Perfect Competition Outline Competition and socially efficient resource allocation Structural features of competitive markets The supply curve of the competitive firm Consumer and producer surplus The market for daycare

Socially Optimal Resource Allocation To say that the scheme of resource allocation is “socially optimal” means that a re-allocation of resources could not make any one person better off without making at least one other person worse off.

We can trust market forces to allocate resources in a socially optimal way—that is, if markets are “competitive” in structure. If markets are “imperfectly” competitive in structure, then all bets are off.

Structural features of competitive markets 1.Large number of buyers and sellers 2.No barriers to entry 3.Homogeneous or standardized product 4.Buyers and sellers are “price takers.”

Short run supply curve for the competitive firm Cost per unit Output (Thousands of Units) ATC AVC MC The supply curve for the firm is given by MC above the minimum of AVC.

Demand curve facing the competitive firm Output (Thousands of Units) Revenue per unit P = AR = MR $6 Competitive firm faces an infinitely elastic demand curve at the market determined price

Competitive firm can earn an economic profit in short run

S1S1 S2S2 D Price Quantity Entry shifts the market supply curve to the right $6.50 $8.00 The opportunity to earn an economic profit attracts new firms to the market

Economic profits eroded by entry

Effect of a change in demand before and after entry P = $6 $4 $8 Cost and Revenue per Unit Output (Thousands of Units) E E* E' D' D Supply curve after entry D' D Supply curve before entry 0

The Invisible Hand According to Adam Smith 1, even self-centered people like me are led by the “invisible hand” of competition to promote the best interests of society. 1 Adam Smith. The Wealth of Nations, 1776

What assumptions must one make about the structure of markets to “prove” that the market system produces socially efficient resource allocation? Modern welfare economics has this all worked out.

Why competitive markets are efficient Competitive markets provide efficient amounts of goods and services at minimum cost to the consumers who are most willing (and able) to pay for them. Samuelson and Marks (1999, p. 330).

Consumer and Producer Surplus Consumer surplus (CS) is the difference between the maximum amount the consumer is willing to pay for a given quantity of a good or service rather than go without it and what they actually pay for a given quantity of the good or service. Producer surplus (PS) is the difference between the minimum price a seller would have to get to offer a given quantity of goods and services and the price the seller actually gets for that quantity.

You’re paying $2.69 for a gallon of gas—but I bet you would be willing to pay more rather than go without it. If so, there you derive a surplus on the transaction.

Example: The Demand and Supply of Day Care oThe Palmers are willing to pay a maximum of $8 per hour for daycare (10 hours per day) for their two year old. oA grandmother in the neighborhood is willing to provide the service. Her minimum acceptable fee is $4 per hour.

Daycare transaction If the negotiated price is $6, then each party gets a surplus of $20 per week

The Regional Market for Daycare Blue shaded area shows consumer surplus accruing to all consumers in the market for daycare services if P =$ 4 per hr.

Figure 8.7: A Competitive Daycare Market Q Hours of Day Care (Millions) Hourly Price 2 6 Equilibrium: P C = $2.50 Q C = 9.5 million hours P C = 'Store-bought" day care $4 Grandmothers' day-care supply Regional day- care demand $14 0