eaton micro 6e ch08

7/27/2019 Eaton Micro 6e Ch08

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2005 Pearson Education Canada Inc .8.1

Chapter 8

The Theory of PerfectCompetition


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A Competitive Model of exchange

In an Exchange Economy, goods areexchanged but not produced.Reservation price is the maximumamount a person is willing to pay for agood.Market demand & supply functions givethe total number of units demanded & supplied at a given price.


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Figure 8.1 Demand and supply


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From Figure 8.1

All individuals supply/demand onlyone unit of the good, and theirindividual demand/supply curves aregiven by their reservation willingnessto pay for a good.The decision to be in or out of themarket is called the extensivemargin.


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Figure 8.2 Competitive equilibriumin an exchange economy


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From Figure 8.2

Imagine there is a Walrasian auctioneer who acts as a price setter.If quantity demanded/supplied at theannounced price exceeds quantitysupplied/demanded there is excessdemand/supply.The auction ends in a competitiveequilibrium only when quantity demanded

equals quantity supplied.This competitive allocation is Pareto-optimal or efficient.


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The Assumptions of Perfect Competition

1. Large Numbers : No individual demander orsupplier produces a significant proportion of the total output.

2. Perfect Information : All participants haveperfect knowledge of all relevant prices andtechnology.

3. Product Homogeneity : In any given market,all firms products are identical.

4. Perfect Mobility of Resources (Inputs).5. Independence : Individual consumption and

production decisions are independent of allother consumption/production decisions.


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Firms Short -run Supply Decision

A firms profit ( ) is its total revenue(TR) minus short-run total costs (STC).The profit function is expressed as:

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

of the exogenous variable price (p).The slope of the profit function withrespect to output is zero at Y *.


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Figure 8.4 Profit maximization


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Marginal Revenue and Marginal Cost

The slope of the total revenuefunction is marginal revenue (MR).The slope of the total cost function ismarginal cost (MC).The firm will maximize profits byequating MR & MC:Notationally: SMC(y * )=MR=p


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Figure 8.5 The competitive firms supply function


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From Figure 8.5

Short-run profit maximizationrequires SMC(y *)=MR=p, subject totwo qualifications:

1. SMC is rising.2. p>minimum value of AVC.


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Profit Maximization

Profit can be expressed as: (y *) = y *[p-SAC(y)]

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


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Figure 8.6 The profit rectangle


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Figure 8.7 Aggregating demand


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Figure 8.8 Aggregating supply


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Figure 8.9 Short-run competitive equilibrium


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Efficiency of the Short-RunCompetitive Equilibrium

The short-run equilibrium shown in Figure8.9 is considered to be efficient becauseit maximizes Consumer Surplus and Producer Surplus.The sum of Consumer Surplus and Producer Surplus, known as Total Surplusis a measure of the aggregate gains fromtrade realized in this market.


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Long-Run Competitive Equilibrium

There are two conditions of long-run equilibrium:

1. No established firm wants to exitthe industry.

2. No potential firm wants to enter theindustry.


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Long-Run Competitive Equilibrium

Positive profit is a signal thatinduces entry, or allocation of additional resources to the industry.Losses are a signal that inducesexit, or the allocation of fewerresources to the industry.In long-run equilibrium, priceequals the minimum average cost.


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Figure 8.10 Exit, entry, andlong-run competitive equilibrium


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Figure 8.11 The firm in long-runcompetitive equilibrium


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Long-Run Supply Function

The long-run competitive equilibrium isdetermined by the intersection of LRSand the demand function.

Deriving LRS incorporates changes ininput prices that arise as industry-wideoutput expands.

These changes determine whether theindustry is a constant, increasing, ordecreasing cost industry.


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Figure 8.12 LRS in the constant-cost case


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Figure 8.13 LRS in the increasing-cost case

eaton micro 6e ch08

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