Lecture 8: Competitive Markets
I.
Producer Surplus in the Short Run
A. Producer Surplus for the Firm

P.S.Firm = sum of (P – MC) for each unit produced.

Firm earns surplus on all but the last unit produced
(where P = MC).

Graphical Example:
1.
Alternative Calculation:
P.S . Firm  R  VC
because
sum of MC  TC q *  TC 0   TC  FC  VC
B.
II.
Producer Surplus for a Market
Supply in the Long Run
A. Long –Run Profit Maximization – P* = MCLR
 MCLR represents the optimal scale of production for each long-term (i.e. stable) price.
B.
Long-Run Competitive Equilibrium
1. Necessary Conditions for Long-Run Equilibrium
C. All firms are maximizing profits.
i) All firms are earning zero economic profits.
→ No entry or exit
ii) At the market price (P*), quantity demanded = quantity supplied.
D. Zero Economic Profit
 In each firm, inputs are earning just as much as they would if invested anywhere else.
 Firm is getting a normal return on capital investment.
 Firm is producing at the minimum of the long-run average cost curve.
1.
Market Mechanism: Entry and Exit
i) If an Industry has positive profits: firms enter since other industries are at
zero profits
ii) With entry, the market supply curve shifts out.
→ decreases price and increases quantity
iii) This process continues until all the firms earn zero profits.
→ P decreases until it is tangent to ACLR.at its minimum.
2.
Economic Rent
 It is possible for a firm to have zero economic profits but a positive accounting
profit.
o Occurs when a firm owns scarce factors of production.
 Definition:
Economic Rent = Positive Accounting Profits
= Amount firms would pay for an input – actual cost to obtain it.
 Positive Accounting Profits does not induce entry because the scarce input is
not available to other firms.
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III.
Industry Long-Run Supply Curve
 When calculating the short-run supply curve, we did not have to consider entry and
exit.
→ This will make the calculation of the long-run supply curve different.
→ Shape of the long-run supply curve reflects changes in input prices.
 3 Types of Long-Run Supply Curves:
1) Constant-Cost Industry
2) Increasing –Cost Industry
3) Decreasing Cost Industry
1.
The Process
 Start at equilibrium.
 Shift Demand Outward.
→ temporary increase in P from P 1 to PT
→ Existing firms increase production.
→ Firms are also now making positive profits.
 Shift in Supply
→ Firms enter the market because of the positive profits.
→ Existing firms expand production.
→ Results in increased demand for inputs.
→ The input markets’ response will determine what kind of cost industry and the
shape of the supply curve.
1) Constant-Cost Industry: input prices do not change.
→ All firms return to the original minimum ACLR.
2)
Increasing-Cost Industry: input prices increase.
→ All firms end up at a higher than original minimum AC LR.
3)
Decreasing-Cost Industry: input prices decrease.
→ All firms end up at a lower than original minimum AC LR.
I.
A.
Analysis of Competitive Markets: Tax Problem
Overview of Tax Issues
1. Main Questions:
2.
a.
Who shoulders the burden of a tax?

Both consumers and producers

Share of the burden is dependent on the relative elasticities of demand
and supply
b.
How does the market price change in response to the tax?

By what proportion of the tax?
Types of Taxes
a.


Ad Valorem Tax
The tax is a percent of the price of the item.
Sales Tax
b.


Specific Tax
Tax (t) = the amount paid to the government for every item sold.
Implies 2 prices in the market:
1) PBuyer
2) PSeller
The prices relate through the tax:

PBuyer  PSeller  t
3.
Welfare Effects of a Specific Tax

CS decreases by A + B.


PS decreases by C + D
Tax Revenue:
i)
Consumer’s share is A
ii) Producer’s share is D
iii) Tax Revenue = A + D
Deadweight Loss = B + C
