Perfect Competition - Performance Dr. Jennifer P. Wissink ©2011 John M. Abowd and Jennifer P. Wissink, all rights reserved.

Perfectly Competitive Market Long Run Equilibrium lratc q q* Q* P* mr*=δ* SRS w/N* D Q A a typical firm MARKET $

Long Run Performance Measures What would Zeus want if he were an omnipotent benevolent all knowing social planner? Efficiency: Pareto/Allocative Efficiency An allocation, QPE is Pareto Efficient if no participant in the market can be made better off (feasibly) without making at least one other participant worse off. That is, at QPE net social surplus (NSS) in the market is maximized. NSS = $TBsociety - $TVCsociety When NSS is maximized, $MBsociety = $MCsociety Productive Efficiency Each firm operates at, at least, minimum efficient scale. Each firm operates at the minimum of its long run average total cost curve, or qpe ≥ qmes. Equity: Is the allocation fair? Equitable? Just? Good question that we do not answer here and now.

Will Long Run Market Equilibrium Under Perfect Competition Be Efficient? Is Q* Pareto Efficient? YES! Is q* productively efficient? YES! lratc q q* Q* P* mr*=δ* SRS w/N*=MCsociety D=MBsociety Q A a typical firm MARKET $

The Invisible Hand Adam Smith called the resource allocation efficiency of competitive markets the “invisible hand.” Even though all participants are only trying to improve their own welfare, the result is that the welfare of the entire market (economy) is maximized. Competitive markets allocate goods to the buyers and sellers that have the highest marginal benefits and lowest marginal costs, respectively.

Competitive Markets are Pareto Efficient Because: Quantity demanded equals quantity supplied. Demand represents marginal benefit. All those with willingness to pay greater than or equal to the market price buy. No one else buys. Supply represents marginal cost. All those with seller’s cost less than or equal to the market price sell. No one else sells. All transactions occur at the market price. So, all consumers pay the same price (the market price). And, all producers receive the same price (the market price). There is no transaction among the buyers and sellers that improves the welfare of at least one person without reducing the welfare of at least one other person.

Market Equilibrium The long run market equilibrium occurs at P* & Q*. Consumers’ surplus is the blue shaded area Producers’ surplus is the red shaded area Net social surplus is the blue and red shaded area P Short Run Supply=MC P* Demand=MB Q* Quantity

First Fundamental Theorem of Welfare Economics Modern economists refer to the invisible hand as the first fundamental theorem of welfare economics. If there is a market for every good, and if all markets are competitive (buyers and sellers are price takers), then the competitive equilibrium is Pareto efficient (also called “Pareto optimal”).

Second Fundamental Theorem of Welfare Economics Economists have also established a second property of competitive markets, called the second fundamental theorem of welfare economics. Any Pareto efficient outcome can be achieved as a competitive equilibrium provided that all redistributions are accomplished by lump-sum transfers of wealth.

Why We Study Welfare Economics The invisible hand property of competitive markets provides the justification for using economic competition as the benchmark against which we measure the efficiency and viability of other social institutions for coordinating production and consumption. The second fundamental theorem, although virtually impossible to implement, shows that competitive markets also provide the benchmark for measuring the efficiency and viability of governmental programs designed to redistribute wealth or income. Recommended Reading: