1. Mechanics of Perfect Competition: The Market for Garden Gnomes Agenda: I.Equilibrium price & quantity, producer & consumer surplus II.What about taxes? III. What about advances in technology?

2. P D = a - bQ D P S = c + dQ S

3. Example: Garden Gnomes Market demand: P D = 65 - (1/100)Q D or Q D = 6500 -100P Market supply: P S = (1/1200)Q S or Q S = 1200P FIRM total cost: C(q) = 722 + q 2 /200 FRIM marginal cost: MC(q) = 2q/200 = q/100 1. What is the equilibrium price and quantity for the MARKET? P D = P S OR Q D =Q S P = $5 and Q = 6,000 2. What is the amount supplied by the FIRM? P = MR = MC(q) Q (firm) = 500 3. If all firms have the same cost structure, how many firms will be in this market? 4. What is the profit (loss) for the FIRM? TR – TC = $528 5. What is the producer surplus for the FIRM? P*Q – AVC*Q =$1,250 7. Would you want to go into the Garden Gnome industry? 8. What is the lowest price you would sell your 500 Garden Gnomes for in the short run? Yes! Why? AVC = $2.50 6. What is the consumer surplus for the MARKET? ½ (($65-$5)*6000)=$18,000

4. What if the government imposes a tax of $1 per gnome? Market demand: Q D = 6500 -100P Market supply: Q S = 1200P FIRM total cost: C(q) = 722 + q 2 /200 FRIM marginal cost: MC(q) = 2q/200 = q/100 Garden Gnomes Continued… KEY: The price paid by the consumer is NOT the same as the price received by the supplier! P D = P S + $1 What is the equilibrium price received by the supplier, paid by the consumer and equilibrium quantity? 6500 – 100(P S +$1) = 1200P S P S = $4.92 P D = $5.92 Q = 5,908 How much does each FIRM supply with the tax? 4.92 = q/100 q = 492 What is the new producer surplus for the firm? 492($4.92 – 492/200) = $1,210.32

5. Garden Gnomes Continued… What if the government imposes a tax of $1 per gnome? price Quantity P = MC P = MC + T $5.00 $5.92 P3 Effective price to producers Causes market exit! Long-run supply Market demand: Q D = 6500 -100P Market supply: Q S = 1200P FIRM total cost: C(q) = 722 + q 2 /400 FRIM marginal cost: MC(q) = 2q/400 = q/200 Dead-weight loss ½($1*(6000-5908))= $46 (short run) $4.92 6,000 5,908 What happens in the LONG RUN?

6. Garden Gnomes Continued… What would be the effect on equilibrium supply and demand in the short term if you develop a new manufacturing technology that reduces your marginal costs? (Forget about the tax!) FIRM total cost: C(q) = 722 + q 2 /400 FRIM marginal cost: MC(q) = 2q/400 = q/200 11 firms have the old cost structure, and 1, you, have the new cost structure. What is the market supply? Q S = 1300P → P=(1/1300)Q What is the new market equilibrium supply and demand Price and Quantity Recall: Market demand: Q D = 6500 -100P P = $4.64 Q = 6,036 Test Yourself: What is the new producer surplus and profit?

7. Garden Gnomes Continued… FIRM total cost: C(q) = 722 + q 2 /400 FRIM marginal cost: MC(q) = 2q/400 = q/200 Market demand: Q D = 6500 -100P What if you could NOT get a patent for your new technology (assuming no new entry of firms)? 1. What is the new market supply? P=Q/ 200 Q = (200P)*12 firms Q= 2400P 2. What is the new market equilibrium price and quantity? 2400P=6500-100P P=$2.60 Q = 6,240 3. What is the producer surplus and profit for each firm? Q = 6,240/12 = 520 AVC = 520/400 = $1.30 Profit: 520*$2.60-722-520*$1.30 =-$46 PS = 520*(2.6-1.3)= $676 4. What is likely to happen to this market in the long run?

8. Garden Gnomes Continued… Would the market equilibrium price and quantity change if you were to reduce your fixed costs to $500? Market demand: Q D = 6500 -100P Market supply: Q S = 2400P FIRM total cost: C(q) = 500 + q 2 /400 FRIM marginal cost: MC(q) = 2q/400 = q/200 Test yourself: Will your producer surplus change? Will your profit change?

9. What You Need to Know (AND PRACTICE!) 1. In a perfectly competitive market Price = Marginal Revenue 2. In a perfectly competitive market equilibrium Quantity Demanded = Quantity Supplied OR Price of Demand = Price of Supply 3. FIRM demand is where Price = Marginal Cost 4. Profit = Revenue – Total Expenses Producer Surplus = Revenue – Variable Costs