Chapter 9 Perfect Competition In A Single Market - PowerPoint Presentation

Chapter 9Perfect Competition In A Single Market

ObjectivesWhat are perfectly competitive marketsHow prices are determined in a perfectly competitive marketWhy entry and exit of firms occur and its effectsWelfare consequences

Supply ResponseThe effects of changes in demand depend on the time period consideredIt takes time for suppliers to respondTime framesVery short run – quantity supplied is fixed (market period)Short run – existing firms can respond but no new entryLong run – existing firms can respond and new firms can enter.

Very Short Run Price Quantity per week S Q* Given some demand, D, the equilibrium price, P 1 , is where demand intersects supply. D P 1

Pricing In The Very Short Run Price Quantity per week S Q* If the demand curve increases there is excess demand at P 1 . D P 1 D’ To ration the quantity available, price must rise to P 2 . P 2

Short-Run SupplyAssume that the number of firms in the market is fixed: no new entry or exit.Existing firms can respond to changes in demand by increasing or decreasing their quantity supplied.

Short-Run Supply Price Price Price Output S A S B Firm A Firm B Market P 1 q 1 A q 1 B Q S

Short-Run Price Determination P P P Q Q Q Typical Firm The Market Typical Person SMC SAC S d D Q 1 P 1

Short-Run Price Determination P P P Q Q Q Typical Firm The Market Typical Person SMC SAC S d D Q 1 P 1 P 1 q 1 q 1

Short-Run Price DeterminationPrice serves two functionsIt acts as a signal to producers: given some price they maximize profits where P = SMCIt rations demand. Given some price consumers buy the amount that will maximize their utilityNote that both producers and consumers are content with the outcome.

Short-Run Price Determination: What Happens When Demand Changes P P P Q Q Q Typical Firm The Market Typical Person SMC SAC S d D Q 1 P 1 P 1 q 1 q 1 d’ D’ Q 2 q 2 P 2 q 2

Shifts in Supply and Demand CurvesDemand shifts when:Income increases and the good is normalIncome increases and the good is inferiorThe price of a substitute risesThe price of a complement fallsPreferences for a good change

Shifts in Supply and Demand CurvesReasons for a shift in supply:Input prices fallsTechnology improves

Shifts in Supply Price Price Quantity per week Quantity per week D S S’ P Q Q’ P’ S S’ D Q Q’ P P’ The change in price and quantity depend on the elasticity of demand

Shifts in Demand Price Price Quantity per week Quantity per week D’ D’ D D P Q S S P P’ P’ Q’ Q Q’ The change in price and quantity depend on the elasticity of supply

LR or SR equilibrium? 16 Price FIRM 1 Market 0 Price 0 MC q 1 e ATC π 1 Q S D p e p e

The Long RunIn the long run supply adjusts throughFirms adjust all input.Firms can enter or exit the industry.How does the LR Supply look like?Changes in price cause changes in quantity suppliedWe change price by shifting demandWe examine the quantity produced by the industry after both adjustments take place and an (LR) equilibrium is reached

The Long Run Equilibrium conditionsProfit MaximizationEach firm maximizes profits by producing q where P = MC.Market clearing:Price, P, equates QS and QDEntry and Exitno further changes in the number of firms, n, since firms have entered or exited the industry There are no extra costs to enter or exit the industry. If there are economic profits in the short run, new firms will enter. This will increase supply, push down the market price and reduce profits. If there are economic losses in the short run, firms will exit. This will decrease supply, push the price up and eliminate the economic losses . P=min ATC

Long Run SupplyIn the short runSupply is upward slopingThe long run supply can beFlatUpward slopingDownward slopingThe shape of the LR supply will depend on how entry/exit affects the costs of production 19

Dynamic Changes in Market EquilibriaConstant-cost industriesEntry of new firms has no impact on the cost of produtionThe LRAC is unaffectedFlat long-run supply curve 20

Constant-cost industries 21 With constant costs, the long-run response to an increase in demand re-establishes the original price of p a . Quantity 0 Quantity 0 Price D 1 S 1 p a a Cost SRAC LRAC SRMC D 2 b p b S 2 Long-run supply curve

Increasing-cost industriesAs new firms enterCost of inputs increase LRAC curves – shift upPecuniary externalityAction of one agentUpward sloping long-run supply curve 22

Increasing-cost industries 23 With increasing costs, the long-run response results in a higher price Quantity 0 Quantity 0 Price D 1 S 1 p a a Cost LRAC 1 D 2 b p b Long-run supply curve LRAC 2 S 3 p c c

Decreasing-cost industriesDownward sloping long-run supply curveAs new firms enterDecrease costs of inputsEconomies of scale in making inputsSubsidiary services developLRAC curves – shift down 24

Decreasing-cost industries 25 With decreasing costs, the long-run response results in a lower price. Quantity 0 Quantity 0 Price D 1 S 1 p a a Cost LRAC 1 D 2 b S 2 Long-run supply curve LRAC 2 p c c

Consumer and Producer SurplusConsumer surplus is the extra value individuals receive from consuming a good over what they pay for it. What people are willing to pay for the right to consume a good at its current market price.Producer surplus is the extra value producers receive for a good in excess of the opportunity costs they incur by producing it. What all producers would pay for the right to sell a good at its current market price.

Price P* S D A B Quantity per period Q* Consumer and Producer Surplus Total value to consumers from buying Q* units. Total expenditure by consumers. Consumer Surplus

Price P* S D A B Quantity per period Q* Consumer and Producer Surplus Total revenue earned by firms Minimum amount necessary to produce Q* units. Producer surplus

Consumer and Producer SurplusIn the short run, producer surplus reflects both actual profits in the short run and all fixed costs.It is a measure of how much firms gain by participating in the market rather than shutting down.In the long run, producer surplus measures all of the increased payments relative to the situation in which the industry produces no output.Ricardian Rent – long run profits earned by owners of low-cost firms. These rents may be capitalized into the prices of the resources.

Economic EfficiencyIn what sense is a competitive market efficient?Economically efficient allocation of resources is one in which the sum of consumer and producer surplus is maximized. It reflects the best use of societies resources.At market equilibrium there are no more mutually beneficial exchanges.

Price P* S D A B Quantity per period Q* Economic Efficiency Suppose only Q 1 units are produced. Q 1 There is a loss in total surplus.

Price P* S D A B Quantity per period Q* Economic Efficiency Q 1 At Q 1 , consumers are willing to pay P 1 and producers are willing to accept P 2 : mutually beneficial exchange possible. P 2 P 1

Some Applications: Tax IncidenceTax incidence considers the burden of a tax after considering all market reactions to it.Suppose a fixed per unit tax is imposed on all firms. Although the firms are legally obligated to pay the tax to the government, who actually end up paying?

Price Output (a) Typical Firm q 1 Price Quantity per week (b) The Market Tax Incidence in the Short Run: Constant Costs D S P 1 Q 1 AC MC D’ Tax Q 2 P 3 P 2 Consumer pays Firm keeps after tax q 2

Tax Incidence in the Short Run: Constant CostsSo in the short run, the tax is borne by consumers and producers:P3 > P1 > P2 and P3 – P2 = taxWhat will happen in the long run?Since P2 < AC, there are economic losses. Some firms will exit, which will reduce supply and cause the price to rise. Exit will continue until the price has risen by the full amount of the tax.

Price Output (a) Typical Firm q 1 Price Quantity per week (b) The Market Tax Incidence in the Long Run: Constant Costs D S P 1 Q 1 AC MC D’ Tax Q 2 P 3 P 2 q 2 S’ Q 3 P 4 Tax

Long Run Incidence: Increasing Costs Price Quantity per week D S P 1 Q 1 D’ Q 2 P 2 P 3 Tax P 2 is the price retained by firms after paying tax. P 3 is the full price paid by the consumer. TAX REVENUE CONSUMER BURDEN FIRM BURDEN Deadweight loss.

Summary of Tax IncidenceIn a constant cost industry the burden of the tax falls fully on consumers in the long run.In an increasing cost industry, the burden of the tax is shared between consumers and producers.The relative burden will depend on the elasticity of demand and supply.If demand is relatively inelastic and/or supply elastic, demanders will pay a relatively larger share of the tax.Since taxation reduces output compared to what normally would occur, there is a deadweight loss and a loss of efficiency.

Recap IThe short run supply curve, which represents the decisions of price taking firms is positively sloped since the firms’ marginal costs curves are positively sloped.At the equilibrium price the quantity supplied is exactly equal to the quantity demanded.The effects of shifts in supply and/or demand on price will depend on the shapes of both curves.Economic profits will attract new firms and shift the supply curve outward. Economic loss will cause some firms to leave the industry and shift the supply curve inward. This will continue until economic profits are zero in the long run.

Recap IIThe long run supply curve is horizontal when the entry of new firms has no effect on input prices. The long run supply curve is increasing if the entry of new firms causes input prices to rise.As long as there are no market imperfections, the sum of producer and consumer surplus (welfare) is maximized under perfect competition.In a constant cost industry the incidence of the tax will fall completely on the consumer in the long run. In an increasing cost industry the incidence of the tax will fall on both the consumer and the producer and will depend on the elasticity of demand and supply.A tariff will lead to a transfer of surplus from consumers to produces and a welfare loss.