purchase at
any given price. For example, consider the market demand function QD (p) = 10 2p. For a price
p = 5 (or higher), the demand is zero, which means that no one is willing to purchase the good at
that price. In other words, the good gives a utility less than 5$ for any of the consumers. At price
p = 4, the demand is QD (4) = 10 8 = 2, which means that each of the units consumed deliver a
utility (‘happiness’ / value) of at least 4$. Hence, for p = 4, the total utility measured in dollars,
or in other words - consumer surplus, is approximately equal to 2 · 4 = 8 dollars. Now suppose the
price is p = 3. In that case, QD (3) = 10 6 = 4. Hence, each of the four units consumed delivers
utility of at least 3$. Moreover, we already know that the first two units deliver a utility of at least
4$. Therefore, for p = 3 the consumer surplus is approximately equal to 2 · 4 + 2 · 3 = 14 dollars.
etc.

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Aram Grigoryan Econ 100B, Spring 2023

1 p=1

Q
2 4 6 8 10

We can represent the consumer surplus graphically, as the area under the market demand curve.
In the graph above, consumer surplus at price p = 1 approximately equals the sum of the areas of
the rectangles. This equality is ‘approximate’: to get exact inequality, we need to divide items into
infinitesimal pieces when computing consumer surplus (utility). By doing so, we will get that the
consumer surplus as the area between the demand curve and the price.

p=1

Producer Surplus: The producer surplus measures the ‘happiness’ of all firms, and hence, it is
closely related to the sum of all profits. For simplicity, suppose there is only one firm. The firm’s
cost function is q 2 + q. Hence, the marginal cost is M C(q) = 2q + 1, the average (variable) cost is
AC(q) = AV C(q) = q + 1, and min AC = min AV C = 1. The M C is always above the min AC,
and therefore, the firm’s supply curve coincides with the the marginal cost curve.
Suppose the price is p = 9. Producing the first unit costs no more than 3$ to the firm, yet it
can be sold at a price 9$, bring a marginal profit of at least 6$. Producing the second unit costs
no more than 5$ to the firm, yet it can be sold at a price 9$, bring a marginal profit of at least 4$.

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Aram Grigoryan Econ 100B, Spring 2023

Similarly, producing the third unit costs no more than 7$, so it brings a marginal profit of at least
2$.

M C or supply curve

9 p=9

q
1 2 3 4

(Note: the ’x-axis’ on the graph above has a label of small q instead of capital Q, because we are
talking about the production of a single firm for now.)

By adding up all the marginal profits, we will get the sums of the area of the rectangle in the picture
above. This would be ‘approximately’ equal to the producer surplus. To get the exact number, we
will need to add up the marginal profits of infinitesimally small production levels. If we do that,
we will get the producer surplus as the area between the price and the supply curve.

M C or supply curve
p=9

Profit ⇡ the between the price and the MC (supply) curve From our calculus knowledge,
we know that the area between two functions’ graphs equals the integral of their di↵erence. For
example, at some fixed price p, the firm will produce q ⇤ units, where q ⇤ solves the FOC M C(q ⇤ ) = p
(assuming that the local maximizer q ⇤ is also the global one).

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The producer surplus (PS) is the area between the price and the marginal cost, for the range
of q 0 and q  q ⇤ . Using the integral formula for this area, we get that
Z q⇤ Z q⇤ Z q⇤
⇥ ⇤
PS = p M C(q) dq = pdq M C(q)dq =
0 0 0

q⇤ q⇤
= pq c(q) = pq ⇤ 0 c(q ⇤ ) + c(0) = pq ⇤ c(q ⇤ ) + c(0) = ⇡(q ⇤ ) + F C.
0 0

We established that the producer surplus is equal to the firms profit, plus the fixed costs. Assuming
that there are no fixed costs, the producer surplus is equal to the firm’s profit. This is the reason
that the producer surplus is used to evaluate the ‘happiness’ of the firm.

The analysis so assumed that there is only one firm on the market. When there are multiple
firms, the producer surplus is defined analogously:

The producer surplus is the area between the price and the market supply curve.

QS
p

There is a close connection between the producer surplus and the sum of profits of all active
firms on the market. If there are no fixed costs, the two are equivalent.

Total Welfare in the Competitive Equilibrium: One of the main lessons that we learned
from the competitive markets model is that the equilibrium price and quantity maximize the total
surplus, which is the sum of the consumer and producer surpluses. That is,

Total Surplus (TS) = Consumer Surplus (CS) + Producer Surplus (PS)

Competitive equilibrium maximizes the total surplus!

As usual, let’s denote the equilibrium price and quantity by p⇤ and Q⇤ , respectively. We will

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Aram Grigoryan Econ 100B, Spring 2023

consider two cases (1) Q < Q⇤ , and (2) Q̄ > Q⇤ , and we will show that both of these cases result
in a lower total surplus than the equilibrium.

Case 1: Q < Q⇤ Suppose the price p is determined by the demand function (the assumption does
not a↵ect the total surplus), that is p solves QD (p) = Q. This price p and quantity Q are shown
on the graph below.

QS

A
p

B D
p⇤
C E

QD

Q
Q Q⇤

The following table compares the welfare at the equilibrium (p⇤ , Q⇤ ) with that of the outcome
(p, Q).

CS PS TS
p ⇤ , Q⇤ A+B+D C+E A+B+C+D+E
p, Q A B+C A+B+C
Di↵erence B+D E-B D+E

CS denotes the consumer surplus, PS denotes the producer surplus, and TS denotes the total
surplus. Those variables are computed according to their definitions (as areas between the price and
the demand/supply curves). The last entry on the table, which is D+E is of particular importance.
The triangle D + E is the di↵erence between the equilibrium total surplus and the total surplus at
the outcome (p, Q). In other words, this triangle measures how inefficient is the outcome (p, Q),
and it is called the deadweight loss (DWL).

Case 2: Q̄ > Q⇤ Suppose that the price p̄ is again determined by the demand function. That is, p̄
solves QD (p̄) = Q̄. This price p̄ and quantity Q̄ are shown on the graph.

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Aram Grigoryan Econ 100B, Spring 2023

QS

A
p⇤ F

B D E
p̄
C
QD

Q
Q⇤ Q̄

The following table compares the welfare at the equilibrium (p⇤ , Q⇤ ) with that of the outcome
(p̄, Q̄).

CS PS TS
p ⇤ , Q⇤ A B+C A+B+C
p, Q A+B+D+E C-D-E-F A+B+C-F
Di↵erence -B-D-E B+D+E+F F

The deadweight loss in this case is F.

We just proved that the competitive equilibrium (p⇤ , Q⇤ ) maximizes total surplus.

Taxes and Price Controls (IMVH E1.h,i,j, Perlo↵ 9.5)

Taxes play a crucial role for the society. There are two main economic benefits of taxation:

• generating revenues for providing public goods, such as rule of law, defense, parks, cities /
infrastructure, environment, education.

• fixing market failures when there are externalities, such as the consumption of gas or alcohol.

In future (or past) economics classes you will learn how tax e↵ects can benefit the markets when
there are externalities. In this section we will study the model without externalities, and we will
show that taxes can be disruptive and can reduce welfare in the market under consideration. Even

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in those examples though, it is important to note that typically taxes are overall beneficial: they
create a deadweight loss, but they also generate a tax revenue which is used to improve social
welfare through public goods in other markets.

Taxes create a ‘wedge’ between the price that consumers pay, and the price that firms receive. The
former price we denote by pc , and the latter by pf . The wedge between these two prices depends
on whether we use a per-unit (or specific) tax or a sales tax.

There are two types of taxes:

1. Per-unit tax: pc = pf + t

2. Sales tax: pc = (1 + t)pf

The quantity after the tax (let’s denote it by Q̄) is determined by the market-clearing equation
(demand equals supply):
Q̄ = QD (pc ) = QS (pf )

Numerical Example: Short-Run Taxes. The demand and supply are:

QD (p) = 90 p

QS (p) = 2p

We want to evaluate the impact of the taxes on the consumer, producer, and total surpluses in
this economy. We will consider two cases: (i) a per-unit tax of t = 6, and, (ii) a sales tax of t = 2.
Per-unit tax t = 6: We can find the consumer and producer prices using a system of two equations
with two unknowns.
pc = pf + 6

90 pc = 2pf

We substitute pc with pf + 6, to get 90 pf 6 = 2pf . Hence, pf = 28 and pc = 34. The quantity

produced after the text (Q̄) can be computed either by plugging the consumer price in the demand
function, or the producer price in the supply function:

Q̄ = QD (pc ) = QS (pf ) = 56.

The graph below shows the areas for CS, PS, TR, and DWL.

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Aram Grigoryan Econ 100B, Spring 2023

90

34
28

Q
54 60 90

Sales tax t = 2 (or 200%). We can find the consumer and producer prices using a system of two
equations with two unknowns.
pc = 1 + 2 pf = 3pf

90 pc = 2pf

We substitute pc with 3pf , to get 90 3pf = 2pf . Hence, pf = 18 and pc = 54. The quantity
produced after the text (Q̄) can be computed either by plugging the consumer price in the demand
function, or the producer price in the supply function:

Q̄ = QD (pc ) = QS (pf ) = 36.

The graph below shows the areas for CS, PS, TR, and DWL.
p

90

54

18

Q
36 60 90

Numerical Example: Long-Run Taxes. All firms are identical, and each firm’s cost function
is
c(q) = q 2 + 25.

The demand function is

QD (p) = 100 2p

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Aram Grigoryan Econ 100B, Spring 2023

The main ‘trick’ for solving the long-run tax examples, is to directly compute pf as the minimum
of the average cost. This follows from the definition of the producer price, and the fact that the
long-run market supply (with identical firms) is horizontal. The minimum of the AC(q) = q + 25 q
can be computed from the FOC:

25
1 = 0 =) q̂ = 5 =) min AC = AC(5) = 10.
q2

The consumer price will depend on the tax level. We will consider two cases: (i) a per-unit tax
t = 20, and a sales tax (ii) t = 12 (or 50%).

Per-unit tax t = 20. The consumer price can be directly computed:

pc = pf + t = 10 + 20 = 30.

The quantity after the tax is determined by the demand function:

Q̄ = 100 2pc = 40.

The graph below shows the areas for CS, Tax Revenue, and DWL. Note that PS is zero!

50

30

10
Q
40 80

Sales tax t = 12 . The consumer price can be directly computed:

1 3
pc = 1 + pf = · 10 = 15.
2 2

The quantity after the tax is determined by the demand function:

Q̄ = 100 2pc = 70.

The graph below shows the areas for CS, Tax Revenue, and DWL. PS is zero.

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50

15
10
Q
70 80

Price Floors and Price Ceilings. Price control is a common policy for guaranteeing equi-
table access to resources or regulating incomplete markets. In perfectly competitive markets these
regulations may come with an efficiency cost. We will learn how to evaluate these potential costs.

Consider the numerical example from before.

QD (p) = 90 p

QS (p) = 2p

The equilibrium price in this market is p⇤ = 30 and Q⇤ = 60. Now suppose we impose a price floor
p = 40, so that the firms cannot charge less that 40. In that case, the quantity will be determined
by the demand function QD (40) = 50. We can compute CS, PS, and DWL using the definitions.
Those are shown in the graph below.

90

40
25

Q
50 60 90

Now consider the same example with a price ceiling p̄ = 10, so that the consumers cannot pay
more than 10. In that case, the quantity will be determined by the supply function QS (10) = 20.
We can compute CS, PS, and DWL using the definitions. Those are shown in the graph below.

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90

70

10
Q
20 60 90

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