Chapter 14

Equilibrium and Efficiency

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

Market Demand and Supply

Market demand for a product is the sum of the demands of all individual consumersGraphically, this is the horizontal sum of the

individual demand curvesMarket supply of a product is the sum of the

supply of all the individual sellersGraphically this is the horizontal sum of the

individual supply curvesVery similar to the procedure for constructing market

demand curves

Figure 14.1: Market Demand

Figure 14.2: Market Supply

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

Figure 14.4: Long-Run Supply

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

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

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)

Figure 14.7: Response to an Increase in Demand

Garden Benches per Month

Pri

ce (

$/b

ench

)

4000

P* = ACmin

D

2000

D̂

S10

C

B

A

= 100

S∞

Initial LE Equl

New SR Equl

Figure 14.7: Response to an Increase in Demand

Garden Benches per Month

Pri

ce (

$/b

ench

)

4000

P* = ACmin

D

2000

D̂

S10

C

B

A

= 100

S∞

The importance of free entry assumption

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

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

Responses to Changes in Variable Cost

Start from a long-run equilibriumIf variable costs change, firm’s marginal and

average cost curves both shiftShort-run supply curve shiftsSort-run equilibrium changes

Basic procedure in all cases:Find new short-run equilibrium using new short-run

supply curve of initially active firmsFind new long-run equilibrium using new long-run

supply curve which reflects free entry

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

Figure 14.11: Price Changes in the Long-Run

Garden Benches per Month

Pri

ce (

$/b

ench

)

4000

ACmin=100

D

2000

D̂

S10

C

B

AS∞

S∞^EACmin=110^

In LR: increase in D leads to P increases (input cost increases)

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

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

Effects of a Change in Who Consumes the Good

Begin from the competitive equilibriumTake one unit of the good from Consumer A

and give it to Consumer BCannot 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

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

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

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 quantityWhen 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 quantityWhen all producers face the same market price

Figure 14.18: Measuring Total Willingness to Pay

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 maximizedNo deadweight loss: reduction in aggregate

surplus below its maximum possible value

Consumer and Producer Surplus

Consumer surplus is the sum of consumers’ total willingness to pay less their total expenditureSum of individual consumers’ surplusesAlso called aggregate consumer surplus

Producer surplus is the sum of firms’ revenues less avoidable costsSum of individual firms’ producer surplusesAlso called aggregate producer surplus

Aggregate surplus = Consumer surplus + Producer Surplus

Figure 14.19: Aggregate, Consumer, and Producer Surplus