the benchmark of perfect competition defining perfect competition modelling market interactions...

The benchmark of perfect competition

Defining perfect competitionModelling market interactions

Welfare and efficiency


We have seen : How much consumers choose of a given good,

for all levels of price Through consumer choice theory

How much producers produce of a good, for all levels of price Through the model of the firm

We now need to work out : How this supply and demand interact to

provide the market price and quantity We need a model of the market !


The interaction of supply and demand

The 5 conditions of perfect competition

Short run and long run in perfect competition

Surplus and welfare


2.50

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Price

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Reminder: the demand curve


The demand function depends on:

The market price of the goodThe income of consumers (BC)The preferences of consumers (IC)The price of other goods (S or C)Expectations (future endowments)

1 1, ,i iothersx p p I


A change in… ..brings the following effect on the demand curve …

Price A movement on the curve

Income A movement of the curve itself

Preferences A movement of the curve itself

Price of other goods A movement of the curve itself

N˚ of consumers A movement of the curve itself

Expectations A movement of the curve itself


0

Price

Quantity

Increase in demand

Fall in demand


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2.00

1.50

1.00

0.50

Price

21 3 4 5 6 7 8 9 10 11 Quantity0

Reminder: the supply curve


The supply function depends on:

The market price of the goodThe price of inputs (cost function)Technology (production function)N˚ of producersExpectations

1 1, ,i iinputss p p n


A change in… ..brings the following effect on the supply curve …

Price A movement on the curve

Price of inputs A movement of the curve itself

Available techologies A movement of the curve itself

N˚ of producers A movement of the curve itself

Expectations A movement of the curve itself


0

Price

Quantity

Increase in supplyFall in

supply


S

D

Price

Quantity21 3 4 5 6 7 8 9 10 12110

3.002.502.00

1.501.00

0.50

Equilibrium


Quantity21 3 4 5 6 7 8 9 10 12

11

0

3.00

2.50

2.00

1.501.00

0.50

S

D

Excess supply

Price


2.00

S

D

1.50

rationing

Price

Quantity21 3 4 5 6 7 8 9 10 12110


Price

2.00

0 7 Quantity

S

D1

1. An increase in demand (through exterior cause)…

D2

2. ... increases the price ...

2.50

103. ... and the amount sold

New equilibrium

Initial Equilibrium


S2

Price

2.00

4 7 Quantity

D

Initial equilibrium

S1

1. A fall in supply ...

New equilibrium

2. ...increases prices...

2.50

3. ...and reduces the quantity sold.





Surplus and welfare


Perfect competition is defined by the following 5 conditions:

1. Large number of agents (Atomicity) 2. Homogeneous products3. Free entry and exit from the market4. Perfect information5. Perfect mobility of inputs

All 5 are required for an optimal coordination of supply and demand


Let’s detail what these conditions imply:

Large number of producers (Atomicity) There are many producers and consumers None is large enough to individually influence

the market outcome

Homogeneous products On any given market, the good is exactly the

same regardless of who produced it. Consumers have no preferences w.r.t. producers


Free entry and exit from the market Agents are free to enter and exit markets in

response to changing market conditions There are no barriers to entry or exit

Perfect information Agents constantly are constantly informed,

without delay, of the changing market conditions Agents also know all perfectly all the

characteristics of the goods: No hidden defects, etc.


Perfect mobility of inputs Similar to the “no barriers to entry” condition Inputs can change markets freely

If even a single one of these conditions fails to hold, then we have imperfect competition Clearly, this set of conditions is never met in

reality !! But the concept of perfect competition is

important as a benchmark for assessing the different kinds of imperfect competition.





Surplus and welfare

SR and LR in perfect competition

Profit of the firm:

The profit maximisation condition finds output q such that :

What it mR equal to in perfect competition?

0 0TR TC

q q q

TR TC

0m

m m

C

C

R m

R


Total revenue is simply equal to the quantity sold times the price at which the output is sold:

Marginal revenue is the sum of: The extra quantity produced ∂q times the price The effect of the increase on the market price

TR p q p q

TR p q

But the atomicity assumption guarantees that this second effect is zero !!!

TR

mT RR q pq

p


mC

AC

Price Price

S

D

Firm-market equilibrium

Firm level Market level

Quantityquantity

d=mRp

q Q

Zero profits in equilibrium


mC

AC

Price Price

S

D



Quantityquantity

d=mRp

q Q

D2

Q2

p2

q2

d2=mR2

Imagine a positive demand shock (ex: new “fashion”)

Total Cost

p q TC

Positive profits in SR


mC

AC

Price Price

S



Quantityquantity

d=mRp

q Q3

D2

Q2

p2

q2

d2=mR2

S2

Positive profits attract firms to the market (free entry + perfect information)

Return to zero profits in LR


mC

AC

Price

quantity

d=mRp

q

Zero profits in LR equilibrium

The significance of zero-profits Remember that total

costs include the opportunity cost

Zero economic profits does not mean zero accounting profits

It means that the accounting profits are equal to the opportunity cost

i.e the reward for producing is “fair”


Efficiency: At equilibrium, P=mc=AC All the increasing returns

to scale opportunities are used up, but decreasing returns to scale have not yet appeared

Firms are producing at the most efficient point

Resources are allocated efficiently: the smallest amount of resources possible is allocated to the production

mC

AC

Price

quantity

d=mRp

q

Zero profits in LR equilibrium





Surplus and welfare

Surplus and welfare

What is “surplus” ? It measures the net benefit to the consumers of

purchasing the good... ...or the net benefit to the producer of selling

the good

It is the difference between: The reservation price of the agents : the

“willingness to pay” for consumers and the marginal cost for producers

The price the good is exchanged on the market.

Surplus and welfare

But how it is worked out ? Actually, very simply !!

Reminder: the demand function is derived from the utility function (in fact from the indifference curves which map the utility function) It contains information about preferences, i.e. what a given

good/bundle is worth to the consumer in terms of utility

The same is true for the supply curve: It contains information about the marginal cost of

production, i.e. the value of the good under which producers will not produce

Surplus and welfare

2.50

2.00

1.50

1.00

0.50

Price

21 3 4 5 6 7 8 9 10 11 Quantity0

Example: Auction vs market

D

1st unit bought by the most “desperate” consumer: The one willing to pay the most

2nd unit bought by the second most “desperate” consumer: The one willing to pay the most from the remaining agents

But on a market, all 8 units are available at p = 1.

Surplus and welfare

P

QQ1

P1

Consumer surplus

Effect of a fall in price on the surplus of existing consumers

Surplus of new consumers who can now afford the good

P2

Q2

D

Consumer surplus

Producer surplus

Surplus and welfare

P

Q

P2

Q2Q1

P1

Effect of an increase in price on the surplus of existing producers

Surplus of new producers who can now supply the good

S

Producer surplus

Surplus and welfare

P

Q

P*

Q*

S

D

Global surplus under perfect competition

the benchmark of perfect competition defining perfect competition modelling market interactions...

Documents

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