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Perfect Competition & Welfare

Perfect Competition & Welfare. Outline. Derive aggregate supply function Short and Long run equilibrium Practice problem Consumer and Producer Surplus Dead weight loss Practice problem. Focus on profit maximizing behavior of firms Take as given the market demand curve.

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Perfect Competition & Welfare

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  1. Perfect Competition & Welfare

  2. Outline • Derive aggregate supply function • Short and Long run equilibrium • Practice problem • Consumer and Producer Surplus • Dead weight loss • Practice problem

  3. Focus on profit maximizing behavior of firms • Take as given the market demand curve Maximum willingness to pay $/unit Equation: P = A - B.Q linear demand A Constant slope P1 Demand • Inverse demand function: willingness to pay Q1 A/B Quantity At price P1 a consumer will buy quantity Q1

  4. Perfect Competition • Firms and consumers are price-takers • Firm can sell as much as it likes at the ruling market price • do not need many firms • do need the idea that firms believe that their actions will not affect the market price • Therefore, marginal revenue equals price • To maximize profit a firm of any type must equate marginal revenue with marginal cost • So in perfect competition price equals marginal cost

  5. MR = MC • Profit is p(q) = R(q) - C(q) • Profit maximization: dp/dq = 0 • This implies dR(q)/dq - dC(q)/dq = 0 • But dR(q)/dq = marginal revenue • dC(q)/dq = marginal cost • So profit maximization implies MR = MC

  6. Perfect competition: an illustration With market demand D2 and market supply S1 equilibrium price is P1 and quantity is Q1 With market demand D1 and market supply S1 equilibrium price is PC and quantity is QC • The supply curve moves to the right (a) The Firm (b) The Industry With market price PC the firm maximizes profit by setting MR (= PC) = MC and producing quantity qc • Price falls $/unit $/unit • Entry continues while profits exist Now assume that demand increases to D2 Existing firms maximize profits by increasing output to q1 • Long-run equilibrium is restored MC at price PC and supply curve S2 S1 D1 AC S2 P1 P1 Excess profits induce new firms to enter the market PC PC D2 qc q1 Quantity QC Q1 Q´C Quantity

  7. Perfect competition: additional points • Derivation of the short-run supply curve • this is the horizontal summation of the individual firms’ marginal cost curves Firm 3 $/unit Firm 1 Example 1: Three firms Firm 2 Firm 1: q = MC/4 - 2 Firm 1: MC = 4q + 8 q1+q2+q3 Firm 2: q = MC/2 - 4 Firm 2: MC = 2q + 8 Firm 3: q = MC/6 - 4/3 Firm 3: MC = 6q + 8 Invert these 8 Aggregate: Q= q1+q2+q3 = 11MC/12 - 22/3 MC = 12Q/11 + 8 Quantity

  8. $/unit Example 2: Eighty firms Firm i Each firm: MC = 4q + 8 Each firm: q = MC/4 - 2 Invert these Aggregate: Q= 80q = 20MC - 160 Aggregate 8 MC = Q/20 + 8 Quantity • Definition of normal profit • not the same as zero profit • implies that a firm is making the market return on the assets employed in the business

  9. Practice problem • Initial number of firms = 20 • Find short run equilibrium • Find long run equilibrium

  10. Short run

  11. Long run • P = min avg cost • Point at which MC=AC

  12. Exercise • Competitive Industry – 2 types of firms • Low cost firms: • Constant marginal cost 10 cents per unit – no fixed cost. • Total capacity of group = 1000 units • High cost firms: • marginal cost of 20 cents per unit • When producing at full capacity average cost = 30 cents • total group capacity of 2000 units • a) Draw the long run supply curve of this industry and the short run • supply curve assuming all firms are active.

  13. (b) After a fall in demand, there has been an initial price reduction in the short run, followed by a price increase in the long run. Draw demand curves before and after the fall in demand that would lead to this situation. Explain. (c) Consider again the initial situation and suppose the low cost firms discover extra capacity (e.g. new oil wells) at the same marginal cost of 10 cents per unit and that in the short run this lead to a reduction in price but in the long run the price returned to its previous level. Draw a picture for the supply function of this industry prior and after the change and the demand function that would explain this situation.

  14. Efficiency and Surplus • Can we reallocate resources to make some individuals better off without making others worse off? • Need a measure of well-being • consumer surplus: difference between the maximum amount a consumer is willing to pay for a unit of a good and the amount actually paid for that unit • aggregate consumer surplus is the sum over all units consumed and all consumers • producer surplus: difference between the amount a producer receives from the sale of a unit and the amount that unit costs to produce • aggregate producer surplus is the sum over all units produced and all producers • total surplus = consumer surplus + producer surplus

  15. Efficiency and surplus: illustration $/unit The demand curve measures the willingness to pay for each unit Competitive Supply Consumer surplus is the area between the demand curve and the equilibrium price Consumer surplus Equilibrium occurs where supply equals demand: price PC quantity QC The supply curve measures the marginal cost of each unit PC Producer surplus Producer surplus is the area between the supply curve and the equilibrium price Demand Aggregate surplus is the sum of consumer surplus and producer surplus QC Quantity The competitive equilibrium is efficient

  16. Illustration (cont.) Assume that a greater quantity QG is traded $/unit The net effect is a reduction in total surplus Competitive Supply Price falls to PG Producer surplus is now a positive part and a negative part PC Consumer surplus increases PG Part of this is a transfer from producers Demand Part offsets the negative producer surplus QC QG Quantity

  17. Output restricted to QM $/unit Suppose output is restricted to QM Competitive Supply The market clearing price is PM This is the deadweight loss of monopoly PM Consumer surplus is given by this area PC And producer surplus is given by this area There are mutually beneficial trades that do not take place: between QM and QC Demand QM QC MR Quantity

  18. Exercise • Consider a competitive industry where all firms are identical with cost • function: C = 200 +q2/2 + 10q. • Market demand is given by: p = 55 -Q/20 • Find the long run equilibrium (price, quantity and number of firms.) • Mc=q+10, AC=200/q+q/2+10 • Equating get: q/2=200/q  q2 = 400  q=20 • p=mc=30 • Substituting in demand function: 30=55-Q/20  Q=500 • Number of firms nq=Q  n=Q/q=500/20=25

  19. Exercise (continued) Suppose now the government introduces a regulation that limits the size of firms to no more than 10 units. Will there be exit or entry of firms? Find the new long run equilibrium. AC=200/q+q/2+10 AC(10)=35 P=35=55-Q/20 Q=400 n=40 AC 35 30 q 10 20

  20. Exercise (continued) Suppose now the government introduces a regulation that forces firms to produce no less than 40 units. Find the new long run equilibrium. AC=200/q+q/2+10 AC(40)=35 P=35=55-Q/20 Q=400 n=10 AC 35 30 q 20 40

  21. Exercise (continued) Welfare cost: Welfare loss: 5*400+100*5/2 =2,250 Original Surplus: 500*25/2=6,250 % loss = 36% 55 35 30 Qs Welfare loss 400 500 Q

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