© 2008 Pearson Addison Wesley. All rights reserved Review Perfect Competition Market

Competition Competition is a common market structure that has very desirable properties, so it is useful to compare other market structures to competition. © 2008 Pearson Addison Wesley. All rights reserved. 8-2

Price Taking Economists say that a market is competitive if each firm in the market is a price taker: a firm that cannot significantly affect the market price for its output or the prices at which it buys its inputs. © 2008 Pearson Addison Wesley. All rights reserved. 8-3

© 2008 Pearson Addison Wesley. All rights reserved. 8-4 Figure 8-3 How a Competitive Firm Maximizes Profit

© 2008 Pearson Addison Wesley. All rights reserved. 8-5 Figure 8.4 The Short-Run Shutdown Decision

Short-Run Firm Supply Curve Tracing Out the Short-Run Supply Curve –The competitive firm’s short-run supply curve is its marginal cost curve above its minimum average variable cost. © 2008 Pearson Addison Wesley. All rights reserved. 8-6

© 2008 Pearson Addison Wesley. All rights reserved. 8-7 Figure 8.5 How the Profit-Maximizing Quantity Varies with Price

Short-Run Competitive Equilibrium By combining the short-run market supply curve and the market demand curve, we can determine the short-run competitive equilibrium. © 2008 Pearson Addison Wesley. All rights reserved. 8-8

© 2008 Pearson Addison Wesley. All rights reserved. 8-9 Figure 8.9 Short-Run Competitive Equilibrium in the Lime Market

Long-Run Firm Supply Curve A firm’s long-run supply curve is its long-run marginal cost curve above the minimum of its long-run average cost curve (because all costs are variable in the long run). © 2008 Pearson Addison Wesley. All rights reserved. 8-10

© 2008 Pearson Addison Wesley. All rights reserved Figure 8.10 The Short-Run and Long-Run Supply Curves

Role of Entry and Exit The number of firms in a market in the long run is determined by the entry and exit of forms. –A firm enters the market if it can make a long-run profit,  > 0. –A firm exits the market to avoid a long-run loss,  < 0. © 2008 Pearson Addison Wesley. All rights reserved. 8-12

© 2008 Pearson Addison Wesley. All rights reserved Figure 8.12 Long-Run Market Supply in an Increasing- Cost Market

Long-Run Competition Equilibrium The intersection of the long-run market supply and demand curves determines the long-run competitive equilibrium. © 2008 Pearson Addison Wesley. All rights reserved. 8-14

© 2008 Pearson Addison Wesley. All rights reserved Figure 8.14 The Short-Run and Long-Run Equilibria for Vegetable Oil

Properties of the Competitive Model –Zero Profit for Competitive Firms in the Long Run –Competition Maximizes Welfare © 2008 Pearson Addison Wesley. All rights reserved. 9-2

Zero Profit for Competitive Firms in the Long Run Competitive firms earn zero profit in the long run whether or not entry is completely free. © 2008 Pearson Addison Wesley. All rights reserved. 9-3

How Competition Maximizes Welfare How should we measure society’s welfare? One commonly used measure of the welfare of society, W, is the sum of consumer surplus plus producer surplus: W = CS + PS © 2008 Pearson Addison Wesley. All rights reserved. 9-4

© 2008 Pearson Addison Wesley. All rights reserved. 9-5 Figure 9.3 Why Reducing Output from the Competitive Level Lowers Welfare

© 2008 Pearson Addison Wesley. All rights reserved. 9-6 Figure 9.4 Why Increasing Output from the Competitive Level Lowers Welfare

© 2008 Pearson Addison Wesley. All rights reserved Review General Equilibrium of the Perfectly Competitive Model

© 2008 Pearson Addison Wesley. All rights reserved Figure 10.3 Contract Curve

© 2008 Pearson Addison Wesley. All rights reserved Mutually Beneficial Trades Indifference curves are also tangent at Bundles,, and, so these allocations, like, are Pareto efficient. By connecting all such bundles, we draw the contract curve: the set of all Pareto-efficient bundles.

© 2008 Pearson Addison Wesley. All rights reserved Competitive Exchange The First Theorem of Welfare Economics –The competitive equilibrium is efficient: Competition results in a Pareto- efficient allocation—no one can be made better off without making someone worse off—in all markets.

© 2008 Pearson Addison Wesley. All rights reserved Competitive Exchange The Second Theorem of Welfare Economics –Any efficient allocations can be achieved by competition: All possible efficient allocations can be obtained by competitive exchange, given an appropriate initial allocation of goods.

© 2008 Pearson Addison Wesley. All rights reserved Figure 10.4(a) Competitive Equilibrium

© 2008 Pearson Addison Wesley. All rights reserved The Efficiency of Competi tion The first welfare theorem tells us that society can achieve efficiency by allowing competition. The second welfare theorem adds that society can obtain the particular efficient allocation it prefers based on its value judgments about equity by appropriately redistributing endowments (income).

© 2008 Pearson Addison Wesley. All rights reserved Efficient Product Mix Optimal Product Mix. –The optimal product mix,, could be determined by maximizing an individual’s utility by picking the allocation for which an indifference curve is tangent to the production possibility frontier. –It could also be determined by picking the allocation where the relative competitive price,, equals the slope of the PPF.

© 2008 Pearson Addison Wesley. All rights reserved Figure 10.6 Optimal Product Mix

© 2008 Pearson Addison Wesley. All rights reserved Efficient Product Mix The marginal rate of transformation along this smooth PPF tells us about the marginal cost of producing one good relative to the marginal cost of producing the other good.

© 2008 Pearson Addison Wesley. All rights reserved Competition Each price-taking consumer picks a bundle of goods so that the consumer’s marginal rate of substitution equals the slope of the consumer’s price line (the negative of the relative prices):

© 2008 Pearson Addison Wesley. All rights reserved Competition If candy and wood are sold by competitive firms, and in the competitive equilibrium, the MRS equals the relative prices, which equals the MRT:

© 2008 Pearson Addison Wesley. All rights reserved Competition Because competition ensures that the MRS equals the MRT, a competitive equilibrium achieves an efficient product mix: The rate at which firms can transform one good into another equals the rate at which consumers are willing to substitute between the goods, as reflected by their willingness to pay for the two goods. In this competitive equilibrium, supply equals demand in all markets. The consumers buy the mix of goods at.

© 2008 Pearson Addison Wesley. All rights reserved Figure 10.7 Competitive Equilibrium

© 2008 Pearson Addison Wesley. All rights reserved Efficiency and Equity Role of the Government –By altering the efficiency with which goods are produced and distributed and the endowment of resources, governments help determine how much is produced and how goods are allocated. –By redistributing endowments or by refusing to do so, governments, at least implicitly, are making value judgments about which members of society should get relatively more of society’s goodies.