CHAPTER 9

PERFECT COMPETITION IN A SINGLE MARKET

Objectives• What are perfectly competitive markets• How prices are determined in a perfectly competitive market• Why entry and exit of firms occur and its effects• Welfare consequences

Supply Response• The effects of changes in demand depend on the time

period considered• It takes time for suppliers to respond• Time frames

• Very short run – quantity supplied is fixed (market period)• Short run – existing firms can respond but no new entry• Long 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, P1, is where demand intersects supply.

D

P1

Pricing In The Very Short Run

Price

Quantity per week

S

Q*

If the demand curve increases there is excess demand at P1.

D

P1

D’

To ration the quantity available, price must rise to P2.

P2

Short-Run Supply• Assume 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

SA SB

Firm A Firm B Market

P1

q1A q1

B Q

S

Short-Run Price DeterminationP P P

Q Q Q

Typical Firm The Market Typical Person

SMC

SAC

S

dD

Q1

P1

Short-Run Price DeterminationP P P

Q Q Q

Typical Firm The Market Typical Person

SMC

SAC

S

dD

Q1

P1P1

q1 q1

Short-Run Price Determination• Price serves two functions

• It acts as a signal to producers: given some price they maximize profits where P = SMC

• It rations demand. Given some price consumers buy the amount that will maximize their utility

• Note 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

dD

Q1

P1P1

q1 q1

d’D’

Q2 q2

P2

q2

Shifts in Supply and Demand Curves

• Demand shifts when:• Income increases and the good is normal• Income increases and the good is inferior• The price of a substitute rises• The price of a complement falls• Preferences for a good change

Shifts in Supply and Demand Curves• Reasons for a shift in supply:

• Input prices falls• Technology improves

Shifts in SupplyPrice Price

Quantity per week

Quantity per week

D

S

S’

P

QQ’

P’

S

S’

D

QQ’

P

P’

The change in price and quantity depend on the elasticity of demand

Shifts in DemandPrice Price

Quantity per week

Quantity per week

D’D’

DD

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

q1e

ATC

π1

Q

S

D

pepe

The Long Run• In the long run supply adjusts through

• Firms adjust all input.• Firms can enter or exit the industry.

• How does the LR Supply look like?• Changes in price cause changes in quantity supplied• We change price by shifting demand• We examine the quantity produced by the industry after both

adjustments take place and an (LR) equilibrium is reached

The Long Run Equilibrium conditions• Profit Maximization

• Each firm maximizes profits by producing q where P = MC.

• Market clearing:• Price, P, equates QS and QD

• Entry and Exit• no 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 Supply• In the short run

• Supply is upward sloping• The long run supply can be

• Flat• Upward sloping• Downward sloping

• The shape of the LR supply will depend on how entry/exit affects the costs of production

19

Dynamic Changes in Market Equilibria

• Constant-cost industries• Entry of new firms has no impact on the cost of prodution• The LRAC is unaffected• Flat 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 pa.

Quantity 0 Quantity 0

Price

D1

S1

paa

Cost

SRAC

LRAC

SRMC

D2

bpb

S2

Long-run supply curve

Increasing-cost industries• As new firms enter

• Cost of inputs increase • LRAC curves – shift up• Pecuniary externality• Action of one agent• Upward 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

D1

S1

pa

a

Cost LRAC1

D2

bpb

Long-run supply curve

LRAC2

S3

pcc

Decreasing-cost industries• Downward sloping long-run supply curve• As new firms enter

• Decrease costs of inputs• Economies of scale in making inputs• Subsidiary services develop• LRAC curves – shift down

24

Decreasing-cost industries25

With decreasing costs, the long-run response results in a lower price.

Quantity 0 Quantity 0

Price

D1

S1

pa

a

Cost LRAC1

D2

bS2

Long-run supply curve

LRAC2

pcc

Consumer and Producer Surplus• Consumer 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

Quantityper periodQ*

Consumer and Producer SurplusTotal value to consumers from buying Q* units.

Total expenditure by consumers.

Consumer Surplus

Price

P*

S

D

A

B

Quantityper periodQ*

Consumer and Producer Surplus

Total revenue earned by firmsMinimum amount necessary to produce Q* units.

Producer surplus

Consumer and Producer Surplus• In 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 Efficiency• In 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

Quantityper periodQ*

Economic EfficiencySuppose only Q1 units are produced.

Q1

There is a loss in total surplus.

Price

P*

S

D

A

B

Quantityper periodQ*

Economic Efficiency

Q1

At Q1, consumers are willing to pay P1 and producers are willing to accept P2: mutually beneficial exchange possible.

P2

P1

Some Applications: Tax Incidence• Tax 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

q1

Price

Quantity per week

(b) The Market

Tax Incidence in the Short Run: Constant Costs

D

S

P1

Q1

ACMC

D’

Tax

Q2

P3

P2

Consumer pays

Firm keeps after tax

q2

Tax Incidence in the Short Run: Constant Costs

• So in the short run, the tax is borne by consumers and producers:

• P3 > P1 > P2 and P3 – P2 = tax

• What 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

q1

Price

Quantity per week

(b) The Market

Tax Incidence in the Long Run: Constant Costs

D

S

P1

Q1

ACMC

D’

Tax

Q2

P3

P2

q2

S’

Q3

P4

Tax

Long Run Incidence: Increasing Costs

Price

Quantity per week

D

S

P1

Q1

D’

Q2

P2

P3

Tax

P2 is the price retained by firms after paying tax.

P3 is the full price paid by the consumer.

TAX REVENUE

CONSUMER BURDEN

FIRMBURDEN

Deadweight loss.

Summary of Tax Incidence• In 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 I• The 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 II• The 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.