Download Chapter 14

Chapter 14
Equilibrium and Efficiency
What Makes a Market
Competitive?
 Buyers and sellers have absolutely no effect on price
 Three characteristics:
 Absence of transaction costs
 Product homogeneity: products are identical in the eyes of
their purchasers
 Presence of a large number of sellers, each accounts for a
small fraction of market supply
 Consumers have many options and buy from the firm
that offers the lowest price
 Each firm takes the market price as given and can
focus on how much it wants to sell at that price
 Few markets are perfectly competitive
Market Demand and Supply
Market demand for a product is the sum of the
demands of all individual consumers
Graphically, this is the horizontal sum of the
individual demand curves
Market supply of a product is the sum of the
supply of all the individual sellers
Graphically this is the horizontal sum of the
individual supply curves
Very similar to the procedure for constructing market
demand curves
Figure 14.1: Market Demand
Figure 14.2: Market Supply
Short-Run vs. Long-Run
Market Supply
 Long-run and short-run market supply curves may
differ for two reasons:
 Firm’s short-run and long-run supply curves may differ
 Over time, set of firms able to produce in a market may change
 Long-run supply curve is found by summing supply
curves of all potential suppliers
 Free entry in a market implies that anyone who wishes
to start a firm has access to the same technology and
entry is unrestricted
 With free entry, the number of potential firms in a
market is unlimited
 Long-run market S curve is a horizontal line at ACmin
Figure 14.4: Long-Run Supply
Figure 14.5: Market Equilibrium
At equilibrium price,
Qs=Qd
Market clears at
equilibrium price
Given demand and
supply functions, can
use algebra to find
the equilibrium
Figure 14.6: LR Competitive Equilibrium
Equilibrium price
must equal ACmin
Firms must earn zero
profit
Active firms must
produce at their
efficient scale of
production
Responses to Changes in
Demand
 Market response is different in short-run (number of
firms is fixed) than in long-run (with free entry)
 Begin from a point of long-run equilibrium (point A),
suppose demand curve shifts out
 In short run, new equilibrium is achieved through
movement along the short-run supply curve (point B)
 Price rises
 In LR, firms enter the market
 New equilibrium brings return to initial price but at a higher
quantity (point C)
Price ($/bench)
Figure 14.7: Response to an Increase in
Demand
New SR Equl
S10
B
P* = ACmin
= 100
A
C
S
^
D
D
Initial LE Equl
2000
4000
Garden Benches per Month
Figure 14.7: Response to an Increase in
Demand
Price ($/bench)
The importance
of free entry
assumption
S10
B
P* = ACmin
= 100
A
C
S
^
D
D
2000
4000
Garden Benches per Month
Responses to Changes in
Fixed Cost
 Start from a long-run equilibrium
 Consider the case where fixed costs decrease while
variable costs remain the same
 In short run:
 Average cost curve shifts downward, decreases minimum
average cost and minimum efficient scale
 Since marginal costs have not changed and number of firms is
fixed, equilibrium is unchanged
 Active firms make a positive profit
 In long-run:
 Firms enter market
 Market equilibrium shifts, price falls and quantity rises
Figure 14.8: Response to a Decrease in FC:
Assume FC falls while VC not
SR equil
LR equil
In the SR, firms make profits: P>AVCmin
Responses to Changes in
Variable Cost
Start from a long-run equilibrium
If variable costs change, firm’s marginal and
average cost curves both shift
Short-run supply curve shifts
Sort-run equilibrium changes
Basic procedure in all cases:
Find new short-run equilibrium using new short-run
supply curve of initially active firms
Find new long-run equilibrium using new long-run
supply curve which reflects free entry
Price Changes in the Long-Run
 So far we’ve assumed that the prices of firms’ inputs do
not change
 Reasonable if increases in amounts of inputs used are small
compared to overall market
 Or when supply in input markets is very elastic
 In general, though, when demand for a product
increases, prices of inputs used to make it may change
 This is a general equilibrium effect; the market we are
studying and the market for its inputs must all be in
equilibrium
 Taking the input price effect into account in the
analysis of the market response to an increase in
demand changes the result
 Price of the good rises in the long run
Figure 14.11: Price Changes in the Long-Run
Price ($/bench)
In LR: increase in D leads to
P increases (input cost increases)
S10
B
^ =110
AC
min
ACmin=100
A
^
E
S
S
C
^
D
D
2000
4000
Garden Benches per Month
Aggregate Surplus and
Economic Efficiency
 Perfectly competitive market produces an outcome that
is economically efficient
 Net benefits indicate that consumers’ benefit from the goods
exceed the costs of producing them
 Aggregate surplus equals consumers’ total willingness
to pay for a good less firms’ total avoidable cost of
production
 Total benefits from consumption equal to willingness to
pay
 Area under consumer’s demand curve up to that quantity
 Total avoidable costs of production include all of a
firm’s costs other than sunk costs
 Area under its supply curve up to its production level
Maximizing Aggregate Surplus
 Smith’s The Wealth of Nations (1776) commented on
the “invisible hand” of the market
 The self-interested actions of each individual lead to
economic efficiency
 “he intends only his own gain, and he is in this…led by
an invisible hand to promote an end which was no part
of his intention”
 No way to increase aggregate surplus in perfectly
competitive markets by changing:
 Who consumes the good
 Who produces the good
 How much of the good is produced and consumed
 Competitive markets maximize aggregate surplus
Effects of a Change in Who
Consumes the Good
Begin from the competitive equilibrium
Take one unit of the good from Consumer A
and give it to Consumer B
Cannot increase aggregate surplus
Value any consumer attaches to a unit of the good
they don’t buy must be less than the market price
Value any consumer attaches to a unit of the good
they do buy must be more than the market price
If we take the good from someone who
purchased it and give it to someone who didn’t,
aggregate surplus must fall
Effects of a Change in Who
Produces the Good
 Changing who produces the good can’t increase
aggregate surplus
 To achieve this, would have to reassign sales in a way that
would lower the total cost of production
 Begin from the competitive equilibrium
 Reduce sales of Producer A by one unit, increase
sales of Producer B by one unit
 Cost of producing any unit of output that a firm chooses to sell
must be less than the equilibrium price
 Cost of producing any unit of output that a firm chooses not to
sell must exceed the equilibrium price
 Any shift in production from one firm to another must
raise the total cost of production and lower aggregate
surplus
Effects of a Change in the
Number of Goods
 Changing the total number of units of the good
produced and consumed also lowers aggregate
surplus
 Any unit of a good that is produced and consumed in a
competitive market equilibrium must be worth more
than the market price to the consumers who buy them
 Must also cost less than the market price to produce
 Those units of output must therefore make a positive
contribution to aggregate surplus
 Any units that aren’t produced and consumed should
not be; they will lower aggregate surplus
Measuring Total WTP and
Total Avoidable Cost
Market demand and supply curves can be
used to measure total willingness to pay and
total avoidable cost
Measure consumers’ total willingness to pay
for the units they consume by the area under
the market demand curve up to that quantity
When all consumers face the same market price
Measure producers’ total avoidable costs for
the units they produce by the area under the
market supply curve up to that quantity
When all producers face the same market price
Figure 14.18: Measuring Total
Willingness to Pay
Aggregate Surplus
Can use market supply and demand curves to
measure aggregate surplus
Consumers’ total willingness to pay is area
under market demand curve up to the quantity
consumed
Producers’ total avoidable cost is the area
under the market supply curve up to the
quantity produced
In a competitive market without any
intervention, aggregate surplus is maximized
No deadweight loss: reduction in aggregate
surplus below its maximum possible value
Consumer and Producer Surplus
Consumer surplus is the sum of consumers’
total willingness to pay less their total
expenditure
Sum of individual consumers’ surpluses
Also called aggregate consumer surplus
Producer surplus is the sum of firms’ revenues
less avoidable costs
Sum of individual firms’ producer surpluses
Also called aggregate producer surplus
Aggregate surplus = Consumer surplus + Producer Surplus
Figure 14.19: Aggregate, Consumer, and
Producer Surplus