1. Models of Competition Part I: Perfect Competition
Agenda:
What is Competition?
Assumptions underlying perfect competition
Optimal production quantity, or where do supply curves come from?
A. Short run
1. One firm
2. Market
B. Long run
IV. Producer & Consumer Surplus and Welfare Theorems
Go back to birds and bees…

2. What does “competition” mean to you?
Scarcity – both parties can’t have the same thing
At least two parties
“a fair fight” – rules, referee, “reciprocity” (Ouchi)
Can be either short or long term

3. What happens when we violate these assumptions…
Assumptions that Underlie Perfect Competition
Firms sell standardized products
(commodities).
2. Firms are all price takers:
no one firm’s actions can “move the market.”
3. There is free entry and exit of firms with perfectly mobile factors of production (capital and labor) in the long run.
4. Firms and consumers have perfect information.
What happens when we violate these assumptions…

4. Costs & Revenues Review
What is on the X and Y axis?
Is this a long-run or short run picture?
MR=MC
Max Profit!
What does the slope of the total revenue line reflect?
What do the intersection points reflect?
What does a line tangent to the TC curve reflect?
Is this a short-run or long-run picture?
What is the slope of the total revenue line?
What do the intersection points tell you?
What does the point where the line tangent to the TC curve with the same slope as the TR curve reflect?

5. Short-run Individual firm supply curve
Individual Firm Supply Decisions
Is this a long-run or a short-run graph?
At what point does a firm break even?
At what point should a firm shut down?
Price = Marginal Revenue = Marginal Cost
Short-run Individual firm supply curve
Why not here??
Have to link this graph to the assumptions.
What if price is here?
Economic loss!
Shutdown!
MR=MC on the rising part of the MC curve!

6. The market supply is simply the sum of the individual firm supplies!
Market Supply Curve
The market supply is simply the sum of the individual firm supplies!
Firm Supply curve:
Quantity:
Industry Supply:
100 firms each have identical supply curves: P = Q
What is the industry supply curve?
Vocabulary: note the difference between supply = Q and supply curve, which is a function P = f(Q)
A SUPPLY CURVE IS A FUNCTION THAT MAPPS QUANTITY TO PRICES
Supply = quantity
Need to sum quantities!
Solve for Q
Multiply by n
Solve for P
TEST YOURSELF:
What if firms did NOT have identical supply curves?

7. Short Run Producer Surplus
ATC PL
You can have a producer surplus and an economic loss
Market Supply Curve
Different consumers have different marginal benefits
You can have both a producer surplus AND an economic loss!
Allocative efficiency: no consumer will buy more, no producer will produce more at any other price.
PARETO OPTIMAL
Different firms have different minimum marginal costs

8. What Happens in the Long-Run in the Market?
Shift in Supply
Producer surplus attracts more supply
More supply shifts the supply curve
The shift in the supply curve causes a decline in price but a higher equilibrium quantity.
Movement along the supply curve
A decline in price without a shift in supply would be a movement along the supply curve and result in a lower equilibrium quantity. Q1 Q2
What Happens in the Long-Run in the Firm?
AFTER market prices decline (see above)
The new price intersects with long-run marginal cost at a lower quantity.
If the new price is below the firm’s short-run average variable cost it will shutdown! Firms still in business will have lower ATC curves
Each firm produces less even though the market supplies more.

9. Long-Run Competitive Equilibrium
All firms produce identically at LMC=LAC=SMC=ATC=Price
Do firms earn economic profits in the long run?
Is there producer surplus in the long run?

10. Is there producer surplus in the long run?
Supply when input prices do NOT vary with output quantity.
Long-run supply price=MC=LAC
No producer surplus!
Supply when input prices INCREASE with output quantity.
Recall definition of producer surplus: the difference between price and marginal cost. When the price = marginal cost there is no producer surplus.
There may still be economic rents, but these are embedded in the marginal costs of production.
Supply curve slopes up,
But still no producer surplus!
Why?

11. Price Elasticity of Supply
The percent change in quantity supplied as a result of a change in market price
See Frank p. 360 equations 11.1 and 11.2
If the cost of inputs does not change with quantity, then the supply curve will be horizontal and the elasticity will be zero (technically undefined)
Another way to think about horizontal supply curves in a perfectly competitive market

12. Example: Garden Gnomes
Market demand: QD = P
Market supply: QS = 1200P
FIRM total cost: C(q) = q2/200
FRIM marginal cost: MC(q) = 2q/200 = q/100
QD=QS
P = $5
Q = 6,000
1. What is the equilibrium price and quantity for the MARKET?
P = MR = MC(q)
Q (firm) = 500
2. What is the amount supplied by the FIRM?
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
6. Would you want to go into the Garden Gnome industry?
AVC
= $2.50
Yes! Why?
7. What is the lowest price you would sell your Garden Gnomes for in the short run?

13. Garden Gnomes Continued…
What would be the effect on equilibrium supply and demand in the short and long term if you develop a new manufacturing technology that reduces your marginal costs?
What if you do (do not) get a patent for your technology?
What if the new technology only reduced your fixed costs?
What if the government imposed a new tax of $T on gnomes?
(illustrated below)
price
Long-run supply P3
P = MC + T P2
With a patent – market power. P = MR = MC with any demand left-over going to remaining competitors who will charge higher prices. If your market power is great enough you may become a monopoly!
Without a patent – everyone copies you and P = MR = MC at the new lower MC
At current price, this will mean higher producer surplus, more entry into the market and equilibrium at a higher quantity, lower cost with no producer surplus.
If you only change fixed costs, no impact on the market – remember producer surplus does not equal profit and producer surplus is based on variable costs!
P = MC P1
Effective price to producers
Causes market exit!
Quantity

14. Pareto Optimality & the Welfare Theorems
“…the efficiency claims on behalf of competitive allocations are conditional on the initial distribution of resources among members of society…If you do not believe that the underlying distribution of resources is fair, there is no compelling reason for you to approve of the pattern of goods and services served up by competitive markets.” Frank p. 354
1st Fundamental Welfare Theorem:
Any competitive equilibrium is Pareto Optimal.
Assumptions: local non-satiation (more is better)
The converse is also true!
Consider dropping the welfare theorems??
2st Fundamental Welfare Theorem:
Any Pareto Optimal allocation is consistent with a competitive equilibrium.
Assumptions: local non-satiation (more is better)
convexity of preferences and production technologies (diminishing returns)

15. Step 1: Utility Maximization:
Intuitive proof of the 1st Welfare Theorem: competitive equilibrium is Pareto optimal.
Let’s define some terms:
W = endowments, what we start with
X = consumption
Y = output from the firm
P* = market price
Step 1: Utility Maximization:
each consumer, i, is going to choose x such that the price times quantity will be less than or equal to their budget.
Step 2: Profit Maximization:
each firm, j, will produce y to maximize profit.
Step 3: Market Clearing:
We can’t consume more than the sum of our endowment and what is produced.
Step 4: Local non-satiation (more is better):
Markets will clear with equality because we would never leave resources on the table.

16. But Wait….
Externalities!
Move this to imperfect competition

17. Price = minimum marginal benefit = minimum marginal cost
Summary
1. IF the assumptions underlying perfect competition hold then the MARKET PRICE is all the information you need to know about both supply and demand.
Price = minimum marginal benefit = minimum marginal cost
2. IF the assumptions underlying perfect competition hold then in the long run there is NO producer surplus and NO economic profit.
Price = long-run marginal cost = long-run average cost
3. IF the assumptions underlying perfect competition hold then in the long run ALL firms produce the same quantity at the same cost.
Point #4 goes back to Point #1 – why?
Price = LMC=LAC=SMC=SAC
4. IF the assumptions underlying perfect competition hold then the long-run equilibrium is PARETO OPTIMAL.
But NOT SOCIALLY OPTIMAL when we consider externalities and non-private goods