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Perfect Competition
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Lecture 8
Dynamics: Cobweb Model
Consumer Theory
• Consumers optimize their well being subject to a budget constraint
• Enjoyment from consumption referred to as utility
Good 1: Number of Units Purchased
1 2 3
Total Value $18 $30 $36
Good 2: Number of Units Purchased
1 2 3
Total value $4 $8 $12
Price of good 1= $12 , price of good 2 = $3
Good 1: Number of Units Purchased
1 2 3
Total Value $18 $30 $36
Good 2: Number of Units Purchased
1 2 3
Total value $4 $8 $12
Price of good 1= $12 , price of good 2 = $3Income = $18
Good 1: Number of Units Purchased 1 2 3
Total Value 18 30 36
Marginal value 18 12 6
Marginal value per dollar 1.5 1 0.5
Good 2: Number of Units Purchased 1 2 3
Total value 4 8 12
Marginal value 4 4 4
Marginal value per dollar 1.33 1.33 1.33
Price of good 1= $12 , price of good 2 = $3, Income = $18
Good 1: Number of Units Purchased 1 2 3
Total Value 18 30 36
Marginal value 18 12 6
Marginal value per dollar 1.5 1 0.5
Good 2: Number of Units Purchased 1 2 3
Total value 4 8 12
Marginal value 4 4 4
Marginal value per dollar .8 .8 .8
Price of good 1= $12 , price of good 2 = $5, Income = $18
Budget Set
• Set of goods and services you can buy with the money you have available to you
• Price of coke = $1 per unit, price of snickers =$2 per unit
coke
snickers
2.5
5
1 unit of coke, 2 units of snickers
List some other combinations
How do you decide what to choose?
coke
snickers
2.5
You rank all the combinations and choose your best one.
3 units coke, 1 unit snickers
Now suppose prices change• Price of coke = $1 per unit, price of snickers =$1 per unit
snickers
52 unit of coke, 3 units of snickers
5 coke
List some other combinations
You rank all the combinations and choose your best one.
snickers
5
coke5
2 units of coke, 3 units of snickers
Individual Demand for snickers
Price of snickers
3 Quantity of snickers
2
1
21
Demand curve for snickers
Notes for individual demand
• Income constant• Price of other goods constant• Tastes constant
Demand curve
Price Rs.
Quantity of Cake per week
Rs. 30
5
Rs. 15
10
Willingness to pay
Market Demand: Horizontal Summation
Marginal Cost
The cost of producing one more unit of good or service
Decreasing marginal returns
• Marginal Product: The additional units of a good or service that can be produced with an additional unit of input ( e.g. labour)
• Principle of decreasing marginal returns– The marginal product of an input decreases as
additional units of the input are employed
Output Labour units Total Cost Marginal Cost
0 0 0
1 1 10 10
2 2.5 25 15
3 4.5 45 20
Price of labor = Rs. 10
Marginal cost curve
Quantity of Cake per week
Rs. 15:Marketprice
20
Rs. 30
• If the market price is Rs. 15 how much should producer produce?
Quantity produced2
Marginal cost in Rs.
10
1
15
• What if the price changes if the producer produces more?
• We assume price remains constant – firm is a price taker
• Marginal cost curve is the supply curve of the individual firm in a perfectly competitive market
Price taker demand curve
D
S
30
• QD = 625 – 25P• QS = 175 + 15P• P = 45• Q = 400• 100 firms, 4 units each• Suppose 1 firm increases output to 5(25% increase)• QS = 176 + 15P• P = 44.9• 1000 firms?
• P = MR
Producer’s decision
Quantity
Rs. 30
MC
Q
• Producers maximize profit by selling the quantity for which marginal revenue equals marginal cost
• Long run equilibrium is attained where MR=MC=ATC
• Economic profit is zero and only normal return is realized
Firm and market supply
price
quantity
price
quantity
AVC
ATC Sshort run
Monopoly
Single seller that produces a good with no close substitutes
Sources of monopolyWhat could be the causes of monopoly to exist
Barriers to entry
• Legal barriers– Patents– Government granted franchises
• Natural barriers– Economies of scaleAverage cost of production is falling through the
relevant range of consumer demand
Is at the opposite extreme of perfect competition. Monopolist is a price maker as against perfect competitor is who price taker
Profit maximising under monopoly
Q O
MR
AR
Rs
Q O
MC
AR
Qm
MR
AR
a
Rs
Q O
AC
MC
AR
AC
Qm
MR
AR
a
b
Rs
c
Case StudyThe Market Value of Monopoly Profits in the New York
City Taxi IndustryNY city requires a license (medallion) to operate a taxi. These are limited in numbers and confer a monopoly power (I.e. ability to earn economic profits) to owners. Value of medallion is the PV of future streams of earnings from medallion. For example the # of medallions in NY city have remained at 11787 since 1937 till 1996. In 1996 it was increased by only 400 to 12187 medallions. The value of medallion has risen from $ 10 in 1937 to 250000 in 1999 (18% p.a.). The price of medallion is lower in other cities (e.g. $ 90000 in Boston, $ 25000 in Chicago) reflecting much lower capacity in these cities.
Proposals to increase the # in NY blocked by Taxi Unions.
Case StudyThe Market Value of Monopoly Profits in the New York
City Taxi Industry (Contd..)
If the city authorities could give freely the medallions then the price of medallions could fall to zero. Alternatively the Municipality has allowed sharp increase in the radio taxis - although they are much less flexible.
As a result the profit of NY taxi operators has come down from 32% to only about 11% in 1999.
Monopoly
Comparison of monopolywith perfect competition:
(a) same industry MC curve
Q O
MC
Q1
MR
AR = D
P1
Equilibrium of industry under perfect competition and monopoly: with the same MC curve
Rs
Q O
MC
Q1
MR
P1
P2
Q2
Equilibrium of industry under perfect competition and monopoly: with the same MC curve
AR = D
Rs
Q O
MC ( = supply under perfect competition)
Q1
MR
P1
P2
Q2
Equilibrium of industry under perfect competition and monopoly: with the same MC curve
AR = D
Rs
Monopoly
Comparison of monopolywith perfect competition:
(b) monopoly has lower MC curve (i.e. it is experiencing economies of scale)
Q O Q1
MR
P1
MCmonopoly
Equilibrium of industry under perfect competition and monopoly: with different MC curves
AR = D
Rs
Q O
MC ( = supply)perfect competition
Q1
MR
P1
P2
Q2
MCmonopoly
AR = D
Equilibrium of industry under perfect competition and monopoly: with different MC curves
Rs
Q O
MC ( = supply)perfect competition
Q1
MR
P1
P2
Q2
MCmonopoly
x
AR = D
Equilibrium of industry under perfect competition and monopoly: with different MC curves
Rs
Q O
MC ( = supply)perfect competition
Q1
MR
P1
P2
Q2
MCmonopoly
Q3
P3
AR = D
Equilibrium of industry under perfect competition and monopoly:with different MC curves
Rs
MONOPOLY
• Disadvantages of monopoly– high prices / low output: short run– high prices / low output: long run– lack of incentive to innovate– X-inefficiency
• Advantages of monopoly– economies of scale– profits can be used for investment
MONOPOLY
• Disadvantages of monopoly– high prices / low output: short run– high prices / low output: long run– lack of incentive to innovate– X-inefficiency
• Advantages of monopoly– economies of scale– profits can be used for investment– promise of high profits encourages risk taking
Deadweight loss under monopoly
Deadweight loss under monopoly
O
£
Q
Ppc
Qpc
MC(= S under perfect competition)
AR = D
(a) Industry equilibrium under perfect competition
Consumersurplus
a
Producersurplus
Deadweight loss under monopoly
O
£
Q
Ppc
Qpc
MC(= S under perfect competition)
AR = D
a
Pm
Qpc
MR
b
(b) Industry equilibrium under monopoly
Consumersurplus
Producersurplus
Deadweightwelfare loss