Models of Competition Part I: Perfect Competition Agenda: What is Competition? Assumptions underlying perfect competition Optimal production quantity, or where do supply curves come from? A. Short run 1. One firm 2. Market B. Long run IV. The market for Garden Gnomes! A. Technological innovations B. Taxes Go back to birds and bees…

What does “competition” mean to you? Scarcity – both parties can’t have the same thing At least two parties “a fair fight” – rules, referee, “reciprocity” (Ouchi) Can be either short or long term

What happens when we violate these assumptions… Assumptions that Underlie Perfect Competition Firms sell standardized products (commodities). 2. Firms are all price takers: no one firm’s actions can “move the market.” 3. There is free entry and exit of firms with perfectly mobile factors of production (capital and labor) in the long run. 4. Firms and consumers have perfect information. What happens when we violate these assumptions…

Costs & Revenues Review What is on the X and Y axis? Is this a long-run or short run picture? MR=MC Max Profit! What does the slope of the total revenue line reflect? What do the intersection points reflect? What does a line tangent to the TC curve reflect? Is this a short-run or long-run picture? What is the slope of the total revenue line? What do the intersection points tell you? What does the point where the line tangent to the TC curve with the same slope as the TR curve reflect?

Short-run Individual firm supply curve Individual Firm Supply Decisions Is this a long-run or a short-run graph? At what point does a firm break even? At what point should a firm shut down? Price = Marginal Revenue = Marginal Cost Short-run Individual firm supply curve Why not here?? Have to link this graph to the assumptions. What if price is here? Economic loss! Shutdown! MR=MC on the rising part of the MC curve!

The market supply is simply the sum of the individual firm supplies! Market Supply Curve The market supply is simply the sum of the individual firm supplies! Firm Supply curve: Quantity: Industry Supply: 100 firms each have identical supply curves: P = 5 + 200Q What is the industry supply curve? Vocabulary: note the difference between supply = Q and supply curve, which is a function P = f(Q) A SUPPLY CURVE IS A FUNCTION THAT MAPPS QUANTITY TO PRICES Supply = quantity Need to sum quantities! Solve for Q Multiply by n Solve for P TEST YOURSELF: What if firms did NOT have identical supply curves?

Short Run Producer Surplus ATC PL You can have a producer surplus and an economic loss Market Supply Curve Different consumers have different marginal benefits You can have both a producer surplus AND an economic loss! Allocative efficiency: no consumer will buy more, no producer will produce more at any other price. PARETO OPTIMAL Different firms have different minimum marginal costs

What Happens in the Long-Run in the Market? Shift in Supply Producer surplus attracts more supply More supply shifts the supply curve The shift in the supply curve causes a decline in price but a higher equilibrium quantity. Movement along the supply curve A decline in price without a shift in supply would be a movement along the supply curve and result in a lower equilibrium quantity. Q1 Q2 What Happens in the Long-Run in the Firm? AFTER market prices decline (see above) The new price intersects with long-run marginal cost at a lower quantity. If the new price is below the firm’s short-run average variable cost it will shutdown! Firms still in business will have lower ATC curves Each firm produces less even though the market supplies more.

Long-Run Competitive Equilibrium All firms produce identically at LMC=LAC=SMC=ATC=Price Do firms earn economic profits in the long run? Is there producer surplus in the long run?

Is there producer surplus in the long run? Supply when input prices do NOT vary with output quantity. Long-run supply price=MC=LAC No producer surplus! Supply when input prices INCREASE with output quantity. Recall definition of producer surplus: the difference between price and marginal cost. When the price = marginal cost there is no producer surplus. There may still be economic rents, but these are embedded in the marginal costs of production. Supply curve slopes up, But still no producer surplus! Why?

Price Elasticity of Supply The percent change in quantity supplied as a result of a change in market price If the cost of inputs does not change with quantity, then the supply curve will be horizontal and the elasticity will be zero (technically undefined) Another way to think about horizontal supply curves in a perfectly competitive market

Example: Garden Gnomes Market demand: QD = 6500 -100P Market supply: QS = 1200P FIRM total cost: C(q) = 722 + q2/200 FRIM marginal cost: MC(q) = 2q/200 = q/100 QD=QS P = $5 Q = 6,000 1. What is the equilibrium price and quantity for the MARKET? P = MR = MC(q) Q (firm) = 500 2. What is the amount supplied by the FIRM? 3. If all firms have the same cost structure, how many firms will be in this market? 4. What is the profit (loss) for the FIRM? TR – TC = $528 5. What is the producer surplus for the FIRM? P*Q – AVC*Q =$1,250 6. Would you want to go into the Garden Gnome industry? Yes! Why? AVC = $2.50 7. What is the lowest price you would sell your 500 Garden Gnomes for in the short run?

Garden Gnomes Continued… What would be the effect on equilibrium supply and demand in the short term if you develop a new manufacturing technology that reduces your marginal costs? FIRM total cost: C(q) = 722 + q2/400 FRIM marginal cost: MC(q) = 2q/400 = q/200 Test Yourself: What is the new producer surplus and profit? 11(100P) + 200P = 1300P 11 firms have the old cost structure, and 1, you, have the new cost structure. What is the market supply? QS = 1300P What is the new market equilibrium supply and demand Price and Quantity Recall: Market demand: QD = 6500 -100P P = $4.64 Q = 6,036

Garden Gnomes Continued… What if you could NOT get a patent for your new technology (assuming no new entry of firms)? FIRM total cost: C(q) = 722 + q2/400 FRIM marginal cost: MC(q) = 2q/400 = q/200 Market demand: QD = 6500 -100P P=Q/ 200 Q = (200P)*12 firms Q= 2400P 1. What is the new market supply? 2. What is the new market equilibrium price and quantity? 2400P=6500-100P P=$2.60 Q = 6,240 3. What is the producer surplus and profit for each firm? Q = 6,240/12 = 520 AVC = 520/400 = $1.30 Profit: 520*$2.60-722-520*$1.30 =-$46 PS = 520*(2.6-1.3)= $520

Garden Gnomes Continued… Would the market equilibrium price and quantity change if you were to reduce your fixed costs to $500? Market demand: QD = 6500 -100P Market supply: QS = 2400P FIRM total cost: C(q) = 500 + q2/400 FRIM marginal cost: MC(q) = 2q/400 = q/200 Test yourself: Will your producer surplus change? Will your profit change?

Garden Gnomes Continued… What if the government imposes a tax of $1 per gnome? Market demand: QD = 6500 -100P Market supply: QS = 2400P FIRM total cost: C(q) = 500 + q2/400 FRIM marginal cost: MC(q) = 2q/400 = q/200 What is the equilibrium price received by the supplier, paid by the consumer and equilibrium quantity? KEY: The price paid by the consumer is NOT the same as the price received by the supplier! 6500 – 100(Ps+$1) = 2400Ps Ps = $2.56 Pd = $3.56 Q = 6,144

Garden Gnomes Continued… What if the government imposes a tax of $1 per gnome? Market demand: QD = 6500 -100P Market supply: QS = 2400P FIRM total cost: C(q) = 500 + q2/400 FRIM marginal cost: MC(q) = 2q/400 = q/200 price Long-run supply P3 P = MC + T P2 With a patent – market power. P = MR = MC with any demand left-over going to remaining competitors who will charge higher prices. If your market power is great enough you may become a monopoly! Without a patent – everyone copies you and P = MR = MC at the new lower MC If you only change fixed costs, no impact on the market – remember producer surplus does not equal profit and producer surplus is based on variable costs! P = MC P1 Dead-weight loss Effective price to producers Causes market exit! Quantity

Externalities & Goods that are NOT Commodities But Wait…. Externalities & Goods that are NOT Commodities Move this to imperfect competition

Price = minimum marginal benefit = minimum marginal cost Summary 1. IF the assumptions underlying perfect competition hold then the MARKET PRICE is all the information you need to know about both supply and demand. Price = minimum marginal benefit = minimum marginal cost 2. IF the assumptions underlying perfect competition hold then in the long run there is NO producer surplus and NO economic profit. Price = long-run marginal cost = long-run average cost 3. IF the assumptions underlying perfect competition hold then in the long run ALL firms produce the same quantity at the same cost. Point #4 goes back to Point #1 – why? Price = LMC=LAC=SMC=SAC 4. IF the assumptions underlying perfect competition hold then the long-run equilibrium is PARETO OPTIMAL. But NOT SOCIALLY OPTIMAL when we consider externalities and non-commodities