Models of Competition Part I: Perfect Competition Agenda: I.What is Competition? II.Assumptions underlying perfect competition III.Optimal production quantity,

Models of CompetitionPart I: Perfect Competition

Agenda:I. What is Competition?II. Assumptions underlying perfect competitionIII. Optimal production quantity, or where do supply curves

come from? A. Short run

1. One firm2. Market

B. Long run1. One firm2. Market

IV. The market for Garden Gnomes! A. Technological innovations B. Taxes

What does “competition” mean to you?

Assumptions that Underlie Perfect Competition

4. Firms and consumers have perfect information.

What happens when we violate these assumptions…

1. 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.

What is on the X and Y axis?

Is this a long-run or short run picture?

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?

What does the point where the line tangent to the TC curve with the same slope as the TR curve reflect?

MR=MCMax Profit!

Costs & Revenues Review

Individual Firm Supply Decisions

MR=MC on the rising part of the MC curve!

Short-run Individual firm supply

curveWhy not here??

Price = Marginal Revenue = Marginal Cost

Shutdown!

What if price is here? Economic loss!

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?

Market Supply Curve

The market supply is simply the sum of the individual firm supplies!

P c dQ Firm Supply curve: P c

Qd d

Quantity:

Industry Supply: n

nn n n

P cQ Q

d d

100 firms each have identical supply curves: P = 5 + 200QWhat is the industry supply curve?

5

2005

100200

5 2

PQ

PQ

P Q

1. Solve for Q

2. Multiply by n

3. Solve for P

TEST YOURSELF:What if firms did NOT have

identical supply curves?

Short Run Producer Surplus

P Q AVC Q QQ

P MC

Different firms have different minimum

marginal costs

PL

ATC

You can have a producer surplus and an economic loss

Market Supply Curve

Allocative efficiency: no consumer will buy more, no producer will produce more at any other price.

PARETO OPTIMAL

Different consumers have different

marginal benefits

What Happens in the Long-Run in the Market?Shift in Supply

Mov

emen

t alon

g the

supp

ly cu

rve

Q1Q2

1. Producer surplus attracts more supply2. More supply shifts the supply curve3. The shift in the supply curve causes a decline

in price but a higher equilibrium quantity.

A decline in price without a shift in supply would be a movement along the supply curve and result

in a lower equilibrium quantity.

What Happens in the Long-Run in the Firm?1. AFTER market prices decline (see above)2. The new price intersects with long-run

marginal cost at a lower quantity.3. 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

4. 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?

Long-run supply price=MC=LAC

Is there producer surplus in the long run?

Supply when input prices do NOT vary with output quantity.

No producer surplus!

Supply when input prices INCREASE with output quantity.

Supply curve slopes up, But still no producer surplus!

Why?

Price Elasticity of Supply

1

S Q P

P Q

P

Q slope

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)

Example: Garden GnomesMarket demand: QD = 6500 -100PMarket supply: QS = 1200P

FIRM total cost: C(q) = 722 + q2/200FRIM marginal cost: MC(q) = 2q/200 = q/100

1. What is the equilibrium price and quantity for the MARKET?

QD=QS

P = $5Q = 6,000

2. What is the amount supplied by the FIRM?P = MR = MC(q)Q (firm) = 500

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?

7. What is the lowest price you would sell your 500 Garden Gnomes for in the short run?

6000 500 12M FQ Q

Yes! Why?AVC = $2.50

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 + q2/400FRIM marginal cost: MC(q) = 2q/400 = q/200

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 QuantityRecall: Market demand: QD = 6500 -100P P = $4.64 Q = 6,036

Test Yourself:What is the new producer surplus and profit?

Garden Gnomes Continued…

FIRM total cost: C(q) = 722 + q2/400FRIM marginal cost: MC(q) = 2q/400 = q/200Market demand: QD = 6500 -100P

What if you could NOT get a patent for your new technology (assuming no new entry of firms)?

1. What is the new market supply?P=Q/ 200Q = (200P)*12 firmsQ= 2400P

2. What is the new market equilibrium price and quantity?

2400P=6500-100PP=$2.60 Q = 6,240

3. What is the producer surplus and profit for each firm?

Q = 6,240/12 = 520AVC = 520/400 = $1.30

Profit: 520*$2.60-722-520*$1.30 =-$46PS = 520*(2.6-1.3)= $520


Would the market equilibrium price and quantity change if you were to reduce your fixed costs to $500?

Market demand: QD = 6500 -100PMarket supply: QS = 2400PFIRM total cost: C(q) = 500 + q2/400FRIM marginal cost: MC(q) = 2q/400 = q/200

Test yourself:Will your producer surplus change?Will your profit change?

What if the government imposes a tax of $1 per gnome?



KEY: The price paid by the consumer is NOT the same as the price received by the supplier!

What is the equilibrium price received by the supplier, paid by the consumer and equilibrium quantity?

6500 – 100(Ps+$1) = 2400PsPs = $2.56Pd = $3.56Q = 6,144


What if the government imposes a tax of $1 per gnome?

price

Quantity

P = MC

P = MC + T

P1

P2

P3

Effective price to producersCauses market exit!

Long-run supply


Dead-weight loss

But Wait….

Externalities & Goods that are

NOT Commodities

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.

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

Documents

Models of Competition Part I: Perfect Competition Agenda: I.What is Competition? II.Assumptions underlying perfect competition III.Optimal production quantity,