CHAPTER 9 PERFECT COMPETITION IN A SINGLE MARKET Objectives • What are perfectly competitive markets • How prices are determined in a perfectly competitive market • Why entry and exit of firms occur and its effects • Welfare consequences Supply Response • The effects of changes in demand depend on the time period considered • It takes time for suppliers to respond • Time frames • Very short run – quantity supplied is fixed (market period) • Short run – existing firms can respond but no new entry • Long run – existing firms can respond and new firms can enter. Very Short Run Price S Given some demand, D, the equilibrium price, P1, is where demand intersects supply. P1 D Q* Quantity per week Pricing In The Very Short Run Price S If the demand curve increases there is excess demand at P1. To ration the quantity available, price must rise to P2. P2 P1 D’ D Q* Quantity per week Short-Run Supply • Assume that the number of firms in the market is fixed: no new entry or exit. • Existing firms can respond to changes in demand by increasing or decreasing their quantity supplied. Short-Run Supply Firm A Firm B Price Price Market Price S SA SB P1 q1A q1B Q Output Short-Run Price Determination P SMC P P S SAC P1 d D Q Typical Firm Q1 The Market Q Q Typical Person Short-Run Price Determination P SMC P P S SAC P1 P1 d D q1 Typical Firm Q Q1 The Market Q q1 Typical Person Q Short-Run Price Determination • Price serves two functions • It acts as a signal to producers: given some price they maximize profits where P = SMC • It rations demand. Given some price consumers buy the amount that will maximize their utility • Note that both producers and consumers are content with the outcome. Short-Run Price Determination: What Happens When Demand Changes P SMC P P2 SAC P1 P1 P S d’ D’ d D q1 q2 Typical Firm Q Q 1 Q2 The Market Q q1 q2 Typical Person Q Shifts in Supply and Demand Curves • Demand shifts when: • Income increases and the good is normal • Income increases and the good is inferior • The price of a substitute rises • The price of a complement falls • Preferences for a good change Shifts in Supply and Demand Curves • Reasons for a shift in supply: • Input prices falls • Technology improves Shifts in Supply Price Price S’ S’ S S P’ P P’ P D D Q’ Q Quantity per week Q’ Q Quantity per week The change in price and quantity depend on the elasticity of demand Shifts in Demand S Price Price S P’ P’ P P D’ D’ D D Q Q’ Quantity per week Q Q’ Quantity per week The change in price and quantity depend on the elasticity of supply 16 LR or SR equilibrium? Price Price MC π1 ATC S pe pe D 0 q1e FIRM 1 0 Q Market The Long Run • In the long run supply adjusts through • Firms adjust all input. • Firms can enter or exit the industry. • How does the LR Supply look like? • Changes in price cause changes in quantity supplied • We change price by shifting demand • We examine the quantity produced by the industry after both adjustments take place and an (LR) equilibrium is reached The Long Run Equilibrium conditions • Profit Maximization • Each firm maximizes profits by producing q where P = MC. • Market clearing: • Price, P, equates QS and QD • Entry and Exit • no further changes in the number of firms, n, since firms have entered or exited the industry • There are no extra costs to enter or exit the industry. • If there are economic profits in the short run, new firms will enter. This will increase supply, push down the market price and reduce profits. • If there are economic losses in the short run, firms will exit. This will decrease supply, push the price up and eliminate the economic losses. • P=min ATC 19 Long Run Supply • In the short run • Supply is upward sloping • The long run supply can be • Flat • Upward sloping • Downward sloping • The shape of the LR supply will depend on how entry/exit affects the costs of production 20 Dynamic Changes in Market Equilibria • Constant-cost industries • Entry of new firms has no impact on the cost of prodution • The LRAC is unaffected • Flat long-run supply curve 21 Constant-cost industries Price Cost Long-run supply curve SRMC S1 SRAC S2 b pb LRAC a pa D2 D1 0 Quantity 0 Quantity With constant costs, the long-run response to an increase in demand re-establishes the original price of pa. 22 Increasing-cost industries • As new firms enter • Cost of inputs increase • LRAC curves – shift up • Pecuniary externality • Action of one agent • Upward sloping long-run supply curve 23 Increasing-cost industries Price Cost Long-run supply curve LRAC2 LRAC1 S1 S3 b c pb pc pa a D2 D1 0 Quantity 0 With increasing costs, the long-run response results in a higher price Quantity 24 Decreasing-cost industries • Downward sloping long-run supply curve • As new firms enter • Decrease costs of inputs • Economies of scale in making inputs • Subsidiary services develop • LRAC curves – shift down 25 Decreasing-cost industries Price Cost Long-run supply curve LRAC1 S1 LRAC2 b S2 pa pc a c D2 D1 0 Quantity 0 With decreasing costs, the long-run response results in a lower price. Quantity Consumer and Producer Surplus • Consumer surplus is the extra value individuals receive from consuming a good over what they pay for it. What people are willing to pay for the right to consume a good at its current market price. • Producer surplus is the extra value producers receive for a good in excess of the opportunity costs they incur by producing it. What all producers would pay for the right to sell a good at its current market price. Consumer and Producer Surplus Total value to consumers from buying Q* units. Price A S Total expenditure by consumers. P* Consumer Surplus D B Q* Quantity per period Consumer and Producer Surplus Total revenue earned by firms Minimum amount necessary to produce Q* units. Price A S Producer surplus P* D B Q* Quantity per period Consumer and Producer Surplus • In the short run, producer surplus reflects both actual profits in the short run and all fixed costs. • It is a measure of how much firms gain by participating in the market rather than shutting down. • In the long run, producer surplus measures all of the increased payments relative to the situation in which the industry produces no output. • Ricardian Rent – long run profits earned by owners of low-cost firms. These rents may be capitalized into the prices of the resources. Economic Efficiency • In what sense is a competitive market efficient? • Economically efficient allocation of resources is one in which the sum of consumer and producer surplus is maximized. It reflects the best use of societies resources. • At market equilibrium there are no more mutually beneficial exchanges. Economic Efficiency Suppose only Q1 units are produced. Price A There is a loss in total surplus. S P* D B Q1 Q* Quantity per period Economic Efficiency Price A At Q1, consumers are willing to pay P1 and producers are willing to accept P2: mutually beneficial exchange possible. S P1 P* P2 D B Q1 Q* Quantity per period Some Applications: Tax Incidence • Tax incidence considers the burden of a tax after considering all market reactions to it. • Suppose a fixed per unit tax is imposed on all firms. Although the firms are legally obligated to pay the tax to the government, who actually end up paying? Tax Incidence in the Short Run: Constant Costs (b) The Market (a) Typical Firm Price Price Consumer pays S MC AC P3 P1 P2 Tax Firm keeps after tax D’ q2 q1 Output Q2 Q1 D Quantity per week Tax Incidence in the Short Run: Constant Costs • So in the short run, the tax is borne by consumers and producers: • P3 > P1 > P2 and P3 – P2 = tax • What will happen in the long run? • Since P2 < AC, there are economic losses. Some firms will exit, which will reduce supply and cause the price to rise. Exit will continue until the price has risen by the full amount of the tax. Tax Incidence in the Long Run: Constant Costs (b) The Market (a) Typical Firm Price Price MC AC S’ S P4 P3 Tax P1 P2 Tax D’ q2 q1 Output Q3 Q2 Q1 D Quantity per week Long Run Incidence: Increasing Costs Price S P2 is the price retained by firms after paying tax. P3 CONSUMER BURDEN TAX P1 REVENUE FIRM P2 BURDEN P3 is the full price paid by the consumer. Deadweight loss. Tax D’ Q2 Q1 D Quantity per week Summary of Tax Incidence • In a constant cost industry the burden of the tax falls fully on consumers in the long run. • In an increasing cost industry, the burden of the tax is shared between consumers and producers. • The relative burden will depend on the elasticity of demand and supply. • If demand is relatively inelastic and/or supply elastic, demanders will pay a relatively larger share of the tax. • Since taxation reduces output compared to what normally would occur, there is a deadweight loss and a loss of efficiency. Recap I • The short run supply curve, which represents the decisions of price taking firms is positively sloped since the firms’ marginal costs curves are positively sloped. • At the equilibrium price the quantity supplied is exactly equal to the quantity demanded. • The effects of shifts in supply and/or demand on price will depend on the shapes of both curves. • Economic profits will attract new firms and shift the supply curve outward. Economic loss will cause some firms to leave the industry and shift the supply curve inward. This will continue until economic profits are zero in the long run. Recap II • The long run supply curve is horizontal when the entry of new firms has no effect on input prices. The long run supply curve is increasing if the entry of new firms causes input prices to rise. • As long as there are no market imperfections, the sum of producer and consumer surplus (welfare) is maximized under perfect competition. • In a constant cost industry the incidence of the tax will fall completely on the consumer in the long run. In an increasing cost industry the incidence of the tax will fall on both the consumer and the producer and will depend on the elasticity of demand and supply. • A tariff will lead to a transfer of surplus from consumers to produces and a welfare loss.