Perfectly Competitive Markets and the Invisible Hand PDF

CHAPTER 2 Perfectly Competitive Markets and the Invisible Hand © chapter 2 Characteristics of a perfectly competitive market Introductory macroeconomics, Jan 2021 © Cartago Research and Development, 12/25/20 10:17 PM...

CHAPTER 2 Perfectly Competitive Markets and the Invisible Hand © chapter 2 Characteristics of a perfectly competitive market Introductory macroeconomics, Jan 2021 © Cartago Research and Development, 12/25/20 10:17 PM 2-1  Learning Objectives S. 2 Definition of perfect competition The concepts of Marginal Social Benefit and Marginal Social Cost The Concept of Equilibrium under perfect competition Characteristics of the efficient allocation of resources Marginal Social Benefit = Marginal Social Cost Markets operating under perfect competition achieve an efficient allocation of resources under certain conditions Markets operating under perfect competition are Stable When Submitted to a shock, due to changes in their economic environment, markets that operate under perfect competition are thrown out of equilibrium: Perfectly competitive markets will return eventually to equilibrium and again achieve an efficient allocation of resources with Marginal Social Benefit = Marginal Social Cost 2-2  Characteristics of a Perfectly Competitive Market S. 3 A market is perfectly competitive if it satisfies the following four conditions: a) The market deals in a homogenous well-defined product b) Market participants or traders have access to full information about the opportunities, the products available and about their going prices, c) There is free entry and exit. d) There is a large number of buyers and sellers All Markets have two sides: Demand side Supply side et = et-1 + ( t - et-1 ) 2-3  Demand Side of the Market: Demand curve S. 4 Demand curve represents : Price - A plan 12 - the Willingness to Pay for an additional unit of the product The demand curve as a plan 10 A Table 1 Demand Schedule B 8 6 C Combination Possible Price Quantity demanded A 10 0 4 D B 8 100 E 2 C 6 200 0 D 4 300 0 100 200 300 400 et = et-1 + ( t - et-1 ) Quantity demanded E 2 400 2-4  Demand Curve as Willingness to Pay S. 5 Willingness to pay for one more unit = Additional benefit from consuming one more unit Height of the demand curve at a given quantity = Willingness to pay for an additional unit of the product = Additional benefit from consuming one more unit = Marginal benefit The principle of diminishing Marginal benefit: As we consume more units of a product, the marginal benefit from consuming one more unit of it  The principle of diminishing Marginal benefit justifies a downward sloping demand curve Textbook authors, call the principle of diminishing Marginal benefit:The Law of Demand 2-5  Demand Curve as Marginal Benefit , Willingness to Pay Curve S. 6 Demand curve is also the marginal 11Possible Price benefit curve from consuming one more A 10 unit at a given quantity consumed. 9 When the quantity demanded and B 8 consumed = 100 as at B, 7 Height of demand curve AE at B = $8 = 6 C Marginal Benefit = maximum amount 5 the consumer is Willing to pay for D 4 getting one more unit of the product 3 When the quantity demanded and E 2 consumed = 300 as at D, 1 Height of demand curve AE at D = $4 = 0 Marginal Benefit= maximum amount the 0 100 200 300 400 consumer is Willing to pay for getting one more unit of the product Quantity demanded 2-6  Justification of Demand Curve As a Plan S. 7 Net Marginal Benefit = Marginal Benefit – Price Total Net Benefit = sum of Net Marginal Benefits 12Possible Price 11 A Decreasing Marginal Net Benefit When the market price = $7, the consumer, driven by self-interest, would buy every unit for which the 10 marginal benefit i.e.at which the height of the 9 B demand curve  price =$7 and no more no less. 8 C When the market price = $7, the quantity 7 F demanded by the consumer is 80 units. At this 6 quantity the market price of $7 is equal to the 5 marginal benefit of $7 = height of demand curve at 80 units. 4 D 3 At that quantity (e.g. 80 units), the consumer maximizes her Total Net Benefit when the market 2 E price = $7. 1 Consumer’s Goal = Maximize Total Net Benefit 0 0 20 40 60 80 100 120 140 160 180 20 2-7  Justification of Demand Curve As a Plan S. 8 Net Marginal Benefit = Marginal Benefit – Price 12Price 11 A Decreasing Net Marginal Benefit Total Net Benefit = sum of Net Marginal Benefits 10 ·Consumer Surplus: Consumer Surplus is the 9 B maximum total amount that consumers are 8 willing to pay but they don't actually pay to C 7 acquire a certain quantity of a product. F 6 At the price of $7 and quantity demanded of 80 5 units consumer surplus = area of triangle AFC = 4 $160 = [($11 - $7)x80]/2 D 3 At the price of $3, the marginal benefit of every 2 G E unit between 0 and 160  price = $3. Thus, the 1 quantity quantity demanded = 160 units 0 consumer surplus = area of triangle AGD = 0 20 40 60 80 100 120 140 160 180 200 $640 = [($11 - $3)x160]/2 Quantity demanded The quantity demanded  when the price 2-8  Consumer Surplus and Market Price S. 9 Price Price 12 12 Maximum Total Net Benefit = Maximum Total Net Benefit = Consumer Surplus = Area ABF A A Consumer Surplus= area ACG when market price =$8 10 10 when price =$6 F B B 8 8 F C C 6 6 G D D 4 4 E 2 2 0 0 0 100 200 300 4000 100 200 300 Quantity Quantity 2-9  Market Demand Curve S. 10 1consumer Market DemandCurve Price Price Price $2A B $2 E F $2 J B K 2consumers G M $1C D $1 G H $1 L D 2 4 1 3 2 3 4 5 7 Quantity Quantity Quantity Consum er 1 Consum er 2 Market Dem andCurve DemandC urve DemandC urve 11.c 11.a 11.b 2-10  Supply Side of the Market: The Supply Curve as a Plan S. 11 Two interpretations of Supply curve Supply curve represents : 12Possible Market Price * A plan E * Minimum additional cost of producing an 10 additional unit of the product D The Supply curve as a plan: Schedule 8 C 6 B Combination Possible Price Quantity supplied 4 A 10 400 2 B 8 300 A C 6 200 0 0 100 200 300 400 D 4 100 Quantity Supplied et =Eet-1 + ( t - 2et-1 ) 0 2-11  Supply Curve as Marginal Cost Curve S. 12 Marginal Cost = Minimum additional 11Possible Price Cost of producing an additional unit 10 Supply curve is also the marginal cost 9 E curve of producing one more unit at a 8 given quantity consumed. 7 D When the quantity produced and 6 supplied = 300 5 C B Height of supply curve AE at D = $8 = 4 Marginal Cost 3 When the quantity produced and 2 A supplied = 100 1 Height of supply curve AE at B = $4 = 0 Marginal Cost 0 100 200 300 400 · Principle of increasing marginal cost Quantity Supplied For Textbook: increasing marginal cost principle = Law of Supply 2-12  Justification of Supply Curve As a Plan S. 13 Marginal profit = Price - Marginal Cost 12Possible Price Total Economic Profit = sum of Marginal profits 11 Supply Curve Marginal Cost Curve Driven by self-interest a producer produces and supplies that quantity (e.g 160 units)) which equates the possible market price (e.g. $9) to the 10 E G marginal cost (e.g. $9) = height of Supply curve or marginal cost curve (at 160 units) from producing an additional unit of the product. 9 At that quantity (e.g. 160 units), the producer maximizes her Total 8 Producer Surplus = D economic profit. 7 Maximum Total Total Revenue = price x quantity supplied 6 Economic Profit C Self interest = maximization of total economic profit 5 B 4 3 Total Cost 2 A 1 O F 0 0 20 40 60 80 100 120 140 160 180 20 Quantity Supplied  e t = e  t-1 + ( t -  e t-1 ) 2-13  Producer Surplus and Market Price S. 14 12Possible Price 12Possible Price Supply Curve Marginal Cost Curve 11 Supply Curve Marginal Cost Curve 11 10 10 E E G G 9 9 Producer Surplus = 8 8 Producer Surplus = D Maximum Total Economic D 7 7 Maximum Total 6 6 Economic Profit C C B 5 5 4 4 B Total Cost 3 Total Cost 3 2 A 2 A 1 1 O F O F 0 0 0 20 40 60 80 100 120 140 160 180 200 0 20 40 60 80 100 120 140 160 180 200 Quantity Supplied Quantity Supplied 2-14  Marginal Social Cost Curve: Market Supply Curve S. 15 1 supplier Market Supply Curve Price Price Price 2 Suppliers $2 A B $2 E F $2 J B K $1 C $1 G $1 L D D H M 2 4 1 3 2 3 4 7 Quantity Quantity Quantity Supplier 1 Supplier 2 Market Supply Curve Supply Curve Supply Curve 2-15  Review S. 16 At every quantity supplied, the height of the supply curve is equal to :  The minimum price the producer or supplier is willing to accept in order to produce an additional unit of the product  Marginal Cost of producing an additional unit of the product At every quantity demanded, the height of the demand curve is:  The maximum price the demander is willing to pay to acquire an additional unit of the product.  Her/his Marginal Benefit of consuming one more unit of the product Market supply curve is upward sloping Height of market Supply curve = marginal social Cost Market demand curve is downward sloping Height of market demand curve = marginal social benefit 2-16  Resource Allocation in Markets with Perfect Competition S. 16 Two goals:: a) Competitive Markets produce an efficient allocation of resources Total Net Social Benefit = Total social Benefit – Total Social Cost Meaning of efficiency: Maximization of Total Net Social Benefit Marginal social benefit = Marginal social cost. b) The Competitive Market equilibrium is stable 2-17  Concept of Efficient Allocation of Resources S. 18 Price Net Marginal social benefit= 11 one green bar F Demand Curve = Marginal 10 E Total net social Benefit at a Social Benenfit Curve 9 given quantity = Sum of green G bars to the left of the vertical 8 D line at the quantity 7 Supply Curve = Maximum total net social 6 C Marginal Social Cost benefit achieved at C with a Curve 5 quantity of 200 units of the product produced and 4 B consumed 3 The quantity of 200 units is 2 A Net Marginal K Efficient quantity to efficient: Social Benenfit produce and consume 1 Marginal social Benefit = 0 Marginal Social Cost 0 100 200 300 400 Quantity 2-18  Maximum total Net Social Benefit S. 19 12 Price Area of Green Triangle AFC = Supply Curve = Maximum total net social benefit = F Marginal Social Cost (Base x height )/2 10 E = ( (10-2) x 200 ) / 2 = G $800 8 D M 6 C Demand Curve = Marginal Social Benenfit Curve 4 B 2 A Net Marginal K Social Benenfit 0 0 100 200 300 Quantity 400 2-19  Under Perfectly Competition, Markets are Efficient S. 20 Price At a price of $6 11 o Demanders driven by self interests 10 At a price of 8, Excess Supply = 200 would buy 200 units and maximize their consumer surplus 9 o Producers or suppliers driven by 8 C B self-interests would supply 200 7 units and maximize their total 6 economic profit or producer 5 E surplus. 4 o The Marginal benefit of the 201st A D 3 unit = its Marginal cost. o Quantity supplied = Quantity 2 At a price of 3, Excess Demand = 300 demanded = 200 units. 1 o The allocation of resources is 0 overall efficient. 0 50 100 200 300 35 Competitive markets maximize total net Quantity demanded or supplied social benefit. 2-20  Perfectly Competitive Markets are Stable S. 21 At point E we have an equilibrium Price Price 11 11 Point E is stable, at a price of $6 10 At a Lower price than $6 (e.g. $3) there is Excess 10 At a price At of a8,price Excessof Supply 8, Excess Demand = 200 = 200 Demand (e.g. 300) 9 9 Competition forces price  to $6 8 8 A Higher price than $6 (e.g. $8) there is Excess Supply C C B B (e.g. 200) 7 7 Competition forces price to  to $6 6 6 Perfectly competitive markets yield an equilibrium that is 5 5 E E both efficient and stable 4 Perfectly competitive markets may not yield an equitable 4 income distribution A A D D 3 3 2 2 At3,a Excess At a price of price ofDemand 3, Excess Demand = 300 = 300 1 1  0 0 0 050 50 100 100 200 200 300 35300 35 400 Quantity or Quantity demanded demanded supplied or supplied  2-21  Factors that affect the Market Demand Curve Average income of Demanders Price of a substitute Price of a complement Expected future price of the product Number of Demanders 2-22  Factors that Shift Demand Curves and Supply Curves S. 22 Demand Curve Shifters: Shift of the Demand Curve v.s. Average Income Movement Along the Demand Curve Price Price of a Substitute, 16 Price of a Complement 14 B Number of consumers Other factors change Tastes 12 Expected future equilibrium 10 F price of the product: if Storable D good 8 Supply Curve Shifters: An increase in the wage rate 6 C G price of product Improvement in Technology 4 increases Expected future price of the product 2 K Price of other goods 0 Number of Suppliers 0 100 200 300 Quantity 400 2-23  Average Income Increases, Demand Curve: Shifts up or Right S. 23 Average income   16 Price One of Demand Curve Factors changed No Supply Curve Factor Changed B 14 Excess Demand = 200 At every quantity demanded Willingness to pay  12 Demand Curve shifts : FK to BG Supply Curve does not shift F 10 E At old equilibrium at C, Excess Demand = CG = 200 D 8 Price increases, Quantity demanded falls, Quantity supplied increases 6 New Equilibrium at D C G 4 A 2 K 0 0 100 200 300 400 Quantity   2-24  Number of Consumers Increases Demand Curve: Shifts Right S. 24  1consumer Market DemandCurve Price Price Price $2A B $2 E F $2 J B K 2consumers 1.3 G M $1C D $1 G H $1 L D 2 4 1 3 2 3 4 5 7 Quantity Q uantity Quantity Consum er 1 Consum er 2 Market Dem andCurve DemandC urve DemandC urve 11.c 11.a 11.b 2-25  Factors that affect the Market Demand Curve wages Price of a substitute Price of a complement Improvement in technology Number of Suppliers or producers 2-26  Wages increase, Supply Curve: Shifts up or Left S. 25 Supply Curve = Marginal Cost Curve Price Figure 12  An increase in the Wage Rate Supply Curve shifts : AE to BG 16 Demand Curve does not shift 14 F G At old equilibrium at D price = $8, Excess Demand = CG = 200 12 C E Price increases, Quantity demanded 10 Wage falls, Quantity supplied decreases Increase New Equilibrium at C 8 D 6 B K 4 Excess Demand = 200 2 A 0 0 100 200 300 400 Quantity   2-27  Number of Producers Increases Supply Curve: Shifts Right S. 26  1supplier Market SupplyCurve Price Price Price 2Suppliers $2A F $2 B K B $2 E J $1.5 G J $1C $1 G $1 L D D H M 2 4 1 3 2 3 4 5 7 Quantity Quantity Q uantity Supplier 1 Supplier 2 Market SupplyCurve SupplyC urve SupplyC urve 2-28  S. 26 End 2-29