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Chapter 8 The Theory of Perfect Competition. 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.
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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.
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.
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.
From Figure 8.2 • The auction ends in a competitive equilibrium only when quantity demanded equals quantity supplied. • This competitive allocation is Pareto-optimal orefficient.
The Function of Price • In a market economy, prices are the signal that guide and direct allocation.
The Assumptions of Perfect Competition • Large Numbers: No individual demander or supplier produces a significant proportion of the total output. • Perfect Information: All participants have perfect knowledge of all relevant prices and technology. • Product Homogeneity: In any given market, all firms’ products are identical. • Perfect Mobility of Resources (Inputs). • Independence: Individual consumption and production decisions are independent of all other consumption/production decisions.
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) • 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*.
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
From Figure 8.5 • Short-run profit maximization requires SMC(y*)=MR=p, subject to two qualifications: • SMC is rising. • p>minimum value of AVC.
Profit Maximization • Profit can be expressed as: π(y*) = y*[p-SAC(y)] Where: p-SAC(y) is profit per unit of y
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.
Long-Run Competitive Equilibrium • There are two conditions of long-run equilibrium: • No established firm wants to exit the industry. • No potential firm wants to enter the industry.
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.
Figure 8.10 Exit, entry, and long-run competitive equilibrium
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.
