Equilibrium and Welfare - cms.phbs.pku.edu.cn

Equilibrium and Welfare

Marshall Urias

Marshall Urias Equilibrium and Welfare 1 / 24

The Competitive Market

We have seen how consumers and producers make decisions in pursuit oftheir own economic interests.

An equilibrium is an outcome where every agents is satisfied with theirdecisions so that there is no incentive to change decisions.

In economics, prices are the key adjustment mechanism to guarantee thatthe demand and supply decisions of economic agents are compatible.


The Competitive Market

Recall that the supply curve for an individual firm is its marginal cost(MC) curve above the minimum of the average variable cost (AVC) curve.


Short-Run Equilibrium

Suppose that there are n identical firms and that all fixed costs are sunk inthe short-run.

The short-run market supply curve, S(p) is the horizontal sum of thesupply curves for each firm

The horizontal part of the supply curve reflects that no output isproduced at a price below the shutdown point, and at a price slightlyabove the shutdown point, all firms produce.

The intersection of the demand curve with the short-run supply curvedetermines the short-run equilibrium price p0. At this price, all firms aresupplying what they want, and all consumers are buying what theywant—equilibrium quantity Q0.





In the short-run, a typical firm may earn a profit, which provides anincentive for firms to enter the market. However, in the short-run entrycannot occur because firms cannot build new plants in the short-run.




Long-Run Equilibrium

In the long-run, firms can adjust their levels of capital so that they canenter the market.

Short-run profits or losses induce firms to enter or leave the market untilthe equilibrium price is driven to the minimum long-run average cost AC .

Remember that entry and exit affects the total supply of goods in themarket which affects the equilibrium price. It is the price that adjusts untileconomic profits are driven to zero in the long-run.

p∗ = AC ∗




Entry and Exit

Entry and exit plays a critical role in determining the market structure andthe subsequent equilibrium and performance of firms.

In many industries, governments or groups of firms collectively setlicensing requirements that restrict entry (e.g. limited taxicabsallowed in Shenzhen...but then Didi).

Barriers to entry is anything that prevents an entrepreneur frominstantaneously creating a new firm in the market (e.g. patent, highnecessary start-up costs, time to form connections with vendors)

Empirical evidence suggests that there is a lot of entry and exit andthat entrants tend to be small. Agriculture, construction, wholesaleand retail trade, and services are generally thought o have easy entryand exit. Manufacturing, mining, and certain regulated industries(insurance and public utilities) have high barriers to entry.


Entry and Exit

Bain (1956) pioneered the approach to analyzing barriers to entry. Heidentified three such barriers:

Absolute cost advantage

Economies of large-scale production that require large capitalexpenditures

Product differentiation



If a very large number of firms could enter the market and produce at thesame cost function, the the long-run supply curve is perfectly flat at AC .

If expansion of output causes the prices of some key inputs to rise (e.g.labor and capital) then the supply curve tends to be upward sloping. Thishappens only if the industry is large enough to affect prices of inputs.

Example: As the output of wheat production increases, farmland becomesmore valuable, and the land rents increase. As rents increase, the AC curveof each farmer rises to the minimum average cost increases. Therefore thelong-run supply curve for the wheat market rises as output expands.

Prices of inputs could also decrease as output expands if there areeconomies of scale. In this case the supply curve could slope downward.



Another reason the supply curve can slope upward is if there are only a fewfirms that can produce at low costs. For market output to increase, lessefficient firms have to enter the market.




Efficiency

An economic situation is Pareto efficient if there is no way to make anyperson better off without hurting anybody else.

The competitive equilibrium has two desirable efficiency properties:

Production is efficient—there is no possible rearrangement of inputsthat can produce output at a lower cost

Consumption is efficient—the value that the buyer places onconsuming the good is exactly equal to the marginal cost ofproducing it (remember p = MC in competitive equilibria).


Efficiency


Welfare

Economist have developed a way to measure societal welfare in thecontext of consumption and production.

Consumer surplus is the amount above the price pad that aconsumer would willingly spend, if necessary, to consume the unitspurchased

Producer surplus is the largest amount that could be subtractedfrom a supplier’s revenues and yet the supplier would still willinglyproduce the product.

Welfare is the sum of consumer surplus and producer surplus.


Many Meanings of Competition

We have to be careful about using the word competition. Many people(economists included) use the term loosely to apply to markets that do notobey the definition of perfect competition.

Often we speak of certain types of industries being reasonably competitiveif they have certain characteristics:

Price-taking behavior

Free entry and exit

Example: Barber shops. Even though barbers are not identical in eitherquality or prices, most economists would describe the provision of haircutsas a reasonably competitive industry.


Limitations of Perfect Competition

Not many markets satisfy the definition of perfect competition, eventhough some come close (stock exchanges, some services, agriculture).

Perfect competition is a benchmark by which we use to understand whatforces generate efficient outcomes. However, this notion of efficiencyexcludes any concept of inequality. Is this a problem?

Maybe not. The morally just distribution of wealth is a deepphilosophical/political/economic question. We can objectively discusswhether efficiency is achieved, but we are in no position to ascribe a moraljudgement on distribution using the tools of economic analysis.

Maybe efficiency, in principle, is enough. We could (theoretically!) devicea system of redistribution to achieve whatever societal moral goals wehave in mind, but to make wealth as large as possible, we need efficiency.


Monopolists and Welfare Loss

A monopolist, in contrast to a competitive firm, knows that can set itsown price and that its price chosen affects the quantity it sells.

When a firm can set its price above its marginal cost without making aloss, we say it has monopoly power or market power.

If a monopoly restricts its output and raises its price above marginal cost,society suffers a welfare loss. (This is not to say that a monopolist strivesless hard to operate efficiently!)


Efficiency



The gap between the monopolist’s price and marginal cost represents adifference between the value (price) that a consumer places on the productand the marginal cost of producing it.

When consumers must pay pm > pc , they lose consumer surplus

When monopolists charge pm > pc , they gain profits

The monopoly profit is less than the consumer surplus loss, so societysuffers a deadweight loss that equals the consumers’ loss less themonopolist’s gain.



Some economists prefer an alternative measure of deadweight loss thatincludes an amount equal to some or all of the monopolists profits. Theargument is...

Monopoly profits creates incentives for a firm to use resources (e.g.lobbying, bribery, dirty business tactics) to become a monopoly

These resources could have been put to productive use, so thisrent-seeking behavior is a loss to society

Note that this argument doesn’t support bigger government, in fact, itusually supports the rescinding of many government regulations.


Benefits of Monopoly

There are many benefits from monopoly that we are ignoring in our staticanalysis:

The prospect of receiving monopoly profits may motivate firms todevelop new products, improve products, or find lower-cost methodsof production

Important example: research and development is worthwhile to firmsthat know its innovation can be patented to generate monopolyprofits. Importantly, the ability of other firms to copy a product (andavoid R and D expenses) would remove a big incentive for innovation.


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Equilibrium and Welfare - cms.phbs.pku.edu.cn