chapter 8 the theory of perfect competition

© 2009 Pearson Education Canada8/1

Chapter 8Chapter 8

The Theory of Perfect The Theory of Perfect CompetitionCompetition


A Competitive Model of exchangeA Competitive Model of exchange

In an In an exchange economyexchange economy, , goods are goods are exchanged but not produced. exchanged but not produced.

Reservation priceReservation price is the maximum is the maximum amount a person is willing to pay for a amount a person is willing to pay for a good.good.

Market demandMarket demand & & market supplymarket supply functions give the total number of units functions give the total number of units demanded & supplied at a given price. demanded & supplied at a given price.


Figure 8.1 Demand and supplyFigure 8.1 Demand and supply


From Figure 8.1From Figure 8.1

All individuals supply/demand only All individuals supply/demand only one unit of the good and their one unit of the good and their individual demand/supply curves are individual demand/supply curves are given by their reservation willingness given by their reservation willingness to pay for a good.to pay for a good.

The decision to be “in” or “out” of The decision to be “in” or “out” of the market is called the the market is called the extensive extensive margin.margin.


Figure 8.2 Competitive equilibrium Figure 8.2 Competitive equilibrium in an exchange economyin an exchange economy


From Figure 8.2 From Figure 8.2

Imagine there is a Imagine there is a Walrasian Walrasian auctioneerauctioneer who acts as a price setter. who acts as a price setter.

If quantity demanded/supplied at the If quantity demanded/supplied at the announced price exceeds quantity announced price exceeds quantity supplied/demanded there is supplied/demanded there is excess excess demand/supply.demand/supply.


From Figure 8.2 From Figure 8.2

The auction ends in a The auction ends in a competitive competitive equilibriumequilibrium only when quantity only when quantity demanded equals quantity supplied.demanded equals quantity supplied.

This competitive allocation is This competitive allocation is Pareto-Pareto-optimal optimal oror efficient.efficient.


The Function of PriceThe Function of Price

In a market economy, prices are the In a market economy, prices are the signal that guide and direct signal that guide and direct allocation. allocation.


The Assumptions of Perfect CompetitionThe Assumptions of Perfect Competition

1.1. Large NumbersLarge Numbers: No individual demander or supplier : No individual demander or supplier produces a significant proportion of the total output.produces a significant proportion of the total output.

2.2. Perfect InformationPerfect Information: All participants have perfect : All participants have perfect knowledge of all relevant prices and technology.knowledge of all relevant prices and technology.

3.3. Product HomogeneityProduct Homogeneity: In any given market, all : In any given market, all firms’ products are identical. firms’ products are identical.

4.4. Perfect Mobility of ResourcesPerfect Mobility of Resources (Inputs). (Inputs).

5.5. IndependenceIndependence: Individual consumption and : Individual consumption and production decisions are independent of all other production decisions are independent of all other consumption/production decisions. consumption/production decisions.


Firm’s Short-run Supply DecisionFirm’s Short-run Supply Decision

A firm’s profit (A firm’s profit (ππ)) is its total revenue is its total revenue (TR)(TR) minus short-run total costs minus short-run total costs (STC).(STC).

The profit function is expressed as:The profit function is expressed as:

ππ(y) = TR(y)-STC(y)(y) = TR(y)-STC(y) Profit is maximized at Profit is maximized at yy**,, as a function as a function

of the exogenous variable price of the exogenous variable price (p).(p). The slope of the profit function with The slope of the profit function with

respect to output is zero at respect to output is zero at yy*.*.


Figure 8.4 Profit maximizationFigure 8.4 Profit maximization


Marginal Revenue and Marginal CostMarginal Revenue and Marginal Cost

The slope of the total revenue The slope of the total revenue function is marginal revenue function is marginal revenue (MR).(MR).

The slope of the total cost function is The slope of the total cost function is marginal cost marginal cost (MC).(MC).

The firm will maximize profits by The firm will maximize profits by equating equating MR MR & & MCMC::

SMC(ySMC(y**)=MR=p)=MR=p


Figure 8.5 The competitive firm’s supply functionFigure 8.5 The competitive firm’s supply function


From Figure 8.5From Figure 8.5

Short-run profit maximization Short-run profit maximization requires requires SMC(ySMC(y**)=MR=p)=MR=p, subject to , subject to two qualifications:two qualifications:

1.1. SMCSMC is rising. is rising.

2.2. pp>minimum value of >minimum value of AVC.AVC.


Profit MaximizationProfit Maximization

Profit can be expressed as:Profit can be expressed as:

ππ(y(y**) = y) = y**[p-SAC(y)][p-SAC(y)]

Where: Where: p-SAC(y)p-SAC(y) is profit per unit of is profit per unit of yy


Figure 8.6 The profit rectangleFigure 8.6 The profit rectangle


Figure 8.7 Aggregating demandFigure 8.7 Aggregating demand


Figure 8.8 Aggregating supplyFigure 8.8 Aggregating supply


Figure 8.9 Short-run competitive equilibriumFigure 8.9 Short-run competitive equilibrium


Efficiency of the Short-Run Efficiency of the Short-Run Competitive EquilibriumCompetitive Equilibrium

The short-run equilibrium shown in Figure The short-run equilibrium shown in Figure 8.9 is considered to be efficient because 8.9 is considered to be efficient because it maximizes it maximizes consumer surplusconsumer surplus and and producer surplusproducer surplus..

The sum of The sum of consumer surplus and consumer surplus and producer surplus,producer surplus, known as known as total total surplussurplus, , is a measure of theis a measure of the aggregate aggregate gains from trade realized in this market.gains from trade realized in this market.


Long-Run Competitive EquilibriumLong-Run Competitive Equilibrium

There are two conditions of long-run There are two conditions of long-run equilibrium:equilibrium:

1.1. No established firm wants to exit No established firm wants to exit the industry.the industry.

2.2. No potential firm wants to enter the No potential firm wants to enter the industry.industry.


Long-Run Competitive EquilibriumLong-Run Competitive Equilibrium

Positive profit is a signal that induces Positive profit is a signal that induces entry, or allocation of additional entry, or allocation of additional resources to the industry. resources to the industry.

Losses are a signal that induces exit, or Losses are a signal that induces exit, or the allocation of fewer resources to the the allocation of fewer resources to the industry.industry.

In long-run equilibrium, price equals the In long-run equilibrium, price equals the minimum average cost minimum average cost which is the which is the efficient scale of productionefficient scale of production. .


Figure 8.10 Exit, entry, and Figure 8.10 Exit, entry, and long-run competitive equilibriumlong-run competitive equilibrium


Figure 8.11 The firm in long-run Figure 8.11 The firm in long-run competitive equilibriumcompetitive equilibrium


Long-Run Supply FunctionLong-Run Supply Function

The long-run competitive equilibrium is The long-run competitive equilibrium is determined by the intersection of LRS determined by the intersection of LRS and the demand function.and the demand function.

Deriving LRS incorporates changes in Deriving LRS incorporates changes in input prices that arise as industry-wide input prices that arise as industry-wide output expands.output expands.

These changes determine whether the These changes determine whether the industry is a industry is a constant, increasing, or constant, increasing, or decreasing cost industrydecreasing cost industry. .


Figure 8.12 Figure 8.12 LRS LRS in the constant-cost casein the constant-cost case


Figure 8.13 Figure 8.13 LRSLRS in the increasing-cost case in the increasing-cost case

chapter 8 the theory of perfect competition

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