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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
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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
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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.
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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.
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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.
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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.
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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

Market supply is the sum of
the single firms‘ supply.

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.
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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.
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Market mechanics
• at all other prices, there will be excess supply or excess demand
• Market mechanics will bring the market back to equilibrium
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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.
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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.
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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.
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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.
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Welfare Economics
• Consumer surplus measures economic welfare from the
buyer’s side.
• Producer surplus measures economic welfare from the seller’s
side.
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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.
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CONSUMER SURPLUS
• Consumer surplus is the buyer’s willingness to pay for a good
minus the amount the buyer actually pays for it.
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Table 1 Four Possible Buyers’ Willingness to Pay
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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.
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The Demand Schedule and the Demand Curve
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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
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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
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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
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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.
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Figure 3 How the Price Affects Consumer Surplus
(a) Consumer Surplus at Price P
Price
A
Consumer
surplus
P1
B
C
Demand
0
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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
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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.
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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.
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Table 2 The Costs of Four Possible Sellers
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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.
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The Supply Schedule and the Supply Curve
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Figure 4 The Supply Schedule and the Supply Curve
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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.
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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
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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
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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
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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
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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?
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MARKET EFFICIENCY
Consumer Surplus
= Value to buyers – Amount paid by buyers
and
Producer Surplus
= Amount received by sellers – Cost to sellers
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MARKET EFFICIENCY
Total surplus
= Consumer surplus + Producer surplus
or
Total surplus
= Value to buyers – Cost to sellers
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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
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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
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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
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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.
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Figure 8 The Efficiency of the Equilibrium Quantity
Price
Supply
Value
to
buyers
Cost
to
sellers
Cost
to
sellers
0
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Value
to
buyers
Equilibrium
quantity
Value to buyers is greater
than cost to sellers.
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.
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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.
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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.
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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.
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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.
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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.
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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
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