© 2009 Pearson Education Canada 8/1 Chapter 8 The Theory of Perfect Competition

© 2009 Pearson Education Canada 8/2 A Competitive Model of exchange  In an exchange economy, goods are exchanged but not produced.  Reservation price is the maximum amount a person is willing to pay for a good.  Market demand & market supply functions give the total number of units demanded & supplied at a given price.

© 2009 Pearson Education Canada 8/3 Figure 8.1 Demand and supply

© 2009 Pearson Education Canada 8/4 From Figure 8.1  All individuals supply/demand only one unit of the good and their individual demand/supply curves are given by their reservation willingness to pay for a good.  The decision to be “in” or “out” of the market is called the extensive margin.

© 2009 Pearson Education Canada 8/5 Figure 8.2 Competitive equilibrium in an exchange economy

© 2009 Pearson Education Canada 8/6 From Figure 8.2  Imagine there is a Walrasian auctioneer who acts as a price setter.  If quantity demanded/supplied at the announced price exceeds quantity supplied/demanded there is excess demand/supply.

© 2009 Pearson Education Canada 8/7 From Figure 8.2  The auction ends in a competitive equilibrium only when quantity demanded equals quantity supplied.  This competitive allocation is Pareto- optimal or efficient.

© 2009 Pearson Education Canada 8/8 The Function of Price  In a market economy, prices are the signal that guide and direct allocation.

© 2009 Pearson Education Canada 8/9 The Assumptions of Perfect Competition 1. Large Numbers : No individual demander or supplier produces a significant proportion of the total output. 2. Perfect Information : All participants have perfect knowledge of all relevant prices and technology. 3. Product Homogeneity : In any given market, all firms’ products are identical. 4. Perfect Mobility of Resources (Inputs). 5. Independence : Individual consumption and production decisions are independent of all other consumption/production decisions.

© 2009 Pearson Education Canada 8/10 Firm’s Short-run Supply Decision  A firm’s profit ( π) is its total revenue (TR) minus short-run total costs (STC).  The profit function is expressed as: π (y) = TR(y)-STC(y) π (y) = TR(y)-STC(y)  Profit is maximized at y *, as a function of the exogenous variable price (p).  The slope of the profit function with respect to output is zero at y *.

© 2009 Pearson Education Canada 8/11 Figure 8.4 Profit maximization

© 2009 Pearson Education Canada 8/12 Marginal Revenue and Marginal Cost  The slope of the total revenue function is marginal revenue (MR).  The slope of the total cost function is marginal cost (MC).  The firm will maximize profits by equating MR & MC:  SMC(y * )=MR=p

© 2009 Pearson Education Canada 8/13 Figure 8.5 The competitive firm’s supply function

© 2009 Pearson Education Canada 8/14 From Figure 8.5  Short-run profit maximization requires SMC(y * )=MR=p, subject to two qualifications: 1. SMC is rising. 2. p>minimum value of AVC.

© 2009 Pearson Education Canada 8/15 Profit Maximization  Profit can be expressed as: π (y * ) = y * [p-SAC(y)] Where: p-SAC(y) is profit per unit of y

© 2009 Pearson Education Canada 8/16 Figure 8.6 The profit rectangle

© 2009 Pearson Education Canada 8/17 Figure 8.7 Aggregating demand

© 2009 Pearson Education Canada 8/18 Figure 8.8 Aggregating supply

© 2009 Pearson Education Canada 8/19 Figure 8.9 Short-run competitive equilibrium

© 2009 Pearson Education Canada 8/20 Efficiency of the Short-Run Competitive Equilibrium  The short-run equilibrium shown in Figure 8.9 is considered to be efficient because it maximizes consumer surplus and producer surplus.  The sum of consumer surplus and producer surplus, known as total surplus, is a measure of the aggregate gains from trade realized in this market.

© 2009 Pearson Education Canada 8/21 Long-Run Competitive Equilibrium  There are two conditions of long- run equilibrium: 1. No established firm wants to exit the industry. 2. No potential firm wants to enter the industry.

© 2009 Pearson Education Canada 8/22 Long-Run Competitive Equilibrium  Positive profit is a signal that induces entry, or allocation of additional resources to the industry.  Losses are a signal that induces exit, or the allocation of fewer resources to the industry.  In long-run equilibrium, price equals the minimum average cost which is the efficient scale of production.

© 2009 Pearson Education Canada 8/23 Figure 8.10 Exit, entry, and long-run competitive equilibrium

© 2009 Pearson Education Canada 8/24 Figure 8.11 The firm in long-run competitive equilibrium

© 2009 Pearson Education Canada 8/25 Long-Run Supply Function  The long-run competitive equilibrium is determined by the intersection of LRS and the demand function.  Deriving LRS incorporates changes in input prices that arise as industry-wide output expands.  These changes determine whether the industry is a constant, increasing, or decreasing cost industry.

© 2009 Pearson Education Canada 8/26 Figure 8.12 LRS in the constant-cost case

© 2009 Pearson Education Canada 8/27 Figure 8.13 LRS in the increasing-cost case