the benchmark of perfect competition
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The benchmark of perfect competition. Defining perfect competition Modelling market interactions Welfare and efficiency. The benchmark of perfect competition. We have seen : How much consumers choose of a given good, for all levels of price Through consumer choice theory - PowerPoint PPT PresentationTRANSCRIPT
The benchmark of perfect competition
Defining perfect competitionModelling market interactions
Welfare and efficiency
The benchmark of perfect competition
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 benchmark of perfect competition
The interaction of supply and demand
The 5 conditions of perfect competition
Short run and long run in perfect competition
Surplus and welfare
The interaction of supply and demand
2.50
2.00
1.50
1.00
0.50
Price
21 3 4 5 6 7 8 9 10 11 Quantity0
Reminder: the demand curve
The interaction of supply and demand
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
The interaction of supply and demand
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
The interaction of supply and demand
0
Price
Quantity
Increase in demand
Fall in demand
The interaction of supply and demand
2.50
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 interaction of supply and demand
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
The interaction of supply and demand
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
The interaction of supply and demand
0
Price
Quantity
Increase in supplyFall in
supply
The interaction of supply and demand
S
D
Price
Quantity21 3 4 5 6 7 8 9 10 12110
3.002.502.00
1.501.00
0.50
Equilibrium
The interaction of supply and demand
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
The interaction of supply and demand
2.00
S
D
1.50
Rationing
Price
Quantity21 3 4 5 6 7 8 9 10 12110
The interaction of supply and demand
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
The interaction of supply and demand
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.
The benchmark of perfect competition
The interaction of supply and demand
The 5 conditions of perfect competition
Short run and long run in perfect competition
Surplus and welfare
The 5 conditions of perfect competition
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
The 5 conditions of perfect competition
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
The 5 conditions of perfect competition
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.
The 5 conditions of perfect competition
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.
The benchmark of perfect competition
The interaction of supply and demand
The 5 conditions of perfect competition
Short run and long run in perfect 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
SR and LR in perfect competition
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
SR and LR in perfect competition
mC
AC
Price Price
S
D
Firm-market equilibrium
Firm level Market level
Quantityquantity
d=mRp
q Q
Zero profits in equilibrium
SR and LR in perfect competition
mC
AC
Price Price
S
D
Firm-market equilibrium
Firm level Market level
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
SR and LR in perfect competition
mC
AC
Price Price
S
Firm-market equilibrium
Firm level Market level
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
SR and LR in perfect competition
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”
SR and LR in perfect competition
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
The benchmark of perfect competition
The interaction of supply and demand
The 5 conditions of perfect competition
Short run and long run in perfect competition
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