13. Perfectly Competitive Markets

1. 13. Perfectly Competitive Markets If a monopolist cannot prevent market entry, firms will enter as long as this pays if entry pays for many firms, this will eventually lead to a perfectly competitive market, with a large number of firms, free entry, a homogeneous product, factor mobility and complete information 13.1 Competitive Markets in the Short Run Quantity Decision of a Competitive Firm in the Short Run In the short run, there is no further entry and firms have at least one fixed factor, call this capital, hence average total cost differs from average variable cost (in long run all costs are variable) (Fig 13.1) in perfectly competitive market a firm has no influence on the price, so MR=p and hence the firm will choose a quantity such that p=MC if pAVC, and q=0 if p<AVC the price need not cover the ATC because fixed cost are sunk

2. Supply Function of a Competitive Firm in the Short Run supply function specifies how much a firm would be willing to sell at each possible price this quantity is the one where p=MC unless p<AVC, hence unless MC<AVC, i.e. unless q is smaller than the quantity q0 where AVC is minimal or p is smaller than p0=MC(q0) thus supply curve coincides with MC curve above (p0,q0) and is 0 below p0(Fig 13.2) The Market Supply Curve like market demand curve, market supply curve or aggregate supply curve is obtained by horizontally adding the individual firm’s supply curves; the result is the aggregate short-run marginal cost of supplying each unit (Fig 13.3)

3. Price Determination and the Definition of a Short-Run Equilibrium in a Competitive Market a short-run equilibrium for a competitive market is a price-quantity combination such that • no firm wishes to change the quantity it supplies • no consumer wishes to change the quantity he demands • the aggregate supply equals the aggregate demand this means there is no force to change price or quantity equilibrium is at the intersection of supply and demand otherwise firms would offer lower prices (if S>D) or consumers higher prices (if D>S) (Fig 13.4) In short-run equilibrium firms can make positive profits, which may differ according to their individual cost structure (Fig 13.5)

4. Policy Analysis in the Short Run: Comparative Static Analysis Policy changes can be evaluated by comparative static analysis, i.e. comparing the static equilibria before and after the change (e.g. in terms of consumer surplus) in a dynamic analysis the path how the market moves from old to new equilibrium is examined Example 13.1: The Market for Illegal Drugs increasing prosecution of trade of illegal drugs increases costs for dealers and users targeting the dealers will shift up the supply curve, leading to a smaller quantity and a higher price targeting the users will shift down the demand curve, leading to a smaller quantity and a lower price the most effective strategy depends on which side is more sensitive to punishments (Fig 13.7)

5. Example 13.2: The Incidence of a Tax who is actually paying a tax, i.e. if a tax is levied on producers, will this simply lead to an increase in prices? the incidence of a tax, i.e. the ultimate distribution of the burden depends on the elasticity of demand (and supply) if demand is perfectly inelastic, the consumers carry the whole burden, if it is perfectly inelastic, the producers do, for intermediate levels both share the burden, with the share of the producers increasing in the elasticity of demand (Fig 13.8) Tax Liability Side Equivalence: it does not matter which side of the market a tax is levied on, i.e. for the economic incidence of the tax, the statutory (legal) incidence is irrelevant Experimental Evidence: Borck et al. (SEJ, 2002): in posted-offer markets tax liability side equivalence is confirmed; net prices do not differ between treatments where either buyers or sellers pay the tax

6. Figure 2: Summary of experimental results (: SellerTax, ▲: BuyerTax)

7. Example 13.3: Minimum Wage installing a minimum wage above the equilibrium wage will lead to lower employment but a higher wage for those employed (Fig 13.9) since unemployment might increase susceptibility for crime, abolishing minimum wage might appear an effective crime prevention strategy but low wages (as in equilibrium) may make crime appear an alternative option as well hence more effective might be to subsidize wages for low-skill workers, this leads to both higher wages and more employment (Fig 13.10) disadvantages: can be quite costly and leads to inefficiencies: the marginal workers are paid more than their marginal product

8. 13.3 Competitive Markets in the Long Run The Long-Run Equilibrium for Identical Firms in a short-run equilibrium, firms can make extra-normal profits but this situation cannot continue in the long run: as long as firms make extra-normal profits, this will attract entry long-run equilibrium is a price-quantity combination such that • no firm wishes to change the amount it supplies • no consumer wishes to change the amount he demands • no firm in the market has an incentive to change the combination of inputs it uses or to exit the market • no firm outside the market has an incentive to enter it • the aggregate supply equals the aggregate demand extends short-run requirements by absence of incentives for entry and exit and capital expansion

9. if a firm makes extra-normal profits at the price that is determined by the intersection of aggregate supply and aggregate demand, and its optimal long-run level of capital and its profit maximizing quantity (i.e. where p= long-run marginal cost), this will attract other firms to enter, which will shift the supply curve to the right (Fig 13.20) the incentive for new firms to enter disappears when firms in the market do not make extra-normal profits, hence when the price equals the minimal long-run average cost (where they are equal to long-run marginal costs) thus in long-run equilibrium firms use amount of capital that allows them to produce at minimal long-run average cost The Long-Run Equilibrium for Heterogeneous Firms if a firm has a lower cost due to a special factor, it earns an economic rent. Since this factor could be sold, the price the firm could obtain is the opportunity cost of using the factor; including this opportunity cost in the total cost, the firm does not make extra-normal profits

10. Dynamic Changes in Market Equilibria in the short run an increase in demand leads to a higher price, because the short-run supply curve is upward sloping this implies firms in the market make extra-normal profits this attracts new firms, which shifts supply curve right if the industry has only a small share in the input markets, entry will not affect input prices (Fig 13.23) • entry does not change costs of existing or new firms • long-run supply curve is flat; constant-cost industry if supplying more inputs is increasingly costly, entry has a pecuniary externality on the market, because it increases cost for existing firms; increasing-cost industry • long-run supply curve is upward sloping if the supplier of an input has increasing returns to scale, prices for inputs can decrease by entry; decreasing-cost industry • long-run supply curve is downward-sloping

11. Why Are Long-Run Competitive Equilibria So Good? Welfare Proposition 1: Consumer and Producer Surplus Are Maximized: at any smaller quantity there is a dead-weight loss, at any larger quantity marginal cost exceeds willingness to pay Welfare Proposition 2: Price Is Set at Marginal Cost In long-run equilibrium of a competitive industry price is at intersection of supply and demand and supply equals MC Welfare Proposition 3: Goods Are Produced at the Lowest Possible Cost and in the Most Efficient Manner If firms do not produce with the level of capital that minimizes average cost, they earn extra-normal profits that attract entry Production is organized efficiently among firms: output shares are allocated such that all firms have the same marginal cost; if C’(qi)>C’(qk), the same output could be obtained at lower cost by decreasing qi and increasing qk

12. 13.2 Market Institutions and Market Equilibria the analysis so far has been institution-free, ignoring the specific rules that organize behavior in different markets does it depend on the rules that organize a market whether a market equilibrium is reached? this has been investigated in thousands of experiments (notably by Vernon Smith, Nobel Prize Laureate 2002) these experiments use induced demand and supply curves, i.e. buyers are paid by the experimenter a predetermined value for each (fictitious) unit purchased and sellers have to pay the experimenter a cost for each unit they sells buyers have incentive to buy for a price as low as possible, sellers have incentive to sell for a price as high as possible this allows the experimenter to compare experimentally different market institutions with exactly the same supply and demand schedules, hence isolating the effect of the market institution

13. examples for market institutions: • double oral auction: buyers and sellers shout bids and offers simultaneously and at any time each buyer or seller can accept the best standing offer or bid • one-sided oral auction: only the buyers (or the sellers) can make bids (or offers) the sellers (or buyers) can only accept the best standing bid (or offer) experimental results: double oral auctions converge quickly to the market equilibrium, one-sided oral auctions tend to favor the passive side Note: with upward-sloping supply and downward-sloping demand, the competitive equilibrium does not maximize the number of units sold, but it does maximize the total surplus

14. Other Auction Institutions an auction is a market institution to sell (or buy) an object where potential buyers make bids and the outcome (who obtains the good and who pays how much) depends only on the bids hence auctions are universal: any object can be sold by any auction, and anonymous: the result for a bidder does only depend on the bids, but not on his identity examples: English auction: bidders openly place increasing bids Dutch auction: price starts at high level and decreases until one buyer accepts Sealed-bid auctions: bidders submit written bids, highest wins First-price auction: winner pays his bid Second-price auction: winner pays second highest bid Dutch and first-price sealed-bid auctions are strategically equivalent: they define the same game: choose a number, the highest number wins and the winner pays his bid

15. auctions can be differentiated into private value auctions: each bidder has an independent value of the object, knows only his own value (e.g. works of art) (pure) common value auctions: there is an objective value of the object, identical for all bidders; value is unknown, but each bidder has some signal of this value (e.g. oil field) Private Value Auctions Outcomes in English and second-price auctions are identical: in both it is a weakly dominant strategy to bid one’s own value; hence the bidder with the highest value wins (thus they are efficient) and pays the second highest value standard auction: the bidder who bids the highest amount wins the object Revenue Equivalence Theorem: if bidders’ values are drawn independently from the same distribution and all bidders are risk-neutral, then all standard auctions generate the same expected revenue, which is identical to the expected second highest value

16. Common Value Auctions and the Winner’s Curse winning a common value auction brings bad news, because it means that the other bidders had information that led them to a lower estimate of the value not taking this into account leads to the winner’s curse, the winner of the auction pays too much assume you are bidding with a thousand other people for a jar full of 20 CZK coins; if everybody bids his or her estimate, then if you win, it is extremely probable that your estimate was too high and hence you make a loss note that the winner’s curse does not occur in equilibrium; equilibrium bids take it properly into account, by bidding the estimate of the value conditional on one’s own signal being the highest