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5 Competitive Markets Introduction to Economics ETH Zürich, Prof. Dr. Jan-Egbert Sturm Winter Term 2006/07 Exam • Date: Tuesday, February 13, 2007 • Time: 15:15 – 16:45 (90 minutes) • Place: HG E 7 Konjunkturforschungsstelle Swiss Institute for Business Cycle Research KOF General Information 24.10. Introduction; Transformation Curve, Opportunity Cost Mankiw ch.1,2 31.10. Markets: Demand and Supply Ch. 4 7.11. Elasticities Ch. 5 14.11. Costs, Production Function Ch. 13 21.11. Markets with perfect competiton Ch. 7, 14 28.11. Taxation Ch. 8 5.12. International Trade Ch. 9 12.12. Imperfect competition: Monopoly, and Oligoploy Ch. 15, 16 19.12. Public Goods, Externalities Ch. 10,11 9.1. National Accounting, Gross Domestic Product, Growth Ch. 23, 25 16.1. Money and Inflation Ch. 24, 29, 30 23.1. Business Cycles Ch. 33, 34 30.1. Open Economy Macro Ch. 31 Konjunkturforschungsstelle Swiss Institute for Business Cycle Research KOF WHAT IS A COMPETITIVE MARKET? • A perfectly competitive market has the following characteristics: • There are many buyers and sellers in the market. • The goods offered by the various sellers are largely the same. • Firms can freely enter or exit the market. Konjunkturforschungsstelle Swiss Institute for Business Cycle Research KOF WHAT IS A COMPETITIVE MARKET? • As a result of its characteristics, the perfectly competitive market has the following outcomes: • The actions of any single buyer or seller in the market have a negligible impact on the market price. • Each buyer and seller takes the market price as given. Konjunkturforschungsstelle Swiss Institute for Business Cycle Research KOF WHAT IS A COMPETITIVE MARKET? • A competitive market has many buyers and sellers trading identical products so that each buyer and seller is a price taker. • Buyers and sellers must accept the price determined by the market. Konjunkturforschungsstelle Swiss Institute for Business Cycle Research KOF PROFIT MAXIMIZATION AND THE COMPETITIVE FIRM’S SUPPLY CURVE • The goal of a competitive firm is to maximize profit. • This means that the firm will want to produce the quantity that maximizes the difference between total revenue and total cost. Konjunkturforschungsstelle Swiss Institute for Business Cycle Research KOF Figure 1 Profit Maximization for a Competitive Firm •Long run supply is given by the part of marginal cost curve above average total cost Cost per Unit MC The firm maximizes profits by producing the quantity at which MC=MR 800 600 ATC Price=MR 400 200 0 0 5 10 15 20 Quantity Figure 2 Market Supply Company A Company B Supply B Supply A Cost per Unit Cost per Unit 600 290 15 15 Quantity Quantity Companies A + B Supply A Supply A+B Preis 600 290 15 30 Quantity Î Market supply is the sum of the single firms‘ supply. Î As long as firms make profits, market entry takes place Figure 3 Market Entry 2 3 5 4 1 Number of Firms: Price 800 640 600 490 410 400 340 290 Market entry until MC=MR=Price 200 Demand 0 0 20 40 60 80 Quantity Figure 4 Market Equilibrium Zero Demand at 5.8$ Supply Price per unit 8 Demand 6 4 Minimum of ATC 2 Revenue covers AVC No supply at prices below 1.8 $. 0 0 100 200 Quantity 300 400 500 Figure 5 Market Equilibrium market price = 4 Supply price per unit 8 Demand 6 4 2 quantity traded=240 0 0 100 200 Quantity 300 400 500 Figure 6 Market Equilibrium Consumers can buy the quantity they demand at the given price Producers can sell the quantity they want to produce at the given price. Supply price per unit 8 Demand 6 Market equilibrium 4 2 0 0 100 200 Quantity 300 400 500 The Long Run: Market Supply with Entry and Exit • At the end of the process of entry and exit, firms that remain must be making zero economic profit. • The process of entry and exit ends only when price and average total cost are driven to equality. • Long-run equilibrium must have firms operating at their efficient scale. Konjunkturforschungsstelle Swiss Institute for Business Cycle Research KOF Why Do Competitive Firms Stay in Business If They Make Zero Profit? • Profit equals total revenue minus total cost. • Total cost includes all the opportunity costs of the firm. • In the zero-profit equilibrium, the firm’s revenue compensates the owners for the time and money they expend to keep the business going. Konjunkturforschungsstelle Swiss Institute for Business Cycle Research KOF Market mechanics • at all other prices, there will be excess supply or excess demand • Market mechanics will bring the market back to equilibrium Konjunkturforschungsstelle Swiss Institute for Business Cycle Research KOF Figure 8 Market Equilibrium price too low supply too low, demand cannot be fully satisfied Supply price per unit 8 Demand 6 excess demand 4 3 2 Demand Supply 0 0 100 200 Quantity 300 400 500 Figure 9 Market Equilibrium price too low demand cannot be fully satisfied Supply price per unit 8 Producers can raise prices without losing customers Demand 6 4 3 2 price rises excess demand disappears 0 0 100 200 Quantity 300 400 500 Figure 10 Market Equilibrium price too high Part of the production cannot be sold Supply price per unit 8 Price must fall for goods to be sold Demand 6 5 4 Price falls-excess supply disappears 2 0 0 100 200 Quantity 300 400 500 A Shift in Demand in the Short Run and Long Run • An increase in demand raises price and quantity in the short run. • Firms earn profits because price now exceeds average total cost. • In the long run, new firms will enter the market until profits are zero. Konjunkturforschungsstelle Swiss Institute for Business Cycle Research KOF Figure 11 Market Dynamics: higher income price per unit demand at higher income short run supply 8 6 demand Short run supply (after market entry new firms) 2 3 1 4 long run supply 2 100 200 Quantity 300 400 500 REVISITING THE MARKET EQUILIBRIUM • Do the equilibrium price and quantity maximize the total welfare of buyers and sellers? • Market equilibrium reflects the way markets allocate scarce resources. • Whether the market allocation is desirable can be addressed by welfare economics. Konjunkturforschungsstelle Swiss Institute for Business Cycle Research KOF Welfare Economics • Welfare economics is the study of how the allocation of resources affects economic well-being. • Buyers and sellers receive benefits from taking part in the market. • The equilibrium in a market maximizes the total welfare of buyers and sellers. Konjunkturforschungsstelle Swiss Institute for Business Cycle Research KOF Welfare Economics • Equilibrium in the market results in maximum benefits, and therefore maximum total welfare for both the consumers and the producers of the product. Konjunkturforschungsstelle Swiss Institute for Business Cycle Research KOF Welfare Economics • Consumer surplus measures economic welfare from the buyer’s side. • Producer surplus measures economic welfare from the seller’s side. Konjunkturforschungsstelle Swiss Institute for Business Cycle Research KOF CONSUMER SURPLUS • Willingness to pay is the maximum amount that a buyer will pay for a good. • It measures how much the buyer values the good or service. Konjunkturforschungsstelle Swiss Institute for Business Cycle Research KOF CONSUMER SURPLUS • Consumer surplus is the buyer’s willingness to pay for a good minus the amount the buyer actually pays for it. Konjunkturforschungsstelle Swiss Institute for Business Cycle Research KOF Table 1 Four Possible Buyers’ Willingness to Pay Konjunkturforschungsstelle Swiss Institute for Business Cycle Research KOF Copyright©2004 South-Western CONSUMER SURPLUS • The market demand curve depicts the various quantities that buyers would be willing and able to purchase at different prices. Konjunkturforschungsstelle Swiss Institute for Business Cycle Research KOF The Demand Schedule and the Demand Curve Konjunkturforschungsstelle Swiss Institute for Business Cycle Research KOF Figure 1 The Demand Schedule and the Demand Curve Price of Album John’s willingness to pay $100 Paul’s willingness to pay 80 George’s willingness to pay 70 Ringo’s willingness to pay 50 Demand 0 Konjunkturforschungsstelle Swiss Institute for Business Cycle Research KOF 1 2 3 4 Quantity of Albums Copyright©2003 Southwestern/Thomson Learning Figure 2 Measuring Consumer Surplus with the Demand Curve (a) Price = $80 Price of Album $100 John’s consumer surplus ($20) 80 70 50 Demand 0 Konjunkturforschungsstelle Swiss Institute for Business Cycle Research KOF 1 2 3 4 Quantity of Albums Copyright©2003 Southwestern/Thomson Learning Figure 2 Measuring Consumer Surplus with the Demand Curve (b) Price = $70 Price of Album $100 John’s consumer surplus ($30) 80 Paul’s consumer surplus ($10) 70 50 Total consumer surplus ($40) Demand 0 Konjunkturforschungsstelle Swiss Institute for Business Cycle Research KOF 1 2 3 4 Quantity of Albums Copyright©2003 Southwestern/Thomson Learning Using the Demand Curve to Measure Consumer Surplus • The area below the demand curve and above the price measures the consumer surplus in the market. Konjunkturforschungsstelle Swiss Institute for Business Cycle Research KOF Figure 3 How the Price Affects Consumer Surplus (a) Consumer Surplus at Price P Price A Consumer surplus P1 B C Demand 0 Konjunkturforschungsstelle Swiss Institute for Business Cycle Research KOF Q1 Quantity Copyright©2003 Southwestern/Thomson Learning Figure 3 How the Price Affects Consumer Surplus (b) Consumer Surplus at Price P Price A Initial consumer surplus P1 P2 0 Konjunkturforschungsstelle Swiss Institute for Business Cycle Research KOF C B Consumer surplus to new consumers F D E Additional consumer surplus to initial consumers Q1 Demand Q2 Quantity Copyright©2003 Southwestern/Thomson Learning What Does Consumer Surplus Measure? • Consumer surplus, the amount that buyers are willing to pay for a good minus the amount they actually pay for it, measures the benefit that buyers receive from a good as the buyers themselves perceive it. Konjunkturforschungsstelle Swiss Institute for Business Cycle Research KOF PRODUCER SURPLUS • Producer surplus is the amount a seller is paid for a good minus the seller’s cost. • It measures the benefit to sellers participating in a market. Konjunkturforschungsstelle Swiss Institute for Business Cycle Research KOF Table 2 The Costs of Four Possible Sellers Konjunkturforschungsstelle Swiss Institute for Business Cycle Research KOF Copyright©2004 South-Western Using the Supply Curve to Measure Producer Surplus • Just as consumer surplus is related to the demand curve, producer surplus is closely related to the supply curve. Konjunkturforschungsstelle Swiss Institute for Business Cycle Research KOF The Supply Schedule and the Supply Curve Konjunkturforschungsstelle Swiss Institute for Business Cycle Research KOF Figure 4 The Supply Schedule and the Supply Curve Konjunkturforschungsstelle Swiss Institute for Business Cycle Research KOF Using the Supply Curve to Measure Producer Surplus • The area below the price and above the supply curve measures the producer surplus in a market. Konjunkturforschungsstelle Swiss Institute for Business Cycle Research KOF Figure 5 Measuring Producer Surplus with the Supply Curve (a) Price = $600 Price of House Painting Supply $900 800 600 500 Grandma’s producer surplus ($100) 0 Konjunkturforschungsstelle Swiss Institute for Business Cycle Research KOF 1 2 3 4 Quantity of Houses Painted Copyright©2003 Southwestern/Thomson Learning Figure 5 Measuring Producer Surplus with the Supply Curve (b) Price = $800 Price of House Painting $900 Supply Total producer surplus ($500) 800 600 Georgia’s producer surplus ($200) 500 Grandma’s producer surplus ($300) 0 Konjunkturforschungsstelle Swiss Institute for Business Cycle Research KOF 1 2 3 4 Quantity of Houses Painted Copyright©2003 Southwestern/Thomson Learning Figure 6 How the Price Affects Producer Surplus (a) Producer Surplus at Price P Price Supply P1 B Producer surplus C A 0 Konjunkturforschungsstelle Swiss Institute for Business Cycle Research KOF Q1 Quantity Copyright©2003 Southwestern/Thomson Learning Figure 6 How the Price Affects Producer Surplus (b) Producer Surplus at Price P Price Supply Additional producer surplus to initial producers P2 P1 D E F B Initial producer surplus C Producer surplus to new producers A Konjunkturforschungsstelle Swiss Institute for Business Cycle Research KOF 0 Q1 Q2 Quantity Copyright©2003 Southwestern/Thomson Learning MARKET EFFICIENCY • Consumer surplus and producer surplus may be used to address the following question: • Is the allocation of resources determined by free markets in any way desirable? Konjunkturforschungsstelle Swiss Institute for Business Cycle Research KOF MARKET EFFICIENCY Consumer Surplus = Value to buyers – Amount paid by buyers and Producer Surplus = Amount received by sellers – Cost to sellers Konjunkturforschungsstelle Swiss Institute for Business Cycle Research KOF MARKET EFFICIENCY Total surplus = Consumer surplus + Producer surplus or Total surplus = Value to buyers – Cost to sellers Konjunkturforschungsstelle Swiss Institute for Business Cycle Research KOF MARKET EFFICIENCY • Efficiency is the property of a resource allocation of maximizing the total surplus received by all members of society. • An allocation is Pareto efficient if no individual can be made better off without another being made worse off Konjunkturforschungsstelle Swiss Institute for Business Cycle Research KOF MARKET EFFICIENCY • In the equilibrium of a competitive market • the sum of consumer surplus and producer surplus is maximized • consumer surplus cannot be raised without lowering producer surplus Konjunkturforschungsstelle Swiss Institute for Business Cycle Research KOF Figure 7 Consumer and Producer Surplus in the Market Equilibrium Price A D Supply Consumer surplus Equilibrium price E Producer surplus B Demand C 0 Konjunkturforschungsstelle Swiss Institute for Business Cycle Research KOF Equilibrium quantity Quantity Copyright©2003 Southwestern/Thomson Learning MARKET EFFICIENCY • Three Insights Concerning Market Outcomes • Free markets allocate the supply of goods to the buyers who value them most highly, as measured by their willingness to pay. • Free markets allocate the demand for goods to the sellers who can produce them at least cost. • Free markets produce the quantity of goods that maximizes the sum of consumer and producer surplus. Konjunkturforschungsstelle Swiss Institute for Business Cycle Research KOF Figure 8 The Efficiency of the Equilibrium Quantity Price Supply Value to buyers Cost to sellers Cost to sellers 0 Value to buyers Equilibrium quantity Value to buyers is greater than cost to sellers. Konjunkturforschungsstelle Swiss Institute for Business Cycle Research KOF Demand Quantity Value to buyers is less than cost to sellers. Copyright©2003 Southwestern/Thomson Learning Evaluating the Market Equilibrium • Because the equilibrium outcome is an efficient allocation of resources, the social planner can leave the market outcome as he/she finds it. • This policy of leaving well enough alone goes by the French expression laissez faire. Konjunkturforschungsstelle Swiss Institute for Business Cycle Research KOF Summary • To maximize profit, a firm chooses the quantity of output such that marginal revenue equals marginal cost. • This is also the quantity at which price equals marginal cost. • Therefore, the firm’s marginal cost curve is its supply curve. Konjunkturforschungsstelle Swiss Institute for Business Cycle Research KOF Summary • In the short run, when a firm cannot recover its fixed costs, the firm will choose to shut down temporarily if the price of the good is less than average variable cost. • In the long run, when the firm can recover both fixed and variable costs, it will choose to exit if the price is less than average total cost. Konjunkturforschungsstelle Swiss Institute for Business Cycle Research KOF Summary • In a market with free entry and exit, profits are driven to zero in the long run and all firms produce at the efficient scale. • Changes in demand have different effects over different time horizons. • In the long run, the number of firms adjusts to drive the market back to the zero-profit equilibrium. Konjunkturforschungsstelle Swiss Institute for Business Cycle Research KOF Summary • Consumer surplus equals buyers’ willingness to pay for a good minus the amount they actually pay for it. • Consumer surplus measures the benefit buyers get from participating in a market. • Consumer surplus can be computed by finding the area below the demand curve and above the price. Konjunkturforschungsstelle Swiss Institute for Business Cycle Research KOF Summary • Producer surplus equals the amount sellers receive for their goods minus their costs of production. • Producer surplus measures the benefit sellers get from participating in a market. • Producer surplus can be computed by finding the area below the price and above the supply curve. Konjunkturforschungsstelle Swiss Institute for Business Cycle Research KOF Summary • An allocation of resources that maximizes the sum of consumer and producer surplus is said to be efficient. • The equilibrium of demand and supply maximizes the sum of consumer and producer surplus. • This is as if the invisible hand of the marketplace leads buyers and sellers to allocate resources efficiently. • Free markets ensure a (pareto-)efficient allocation Konjunkturforschungsstelle Swiss Institute for Business Cycle Research KOF