Chapter 7 Perfect Competition and the Invisible Hand

Chapter 7 Outline 7 Perfect Competition and the Invisible Hand 7.1 Perfect Competition and Efficiency 7.2 Extending the Reach of the Invisible Hand: From the Individual to the Firm 7.3 Extending the Reach of the Invisible Hand: Allocation of Resources across Industries 7.4 Prices Guide the Invisible Hand 7.5 Equity and Efficiency Key Ideas The invisible hand efficiently allocates goods and services to buyers and sellers. The invisible hand leads to efficient production within an industry. The invisible hand efficiently allocates resources across industries. 4. Prices direct the invisible hand. 5. There are trade-offs between making the economic pie as big as possible and dividing the pieces equally.

7.1 Perfect Competition and Efficiency Reservation Values of Buyers and Sellers in the iPod Market Buyers Res. Value ($) Cum. Q Sellers Madeline $70 1 Tom $10 Katie $60 2 Mary $20 Sean $50 3 Jeff $30 Dave $40 4 Phil Ian 5 Adam Kim 6 Matt Ty 7 Fiona Concept of reservation values—for a consumer, the maximum that’s willing to be paid; for a seller, the minimum that’s willing to be accepted. Most of you easily see that the only place where the prices (reservation values) and the quantities are equal are at 4 units for $40 each. To drive home the concept, pick another price, say $60. At that price, there are two people willing to buy (Madeline and Katie), and 6 people willing to sell, so this is not an equilibrium.

Exhibit 7.2 Demand and Supply Curves in the iPod Market 7.1 Perfect Competition and Efficiency Exhibit 7.2 Demand and Supply Curves in the iPod Market

Reservation Values of Buyers and Sellers in the iPod Market 7.1 Perfect Competition and Efficiency Social Surplus Reservation Values of Buyers and Sellers in the iPod Market Buyers Res. Value ($) Consumer Surplus Cum. Q Madeline $70 $30 1 Katie $60 $20 2 Sean $50 $10 3 Dave $40 $0 4 Ian 5 Kim 6 Ty 7 Total If the equilibrium price is $40, how much consumer surplus is there? Remember, four units will be exchanged.

Reservation Values of Buyers and Sellers in the iPod Market 7.1 Perfect Competition and Efficiency Social Surplus Reservation Values of Buyers and Sellers in the iPod Market Sellers Res. Value ($) Producer Surplus Cum. Q Tom $10 $30 1 Mary $20 2 Jeff 3 Phil $40 $0 4 Adam $50 5 Matt $60 6 Fiona $70 7 Total How much is producer surplus at 4 units?

7.1 Perfect Competition and Efficiency Social Surplus Social surplus = The sum of consumer and producer surplus $60 + $60= $120

7.1 Perfect Competition and Efficiency Social Surplus Reservation Values of Buyers and Sellers in the iPod Market Buyers Res. Value ($) Consumer Surplus Cum. Q Madeline $70 $30 1 Katie $60 $20 2 Sean $50 3 Dave $40 4 Ian 5 Kim 6 Ty $10 7 Total $100 What if we only allowed 2 units to be exchanged at $40? Then the two highest-value participants would exchange the units: Madeline and Katie would buy from Tom and Mary. Direct students to notice that when quantity is restricted, the price is really irrelevant and can be computed by adding the differences between consumer and producer reservation values: Madeline ($70) – Tom ($10) and Katie ($60) – Mary ($20) or $60 + $40.

Social surplus = $100 7.1 Perfect Competition and Efficiency Reservation Values of Buyers and Sellers in the iPod Market Sellers Res. Value ($) Producer Surplus Cum. Q Tom $10 $30 1 Mary $20 2 Jeff 3 Phil $40 4 Adam $50 5 Matt $60 6 Fiona $70 7 Total $100 Social surplus = $100

Exhibit 7.3 Maximizing Social Surplus 7.1 Perfect Competition and Efficiency Social Surplus Shows the same analysis graphically Exhibit 7.3 Maximizing Social Surplus

And leads to the highest level of social welfare. 7.1 Perfect Competition and Efficiency Pareto Efficiency Pareto efficiency = When no one can be made better off without making someone else worse off Example: When price was set at $20, consumers were made better off, but producers were made worse off. The invisible hand directs consumers and producers to maximize their surplus… And leads to the highest level of social welfare. Note: New consumer surplus was $90 (instead of $60), but producer surplus was $10 (instead of $60).

7.2 Extending the Reach of the Invisible Hand: From the Individual to the Firm You’re the new CEO of a company that operates two manufacturing plants. Old Plant New Plant 50 years old 4 years old Old machinery New technology The old plant has higher MC at every level of production than the new plant.

Exhibit 7.4 Marginal Costs for Two Manufacturing Plants 7.2 Extending the Reach of the Invisible Hand: From the Individual to the Firm Exhibit 7.4 Marginal Costs for Two Manufacturing Plants

7.2 Extending the Reach of the Invisible Hand: From the Individual to the Firm In the past, each plant has been run independently, and each plant manager is charged with maximizing profit at his/her plant.

Exhibit 7.5 Optimal Production Quantity at the Old Manufacturing Plant 7.2 Extending the Reach of the Invisible Hand: From the Individual to the Firm Exhibit 7.5 Optimal Production Quantity at the Old Manufacturing Plant In the past, each plant has been run independently, and each plant manager is charged with maximizing profit at his/her plant. Profit maximization occurs where MC, which is $10, is equal to MR or P, at 20,000 units for the old plant

Exhibit 7.6 Optimal Production Quantity at the New Manufacturing Plant 7.2 Extending the Reach of the Invisible Hand: From the Individual to the Firm Profit maximization occurs where MC, which is $10, is equal to MR or P, at 50,000 units for the new plant. Exhibit 7.6 Optimal Production Quantity at the New Manufacturing Plant Total revenue for new plant: $10 x 50,000 = $500,000 Total costs for new plant: 50,000 x $7.50 (ATC) = $375,000 Economic profit = $125,000

7.2 Extending the Reach of the Invisible Hand: From the Individual to the Firm As the CEO, should you close the old plant and shift production to the new plant? The new plant: Earns more profit Has lower costs Has newer technology One year later… Old Plant: Output = 0 Profit = $0 New Plant: Output = 70,000 Profit = -$875,000 What? Tell students to assume that they decide yes, the old plant should be shut down and all 70,000 units should be produced at the new plant.

7.2 Extending the Reach of the Invisible Hand: From the Individual to the Firm Point out that because the new plant could not operate at the point that maximized profits, it incurred higher costs than it otherwise would have had. At a level of output of 70,000, ATC is $22.50, and the MC of producing the 70,000th unit is $30—far above the price, or marginal revenue, for that last unit. So producing the 70,000th unit yields a loss of $20. If the 70,000th unit produced at the new plant would have instead been produced at the old factory, it would have cost $10 to produce Exhibit 7.7 The Impact of Enforced Production Schedules

7.2 Extending the Reach of the Invisible Hand: From the Individual to the Firm The invisible hand directs managers to pursue their own self-interest… And results in the most efficient (least- cost) production allocation. What if industries are different? The invisible hand directs firms to seek out profits… And results in resources being allocated to their highest value of use.

7.3 Extending the Reach of the Invisible Hand: Allocation of Resources across Industries Exhibit 7.11 Economic Losses in the Trucking Market Exhibit 7.9 Economic Profits in the Paper Delivery Business

What is the economic function of parking meters? 7.4 Prices Guide the Invisible Hand What is the economic function of parking meters? The function is to raise revenue for a city?? Parking fines and fees represent a small part of city revenue and are partially offset by the cost of enforcement. The primary function of parking meters is to allocate a scarce resource. Price serves as a way to efficiently allocate resources.

Exhibit 7.15 Deadweight Loss from Price Controls 7.4 Prices Guide the Invisible Hand Deadweight Loss Exhibit 7.15 Deadweight Loss from Price Controls Price controls act to restrict efficiency. If something (such as the government) interferes with the ability of price to allocate resources, inefficiency results. Deadweight Loss = The reduction in social surplus resulting from a market intervention

7.4 Prices Guide the Invisible Hand The Command Economy Two problems: Coordination problem = bringing together self-interested economic agents to form markets Incentive problem = how to motivate agents to participate in markets Two possible solutions: Market economy = prices direct flow of resources, provide incentives for participants Command economy = central agency directs resources, provides incentives

K-Mart’s move to a command economy 7.4 Prices Guide the Invisible Hand The Central Planner K-Mart’s move to a command economy The K-Mart story and blue light specials. Originally intended as a way for individual store managers to get rid of merchandise that was piling up in their local stores, the corporate office took over the concept, directing that all local stores discount the same items for the same amount at the same time. By not letting local store managers respond to their local conditions, the command approach from corporate headquarters resulted in lower profits.

Evidence-Based Economics Example 7.5 Equity and Efficiency Equity = Addresses the issue of a “fair” distribution of resources across society Evidence-Based Economics Example Can markets composed of only self-interested people maximize the overall well-being of society? that markets do not make judgments. Markets, as we have seen, are efficient. But they don’t necessarily result in outcomes that we, as a society, would consider to be fair. So equity and efficiency are not necessarily the same thing. Efficiency is a positive position; equity is a normative one. One of the roles of government in our economy is to address efficient outcomes that we may not consider to be equitable.