Maximizing Market Efficiency: Equilibrium and Competition

1. Chapter 14 Equilibrium and Efficiency

2. What Makes a Market Competitive? • Buyers and sellers have absolutely no effect on price • Three characteristics: • Absence of transaction costs • Product homogeneity: products are identical in the eyes of their purchasers • Presence of a large number of sellers, each accounts for a small fraction of market supply • Consumers have many options and buy from the firm that offers the lowest price • Each firm takes the market price as given and can focus on how much it wants to sell at that price • Few markets are perfectly competitive

3. Market Demand and Supply • Market demand for a product is the sum of the demands of all individual consumers • Graphically, this is the horizontal sum of the individual demand curves • Market supply of a product is the sum of the supply of all the individual sellers • Graphically this is the horizontal sum of the individual supply curves • Very similar to the procedure for constructing market demand curves

4. Figure 14.1: Market Demand

5. Figure 14.2: Market Supply

6. Short-Run vs. Long-RunMarket Supply • Long-run and short-run market supply curves may differ for two reasons: • Firm’s short-run and long-run supply curves may differ • Over time, set of firms able to produce in a market may change • Long-run supply curve is found by summing supply curves of all potential suppliers • Free entry in a market implies that anyone who wishes to start a firm has access to the same technology and entry is unrestricted • With free entry, the number of potential firms in a market is unlimited • Long-run market S curve is a horizontal line at ACmin

7. Figure 14.4: Long-Run Supply

8. Figure 14.5: Market Equilibrium • At equilibrium price, Qs=Qd • Market clears at equilibrium price • Given demand and supply functions, can use algebra to find the equilibrium

9. Figure 14.6: LR Competitive Equilibrium • Equilibrium price must equal ACmin • Firms must earn zero profit • Active firms must produce at their efficient scale of production

10. Responses to Changes in Demand • Market response is different in short-run (number of firms is fixed) than in long-run (with free entry) • Begin from a point of long-run equilibrium (point A), suppose demand curve shifts out • In short run, new equilibrium is achieved through movement along the short-run supply curve (point B) • Price rises • In LR, firms enter the market • New equilibrium brings return to initial price but at a higher quantity (point C)

11. ^ Figure 14.7: Response to an Increase in Demand D New SR Equl S10 Price ($/bench) B A C S∞ P* = ACmin = 100 D Initial LE Equl 2000 4000 Garden Benches per Month

12. ^ Figure 14.7: Response to an Increase in Demand D The importance of free entry assumption S10 Price ($/bench) B A C S∞ P* = ACmin = 100 D 2000 4000 Garden Benches per Month

13. Responses to Changes inFixed Cost • Start from a long-run equilibrium • Consider the case where fixed costs decrease while variable costs remain the same • In short run: • Average cost curve shifts downward, decreases minimum average cost and minimum efficient scale • Since marginal costs have not changed and number of firms is fixed, equilibrium is unchanged • Active firms make a positive profit • In long-run: • Firms enter market • Market equilibrium shifts, price falls and quantity rises

14. Figure 14.8: Response to a Decrease in FC:Assume FC falls while VC not SR equil LR equil In the SR, firms make profits: P>AVCmin

15. Responses to Changes in Variable Cost • Start from a long-run equilibrium • If variable costs change, firm’s marginal and average cost curves both shift • Short-run supply curve shifts • Sort-run equilibrium changes • Basic procedure in all cases: • Find new short-run equilibrium using new short-run supply curve of initially active firms • Find new long-run equilibrium using new long-run supply curve which reflects free entry

16. Price Changes in the Long-Run • So far we’ve assumed that the prices of firms’ inputs do not change • Reasonable if increases in amounts of inputs used are small compared to overall market • Or when supply in input markets is very elastic • In general, though, when demand for a product increases, prices of inputs used to make it may change • This is a general equilibrium effect; the market we are studying and the market for its inputs must all be in equilibrium • Taking the input price effect into account in the analysis of the market response to an increase in demand changes the result • Price of the good rises in the long run

17. ^ ^ Figure 14.11: Price Changes in the Long-Run D S∞ In LR: increase in D leads to P increases (input cost increases) S10 Price ($/bench) B ^ E ACmin=110 S∞ ACmin=100 A C D 2000 4000 Garden Benches per Month

18. Aggregate Surplus andEconomic Efficiency • Perfectly competitive market produces an outcome that is economically efficient • Net benefits indicate that consumers’ benefit from the goods exceed the costs of producing them • Aggregate surplus equals consumers’ total willingness to pay for a good less firms’ total avoidable cost of production • Total benefits from consumption equal to willingness to pay • Area under consumer’s demand curve up to that quantity • Total avoidable costs of production include all of a firm’s costs other than sunk costs • Area under its supply curve up to its production level

19. Maximizing Aggregate Surplus • Smith’s The Wealth of Nations (1776) commented on the “invisible hand” of the market • The self-interested actions of each individual lead to economic efficiency • “he intends only his own gain, and he is in this…led by an invisible hand to promote an end which was no part of his intention” • No way to increase aggregate surplus in perfectly competitive markets by changing: • Who consumes the good • Who produces the good • How much of the good is produced and consumed • Competitive markets maximize aggregate surplus

20. Effects of a Change in Who Consumes the Good • Begin from the competitive equilibrium • Take one unit of the good from Consumer A and give it to Consumer B • Cannot increase aggregate surplus • Value any consumer attaches to a unit of the good they don’t buy must be less than the market price • Value any consumer attaches to a unit of the good they do buy must be more than the market price • If we take the good from someone who purchased it and give it to someone who didn’t, aggregate surplus must fall

21. Effects of a Change in Who Produces the Good • Changing who produces the good can’t increase aggregate surplus • To achieve this, would have to reassign sales in a way that would lower the total cost of production • Begin from the competitive equilibrium • Reduce sales of Producer A by one unit, increase sales of Producer B by one unit • Cost of producing any unit of output that a firm chooses to sell must be less than the equilibrium price • Cost of producing any unit of output that a firm chooses not to sell must exceed the equilibrium price • Any shift in production from one firm to another must raise the total cost of production and lower aggregate surplus

22. Effects of a Change in the Number of Goods • Changing the total number of units of the good produced and consumed also lowers aggregate surplus • Any unit of a good that is produced and consumed in a competitive market equilibrium must be worth more than the market price to the consumers who buy them • Must also cost less than the market price to produce • Those units of output must therefore make a positive contribution to aggregate surplus • Any units that aren’t produced and consumed should not be; they will lower aggregate surplus

23. Measuring Total WTP andTotal Avoidable Cost • Market demand and supply curves can be used to measure total willingness to pay and total avoidable cost • Measure consumers’ total willingness to pay for the units they consume by the area under the market demand curve up to that quantity • When all consumers face the same market price • Measure producers’ total avoidable costs for the units they produce by the area under the market supply curve up to that quantity • When all producers face the same market price

24. Figure 14.18: Measuring Total Willingness to Pay

25. Aggregate Surplus • Can use market supply and demand curves to measure aggregate surplus • Consumers’ total willingness to pay is area under market demand curve up to the quantity consumed • Producers’ total avoidable cost is the area under the market supply curve up to the quantity produced • In a competitive market without any intervention, aggregate surplus is maximized • No deadweight loss: reduction in aggregate surplus below its maximum possible value

26. Consumer and Producer Surplus • Consumer surplus is the sum of consumers’ total willingness to pay less their total expenditure • Sum of individual consumers’ surpluses • Also called aggregate consumer surplus • Producer surplus is the sum of firms’ revenues less avoidable costs • Sum of individual firms’ producer surpluses • Also called aggregate producer surplus Aggregate surplus = Consumer surplus + Producer Surplus

27. Figure 14.19: Aggregate, Consumer, and Producer Surplus