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Market Equilibriumand the wonders of perfect competition

Ideological concepts?

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Big IDEAS

In a perfectly competitive market, equilibrium in price and quantity maximizes the sum of consumer and producer surplus.

If a perfectly competitive market maximizes social welfare, then government regulations must make things worse.

But markets are never perfectly competitive; and they always have problems: externalities, maldistribution of income, monopolistic behavior..

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Social Welfare is the Sum of Consumer and Producer Surplus

The difference between costs (sum of MC) and benefits (sum of MU).

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Perfect competition and market equilibrium:

Enjoy it if you can

Supply = demand and everyone is as happy as possible.14:52:09

Monopoly reduces total surplus

It doesn’t produce some units where MU>MC.It also redistributes consumer surplus to producers.

Monopoly and Perfect Competition

$0.00

$2.00

$4.00

$6.00

$8.00

1 2 3 4 5 6 7 8 9 10

Quantity

Price

MC Demand Price Average total costs MR Monopoly price

Reduced output

Lost welfare

Redistributed welfare

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Perfectly Competitive markets maximize net welfare. If and only if:

1. Externalities are included in MC;2. Income is distributed fairly, so that

demand reflects real social MU;3. There is no nonmarket production;4. Perfect competition, producers sell

at MC=MU.

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Under these extreme circumstances,We will be in EQUILIBRIUM

Prices will be such that no one wants to produce more, or consume less.

There are no opportunities to increase welfare by changing the output level.

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In perfect competition, market equilibrium, the right amount is

produced

Where MU> MC: produce.Where MU<MC: don’t

This happens spontaneously, no need for inefficient social planners! So why do we get

junk like this?14:52:09

In equilibrium:

No one could be made better off except by making someone else worse off.

Everyone is satisfied with their situation given the prices they face.

We owe this way of thinking to Vilfredo Pareto (1848-1923).

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They would be happier if they were richer, younger, prettier. Or if they

lived in Paris. Or Amherst.

But life is hard.

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These are pretty strong assumptions

Easily violated

Externalities

Nonmarket production

Income Distribution

Monopoly

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Perfect competition rewards productivity and innovation

With better technology, productive firms can earn extra profits – rents on their innovations.

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With perfect competition, consumers benefit from innovation

and technological progress

• First innovator makes huge profits.• These encourage others to copy to get a share

of the profits.• New entrants drive down prices to the new,

lower cost of production, eliminating super profits.

• Consumers benefit.14:52:09

Capitalists do not profit from creating value; profits come from scarcity.

No profit from goods that are universally available.

Capitalists profit by walling off access so they can charge. This is called private property.

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Examples: Microsoft and Hollywood

Software and other digital materials (e.g. movies and music) cost nothing to transfer – their natural price, socially optimal price, is zero.

But Microsoft, the RIAA (Record Industry Association of America) and others encode and put expiration into their materials to prevent free exchange so they can force you to pay.

You pay twice: once for their profits, and once for the inefficiency.

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The people who run these companies are not stupid. Usually.

They know that their profits depend on both their ability to innovate, and their ability to prevent others from copying them.

We like innovation.We don’t like preventing

others from copying.

Ways to prevent copying:1. Patents2. Secret technologies.3. Lock-in technologies so

customers have to use your stuff.

4. Build brand name loyalty.5. Hire all the good

researchers.6. Other . . .

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Companies try to maintain distinctiveness and rents

They try to hold customers with brand names.

They try to remain aggressive and innovative

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Xerox tried to remain profitable

1. Sued anyone who made a photocopier.2. Advertised that their copiers were better.3. Gave copiers away but sold special paper and

ink at inflated prices.

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Instead of innovating, companies spend to control the market

Xerox sued everyone for patent infringement. Sometimes they even won some money.

After a decade of litigation, IBM paid $25 million.

The Record Industry sues everyone.

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As a society we would be better off if companies would innovate rather than

litigate

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Take-away Points

• A perfectly competitive equilibrium might maximize social welfare.

• Perfect competition encourages innovation and prevents companies from monopolizing the benefits of new technologies.

• But markets are never perfectly competitive. Externalities, maldistribution of income and monopolistic behavior call for regulations.

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