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Perfect Competition Outline •Competition and socially efficient resource allocation •Structural features of competitive markets •The supply curve of the competitive firm •Consumer and producer surplus •The market for daycare Socially Optimal Resource Allocation To say that the scheme of resource allocation is “socially optimal” means that a re-allocation of resources could not make any one person better off without making at least one other person worse off. We can trust market forces to allocate resources in a socially optimal way—that is, if markets are “competitive” in structure. If markets are “imperfectly” competitive in structure, then all bets are off. Structural features of competitive markets 1. Large number of buyers and sellers 2. No barriers to entry 3. Homogeneous or standardized product 4. Buyers and sellers are “price takers.” Short run supply curve for the competitive firm The supply curve for the firm is given by MC above the minimum of AVC. MC ATC AVC Output (Thousands of Units) Demand curve facing the competitive firm Revenue per unit $6 Competitive firm faces an infinitely elastic demand curve at the market determined price P = AR = MR Output (Thousands of Units) Competitive firm can earn an economic profit in short run Cost and Revenue per Unit MC AC P = $8.00 AC = $6.50 P = MR Q=6 Output (Thousands of Units) (a) A Competitive Firm's Optimal Output Price S1 S2 $8.00 The opportunity to earn an economic profit attracts new firms to the market $6.50 D Entry shifts the market supply curve to the right Quantity Economic profits eroded by entry Cost and Revenue per Unit MC AC P = $6.00 P = MR Q=5 Output (Thousands of Units) (b) Long-Run Equilibrium in a Competitive Market Effect of a change in demand before and after entry Cost and Revenue per Unit D $8 P = $6 $4 0 D' Supply curve before entry E' E E* Supply curve after entry D D' 100 200 240 280 Output (Thousands of Units) The Invisible Hand According to Adam Smith1, even self-centered people like me are led by the “invisible hand” of competition to promote the best interests of society. 1Adam Smith. The Wealth of Nations, 1776 What assumptions must one make about the structure of markets to “prove” that the market system produces socially efficient resource allocation? Modern welfare economics has this all worked out. Why competitive markets are efficient Competitive markets provide efficient amounts of goods and services at minimum cost to the consumers who are most willing (and able) to pay for them. Samuelson and Marks (1999, p. 330). Consumer and Producer Surplus •Consumer surplus (CS) is the difference between the maximum amount the consumer is willing to pay for a given quantity of a good or service rather than go without it and what they actually pay for a given quantity of the good or service. •Producer surplus (PS) is the difference between the minimum price a seller would have to get to offer a given quantity of goods and services and the price the seller actually gets for that quantity. You’re paying $2.69 for a gallon of gas—but I bet you would be willing to pay more rather than go without it. If so, there you derive a surplus on the transaction. Example: The Demand and Supply of Day Care oThe Palmers are willing to pay a maximum of $8 per hour for daycare (10 hours per day) for their two year old. oA grandmother in the neighborhood is willing to provide the service. Her minimum acceptable fee is $4 per hour. Daycare transaction Dollars per Hour Couple's maximum value Price $8 Consumer surplus $20 per week 6 Producer surplus $20 per week Grandmother's 4 cost If the negotiated price is $6, then each party gets a surplus of $20 per week 2 0 2 Q 4 6 8 10 12 Hours of Day Care per Week The Regional Market for Daycare Hourly Price $14 12 Regional demand curve 10 8 6 P=4 Consumer surplus $32 million Blue shaded area shows consumer surplus accruing to all consumers in the market for daycare services if P =$ 4 per hr. 2 Q 0 2 4 6 8 10 12 14 Hours of Day Care (Millions) Figure 8.7: A Competitive Daycare Market Hourly Price $14 12 Regional daycare demand 10 Equilibrium: 8 P C = $2.50 QC = 9.5 million hours 6 Grandmothers ' day-care supply 4 $4 'Store-bought " day care P C = 2.50 2 0 2 4 6 8 Q 14 10 12 9.5 Hours of Day Care (Millions)