Question

Explain how, when buyers and sellers are rent-seeking competitors, they will ensure that the economic rents from prices that are too high or too low are competed away to ensure a market-clearing price-quantity equilibrium. Be sure to explain why behaving as a price-taker is therefore a firm’s best response in equilibrium.

Answer 1

For the above question, we need to assume that we are considering an economic condition of perfect competition.

As seen from the graph above, under perfect competition, suppose the equilibrium price is P₀ and the equilibrium quantity is Q₀. If a seller decides to sell quantity Q₂ at a higher price P₁, his economic rent will be the shaded rectangle P₁ACP₀. However, this high economic rent will attract other sellers but drive away buyers. All those sellers who raise their prices to P₁ will soon realize they have fewer buyers. They will be forced to bring the price down gradually, to re-attract buyers. The economic rent will reduce and eventually fade away. Price will be back to the equilibrium price, P₀.

Conversely, if buyers decide to push down the market price, then graphically the situation can be explained as below:

If some buyers decide to buy at the lower price of P₁, then the for the quantity Q₀, the economic rent that these buyers will enjoy is P₁P₀CE. Suppliers will, however, begin to supply the quantity Q₂. When buyers face a supply shortage, they will be pushed to other suppliers, who are charging P₀ and the buyers will be forced to pay the equilibrium price of P₀. Thus, the economic rent that the buyers were enjoying will have competed away.

Therefore, both for buyers and sellers, being a price-taker and accepting the market equilibrium price is the best response as the short-run economic rents will always be competed away due to market dynamics.