CHAPTER 9
PERFECT COMPETITION IN A
SINGLE MARKET
Objectives
• What are perfectly competitive markets
• How prices are determined in a perfectly competitive market
• Why entry and exit of firms occur and its effects
• Welfare consequences
Supply Response
• The effects of changes in demand depend on the time
period considered
• It takes time for suppliers to respond
• Time frames
• Very short run – quantity supplied is fixed (market period)
• Short run – existing firms can respond but no new entry
• Long run – existing firms can respond and new firms can enter.
Very Short Run
Price
S
Given some demand, D, the
equilibrium price, P1, is where
demand intersects supply.
P1
D
Q*
Quantity
per week
Pricing In The Very Short Run
Price
S
If the demand curve increases there is
excess demand at P1.
To ration the quantity available, price
must rise to P2.
P2
P1
D’
D
Q*
Quantity
per week
Short-Run Supply
• Assume that the number of firms in the market is fixed: no
new entry or exit.
• Existing firms can respond to changes in demand by
increasing or decreasing their quantity supplied.
Short-Run Supply
Firm A
Firm B
Price
Price
Market
Price
S
SA
SB
P1
q1A
q1B
Q Output
Short-Run Price Determination
P
SMC
P
P
S
SAC
P1
d
D
Q
Typical Firm
Q1
The Market
Q
Q
Typical Person
Short-Run Price Determination
P
SMC
P
P
S
SAC
P1
P1
d
D
q1
Typical Firm
Q
Q1
The Market
Q
q1
Typical Person
Q
Short-Run Price Determination
• Price serves two functions
• It acts as a signal to producers: given some price they maximize
profits where P = SMC
• It rations demand. Given some price consumers buy the amount
that will maximize their utility
• Note that both producers and consumers are content with the
outcome.
Short-Run Price Determination: What Happens When
Demand Changes
P
SMC
P
P2
SAC
P1
P1
P
S
d’
D’
d
D
q1 q2
Typical Firm
Q
Q 1 Q2
The Market
Q
q1 q2
Typical Person
Q
Shifts in Supply and Demand Curves
• Demand shifts when:
• Income increases and the good is normal
• Income increases and the good is inferior
• The price of a substitute rises
• The price of a complement falls
• Preferences for a good change
Shifts in Supply and Demand Curves
• Reasons for a shift in supply:
• Input prices falls
• Technology improves
Shifts in Supply
Price
Price
S’
S’
S
S
P’
P
P’
P
D
D
Q’
Q
Quantity
per week
Q’ Q
Quantity
per week
The change in price and quantity depend on the elasticity of demand
Shifts in Demand
S
Price
Price
S
P’
P’
P
P
D’
D’
D
D
Q Q’
Quantity
per week
Q
Q’
Quantity
per week
The change in price and quantity depend on the elasticity of supply
16
LR or SR equilibrium?
Price
Price
MC
π1
ATC
S
pe
pe
D
0
q1e
FIRM 1
0
Q
Market
The Long Run
• In the long run supply adjusts through
• Firms adjust all input.
• Firms can enter or exit the industry.
• How does the LR Supply look like?
• Changes in price cause changes in quantity supplied
• We change price by shifting demand
• We examine the quantity produced by the industry after both
adjustments take place and an (LR) equilibrium is reached
The Long Run Equilibrium conditions
• Profit Maximization
• Each firm maximizes profits by producing q where P = MC.
• Market clearing:
• Price, P, equates QS and QD
• Entry and Exit
• no further changes in the number of firms, n, since firms have
entered or exited the industry
• There are no extra costs to enter or exit the industry.
• If there are economic profits in the short run, new firms will enter. This
will increase supply, push down the market price and reduce profits.
• If there are economic losses in the short run, firms will exit. This will
decrease supply, push the price up and eliminate the economic losses.
• P=min ATC
19
Long Run Supply
• In the short run
• Supply is upward sloping
• The long run supply can be
• Flat
• Upward sloping
• Downward sloping
• The shape of the LR supply will depend on how
entry/exit affects the costs of production
20
Dynamic Changes in Market Equilibria
• Constant-cost industries
• Entry of new firms has no impact on the cost of prodution
• The LRAC is unaffected
• Flat long-run supply curve
21
Constant-cost industries
Price
Cost
Long-run
supply curve
SRMC
S1
SRAC
S2
b
pb
LRAC
a
pa
D2
D1
0
Quantity
0
Quantity
With constant costs, the long-run response to an increase in demand re-establishes
the original price of pa.
22
Increasing-cost industries
• As new firms enter
• Cost of inputs increase
• LRAC curves – shift up
• Pecuniary externality
• Action of one agent
• Upward sloping long-run supply curve
23
Increasing-cost industries
Price
Cost
Long-run
supply curve
LRAC2
LRAC1
S1
S3
b
c
pb
pc
pa
a
D2
D1
0
Quantity
0
With increasing costs, the long-run response results in a higher price
Quantity
24
Decreasing-cost industries
• Downward sloping long-run supply curve
• As new firms enter
• Decrease costs of inputs
• Economies of scale in making inputs
• Subsidiary services develop
• LRAC curves – shift down
25
Decreasing-cost industries
Price
Cost
Long-run
supply curve
LRAC1
S1
LRAC2
b
S2
pa
pc
a
c
D2
D1
0
Quantity
0
With decreasing costs, the long-run response results in a lower price.
Quantity
Consumer and Producer Surplus
• Consumer surplus is the extra value individuals receive
from consuming a good over what they pay for it. What
people are willing to pay for the right to consume a good
at its current market price.
• Producer surplus is the extra value producers receive for
a good in excess of the opportunity costs they incur by
producing it. What all producers would pay for the right to
sell a good at its current market price.
Consumer and Producer Surplus
Total value to consumers
from buying Q* units.
Price
A
S
Total expenditure by
consumers.
P*
Consumer Surplus
D
B
Q*
Quantity
per period
Consumer and Producer Surplus
Total revenue earned by firms
Minimum amount necessary to
produce Q* units.
Price
A
S
Producer surplus
P*
D
B
Q*
Quantity
per period
Consumer and Producer Surplus
• In the short run, producer surplus reflects both actual
profits in the short run and all fixed costs.
• It is a measure of how much firms gain by participating in
the market rather than shutting down.
• In the long run, producer surplus measures all of the
increased payments relative to the situation in which the
industry produces no output.
• Ricardian Rent – long run profits earned by owners of
low-cost firms. These rents may be capitalized into the
prices of the resources.
Economic Efficiency
• In what sense is a competitive market efficient?
• Economically efficient allocation of resources is one in
which the sum of consumer and producer surplus is
maximized. It reflects the best use of societies resources.
• At market equilibrium there are no more mutually
beneficial exchanges.
Economic Efficiency
Suppose only Q1 units are produced.
Price
A
There is a loss in total surplus.
S
P*
D
B
Q1
Q*
Quantity
per period
Economic Efficiency
Price
A
At Q1, consumers are willing to pay P1 and
producers are willing to accept P2:
mutually beneficial exchange possible.
S
P1
P*
P2
D
B
Q1
Q*
Quantity
per period
Some Applications: Tax Incidence
• Tax incidence considers the burden of a tax after
considering all market reactions to it.
• Suppose a fixed per unit tax is imposed on all firms.
Although the firms are legally obligated to pay the tax to
the government, who actually end up paying?
Tax Incidence in the Short Run: Constant
Costs
(b) The Market
(a) Typical Firm
Price
Price
Consumer pays
S
MC
AC
P3
P1
P2
Tax
Firm keeps after tax
D’
q2
q1
Output
Q2 Q1
D
Quantity
per week
Tax Incidence in the Short Run: Constant
Costs
• So in the short run, the tax is borne by consumers and
producers:
• P3 > P1 > P2 and P3 – P2 = tax
• What will happen in the long run?
• Since P2 < AC, there are economic losses. Some firms will exit,
which will reduce supply and cause the price to rise. Exit will
continue until the price has risen by the full amount of the tax.
Tax Incidence in the Long Run: Constant Costs
(b) The Market
(a) Typical Firm
Price
Price
MC
AC
S’
S
P4
P3
Tax
P1
P2
Tax
D’
q2
q1
Output
Q3 Q2 Q1
D
Quantity
per week
Long Run Incidence: Increasing Costs
Price
S
P2 is the price retained by firms after
paying tax.
P3
CONSUMER
BURDEN
TAX
P1
REVENUE
FIRM
P2 BURDEN
P3 is the full price paid by the
consumer.
Deadweight loss.
Tax
D’
Q2
Q1
D
Quantity
per week
Summary of Tax Incidence
• In a constant cost industry the burden of the tax falls fully
on consumers in the long run.
• In an increasing cost industry, the burden of the tax is
shared between consumers and producers.
• The relative burden will depend on the elasticity of demand and
supply.
• If demand is relatively inelastic and/or supply elastic, demanders
will pay a relatively larger share of the tax.
• Since taxation reduces output compared to what normally
would occur, there is a deadweight loss and a loss of
efficiency.
Recap I
• The short run supply curve, which represents the decisions of price taking
firms is positively sloped since the firms’ marginal costs curves are
positively sloped.
• At the equilibrium price the quantity supplied is exactly equal to the
quantity demanded.
• The effects of shifts in supply and/or demand on price will depend on the
shapes of both curves.
• Economic profits will attract new firms and shift the supply curve outward.
Economic loss will cause some firms to leave the industry and shift the
supply curve inward. This will continue until economic profits are zero in
the long run.
Recap II
• The long run supply curve is horizontal when the entry of new firms has
no effect on input prices. The long run supply curve is increasing if the
entry of new firms causes input prices to rise.
• As long as there are no market imperfections, the sum of producer and
consumer surplus (welfare) is maximized under perfect competition.
• In a constant cost industry the incidence of the tax will fall completely on
the consumer in the long run. In an increasing cost industry the incidence
of the tax will fall on both the consumer and the producer and will depend
on the elasticity of demand and supply.
• A tariff will lead to a transfer of surplus from consumers to produces and a
welfare loss.