The benchmark of
perfect competition
Defining perfect competition
Modelling market interactions
Welfare and efficiency
The benchmark of perfect competition

We have seen :

How much consumers choose of a given good,
for all levels of price
 Through consumer choice theory

How much producers produce of a good, for all
levels of price
 Through the model of the firm

We now need to work out :


How this supply and demand interact to provide
the market price and quantity
We need a model of the market !
The benchmark of perfect competition
The interaction of supply and demand
The 5 conditions of perfect competition
Short run and long run in perfect
competition
Surplus and welfare
The interaction of supply and demand
Reminder: the demand curve
Price
2.50
2.00
1.50
1.00
0.50
0
1
2
3
4 5
6
7
8
9 10 11
Quantity
The interaction of supply and demand

The demand function depends on:
x  p1 , pothers , I
i
1
i

The market price of the good
 The income of consumers (BC)
 The preferences of consumers (IC)
 The price of other goods (S or C)
 Expectations (future endowments)

The interaction of supply and demand
A change in…
..brings the following effect on the
demand curve …
Price
A movement on the curve
Income
A movement of the curve itself
Preferences
A movement of the curve itself
Price of other goods
A movement of the curve itself
N˚ of consumers
A movement of the curve itself
Expectations
A movement of the curve itself
The interaction of supply and demand
Price
Increase in
demand
Fall in
demand
0
Quantity
The interaction of supply and demand
Reminder: the supply curve
Price
2.50
2.00
1.50
1.00
0.50
0
1
2
3
4 5
6
7
8
9 10 11
Quantity
The interaction of supply and demand

The supply function depends on:
s1i  p1 , pinputs , ni 
The market price of the good
 The price of inputs (cost function)
 Technology (production function)
 N˚ of producers
 Expectations

The interaction of supply and demand
A change in…
..brings the following effect on the
supply curve …
Price
A movement on the curve
Price of inputs
A movement of the curve itself
Available techologies
A movement of the curve itself
N˚ of producers
A movement of the curve itself
Expectations
A movement of the curve itself
The interaction of supply and demand
Price
Fall in
supply
0
Increase in
supply
Quantity
The interaction of supply and demand
Price
S
3.00
Equilibrium
2.50
2.00
1.50
1.00
D
0.50
0
1 2 3 4 5 6 7 8 9 10 11 12
Quantity
The interaction of supply and demand
Price
3.00
Excess supply
S
2.50
2.00
1.50
1.00
D
0.50
0
1
2 3
4 5 6 7 8 9 10 11 12
Quantity
The interaction of supply and demand
Price
S
2.00
1.50
rationing
0
D
1 2 3 4 5 6 7 8 9 10 11 12
Quantity
The interaction of supply and demand
Price
1. An increase in demand (through
exterior cause)…
S
2.50
New equilibrium
2.00
2. ... increases
the price ...
Initial Equilibrium
DD12
0
3. ... and the
amount sold
7
10
Quantity
The interaction of supply and demand
Price
1. A fall in supply ...
S2
S1
New
equilibrium
2.50
2.00
Initial equilibrium
2. ...increases
prices...
D
4
7
3. ...and reduces the
quantity sold.
Quantity
The benchmark of perfect competition
The interaction of supply and demand
The 5 conditions of perfect competition
Short run and long run in perfect
competition
Surplus and welfare
The 5 conditions of perfect competition

1.
2.
3.
4.
5.

Perfect competition is defined by the following 5
conditions:
Large number of agents (Atomicity)
Homogeneous products
Free entry and exit from the market
Perfect information
Perfect mobility of inputs
All 5 are required for an optimal coordination of
supply and demand
The 5 conditions of perfect competition

Let’s detail what these conditions imply:

Large number of producers (Atomicity)



There are many producers and consumers
None is large enough to individually influence
the market outcome
Homogeneous products


On any given market, the good is exactly the
same regardless of who produced it.
Consumers have no preferences w.r.t. producers
The 5 conditions of perfect competition

Free entry and exit from the market



Agents are free to enter and exit markets in
response to changing market conditions
There are no barriers to entry or exit
Perfect information


Agents constantly are constantly informed,
without delay, of the changing market conditions
Agents also know all perfectly all the
characteristics of the goods: No hidden defects,
etc.
The 5 conditions of perfect competition

Perfect mobility of inputs



Similar to the “no barriers to entry” condition
Inputs can change markets freely
If even a single one of these conditions fails
to hold, then we have imperfect competition


Clearly, this set of conditions is never met in
reality !!
But the concept of perfect competition is
important as a benchmark for assessing the
different kinds of imperfect competition.
The benchmark of perfect competition
The interaction of supply and demand
The 5 conditions of perfect competition
Short run and long run in perfect
competition
Surplus and welfare
SR and LR in perfect competition

Profit of the firm:
  TR  TC

The profit maximisation condition finds
output q such that :

TR TC
0 

0
q
q
q
mR  mC  0
mR  mC

What it mR equal to in perfect competition?
SR and LR in perfect competition

Total revenue is simply equal to the quantity sold
times the price at which the output is sold:
TR  p  q

Marginal revenue is the sum of:
 The extra quantity produced ∂q times the price
 The effect of the increase on the market price
TR  p  q  p  q
TR  p  q

But the atomicity assumption
guarantees that this second
effect is zero !!!
TR
 mR  p
q
SR and LR in perfect competition
Firm-market equilibrium
Firm level
Market level
Price
Price
Zero profits in
equilibrium
mC
S
AC
d=mR
p
D
q
quantity
Q
Quantity
SR and LR in perfect competition
Firm-market equilibrium
Firm level
Market level
Price
Price
Positive
profits in SR
  p  q  TC
mC
Imagine a positive demand
shock (ex: new “fashion”)
S
AC
d2=mR2
p2
d=mR
p
Total Cost
q q2
quantity
D
Q
Q2
D2
Quantity
SR and LR in perfect competition
Firm-market equilibrium
Firm level
Market level
Price
Price
Return to zero
profits in LR
mC
Positive profits attract firms
to the market (free entry +
perfect information)
S
AC
S2
d2=mR2
p2
d=mR
p
D2
q q2
quantity
Q2
Q3
Quantity
SR and LR in perfect competition

Price
Zero profits in
LR equilibrium
mC

AC
d=mR
p
q
The significance of
zero-profits


quantity

Remember that total costs
include the opportunity
cost
Zero economic profits
does not mean zero
accounting profits
It means that the
accounting profits are
equal to the opportunity
cost
i.e the reward for
producing is “fair”
SR and LR in perfect competition

Efficiency:

Price
Zero profits in
LR equilibrium
mC

AC
d=mR
p


q
quantity
At equilibrium, P=mc=AC
All the increasing returns
to scale opportunities are
used up, but decreasing
returns to scale have not
yet appeared
Firms are producing at the
most efficient point
Resources are allocated
efficiently: the smallest
amount of resources
possible is allocated to the
production
The benchmark of perfect competition
The interaction of supply and demand
The 5 conditions of perfect competition
Short run and long run in perfect
competition
Surplus and welfare
Surplus and welfare

What is “surplus” ?



It measures the net benefit to the consumers of
purchasing the good...
...or the net benefit to the producer of selling the
good
It is the difference between:


The reservation price of the agents : the
“willingness to pay” for consumers and the
marginal cost for producers
The price the good is exchanged on the market.
Surplus and welfare

But how it is worked out ?


Reminder: the demand function is derived from the
utility function (in fact from the indifference curves
which map the utility function)


Actually, very simply !!
It contains information about preferences, i.e. what a given
good/bundle is worth to the consumer in terms of utility
The same is true for the supply curve:

It contains information about the marginal cost of
production, i.e. the value of the good under which
producers will not produce
Surplus and welfare
Example: Auction vs market
Price
1st unit bought by the most “desperate”
consumer: The one willing to pay the most
2.50
2nd unit bought by the second most
“desperate” consumer: The one willing to
2.00
pay the most from the remaining agents
1.50
But on a market, all 8 units are
available at p = 1.
1.00
0.50
D
0
1
2
3 4 5
6
7
8
9 10 11
Quantity
Surplus and welfare
Consumer surplus
P
Consumer surplus
Effect of a fall in price on the
surplus of existing consumers
P1
P2
Surplus of new consumers
who can now afford the good
D
Q1
Q2
Q
Surplus and welfare
Producer surplus
P
Effect of an increase in price on
the surplus of existing producers
S
P2
Surplus of new producers who
can now supply the good
P1
Producer
surplus
Q1
Q2
Q
Surplus and welfare
Global surplus under perfect competition
P
S
P*
D
Q*
Q