The benchmark of perfect competition Defining perfect competition Modelling market interactions Welfare and efficiency

The benchmark of perfect competition We have seen : How much consumers choose of a given good, for all levels of price  Through consumer choice theory How much producers produce of a good, for all levels of price  Through the model of the firm We now need to work out : How this supply and demand interact to provide the market price and quantity We need a model of the market !

The benchmark of perfect competition The interaction of supply and demand The 5 conditions of perfect competition Short run and long run in perfect competition Surplus and welfare

The interaction of supply and demand Price Quantity 0 Reminder: the demand curve

The interaction of supply and demand The demand function depends on: The market price of the good The income of consumers (BC) The preferences of consumers (IC) The price of other goods (S or C) Expectations (future endowments)

The interaction of supply and demand A change in…..brings the following effect on the demand curve … PriceA movement on the curve IncomeA movement of the curve itself PreferencesA movement of the curve itself Price of other goodsA movement of the curve itself N˚ of consumersA movement of the curve itself ExpectationsA movement of the curve itself

The interaction of supply and demand 0 Price Quantity Increase in demand Fall in demand

The interaction of supply and demand Price Quantity 0 Reminder: the supply curve

The interaction of supply and demand The supply function depends on: The market price of the good The price of inputs (cost function) Technology (production function) N˚ of producers Expectations

The interaction of supply and demand A change in…..brings the following effect on the supply curve … PriceA movement on the curve Price of inputsA movement of the curve itself Available techologiesA movement of the curve itself N˚ of producersA movement of the curve itself ExpectationsA movement of the curve itself

The interaction of supply and demand 0 Price Quantity Increase in supply Fall in supply

The interaction of supply and demand S D Price Quantity Equilibrium

The interaction of supply and demand Quantity S D Excess supply Price

The interaction of supply and demand 2.00 S D 1.50 Rationing Price Quantity

The interaction of supply and demand Price Quantity S D1D1 1. An increase in demand (through exterior cause)… D2D increases the price and the amount sold New equilibrium Initial Equilibrium

The interaction of supply and demand S2S2 Price Quantity D Initial equilibrium S1S1 1. A fall in supply... New equilibrium 2....increases prices and reduces the quantity sold.

The benchmark of perfect competition The interaction of supply and demand The 5 conditions of perfect competition Short run and long run in perfect competition Surplus and welfare

The 5 conditions of perfect competition Perfect competition is defined by the following 5 conditions: 1. Large number of agents (Atomicity) 2. Homogeneous products 3. Free entry and exit from the market 4. Perfect information 5. Perfect mobility of inputs All 5 are required for an optimal coordination of supply and demand

The 5 conditions of perfect competition Let’s detail what these conditions imply: Large number of producers (Atomicity) There are many producers and consumers None is large enough to individually influence the market outcome Homogeneous products On any given market, the good is exactly the same regardless of who produced it. Consumers have no preferences w.r.t. producers

The 5 conditions of perfect competition Free entry and exit from the market Agents are free to enter and exit markets in response to changing market conditions There are no barriers to entry or exit Perfect information Agents constantly are constantly informed, without delay, of the changing market conditions Agents also know all perfectly all the characteristics of the goods: No hidden defects, etc.

The 5 conditions of perfect competition Perfect mobility of inputs Similar to the “no barriers to entry” condition Inputs can change markets freely If even a single one of these conditions fails to hold, then we have imperfect competition Clearly, this set of conditions is never met in reality !! But the concept of perfect competition is important as a benchmark for assessing the different kinds of imperfect competition.

The benchmark of perfect competition The interaction of supply and demand The 5 conditions of perfect competition Short run and long run in perfect competition Surplus and welfare

SR and LR in perfect competition Profit of the firm: The profit maximisation condition finds output q such that : What it mR equal to in perfect competition?

SR and LR in perfect competition Total revenue is simply equal to the quantity sold times the price at which the output is sold: Marginal revenue is the sum of: The extra quantity produced ∂ q times the price The effect of the increase on the market price But the atomicity assumption guarantees that this second effect is zero !!!

SR and LR in perfect competition mC AC Price S D Firm-market equilibrium Firm levelMarket level Quantityquantity d=mR p q Q Zero profits in equilibrium

SR and LR in perfect competition mC AC Price S D Firm-market equilibrium Firm levelMarket level Quantityquantity d=mR p q Q D2D2 Q2Q2 p2p2 q2q2 d 2 =mR 2 Imagine a positive demand shock (ex: new “fashion”) Total Cost Positive profits in SR

SR and LR in perfect competition mC AC Price S Firm-market equilibrium Firm levelMarket level Quantityquantity d=mR p q Q3Q3 D2D2 Q2Q2 p2p2 q2q2 d 2 =mR 2 S2S2 Positive profits attract firms to the market (free entry + perfect information) Return to zero profits in LR

SR and LR in perfect competition mC AC Price quantity d=mR p q Zero profits in LR equilibrium The significance of zero-profits Remember that total costs include the opportunity cost Zero economic profits does not mean zero accounting profits It means that the accounting profits are equal to the opportunity cost i.e the reward for producing is “fair”

SR and LR in perfect competition Efficiency: At equilibrium, P=mc=AC All the increasing returns to scale opportunities are used up, but decreasing returns to scale have not yet appeared Firms are producing at the most efficient point Resources are allocated efficiently: the smallest amount of resources possible is allocated to the production mC AC Price quantity d=mR p q Zero profits in LR equilibrium

The benchmark of perfect competition The interaction of supply and demand The 5 conditions of perfect competition Short run and long run in perfect competition Surplus and welfare

What is “surplus” ? It measures the net benefit to the consumers of purchasing the good......or the net benefit to the producer of selling the good It is the difference between: The reservation price of the agents : the “willingness to pay” for consumers and the marginal cost for producers The price the good is exchanged on the market.

Surplus and welfare But how it is worked out ? Actually, very simply !! Reminder: the demand function is derived from the utility function (in fact from the indifference curves which map the utility function) It contains information about preferences, i.e. what a given good/bundle is worth to the consumer in terms of utility The same is true for the supply curve: It contains information about the marginal cost of production, i.e. the value of the good under which producers will not produce

Surplus and welfare Price Quantity 0 Example: Auction vs market D 1 st unit bought by the most “desperate” consumer: The one willing to pay the most 2 nd unit bought by the second most “desperate” consumer: The one willing to pay the most from the remaining agents But on a market, all 8 units are available at p = 1.

Surplus and welfare P Q Q1Q1 P1P1 Consumer surplus Effect of a fall in price on the surplus of existing consumers Surplus of new consumers who can now afford the good P2P2 Q2Q2 D Consumer surplus

Producer surplus Surplus and welfare P Q P2P2 Q2Q2 Q1Q1 P1P1 Effect of an increase in price on the surplus of existing producers Surplus of new producers who can now supply the good S Producer surplus

Surplus and welfare P Q P*P* Q*Q* S D Global surplus under perfect competition