Lecture 9 Markets without market power: Perfect competition.

Lecture 9

Markets without market power:

Perfect competition

Market power

• Market power: Ability to control, or at least affect, the terms and conditions

of the exchanges in which one participates

• According to traditional neoclassical view:– Market power is considered to be bad: It can create

inefficiency– Competition is considered to be good: the image of a

self-regulating, harmonious, «free» competitive market is at the core of this view

Perfect competition

• Assumptions of the traditional neoclassical model which we had so far are still valid.

• PLUS some additional assumptions:– There are numerous small sellers and buyers, so small that no

individual seller or buyer can affect the market price.– Only one kind of good or service is traded. All units of this

good or service are identical, therefore, buyers don’t care from which seller they buy.

– Producers can freely enter or exit the industry. – Buyers and sellers have perfect information: They know where

the good is available, at what prices it is offered, and whether profits are being made.

Perfect competition• Further assumptions (cont’d):

– Firms have smooth curves with short-run diminishing returns (convexity and marginal thinking)

– Long-run minimum efficient scale of each producer is fairly small (relative to the demand for the output of the industry): constant returns to scale

– The market is assumed to operate in the following manner:• Everyone (hypothetically) gathers together.• Someone compiles all the offers to buy and to sell and based on

that he/she determines the market-clearing price (a hypothetical «auctioneer»)

• The price is announced, everyone who wants to exchange at this price does so.

Perfect competition• So,

– Every individual seller is price-taker– Each individual seller faces a horizontal (perfectly elastic)

demand curve: he/she can sell as many units as she wants, as long as he/she charges the market price

(BUT NOTE THAT market supply and market demand may have various other slopes!)

PE

Pri

ce (

$)

Quantity

Supply = Sum ofIndividual Firms'MC (Supply)Curves

Demand

Demand =MarginalRevenue

Marginal Cost =Individual Firm'sSupply Curve

PE

Pri

ce (

$)

(a) (b)

Quantity

100 10,000

A

Perfect competition

• Any examples?

– Agricultural products, for instance, wheat??

– Financial resale markets, for instance, for shares of certain companies

– Some labor markets

Profit maximization under perfect competition

• Competitive equilibrium:The equilibrium in a market where all buyers and sellers are price-

takers, unable individually to influence the price they pay or charge

• How much will each producer sell?

It depends on demand for the product and on the firm’s cost structure

PE

Pri

ce (

$)

Quantity

Supply = Sum ofIndividual Firms'MC (Supply)Curves

Demand

Demand =MarginalRevenue

Marginal Cost =Individual Firm'sSupply Curve

PE

Pri

ce (

$)

(a) (b)

Quantity

100 10,000

A


How much economic profit will the profit-maximizing competitive firm make? Zero!!

– Zero economic profit (or normal profit):Revenues are just sufficient to compensate for the use of labor, materials, and

other physical inputs, financial and physical capital, and the time inputs—all evaluated at their opportunity costs

– Positive economic profit (or above-normal or supernormal profit)

The amount by which revenues exceed all economic costs (incl. opportunity costs)

BUT WHY ZERO?


The profit-maximizing firm in case of perfect competition will make zero economic profits in the long-run, because of the free entry and exit of firms into the industry!

Quantity

P2

Q2 Q1

P1

Pri

ce (

$)

P2

P1

Pri

ce (

$)

Quantity

MC(a)

D

(b)

E1

MR2

MR1

S1 S2

A

Efficiency and equity in case of perfect competition

Perfectly competitive markets are efficient and lead to the best possible outcomes, if:

– There are no production and consumption externalities (neither positive nor negative)

– There are no public goods– All cost and effects are captured in this static model (i.e., there

are no effects spread out over time)– Society is not concerned about distribution (i.e., the current

distribution of ability to pay is considered acceptable)

THEN;

Market supply curve reflects social marginal cost of production, and market demand curve reflects social marginal benefit of consumption: allocative efficiency

Perfect competition and long-run efficiency

No competitive firm will operate on the downward-sloping or upward-sloping part of the LAC curve.

WHY?

Economiesof scale

Diseconomiesof scale

Competitive firms willproduce at low unit costs.

Lo

ng

-Ru

nA

vera

ge

Co

st (

$) Long-Run Average

Cost Curve

50 200

Quantity

Perfect competition and long-run efficiency

13.50 Price= MR

A

Total Cost = Total Revenue

MC

ATC

Pri

ce (

$)

9876543210

5

10

15

20

25

30

35

40

Quantity of Hair Dryers

Consumer and producer surplus

ConsumerSurplus

PE

Supply

Demand

Pri

ce

Quantity

QE

Consumer surplus:

The excess (summed over all buyers in a market) of the amounts that buyers would be willing to pay for a good or service, over the amounts that they actually pay

Consumer and producer surplus

ProducerSurplus

PE

Supply

Demand

Pric

e

Quantity

QE

Producer surplus:

The excess (summed over all sellers in the market) of the amounts that sellers actually receive, over the amounts that would make them just willing to supply the good or service

Deadweight loss

Consumerandproducersurplus

Supply

Demand

Pri

ce

Quantity

QEQ1

Deadweightloss

Deadweight loss:

The loss in efficiency (measured in terms of consumer and producer surplus) that arises if market transactions take place at other than the competitive market equilibrium level

Policy analysis: Taxation

Quantity

D

S

ConsumerSurplus

TaxRevenue

ProducerSurplus

Splus-tax

t

Pri

ce

DeadweightLoss

QEQ1

Pbuyer

P


Q1

Quantity

S

ConsumerSurplus

TaxRevenue

ProducerSurplus

Pric

e

DeadweightLoss

QE

Pbuyer

Pseller

D

Q2

S

Tax with rather elastic demand


Quantity

D

S

ConsumerSurplus

TaxRevenue

ProducerSurplus

Splus-tax

t

Pri

ce

DeadweightLoss

QEQ1

Pbuyer

P

Q1

Quantity

S

ConsumerSurplus

TaxRevenue

ProducerSurplus

Pric

e

DeadweightLoss

QE

Pbuyer

Pseller

D

Q2

S

Policy analysis: Rent control

Quantity of Apartments Offered for Rent

Rentceiling

Demand

Supply

ConsumerSurplus

Transfer

ProducerSurplusP

rice

(R

en

t p

er

Mo

nth

)

Pceiling

PE

DeadweightLoss

QEQ

Rent control with moderately elastic supply

Policy analysis: Rent control

Supply

Quantity of Apartments Offered for Rent

Rentceiling

Demand

ConsumerSurplus

Transfer

ProducerSurplus

Pri

ce (

Re

nt

pe

r M

on

th)

Pceiling

PE

Q

Rent control with perfectly inelastic supply

Lecture 9 Markets without market power: Perfect competition.

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Transcript of Lecture 9 Markets without market power: Perfect competition.