Models of CompetitionPart I: Perfect Competition
Agenda:I. What is Competition?II. Assumptions underlying perfect competitionIII. Optimal production quantity, or where do supply curves
come from? A. Short run
1. One firm2. Market
B. Long run1. One firm2. Market
IV. The market for Garden Gnomes! A. Technological innovations B. Taxes
What does “competition” mean to you?
Assumptions that Underlie Perfect Competition
4. Firms and consumers have perfect information.
What happens when we violate these assumptions…
1. Firms sell standardized products(commodities).
2. Firms are all price takers:no one firm’s actions can “move the market.”
3. There is free entry and exit of firms with perfectly mobile factors of production (capital and labor) in the long run.
What is on the X and Y axis?
Is this a long-run or short run picture?
What does the slope of the total revenue line reflect?
What do the intersection points reflect?
What does a line tangent to the TC curve reflect?
What does the point where the line tangent to the TC curve with the same slope as the TR curve reflect?
MR=MCMax Profit!
Costs & Revenues Review
Individual Firm Supply Decisions
MR=MC on the rising part of the MC curve!
Short-run Individual firm supply
curveWhy not here??
Price = Marginal Revenue = Marginal Cost
Shutdown!
What if price is here? Economic loss!
Is this a long-run or a short-run graph?
At what point does a firm break even?
At what point should a firm shut down?
Market Supply Curve
The market supply is simply the sum of the individual firm supplies!
P c dQ Firm Supply curve: P c
Qd d
Quantity:
Industry Supply: n
nn n n
P cQ Q
d d
100 firms each have identical supply curves: P = 5 + 200QWhat is the industry supply curve?
5
2005
100200
5 2
PQ
PQ
P Q
1. Solve for Q
2. Multiply by n
3. Solve for P
TEST YOURSELF:What if firms did NOT have
identical supply curves?
Short Run Producer Surplus
P Q AVC Q QQ
P MC
Different firms have different minimum
marginal costs
PL
ATC
You can have a producer surplus and an economic loss
Market Supply Curve
Allocative efficiency: no consumer will buy more, no producer will produce more at any other price.
PARETO OPTIMAL
Different consumers have different
marginal benefits
What Happens in the Long-Run in the Market?Shift in Supply
Mov
emen
t alon
g the
supp
ly cu
rve
Q1Q2
1. Producer surplus attracts more supply2. More supply shifts the supply curve3. The shift in the supply curve causes a decline
in price but a higher equilibrium quantity.
A decline in price without a shift in supply would be a movement along the supply curve and result
in a lower equilibrium quantity.
What Happens in the Long-Run in the Firm?1. AFTER market prices decline (see above)2. The new price intersects with long-run
marginal cost at a lower quantity.3. If the new price is below the firm’s short-run
average variable cost it will shutdown! Firms still in business will have lower ATC curves
4. Each firm produces less even though the market supplies more.
Long-Run Competitive Equilibrium
All firms produce identically at LMC=LAC=SMC=ATC=Price
Do firms earn economic profits in the long run?
Is there producer surplus in the long run?
Long-run supply price=MC=LAC
Is there producer surplus in the long run?
Supply when input prices do NOT vary with output quantity.
No producer surplus!
Supply when input prices INCREASE with output quantity.
Supply curve slopes up, But still no producer surplus!
Why?
Price Elasticity of Supply
1
S Q P
P Q
P
Q slope
The percent change in quantity supplied as a result of a change in market price
If the cost of inputs does not change with quantity, then the supply curve will be horizontal and the elasticity will be zero (technically undefined)
Example: Garden GnomesMarket demand: QD = 6500 -100PMarket supply: QS = 1200P
FIRM total cost: C(q) = 722 + q2/200FRIM marginal cost: MC(q) = 2q/200 = q/100
1. What is the equilibrium price and quantity for the MARKET?
QD=QS
P = $5Q = 6,000
2. What is the amount supplied by the FIRM?P = MR = MC(q)Q (firm) = 500
3. If all firms have the same cost structure, how many firms will be in this market?
4. What is the profit (loss) for the FIRM? TR – TC = $528
5. What is the producer surplus for the FIRM? P*Q – AVC*Q =$1,250
6. Would you want to go into the Garden Gnome industry?
7. What is the lowest price you would sell your 500 Garden Gnomes for in the short run?
6000 500 12M FQ Q
Yes! Why?AVC = $2.50
Garden Gnomes Continued…What would be the effect on equilibrium supply and demand in the short term if you develop a new manufacturing technology that reduces your marginal costs?
FIRM total cost: C(q) = 722 + q2/400FRIM marginal cost: MC(q) = 2q/400 = q/200
11 firms have the old cost structure, and 1, you, have the new cost structure. What is the market supply? QS = 1300P
What is the new market equilibrium supply and demand Price and QuantityRecall: Market demand: QD = 6500 -100P P = $4.64 Q = 6,036
Test Yourself:What is the new producer surplus and profit?
Garden Gnomes Continued…
FIRM total cost: C(q) = 722 + q2/400FRIM marginal cost: MC(q) = 2q/400 = q/200Market demand: QD = 6500 -100P
What if you could NOT get a patent for your new technology (assuming no new entry of firms)?
1. What is the new market supply?P=Q/ 200Q = (200P)*12 firmsQ= 2400P
2. What is the new market equilibrium price and quantity?
2400P=6500-100PP=$2.60 Q = 6,240
3. What is the producer surplus and profit for each firm?
Q = 6,240/12 = 520AVC = 520/400 = $1.30
Profit: 520*$2.60-722-520*$1.30 =-$46PS = 520*(2.6-1.3)= $520
Garden Gnomes Continued…
Would the market equilibrium price and quantity change if you were to reduce your fixed costs to $500?
Market demand: QD = 6500 -100PMarket supply: QS = 2400PFIRM total cost: C(q) = 500 + q2/400FRIM marginal cost: MC(q) = 2q/400 = q/200
Test yourself:Will your producer surplus change?Will your profit change?
What if the government imposes a tax of $1 per gnome?
Market demand: QD = 6500 -100PMarket supply: QS = 2400PFIRM total cost: C(q) = 500 + q2/400FRIM marginal cost: MC(q) = 2q/400 = q/200
Garden Gnomes Continued…
KEY: The price paid by the consumer is NOT the same as the price received by the supplier!
What is the equilibrium price received by the supplier, paid by the consumer and equilibrium quantity?
6500 – 100(Ps+$1) = 2400PsPs = $2.56Pd = $3.56Q = 6,144
Garden Gnomes Continued…
What if the government imposes a tax of $1 per gnome?
price
Quantity
P = MC
P = MC + T
P1
P2
P3
Effective price to producersCauses market exit!
Long-run supply
Market demand: QD = 6500 -100PMarket supply: QS = 2400PFIRM total cost: C(q) = 500 + q2/400FRIM marginal cost: MC(q) = 2q/400 = q/200
Dead-weight loss
But Wait….
Externalities & Goods that are
NOT Commodities
Summary
1. IF the assumptions underlying perfect competition hold then the MARKET PRICE is all the information you need to know about both supply and demand.
Price = minimum marginal benefit = minimum marginal cost
2. IF the assumptions underlying perfect competition hold then in the long run there is NO producer surplus and NO economic profit.
Price = long-run marginal cost = long-run average cost
3. IF the assumptions underlying perfect competition hold then in the long run ALL firms produce the same quantity at the same cost.
Price = LMC=LAC=SMC=SAC
4. IF the assumptions underlying perfect competition hold then the long-run equilibrium is PARETO OPTIMAL.
But NOT SOCIALLY OPTIMAL when we consider externalities and non-commodities