Presentation on theme: "Chapter 9 Perfect Competition In A Single Market"— Presentation transcript:
1 Chapter 9 Perfect Competition In A Single Market
2 Objectives What are perfectly competitive markets How prices are determined in a perfectly competitive marketWhy entry and exit of firms occur and its effectsWelfare consequences
3 Supply ResponseThe effects of changes in demand depend on the time period consideredIt takes time for suppliers to respondTime framesVery short run – quantity supplied is fixed (market period)Short run – existing firms can respond but no new entryLong run – existing firms can respond and new firms can enter.
4 Very Short RunSPriceGiven some demand, D, the equilibrium price, P1, is where demand intersects supply.P1DQuantity per weekQ*
5 Pricing In The Very Short Run If the demand curve increases there is excess demand at P1.SPriceP2To ration the quantity available, price must rise to P2.P1D’DQuantity per weekQ*
6 Short-Run SupplyAssume 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.
7 Short-Run Supply Firm A Firm B Market Price Price Price S SA SB P1 q1A q1BQOutput
10 Short-Run Price Determination Price serves two functionsIt acts as a signal to producers: given some price they maximize profits where P = SMCIt rations demand. Given some price consumers buy the amount that will maximize their utilityNote that both producers and consumers are content with the outcome.
11 Short-Run Price Determination: What Happens When Demand Changes SMCSP2SACP1P1D’d’dDq1q2QQ1Q2Qq1q2QTypical FirmTypical PersonThe Market
12 Shifts in Supply and Demand Curves Demand shifts when:Income increases and the good is normalIncome increases and the good is inferiorThe price of a substitute risesThe price of a complement fallsPreferences for a good change
13 Shifts in Supply and Demand Curves Reasons for a shift in supply:Input prices fallsTechnology improves
14 Shifts in Supply Price Price S’ S’ S S P’ P’ P P D D Q’ Q Quantity per weekQ’QQuantity per weekThe change in price and quantity depend on the elasticity of demand
15 Shifts in Demand S Price Price S P’ P’ P P D’ D’ D D Q Q’ Quantity per weekQQ’Quantity per weekThe change in price and quantity depend on the elasticity of supply
16 LR or SR equilibrium?PricePriceATCSMCDπ1peq1eQMarketFIRM 1
17 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 suppliedWe change price by shifting demandWe examine the quantity produced by the industry after both adjustments take place and an (LR) equilibrium is reached
18 The Long Run Equilibrium conditions Profit MaximizationEach firm maximizes profits by producing q where P = MC.Market clearing:Price, P, equates QS and QDEntry and Exitno further changes in the number of firms, n, since firms have entered or exited the industryThere 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 The long run supply can be Supply is upward slopingThe long run supply can beFlatUpward slopingDownward slopingThe shape of the LR supply will depend on how entry/exit affects the costs of production
20 Dynamic Changes in Market Equilibria Constant-cost industriesEntry of new firms has no impact on the cost of produtionThe LRAC is unaffectedFlat long-run supply curve
21 Constant-cost industries LRACPriceCostD2Long-runsupply curveSRMCSRACD1S1S2bpbapaQuantityQuantityWith 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 enterCost of inputs increaseLRAC curves – shift upPecuniary externalityAction of one agentUpward sloping long-run supply curve
23 Increasing-cost industries PriceCostD2LRAC1LRAC2Long-runsupply curveD1S1S3bpbcpcpaaQuantityQuantityWith increasing costs, the long-run response results in a higher price
24 Decreasing-cost industries Downward sloping long-run supply curveAs new firms enterDecrease costs of inputsEconomies of scale in making inputsSubsidiary services developLRAC curves – shift down
25 Decreasing-cost industries PriceCostD2LRAC1Long-runsupply curveD1S1LRAC2bS2pacapcQuantityQuantityWith decreasing costs, the long-run response results in a lower price.
26 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.
27 Consumer and Producer Surplus Total value to consumers from buying Q* units.PriceASTotal expenditure by consumers.P*Consumer SurplusDBQuantityper periodQ*
28 Consumer and Producer Surplus Total revenue earned by firmsPriceMinimum amount necessary to produce Q* units.ASProducer surplusP*DBQuantityper periodQ*
29 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.
30 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.
31 Economic Efficiency Suppose only Q1 units are produced. PriceThere is a loss in total surplus.ASP*DBQuantityper periodQ1Q*
32 Economic EfficiencyAt Q1, consumers are willing to pay P1 and producers are willing to accept P2: mutually beneficial exchange possible.PriceASP1P*P2DBQuantityper periodQ1Q*
33 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?
34 Tax Incidence in the Short Run: Constant Costs (a) Typical Firm(b) The MarketPricePriceConsumer paysSMCACP3P1P2TaxFirm keeps after taxDD’q2q1Q2Q1OutputQuantityper week
35 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 = taxWhat 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.
36 Tax Incidence in the Long Run: Constant Costs (a) Typical Firm(b) The MarketPricePriceS’SMCP4ACP3TaxP1P2TaxDD’Q3q2q1Q2Q1OutputQuantityper week
37 Long Run Incidence: Increasing Costs PriceSP2 is the price retained by firms after paying tax.P3TAXREVENUECONSUMERBURDENP3 is the full price paid by the consumer.P1FIRMBURDENP2Deadweight loss.TaxDD’Q2Q1Quantityper week
38 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.
39 Recap IThe 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.
40 Recap IIThe 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.