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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 Supply ¢ Market demand for a product is the sum of the demands of all individual consumers ¢Graphically, this is the horizontal sum of the individual demand curves ¢ Market supply of a product is the sum of the supply of all the individual sellers ¢Graphically this is the horizontal sum of the individual supply curves ¢Very similar to the procedure for constructing market demand curves

Figure 14. 1: Market Demand

Figure 14. 2: Market Supply

Short-Run vs. Long-Run Market 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 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)

Price (\$/bench) Figure 14. 7: Response to an Increase in Demand New SR Equl S 10 B P* = ACmin = 100 A C S∞ ^ D D Initial LE Equl 2000 4000 Garden Benches per Month

Figure 14. 7: Response to an Increase in Demand Price (\$/bench) The importance of free entry assumption S 10 B P* = ACmin = 100 A C S∞ ^ D D 2000 4000 Garden Benches per Month

Responses to Changes in Fixed 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 equilibrium ¢ If variable costs change, firm’s marginal and average cost curves both shift ¢Short-run supply curve shifts ¢Sort-run equilibrium changes ¢ Basic procedure in all cases: ¢Find new short-run equilibrium using new short-run supply curve of initially active firms ¢Find 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 Price (\$/bench) In LR: increase in D leads to P increases (input cost increases) S 10 B ^ ACmin=110 ACmin=100 A E C ^ S∞ S∞ ^ D D 2000 4000 Garden Benches per Month

Aggregate Surplus and Economic 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 equilibrium ¢ Take one unit of the good from Consumer A and give it to Consumer B ¢ Cannot 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 and Total Avoidable Cost ¢ Market demand 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 quantity ¢When 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 quantity ¢When 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 maximized ¢No 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 expenditure ¢Sum of individual consumers’ surpluses ¢Also called aggregate consumer surplus ¢ Producer surplus is the sum of firms’ revenues less avoidable costs ¢Sum of individual firms’ producer surpluses ¢Also called aggregate producer surplus Aggregate surplus = Consumer surplus + Producer Surplus

Figure 14. 19: Aggregate, Consumer, and Producer Surplus