Perfect Competition Markets & The Invisible Hand PDF

Chapter 2 ©1 Perfect Competition Markets and the Invisible Hand Chapter 2 Prefect Competition Markets Intro econ Sep 2024, 03/09/2024 4:27 PM We live in economies in which markets allocate resources to the production of a very large number of commodities. In...

Chapter 2 ©1 Perfect Competition Markets and the Invisible Hand Chapter 2 Prefect Competition Markets Intro econ Sep 2024, 03/09/2024 4:27 PM We live in economies in which markets allocate resources to the production of a very large number of commodities. In the process, they also generate incomes for the owners of resources. The following circular flow diagram illustrates this process. Supply of productive Demand for Markets for resources: Labour, services productive capital, natural resources,… services incomes payment of Households: owners incomes of resources Producers expenditures Revenues Markets for products purchases of products Sales of products Households own the resources, and they let them to producers in the factors markets such as labour markets. Producers pay households incomes in the form of wages, rent, interest, and profits. Producers produce products and sell them in the goods and services markets to the households. The latter pays for them with their incomes and the loop is closed. Physical goods and services move clockwise. Payments move in the opposite direction. The commodities are produced by a certain number of producers and consumed by a large number of consumers. In market-based economies, there is no central authority that decides how much to produce of what and when or who consumes what and when. However, a certain number of products are produced in large firms where executives and managers tell workers what to produce, when, and how. For some products, a large firm is necessary to produce them. For many other products, large firms are not necessary, but they are produced by large firms mainly to escape the discipline of competition. In these large firms managers replace markets and without managers, there will be chaos inside large firms. Similarly, some analysts and social reformers argue that without a central authority to decide the allocation of resources, market based economies would eventually fall into chaos. As evidence, they point out to the widespread poverty everywhere in the world, particularly in the rich industrialized countries. Since Adam Smith, many economists have attempted to show that poverty does not have to be a necessary companion to market economies. An important claim, which we inherited from A. Smith, is that by pursuing their self-interest, people living in a market economy will promote the public 1Cartago Research and Development, 9/3/24, 4:27 PM Chapter 2 Competitive Markets and Efficiency, Chapter 2 Prefect Competition Markets Intro econ Sep 2024, 9/3/2024 4:27 PM 2-2 interest as if guided by an invisible hand. The invisible guiding hand is the information contained in prices, which, if left to circulate freely, would coordinate the actions of hundreds of millions of participants in market economies. Prices contain valuable information for evaluating society’s needs for various products and how to produce them and distribute their outputs. Resources move from product lines with depressed profits to product lines with too high profits in an attempt to make a higher profit or avoid a loss. This process would continue until the profits per unit of resources are the same everywhere. If this claim is correct, then markets should not create chaos. To the contrary, Adam Smith and many more economists in his tradition claim that markets permit trade to develop and market economies to prosper. The propensity to trade is the source of prosperity and opulence. Prosperity and opulence will diffuse themselves through the ranks of society and eradicate poverty. This is the so-called trickle-down theory. In this chapter, we investigate the basic questions: Do markets lead to chaos? If not, is the allocation of resources resulting from the operation of a single market overall efficient? In theory, the answer to the first question is negative and the answer to the second question is positive for a special type of markets, which we shall call perfectly competitive markets. These are actually the types of markets that Adam Smith had in mind. However, in the real world of market-based economies, all markets do not operate under perfect competition. By omission or design, governments themselves may distort, prevent, or pervert the functioning of some markets. Similarly, with the help of the country’s financial system, some market participants create monopolies that are the exact opposite of perfect competition markets, resulting in misallocation of resources and the breakdown of the trickle-down theory. Finally, private market participants in a dynamic context may, in their pursuit of self-interest, create instability in the markets resulting in unemployment and misallocation of resources. We will discuss these problems in the following chapters. In this chapter, we deal with markets that operate under perfect competition or perfectly competitive markets in a static non-changing world. Characteristics of a perfectly competitive market A market is perfectly competitive if it satisfies the following four conditions: a) Market participants or traders deal 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 The first two conditions are self-explanatory. We develop the last two. Free Entry and Exit Every person or a group of people who are interested in participating in the market as a demander or a supplier are free to enter and free to exit. This is possible if there are no barriers to entry and no barriers to exit. Barriers to entry take on many forms and shapes. The government of a country may impose tariffs and quotas on foreign producers. In turn, the government of the foreign country may impose tariffs on the products of the first country. Thus, we would not have free entry. Within the same country, such as Canada, provinces impose barriers to the movement of labor and some products. They may also grant monopolies or near monopolies to some producers such as professional Chapter 2 Competitive Markets and Efficiency, Chapter 2 Prefect Competition Markets Intro econ Sep 2024, 9/3/2024 4:27 PM 2-3 associations. There is monopoly when only one producer or one group of producers acting like one can sell or produce a product. Barriers to exit are subtler. They occur mainly in markets where there are large economies of scale arising from large initial setup costs. This is the case for telephone service, railroads, and cars. To produce the first few units of output, the owners of a telephone company need to make a large investment in lines and equipment mainly with borrowed funds from financial institutions. If there were already another company serving the market, the owners of a new company would face large risks in the competition against the established company. The risks relate to the loss of the initial investment if they cannot succeed in earning a minimum share of the market. The large initial costs are sunk costs in the sense that they are irrecoverable if the new company fails to attract enough customers and the owners must exit. Since in this kind of productive activity, the equipments are specialized and involve the investment of a large amount of borrowed funds, the new firm’s owners who must exit cannot sell the equipments if at all to other prospective producers of other products without incurring a large loss. In this case, there is no free exit. Hence, markets in which producers must bear large initial costs associated with the acquisition of specialized equipment have high barriers to exit. Markets for such products do not operate under perfect competition. Large Number of Buyers and Sellers In markets with large numbers of buyers and sellers, any one trader cannot control the market. If there is free entry and exit, no one participant can control the market because potential entrants would prevent it. However, the condition is not sufficient. A market may not be competitive even if this condition is satisfied. For example, the market for milk is not competitive despite the fact that there are large numbers of producers and consumers. This is the consequence of the fact that a new entrant needs to buy a license to produce milk and there is a fixed number of licenses in a province, a number controlled by the province’s government officials. In the real world no single market is perfectly competitive, but many come close to be perfectly competitive. The market for cars is not anywhere near a perfect competition market but the market for wheat is somewhat close. Now that we know what a perfectly competitive market is, we want to understand how these markets operate to allocate resources. For this purpose, it is convenient to divide market participants into two groups: the demanders or the buyers on one hand, and the producers, suppliers, or sellers on the other hand. We study first the behaviour of each group separately, then we study the dynamics of a perfect competition market. Demand Side of the Market Every demander of a product comes to a perfectly competitive market of the product equipped with a demand curve. There are two interesting interpretations of the demand curve. A demand curve is a plan. A demand curve reflects the willingness to pay of the demander. The two interpretations complement each other. We use both of them to understand and predict how perfectly competitive markets respond to changes in the economic social, and political environments. Demand Curve as a Plan Chapter 2 Competitive Markets and Efficiency, Chapter 2 Prefect Competition Markets Intro econ Sep 2024, 9/3/2024 4:27 PM 2-4 In economics, we assume that every demander of buyer of a product comes to the market for the product with a plan. For each possible price of the product, the plan specifies how much to buy of the product during a given period. Table 1 is an example of a plan or a demand schedule. Table 1 The demand schedule Combination Possible Price Quantity demanded A 10 0 B 8 100 C 6 200 D 4 300 E 2 400 Figure 1 plots the quantity demanded against the possible price the demander may face in the market. Each combination in Table 1 is represented by a point in figure 1 bearing the same letter tag. When we connect those points by a curve we obtain demand curve AE. Figure 1 The Demand Curve Price 12 A 10 8 B F 6 C D 4 E 2 0 0 100 200 300 400 Quantity Demanded Figure 1 shows an important property of the demand plan or schedule: As the product price decreases, the buyer or the demander would demand more of the product: A demand curve is downward sloping. To understand why this is so, we use the willingness to pay interpretation of the demand curve. Demand Curve as a Willingness to Pay Curve or A Marginal Benefit Curve Another insightful way to interpret the demand curve is as a willingness to pay curve or marginal benefit curve. Consider figure 1 again. When the quantity demanded is zero, we interpret the corresponding height $10 of the demand curve, as the maximum amount of money the demander is willing to pay for the first unit. This amount is equal to the marginal benefit the demander gets from consuming the first unit of the product. Just like the first glass of water when we are thirsty, it is very valuable; we are willing to pay for it a very large amount. Once we had the first glass of water, the second one is less critical to our life. Thus, the maximum we are willing to pay for the second glass is less than for the first one. This is illustrated in figure 1. The height, $8, of the demand curve at 1 unit is less than its $10 height at 0 units. Chapter 2 Competitive Markets and Efficiency, Chapter 2 Prefect Competition Markets Intro econ Sep 2024, 9/3/2024 4:27 PM 2-5 As we consume more of a product, our willingness to pay for an additional unit of the product diminishes because the marginal benefit from consuming one additional unit of the product decreases with the increase in the quantity consumed or demanded. We call this property of the marginal benefit from consuming one additional unit of the product the principle of decreasing marginal benefit. Principle of Decreasing Marginal Benefit: Everything else equal, a consumer faces a decreasing marginal benefit for every product he/she consumes as the amount he/she consumes of the product increases. We shall demonstrate presently that the principle of decreasing marginal benefit implies that the demand curve of every consumer of any product (with possibly a few exceptions) must be downward sloping as illustrated in figure 1. Suppose that the market price is $8. According to figure 2.a, the consumer will find that the marginal benefit of $10 from consuming the first unit is greater than $8 price. Therefore, at the market price of $8, he/she would find it in her/his best interest to purchase the first unit and realize a positive marginal net benefit equal to $2 = $10 - $8 = marginal benefit – market price, the excess of the height of the demand curve over the market price of $8. Similarly, for any unit between 0 and 100 in figure 2.a, the marginal benefit from consuming that unit is greater than the market price of $8. When the demander buys any one of those units, he/she nets out a positive net marginal benefit equal to the vertical distance between the demand curve and the horizontal line FB at a price of $8. Figure 2 Consumer’s Maximum Net Benefit and Self-interest Figure 2.a Figure 2.b Price 12 Area ABF Maximum Total Net A Benefit when price =$8 10 B 8 F C 6 D 4 E 2 Quantity Demanded 0 0 100 200 300 400 The marginal net benefit from purchasing the first unit is greater than that obtained from purchasing the second and so on because the difference between the willingness to pay or the marginal benefit and the price decreases as more of the product is consumed by virtue of the decreasing marginal benefit principle. At 100 units, when the price is $8 the marginal net benefit from an additional unit purchased is zero. It becomes negative for units purchased beyond 100 units. Since the demander is driven by self-interest, he/she would try to squeeze out as much as possible of marginal net benefit. As long as the marginal net benefit is positive, as is the case of units between Chapter 2 Competitive Markets and Efficiency, Chapter 2 Prefect Competition Markets Intro econ Sep 2024, 9/3/2024 4:27 PM 2-6 0 and 100 units, he/she continues to increase her/his purchases and keeps adding to his/her total net benefit additional (albeit smaller and smaller) amounts until the marginal net benefit is equal to zero. This is illustrated by the green bars in figure 2.a. between zero and 100 units. The total net benefit increases as the demander purchases more units. If the consumer purchases one more unit beyond one hundred, the marginal net benefit becomes negative as the marginal benefit drops below $8. Total net benefit starts falling. To maximize her total net benefit, the demander purchases only 100 units. This is the quantity the demander would demand at a price of $8. It maximizes his/her total net benefit. Driven by self-interest a demander of a product demands that quantity (for example 100 units) which equates the market price (for example $8) to the marginal benefit (for example $8) at that quantity. At that quantity, the consumer maximizes her total net benefit. Area ABF in figure 2.a is the equal to the maximum total net benefit when the market price is $8. We call it, the consumer surplus. The Consumer Surplus associated with a given quantity demanded is the maximum total net benefit or the maximum total amount that consumers are willing to pay at that given quantity, but they don't actually pay. Suppose now that the market price drops to $6 represented by horizontal line GC in figure 2.b. Now, the 101st unit becomes more attractive. Given that the demander has bought and consumed the first 100 units, figure 2.a shows that the height of the demand curve there is $8, which is the marginal benefit from consuming the 101st unit. The marginal benefit $8 from the 101st unit is now greater than the new market price of $6. When he/she buys the 101st unit, then he/she would realize a positive marginal net benefit equal to $2 = $8 - $6. This is also the case for all units between 100 and 200 units. The marginal benefit from consuming any one of them as given by the height of the demand curve is now greater than the new market price of $6. Each one of them yields a positive marginal net benefit. The red bars between 100 and 200 units in figure 2.b illustrate these positive net benefits. To capture these additional net benefits and increase his/her total net benefit, the consumer would increase her quantity demanded from 100 to 200 units. Note that the marginal net benefit on each unit between 0 and 100 units has increased by $2 as well. Her consumer surplus increases from Area ABF in figure 2.a to area ACG in figure 2.b. Thus, the demander would increase her/his quantity demanded from 100 to 200 units. Thanks to the interpretation of the demand curve, that its height at every quantity demanded is the marginal benefit and the principle of diminishing marginal benefit, we have shown that: A demander of a product driven by self-interest would increase her/his quantity demanded when the market price falls. That is the demand curve is downward sloping and A demander driven by self-interest would purchase that quantity of the product at which Her/his Marginal Benefit = Market Price. Market Demand curve and Marginal Social Benefit As we shall show later, we construct the market demand curve from the individual demand curves by adding at each price the quantities demanded by every demander. Because the demand curve Chapter 2 Competitive Markets and Efficiency, Chapter 2 Prefect Competition Markets Intro econ Sep 2024, 9/3/2024 4:27 PM 2-7 of every demander is downward sloping, it follows that the market demand curve is also downward sloping. The height of the market demand curve at the total quantity demanded at a given market price is equal to that market price which in turn is equal to the marginal benefit of every individual demander at the quantity she/he demands at the market price equal to the height of her/his demand curve at the corresponding quantity of the product he/she demands at the market price because every one of the demanders equates her/his marginal benefit to the same market price. For this reason, we call the height of the market demand curve at any total quantity demanded the marginal social benefit of an additional unit demanded. The Supply Side of the Market We assume that every producer has a supply curve. We can interpret the supply curve as a plan or as a curve that represents the minimum unit cost of producing an additional unit of the product as a function of the quantity produced. The marginal cost is this minimum additional cost of producing an additional unit at any given quantity produced Clearly the marginal cost is the minimum price the producer is willing to accept to produce one additional unit of the product at the given quantity produced. Supply Curve as a Plan As a plan, the supply curve of a producer and/or supplier of the product specifies for each possible price in the market the quantity a producer and/or supplier of the product plans to supply during a given period of time. Table 2 provides an example of a supply schedule. Row A of Table 2 shows that when the price is $2 the quantity supplied is zero. The second row, row B, shows that when the price goes up to $4, the quantity supplied goes up to 100 and so on. Table 2 Supply Schedule Figure 3 Supply Curve Price 12 Combination Possible Quantity Price Supplied 10 E A 2 0 8 D B 4 100 6 C C 6 200 4 F B D 8 300 2 A E 10 400 0 0 100 200 300 400 Quantity Supplied Figure 3 provides a graphical representation of the supply schedule of Table 2. We plot the price on the vertical axis and the corresponding quantity supplied on the horizontal axis. Point A in figure 3 represents combination A of Table 2. Point B represents combination B of Table 2 and so on. The supply curve AE is the curve that we obtain by connecting points A, B, C, D, and E. As figure 3 shows, an important characteristic of the supply plan is that as the price increases the supplier would supply more of the product. To understand why this is so, we reinterpret the height of the supply curve at each quantity supplied as the marginal cost or the minimum price the Chapter 2 Competitive Markets and Efficiency, Chapter 2 Prefect Competition Markets Intro econ Sep 2024, 9/3/2024 4:27 PM 2-8 supplier is willing to accept to supply an additional unit of the product at the given quantity supplied or produced. The Supply Curve as the Marginal Cost Curve Let us assume for the moment that a producer and/or supplier of this product takes the product price as given and adapts to it. We shall justify this assumption later. When the quantity supplied is zero, a producer or supplier who is contemplating entering the market for a product would ask the question: Is it worth it to supply the first unit to the market. To answer this question, he/she needs to have two pieces of information: The marginal cost of producing that first unit of output and the market price at which he/she can sell the unit. If the market price is at least as high as the marginal cost of producing the first unit, then he/she will supply the unit. Otherwise, he/she will not. We assume that markets for inputs and products produce this information free of charge. In the real world, this is far from being true. Indeed, real word markets cannot function properly if the government does not provide the appropriate infrastructure to allow information to flow easily. Using the information about the prices of inputs, a producer and/or supplier of the product can compute the minimum cost or marginal cost of producing the first unit, the second unit and so on. The marginal cost includes a market wage for his/her work and fair return on own capital in addition to labor costs and the cost of other inputs including taxes. Due to the overcrowding of production facilities and the use of night shifts, which are costlier, the marginal cost of producing an additional unit increases as the amount produced and supplied increases. This argument justifies the following principle Principle of Increasing Marginal Cost or Decreasing Marginal Returns: As the number of units produced and/or supplied increases, the marginal cost of producing and/or supplying an additional unit increases. Suppose now that the height of the supply curve AD in figures 4.a and 4.b at any given quantity produced and supplied as indicated on the horizontal axis is equal to the marginal cost of producing and/or supplying an additional unit of the product. Thus, curve AD in Figures 4.a and 4.b satisfies the principle of increasing marginal cost. Clearly, the marginal cost is the minimum price a producer and/or supplier of the product is willing to accept to produce the first unit. If he/she gets this minimum price, he/she will supply the unit. Otherwise, he/she will not. In figure 4.a, curve AD indicates that the marginal cost at zero quantity supplied is $2. This means that if the producer and/or supplier of the product gets at least $2 or higher, he/she will supply the first unit. The height of the marginal cost curve AD at the zero quantity is the marginal cost or the minimum price that the supplier is willing to accept to produce and/or supply the first unit of the product. Having produced the first 100 units, the producer or supplier needs to know the marginal cost of producing the 101st unit. This is the minimum price he/she would accept to supply the 101st unit. It is given by the height of the marginal curve AD at a quantity supplied of 100 units. In figure 4.a, the height of the marginal cost curve AD indicates that at 100 units produced and/or supplied the marginal cost is equal to $4. If, instead, the quantity produced and/or supplied is equal to 200 units, the marginal cost Ad indicates that the marginal cost is $6 equal to the height of the marginal cost curve AD at a quantity supplied of 200 units, and so on. Now suppose that the market price is $4. The producer and/or supplier would produce and/or supply the first unit because the marginal cost of $2 is less than the market price $4. He will be Chapter 2 Competitive Markets and Efficiency, Chapter 2 Prefect Competition Markets Intro econ Sep 2024, 9/3/2024 4:27 PM 2-9 able to make a windfall additional profit of $2 = 4 - 2 on the first unit. Similarly, he/she will also produce and/or supply all the units between 0 and 100 units since the market price of $4 is greater than the marginal cost of an additional unit at any quantity between 0 and 100 units as given by the height of the marginal cost curve AD. On any one of these units, he/she will be able to make a windfall additional profit, called the marginal economic profit, equal to $4 minus the corresponding height of the marginal cost curve AD. The green bars in figure 4.a represent the marginal economic profits on the additional units produced and/or supplied between 0 and 100 units, when the market price is equal to $4. Figure 4 Producers Additional Profit and Self-interest Figure 4.a Figure 4.b Price 10 9 Maximum Total Profit 8 if Price =4 D 7 6 C 5 F 4 B 3 2 A 1 0 0 100 200 300 400 Quantity The principle of increasing marginal cost implies that, given a fixed market price, the marginal economic profit at any given quantity produced and/or supplied decreases as the number of units produced increases. The marginal economic profit is zero when the marginal cost of producing an additional unit becomes equal to the market price. Figure 4.a shows that, at a market price of $4, the marginal economic profit is zero when the quantity produced and/or supplied is equal to 100 units. Driven by self-interest, a producer would produce and supply all those units for which the marginal economic profit is greater than zero. At a given quantity produced and/or supplied, the total economic profit is the sum of the marginal economic profit realized on each unit of that quantity produced and/or supplied. Starting from zero, as a producer and/or supplier of the product produces and/or supplies more units, the total economic profit increases by the corresponding marginal economic profit realized on an additional unit produced and or supplied. At the given market price of $4, when the output is 100 units, the marginal economic profit is zero and the total economic profit ceases to increase. If the producer and/or supplier of the product produces and/or supplies more units, he/she would make a loss on each one of these additional units and total economic profit falls. Thus, the producer and/or supplier of the product would not produce and/or supply any unit above 100 units when the market price is $4.00. Hence, when the market price is $4 the quantity that if produced and/or supplied would maximize her/his total economic profit is 100 units. At that output we know that the marginal cost is equal to the given market price. It follows: Driven by self-interest a producer produces and/or supplies that quantity of output where: Marginal Cost = Market Price. Chapter 2 Competitive Markets and Efficiency, Chapter 2 Prefect Competition Markets Intro econ Sep 2024, 9/3/2024 4:27 PM 2-10 Thus point B on the marginal cost AD is also a point on the supply curve of this producer and/or supplier Area ABF in figure 4.a is the sum of all the green bars and represents the maximum total profit when the price is $4. We call area ABF the producer and/or supplier total economic profit or producer surplus. Producer Surplus at a given quantity supplied is the maximum total economic profit a producer or seller does not need to receive to stay in business, but he/she receives it. To induce a producer and/or supplier to increase the quantity supplied, the market price must rise to cover the higher marginal cost of the additional units. For example, if the price increases to $8, all the units between 100 and 300 units would now yield a positive marginal economic profit since the marginal cost (given by the height of the marginal cost curve AD at the corresponding quantity) of producing each one of them is lower than $8. To capture these additional marginal economic profits, a producer and/or supplier would produce and/or supply those units. Also, note that the marginal economic profit on each one of the first 100 units increases by $4. The maximum total economic profit of $900 is now given by area ADG in figure 4.b, greater than the maximum total economic profit of $100 when the market price was $4. This increase in the maximum total economic profit induces the producer and/or supplier to increase the quantity produced and/or supplied from 100 to 300 units. The increase in total economic profit is a signal that the market needs more of the product to be produced. The previous argument shows that the quantity supplied increases as the market price increases because: The increase in the market price helps to cover the higher marginal cost of producing the additional units due to the principle of increasing marginal cost and The increase in the market price produces additional profits to entice the producers to produce more The quantity produced and/or supplied must be an increasing function of the market price This result justifies the following interpretation of the supply curve: At each quantity supplied, the height of the supply curve is equal to the Marginal cost at that quantity supplied The height of the supply curve at a given quantity supplied is also equal to the minimum acceptable price to produce an additional unit of the product or the minimum additional cost of producing the additional unit of the product. Market Supply curve As we shall show later, we construct the market supply curve from the individual supply curves by adding at each price the quantities supplied by every supplier. Because the individual supply curves are upward sloping, it follows that the market supply curve is also upward sloping. The height of the market supply curve at any total quantity supplied is equal to the marginal cost of one of the individual suppliers because all of them have the same marginal cost. For this reason, we call the height of the market supply curve at any total quantity supplied the marginal social cost of an additional unit produced and supplied. Chapter 2 Competitive Markets and Efficiency, Chapter 2 Prefect Competition Markets Intro econ Sep 2024, 9/3/2024 4:27 PM 2-11 Characteristics of an Efficient Allocation of Resources Market economies rely on markets to solve the resource allocation problem. Market prices carry the information needed by market participants to make their decisions. In taking their decisions, market participants promote their respective self-interests. Yet, the market does not end up in chaos and market participants end up promoting the public interest as well. By promoting their self- interests, market participants produce an overall efficient allocation of resources. In this section, we demonstrate that perfectly competitive markets do avoid chaos and do achieve an overall efficient allocation of resources. For this purpose, we draw the market supply and demand curves on the same diagram as in figure 5. We know that The height of the market demand curve at any quantity demanded is the marginal social benefit of consuming an additional unit of the product. The height of the supply curve is the marginal social cost of producing an additional unit of the product. From the social point of view, we should produce a unit of the product as long as the marginal social benefit obtained from consuming that unit is greater than the marginal social cost. Figure 5 shows that for all first 200 units, the marginal social benefit, as given by the height of the marginal social benefit curve EK, is greater than the marginal social cost, as given by the height of the marginal social cost curve AD. For each unit between 0 and 200 units the corresponding solid green bar between the supply and demand curves represents the marginal net social benefit from producing and consuming that unit. It follows that at any quantity, for example a quantity of 100 units, produced and consumed of the product, the total net social benefit is the sum of all the green bars between 0 and that quantity. Figure 5 Efficient Allocation of Resources Now, suppose that the society members agreed to delegate the production and consumption decisions of the product of figure 5 to a benevolent and just dictator and they agreed to provide her/him with all the information about the individual tastes and the production costs of this product. The dictator would then order to produce and consume that quantity of the product that maximizes the total net social benefit. Chapter 2 Competitive Markets and Efficiency, Chapter 2 Prefect Competition Markets Intro econ Sep 2024, 9/3/2024 4:27 PM 2-12 To maximize the total net social benefit, the benevolent dictator would choose to have all of the first 200 units of the product produced and consumed because for all those units the marginal social benefit is greater that the marginal social cost as indicated by the green bars in figure 5. The production of any unit of the product beyond 200 units would result in a negative marginal social benefit and a reduction of the total net social benefit since the corresponding marginal social cost is greater than the corresponding marginal social benefit. The maximum total net social benefit is the sum of all the marginal net social benefits given by the green bars between 0 and 200 units in figure 5. The maximum total net social benefit is equal to the surface of the triangle ACE in figure 5. The maximum total net social benefit is equal to $800 = [($10 - $2) x 200 units] /2. To promote the public interest and thus achieve an efficient allocation of resources, the benevolent dictator would produce 200 units of the product. At this quantity: The quantity demanded and consumed is equal to the quantity produced and/or supplied and The corresponding allocation of resources is efficient since it yields the maximum total net social benefit. We note that a characteristic of an efficient allocation of resources is: Marginal Social Benefit = Marginal Social Cost. There are no benevolent dictators in the real world, but there is plenty of greed since almost every participant in any market is guided by own self-interest. In such real world, would such participants in a perfect competition market for a product achieve the same efficient allocation of resources as did the benevolent dictator? Allocation of Resources in Markets Operating Under Perfect Competition Now we allow free rein to greed to find out if it leads to an efficient allocation of resources and produce at the quantity where the market supply curve intersects the market demand curve such as at point C in figure 5 and where marginal social benefit is equal to marginal social cost. Below, we reproduce figure 5 as figure 6. Associated with the intersection of the market demand and supply curves in figure 6, there is a price of $6 which we shall call the equilibrium price. In the real world, the market price could be equal to the equilibrium price or different from the equilibrium price. We are going to demonstrate that a) If the market price happens to be equal to the equilibrium price, then the market will maintain that price unless it is disturbed. b) If the market price happens to be different from the equilibrium price, private greed on both sides of the market will drive the market price towards the equilibrium price for this market. To start, suppose that the market price happens to be equal to the equilibrium price of $6 as in figure 6. Then All those demanders who are willing to pay the market price for every unit between 0 and 200 units where the demand curve and supply curve intersect will be able to buy them because the total quantity supplied at that price is equal to 200 units. They will be able to achieve the maximum total net benefit for themselves since they would have bought all those units for which their marginal benefit is greater than or equal to the equilibrium price. Chapter 2 Competitive Markets and Efficiency, Chapter 2 Prefect Competition Markets Intro econ Sep 2024, 9/3/2024 4:27 PM 2-13 Every one of them will equate his marginal benefit to the marginal social cost. None of them would want to bid the price up or down. The marginal social benefit is equal to the marginal social cost equal to the market price. All those producers and/or suppliers who are willing to accept the market price for every unit between 0 and 200 units, where the demand curve and the supply curve intersect, will be able to sell the 200 units because the total quantity demanded at that price is equal to 200 units. They will be able to achieve the maximum total economic profit for themselves since they would have sold all those units for which their marginal cost is lower than or equal to the equilibrium price. None of them would want to bid the price up or down. Any additional unit they would wish to sell beyond the total number of units of 200 units will have a marginal cost greater than the market price and they will find no buyer if they try to charge a higher price than $6. Every one of them will equate his marginal cost to the marginal social benefit, which is equal to the market price. Figure 6 Equilibrium in a Perfect Competition Market Price 11 Demand Curve Supply Curve F 10 Excess Supply = GD 9 E 8 G D 7 6 M 5 C 4 L B K 3 2 A Excess Demand = BK 1 0 0 50 100 150 200 250 300 350 400 Quantity Demanded, In conclusion, driven by self-interest and greed, if the market price happens to be equal to the equilibrium price participants in perfectly competitive markets will not attempt to change the market price and they will produce, supply, demand, and consume that total quantity at which Marginal Social Benefit = Marginal Social Cost = Equilibrium Price. Next suppose that the market price happens to be equal to $3, a price that is lower than the equilibrium price of $6. According to supply curve AE of figure 6, when the market price is $3, the producers and/or suppliers would produce and/or supply only 50 units instead of 200 units as when the market price was $6. Also, according to demand curve FK, demanders are willing to buy 350 units at the market price of $3. This quantity demanded is greater than the quantity produced and supplied of 50 units at the price of $3. The maximum total economic profit that producers and/or suppliers would make on the 50 units they would produce and supply to the market at a price of $3 is equal to the area of triangle ABL, which is equal to $25 = [($3 – $2 = $1) x 50] / 2. Chapter 2 Competitive Markets and Efficiency, Chapter 2 Prefect Competition Markets Intro econ Sep 2024, 9/3/2024 4:27 PM 2-14 Now, the height of the demand curve FK in figure 6 at all quantities between 50 and 350 units is higher than $3. Accordingly, with only 50 units produced and offered for sale, many demanders are willing to pay more than $3 for an additional unit but they cannot find a producer willing to sell to them at that price, Demand curve FK in figure 6 shows that at the price of $3, the quantity demanded is 350 units. There is an excess demand of 300 units given by segment BK in figure 6. Those demanders, who cannot buy but they are willing to pay more than $3 per unit, would bid the price higher to convince the producers and/or suppliers to sell to them at a higher price. Demanders are now price makers. Producers are also now price makers. They would ask a higher price than $3. There is a pressure on the price to increase above $3 as indicated by the arrow pointing upward nest to the vertical price axis in figure 6. An excess demand generates a pressure on the market price to increase. The increase in the price above $3 makes some of the additional units beyond 50 units profitable to produce since the market price becomes greater than their marginal costs or the minimum costs to produce those units. Let us draw horizontal line MC at $6. Starting from a market price of $3, let the market price increase to $6 in response to the pressure of the excess demand. Then, all the units between 50 and 200 units become profitable to produce and yield a marginal economic profit given by the vertical distance between the horizontal line MC and supply curve AE. Furthermore, the marginal economic profit on each one of the first 50 units increases by $3. If we add all the marginal economic profits on all 200 units, we get a total economic profit of $300 = [($6 -$2) x 200 units] /2 = $400, as given by the area of triangle ACM in figure 6. The area of triangle ACM is much greater than the $25 area of triangle ABL. Producers and/or suppliers and demanders or consumers driven by their self-interests would cause the market price to increase from $3 to $6. Producers and/or suppliers would increase the quantity produced and/or supplied from 50 to 200 units. Of course, as the output approaches 200 units, the marginal economic profit on the last unit decreases because the marginal cost of producing an additional unit rises. However, self-interest would induce producers and/or suppliers to try to squeeze the last dollar of economic profit. They would continue increasing their quantity produced and/or supplied as long as the height of the supply curve is lower than the market price of $6. Driven by self-interest, the producers and/or suppliers would increase the quantity supplied from 50 units to 200 units sine their total economic profit increases from $25 to $400. After the price rises from $3 to $6, the marginal net benefit to demanders or consumers from purchasing an additional unit of the product up to 200 units is: Marginal net benefit for demanders or consumers = marginal benefit - market price = vertical distance between demand curve FH and the horizontal line MC at $6. For units between 0 and 200 units, and at a market price of 6$, the marginal net benefit is positive. As the quantity produced and supplied increases from 100 to 200 units, the marginal net benefit to demanders or consumers from an additional unit of the product falls and becomes zero at 200 units. As long as the marginal net benefit from an additional unit is positive, demanders or consumers would buy the additional unit of the product. Demanders or consumers would want to buy all those units between 0 and 200 but no more. Their maximum total net benefit will be the sum of the distances between the demand curve FH and the horizontal line MC for all units between 0 Chapter 2 Competitive Markets and Efficiency, Chapter 2 Prefect Competition Markets Intro econ Sep 2024, 9/3/2024 4:27 PM 2-15 and 200. The maximum total net benefit is equal to the area of triangle FMC, which is equal to $400. For units beyond 200 units the marginal net benefit from an additional unit becomes negative. If the demanders or consumers buy more than 200 units, the marginal net benefit on an additional unit becomes negative and this would reduce their maximum total net benefit. Driven by self-interest, the demanders or consumers would want to buy only 200 units at a price of $6 each. This amount is exactly the amount that producers would want to produce and supply at a price of $6. All those demanders of those units between 100 units and 200 units who are willing to pay more than $6 will find a producer or seller who willing to sell to them at $6 a unit. At a price of $6 Demanders or consumers driven by their self-interests would buy 200 units and no more. This number of units maximizes their total net benefit at the equilibrium price. Their total net benefit at the equilibrium price is equal to their consumer surplus. Producers or suppliers driven by their self-interests would produce 200 units and no more no less. This number of units maximizes their total economic profit at the equilibrium price. Their maximum total economic profit at the equilibrium price is their producer surplus. In conclusion, if the market price is less than the equilibrium price, there is an excess demand, and demanders would bid the price upwards, and supplier would ask for a higher price. The market price will rise and converge to the equilibrium price. The quantity produced and demanded will converge to the equilibrium quantity thanks to private greed. A similar argument applies when the market price is greater than the equilibrium price. There will be an excess supply. Producers and/or suppliers who cannot sell and their marginal cost is less than the market price will bid the price down. Demanders will demand a lower price. The market price will fall and converge to the equilibrium price of $6. Some of the producers will exit the market. Thus, An excess supply generates a pressure on the market price to decrease. It follows that if the market price is not equal to the equilibrium price and the quantity demanded of the product is either lower or greater than its quantity produced and/or supplied, then demanders and producers and/or suppliers would compete with each other, including the entry of new producers and/or suppliers and new demanders or exit of some of them in reaction to excess demand or excess supply respectively causing the market price to increase or to fall respectively towards the equilibrium price and the quantity demanded and/or supplied to fall or to increase towards the equilibrium quantity, where the marginal social cost is equal to the marginal social benefit and the total net social benefit is equal to its maximum. Perfect competition markets, if not manipulated by government officials or a corrupted financial system, can achieve an efficient allocation of resources with some adjustment costs. If driven out of equilibrium, they will converge to a new equilibrium which helps them to maintain an efficient allocation of resources. At equilibrium, every participant in perfect competition markets is a price taker. Out of equilibrium, every participant in perfect competition markets is a price maker. At equilibrium of a perfect competition market, Chapter 2 Competitive Markets and Efficiency, Chapter 2 Prefect Competition Markets Intro econ Sep 2024, 9/3/2024 4:27 PM 2-16 The marginal benefit of every demander or consumer of consuming an additional unit of the product is equal to the market’s equilibrium price The marginal cost of every producer of producing and additional unit of the product is equal to the market’s equilibrium price The marginal social benefit = The market’s equilibrium price = The marginal social cost The equilibrium quantity is also the quantity that maximizes total net social benefit The quantity supplied is equal to the quantity demanded. The market achieves equilibrium. The market equilibrium is stable The resulting allocation of resources is overall efficient Markets operating under perfect competition maximize total net social benefit. All the units supplied find a taker. At point equilibrium point C of figure 6, there is no pressure on the price to rise or to fall. At the price of $6 that corresponds to C, the producers and/or suppliers are maximizing their total economic profit, and the demanders or consumers are maximizing their total net benefit. Producers, driven by self-interest produce 200 units and demanders or consumers driven by self-interest demand only 200 units of the product. Self-interest does not lead to chaos. The invisible hand has done its job. Adam Smith is correct. The Invisible Hand at Work The beauty of the information network of the competitive system is in the working. We appreciate better the role of the information network when we analyze the market’s response to a change in the economic environment. Many factors cause a change in the economic environment. We distinguish two groups of factors: Factors that affect mainly the market’s demand schedule and Factors that affect mainly the market’s supply schedule. Factors that affect the Demand Schedule Four major factors cause a change in the whole demand schedule of a product: Average income of demanders or consumers, Prices of substitutes and prices of complements, Tastes of demanders or consumers, and Number of demanders or consumers. We discuss the response of the competitive markets to a change in each one of them separately. An Increase in Average Income: Case of a Normal Good Normally, when income increases, demanders or consumers are willing to pay more for an additional unit of the product. Therefore, at each quantity demanded, the height of the demand curve is greater after the increase in income. In figure 7, the demand curve shifts upward from curve FK to curve BG. Since the supply curve is unaffected, the market equilibrium moves up from point C to point D in figure 7. At point D, the market price of the product is higher, and the quantity demanded and supplied is higher than at point C. According to the new demand curve BG in figure 7, at the original equilibrium quantity of 200 units, the marginal benefit from an additional unit is now $10, higher than the original equilibrium price of $6. Demanders would lure the producers and/or suppliers to supply more by offering to pay a higher price since they are willing to pay more. Producers and/or suppliers would raise the quantity Chapter 2 Competitive Markets and Efficiency, Chapter 2 Prefect Competition Markets Intro econ Sep 2024, 9/3/2024 4:27 PM 2-17 supplied if the price rises to cover their higher marginal cost of producing some units in excess of the original equilibrium quantity of 200 units. For a normal good, an increase in average income causes the demand curve to shift upwards. Figure 7 An increase in average income: The case of a Normal Good Price 15 14 13 B 12 11 10 9 F D 8 7 G 6 5 C 4 3 2 1 A K 0 0 100 200 300 400 Quantity Demanded, Supplied The rise in the price will increase the marginal economic profits on previously produced units and create a positive marginal economic profit on a few units in excess of 200 units. This would induce the producers and/or suppliers to supply more. The price continues to rise, and the quantity produced and/or supplied continues to increase until the market achieves equality between the marginal social benefit and the opportunity cost of an additional unit or its marginal social cost. This happens at the new equilibrium point D. Again, the discrepancy between the marginal social benefit and the marginal social cost at the original equilibrium quantity of 200 units creates an opportunity for producers and/or suppliers and demanders to increase respectively their total net economic profits or total net benefits. Driven by their self-interest, they move the market to a new equilibrium. Since demanders value more the units of the good, they will get more of it by paying a higher price that is necessary to cover the higher marginal costs. An Increase in Average Income: Case of an Inferior Good Now some goods such as potatoes are inferior goods. We are willing to pay for every unit of them less as our income rises. The increase in income makes it possible to buy goods which provide the same nutrition but with a better taste. Therefore, to be able to buy these goods we decrease the consumption of potato and spend the savings on better quality products such as meat. The willingness to pay for an additional unit of meat increases, but the willingness to pay for potatoes falls. In figure 8, the demand curve for potato shifts downward from BG to FK in figure 8. For an inferior good, an increase in average income causes the demand curve to shift downwards. The equilibrium point moves from point D to point C. The market price decreases from $8 to $6, and the quantity demanded falls from 300 to 200 units. According to the new demand curve FK, for any unit between 100 and 300 units, the market price of $8 becomes greater than the marginal benefit that a demander or consumer gets from any one Chapter 2 Competitive Markets and Efficiency, Chapter 2 Prefect Competition Markets Intro econ Sep 2024, 9/3/2024 4:27 PM 2-18 of those units. Demanders would not want to buy them. Demanders or consumers would want to buy only 100 units. The producers of these units would not be able to sell them at the old equilibrium price of $8. The market price must fall to make the profit negative on the units with the highest marginal cost, those closer to 300 units. This would be a signal to the producers of the units with the highest marginal cost to stop producing them and reduce the quantity supplied below 300 units. The fall in the market price would make the marginal benefit on the units above but close to the first 100 units greater than the price. This would entice some demanders to increase their quantity demanded. The total quantity demanded increases beyond 100 units. The total quantity supplied would fall from 300 downwards and the total quantity demanded would rise from 100 units upwards. Figure 8 An Increase in Average Income: The Case of an Inferior Good Price 16 14 B 12 F E 10 D 8 G 6 C 4 2 A K 0 0 100 200 300 400 Quantity Demanded, Supplied The market price would continue to fall until it reaches $6. As the price falls, the excess supply decreases. When the price reaches $6, the excess supply is zero. At this price, the total quantity demanded according to the new demand curve is equal to the total quantity supplied, equal to 200 units. At 200 units, the marginal benefit and the marginal cost of an additional unit of the product are again equal to the equilibrium price. This time, the decrease in the marginal profit of the inferior good caused the necessary adjustment to take place. When we compare the new equilibrium to the old one, we find that the total quantity demanded, and the total quantity supplied are both lower. The resources must move out of the production of potato and shift to the production of meat. Those farmers, who were producing the potato units between 200 and 300 units, move out resources from the production of potato and shift them to the production of meat. An Increase in the Price of a Substitute Many commodities have close substitutes. Close substitutes satisfy almost the same need of the consumer or the producer. Examples of substitute products are small and big cars, public and private transportation, electric based heat or oil-based heat, beef meat or chicken meat, butter or margarine, coffee or tea etc. When the price of its substitute (oil for heating) rises, demanders or consumers would appreciate more the product (electric power) since they will have to pay more for the substitute to get the same enjoyment of heat as before. Therefore, the marginal benefit or willingness to pay from one Chapter 2 Competitive Markets and Efficiency, Chapter 2 Prefect Competition Markets Intro econ Sep 2024, 9/3/2024 4:27 PM 2-19 more unit of the product (electric energy) would rise. In figure 9, the demand curve for electric energy would shift upwards from FK to BG. (Figure 9 describes the market for electric energy). Since the supply curve is unaffected, the equilibrium of the market would move from point C to point D in figure 9. Consequently, the equilibrium price would rise from $6 to $8, and the quantity supplied and demanded of the product (electric energy) increases from 200 to 300 units. As in the previous case, the rise of the equilibrium price is necessary to cover the higher marginal costs of the additional units between 200 and 300 units. The demanders or consumers are willing to pay because they value more those units than before. At the same time, the producers and/or sellers of the product will make additional marginal economic profits on these units, the total of which is given by the area of triangle CDH in figure 9. While producers don't need these profits to stay in business, these additional marginal economic profits provide an incentive to entice them to produce those units. Figure 9 An increase in the Price of a Substitute Price 15 14 13 B 12 11 E 10 F 9 D 8 H 7 M G 6 L C 5 4 3 K 2 1 A 0 0 100 200 300 400 Quantity Demanded, Supplied In our example of electric based heat and oil-based heat, self-interest of every market participant would drive the market to allocate more resources to the production of electric based heat. In contrast, there will be fewer resources allocated to the production of oil-based heat. Thanks to the precipitous rise in the price of oil in the 1970's, The Company Hydro-Quebec was able to borrow more funds and build additional dams to increase tremendously the production of hydroelectricity in Quebec. An Increase in the Price of a Complement Many products complement each other. They complement each other in the sense that together they satisfy a certain need of the consumer. People combine cars and oil in a certain proportion to produce the transportation service. When the price of oil rises, the transportation cost increases more when we use larger cars. We switch to smaller cars because they use less oil to produce essentially the same transportation service. Hence, the maximum amount we are willing to pay (or the marginal benefit we get from) for an additional large car is now lower, and that from the smaller car is larger. Hence, the demand curve for large cars shifts downwards and that for smaller cars upwards. Figure 10 describes the market for large cars. When the price of oil increases, the demand curve for large cars shifts Chapter 2 Competitive Markets and Efficiency, Chapter 2 Prefect Competition Markets Intro econ Sep 2024, 9/3/2024 4:27 PM 2-20 downwards from BG to FK. Since the supply is unaffected, the market equilibrium moves from point D to point C. The equilibrium price for larger cars falls. In addition, the equilibrium quantity demanded, produced and supplied falls. The fall in the equilibrium price lowers the marginal economic profits on the units between 0 and 200 units and creates losses for units between 200 and 300 units. Those producers who continue to produce units between 200 and 300 would experience losses. These losses are given by the area of triangle CDH in figure 10. Figure 10 An increase in the Price of a Complement Price 15 14 B 13 12 11 F E 10 9 D 8 7 G 6 5 H C 4 3 K 2 1 A 0 0 100 200 300 Quantity 400 Many North American car-manufacturing companies experienced huge losses in the late seventies and early eighties following sharp increases in oil prices in 1973 and 1979 because they continued to produce large cars. Only after they reduced substantially the production of large cars and increased the production of smaller cars were they able to return to profitability. Again, driven by self-interest, producers or suppliers and demanders or consumers will adapt by reallocating resources so that the marginal social benefit is equal to the marginal social cost again at a new equilibrium. An increase in the Number of Demanders or consumers Suppose that curve BD in figure 11.a is the demand curve (of one consumer, consumer 1) before an increase in the number of demanders or consumers (from one to two) and demand FH in figure 11.b is the demand curve of an additional number of demanders or consumers (one more consumer). Curve DB in figure 11.c is the market demand curve before the increase in the number of demanders or consumers from one to two. To construct the new market demand curve of two demanders or consumers, we proceed as follows. At each price level say $2, we add the quantity demanded AB or 2 units in figure 11.a to the quantity demanded EF or one unit in figure 11.b. We plot the result JK = AB + EF = 2+ 1 = 3 units against the price of $2 in figure 11.c as point K. We repeat this procedure for every other price say price equal to $1. At this price, the quantity demanded by the first consumer is CD or 4 units as given in figure 11.a and the quantity demanded by the second consumer is GH = 3 units as illustrated in figure 11.b. The total quantity demanded is LM = CD + GH = 7 units which we plot against the price of $1 in figure 11.c as point M. Chapter 2 Competitive Markets and Efficiency, Chapter 2 Prefect Competition Markets Intro econ Sep 2024, 9/3/2024 4:27 PM 2-21 Figure 11 An Increase in the number of Demanders or consumers Figure 11.a Figure 11.b Figure 11.c One Demander Market Demand Curve Price Price Price $2 A B $2 E F $2 J B 2 consumers K M $1 C D $1 G H $1 L D 2 4 1 3 3 7 Quantity Quantity Quantity Demander 1’s Demander 2’s Market Demand Curves Demand Curve Demand Curve Connecting points K and M and other similarly constructed points in figure 11.c, we get the new market demand curve KM. We say demand curve KM is the horizontal sum of demand curves BD and FH. A rise in the number of demanders or consumers shifts the demand curve to the right from BD to KM as illustrated in figure 11.c. The effect on the equilibrium price and equilibrium quantity of an increase in the number of demanders or consumers and the corresponding process of adjustment of a market under perfect competition with free entry and exit and perfect information are similar to the effect of an increase in average income for a normal good and the corresponding adjustment process. Factors that Affect the Supply Curve Essentially, there are four factors that affect the supply curve and cause it to shift when they change: the price of inputs, improvements of technology, the price of other production related products, and the number of producers and/or sellers. An increase in the wage rate When the wage rate increases, the marginal cost at any quantity produced of producing an additional unit of the product increases. The supply curve shifts upward from AE to BF as in figure 12. With the demand curve unchanged as given by curve CK, the equilibrium point moves from point D to point C. The equilibrium price rises from $8 to $10. The equilibrium quantity produced and supplied, and the equilibrium quantity demanded fall from 300 to 200 units. At the old equilibrium price of $8, some of the producers and/or sellers would make a negative profit on the higher marginal costs between 100 and 300 units that they used to produce before the increase in the wage rate. If the price remains equal to $8, no producer would produce these units. Chapter 2 Competitive Markets and Efficiency, Chapter 2 Prefect Competition Markets Intro econ Sep 2024, 9/3/2024 4:27 PM 2-22 However, at a quantity produced and supplied of 100 units, the demanders or consumers’ marginal benefits of the units between 100 and 300 units (given by the height of the demand curve CK in figure 12 at 100 units) are greater than the old equilibrium price of $8. At that price the quantity demanded remains equal to 300. There appears an excess demand of 200 units. When there is excess demand (or supply), demanders and producers and/or sellers cease to be price takers; they are price makers. Figure 12 An increase in the Wage Rate 16 Price 14 F Wage 12 Increase C 10 E 8 D 6 B K 4 2 A 0 0 100 200 300 400 Quantity Demanded, Supplied Some of the demanders or consumers who could not purchase the units between 100 and 200 units would bid the price up since they are willing to pay more. Producers and/or sellers would ask for a higher price for those units to cover their now higher marginal costs. There is a pressure on the price to increase. As the price starts to rise, producers and/or sellers raise their quantity produced and supplied. The quantity demanded decreases. Some demanders or consumers would drop out of the market. The price would continue to rise as long as, at the quantity produced and supplied at that price, the marginal benefit to the demanders or consumers is greater than the minimum price the producer or supplier is willing to accept. When the price reaches the new equilibrium price of $10, the quantity supplied stops rising and the quantity demanded stops falling, they are equal at the new equilibrium C. Now demanders or consumers and producers and/or suppliers lose their power to make prices. They become price takers. The quantity demanded at equilibrium is lower because the equilibrium price is higher. Some of the producers and/or sellers would shift their capital out of the country to other countries where the wage rate is much lower. This was the case for textiles when provincial governments instituted minimum wages, and the federal government introduced social security. A lot of textile manufacturing moved out to such countries as South Korea, Taiwan, Indonesia, and other newly industrialized countries. An Improvement in Technology An improvement in technology results in a decrease in marginal costs. The supply curve shifts downward from BK to AE as in figure 13. With the demand curve unchanged, the equilibrium point Chapter 2 Competitive Markets and Efficiency, Chapter 2 Prefect Competition Markets Intro econ Sep 2024, 9/3/2024 4:27 PM 2-23 moves from C to D. The equilibrium price falls from $10 to $8, and the equilibrium quantity supplied and demanded rises from 200 to 300 units. At the old equilibrium price of $10, all of the current producers and/or sellers would make a higher marginal economic profit on the 200 units currently produced. In addition, all the units between 200 and 400 become profitable to produce. (Why?). New producers and/or sellers would be attracted to this industry as they realize the appearance of the potential total economic profit given by area of triangle CEH in figure 13. Figure 13 Improvement in Technology Price Improvement 15 in Technology 14 13 F K 12 11 10 C E 9 8 7 D G 6 B H 5 4 3 2 A 1 0 0 100 200 300 400 Quantity Demanded, Supplied If the price remains the same at $10 as it was before, an excess supply of 200 units as given by segment CE in figure 13 develops. Now producers and/or suppliers and demanders or consumers are price makers. The appearance of a marginal economic profit on units between 200 and 400 make it possible for existing or new producers and/or sellers to produce more and to offer to sell at a lower price. This would put a pressure on the market price to fall to entice the demanders or consumers to purchase more than 200 units. Yet, the fall in the price leaves an additional positive profit to existing and new producers and/or sellers. For example, when the price falls to 9$, it becomes lower than the marginal benefit to the demanders or consumers from units between 200 and 250 units and will still be higher than the marginal cost of producing each one of those units as given by the height of the new supply curve above those units. The quantity supplied and demanded would increase. However, this price is still higher than the marginal cost of producing units immediately above 250 units. Therefore, the price would continue to fall, as more producers and/or sellers are attracted to the industry. The fall in the price would stop when we reach the new equilibrium price of $8 at D in figure 13. The new producers and/or sellers would bring in new capital and would employ more labour and other factors of production in this line of production in order to allow the market to reach a new efficient allocation of resources. This is what happened, and it is still happening in the cellular phone industry. For example, the improvement in the production of the technology of producing cellular phones lowered their costs and their prices thereby causing a shift of resources to their Chapter 2 Competitive Markets and Efficiency, Chapter 2 Prefect Competition Markets Intro econ Sep 2024, 9/3/2024 4:27 PM 2-24 production away from other industries. The pursuit of self-interest leads to an improvement in the allocation of resources and promotes the public interest. An increase in the price of other products Everything else equal, in particular the price of inputs, an increase in the price of other products causes the profits in other lines of production to be higher. Therefore, the opportunity costs of capital and other factors of production in the production of current goods and services rise. Consequently, the marginal cost of producing an additional unit of a product, which includes that opportunity cost, would also rise. The effect on the equilibrium price and resource allocation is similar to the case of a rise in the wage rate. An increase in the number of producers and/or sellers or suppliers Suppose that curve BD in figure 14.a is the market supply curve of one existing producer and/or seller before an increase in the number of producers and/or sellers from one to two producers and/or sellers and supply curve FH in figure 14.b is the supply curve of an additional producer and/or seller. Figure 14 An Increase in the Number of Producers and/or sellers and the Market Supply Curve Figure 14.a Figure 14.b Figure 14.c 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 H D M 2 4 1 3 2 3 4 7 Quantity Quantity Quantity Supplier 1 Supply Curve Supplier 2 Supply Market Supply Curve Curve Figure 14.c Figure 14.a Figure 14.b To construct the new market supply curve, we proceed as follows. At each price level, say $2, we add the quantity supplied AB = 4 units in figure 14.a to the quantity supplied EF = 3 units in figure 14.b. We plot the result JK = AB + EF = 7units against the price of $2 in figure 14.c as point K. We repeat this procedure for the price of $1. At the price of $1, the quantity supplied by the first producer is CD = 2 units as given in figure 14.a and that by the second producer is GH 1 unit as given in figure 14.b. The total quantity supplied is Chapter 2 Competitive Markets and Efficiency, Chapter 2 Prefect Competition Markets Intro econ Sep 2024, 9/3/2024 4:27 PM 2-25 LM = CD + GH = 2 units +1 unit = 3 units. We plot the quantity LM = 3 units against the price of $1 in figure 14.c as point M. Connecting points K and M in figure 14.c and other similarly constructed points, we get the new market supply curve KM of two producers and/or sellers. We say the supply curve KM is the horizontal sum of the supply curves BD and FH. We also plotted curve DB in figure 14.c. A rise in the number of producers and/or sellers shifts the supply curve to the right from BD to KM as illustrated in figure 14.c. The number of producers and/or suppliers increases because, as figure 15 below shows, the total economic profit in the industry is greater than zero and it is equal to $400 before the increase in the number of producers and/or suppliers. Figure 15 reproduces figure 14.c with its two supply curves and an added demand curve FG. Supply curve DB corresponds to a lower number of producers and/or suppliers and supply KM corresponds to a higher number of producers and/or supplies as in figure 14.c. Figure 15 Effect of an Increase in the Number of Producers and/or Suppliers on Equilibrium Price 16 Supply Curve lower number of F 14 producers B 12 H C M 10 8 D 6 K G D 4 Supply Curve higher number of 2 producers 0 0 100 200 300 400 Quantity The equilibrium price of $10 in figure 15 before the rise in the number of producers and/or sellers is higher than the marginal cost of producing any unit between zero and the product’s equilibrium quantity of 200 units before the increase in the number of producers and/or suppliers. Hence, the existing producers or suppliers, lower in number, are making a large economic profit. The total economic profit before the increase in the number of producers or suppliers is equal to the area of triangle CDH in figure 15, which area is equal to $400 = (($10 – $6) x 200 units)/2. Prospective producers or suppliers enter the market attracted by the possibility to make an economic profit. The entry of new producers shifts the supply curve to the right from supply curve DB to supply curve KM. Consequently, the equilibrium price falls to $8 and causes the marginal economic profits to fall and thus the total economic profit of the existing producers or suppliers to fall. Chapter 2 Competitive Markets and Efficiency, Chapter 2 Prefect Competition Markets Intro econ Sep 2024, 9/3/2024 4:27 PM 2-26 This is what happened in the personal computer industry. First, Apple Computer Company introduced personal computers in the early 80's. Then IBM realized there is a profit in this line of production. IBM entered this line of business with a product of its own. It called it the PC computer. Other smaller producers realized that they could do the same. They acquired the license from IBM and started producing and selling what was called IBM compatible computers. After the entry of these new producers, the price of personal computers dropped sharply. The entry of new producers was motivated by the large profits that the Apple Company and IBM were making initially. They caused the market supply curve to shift to the right from BD to KM as in figure 15. Therefore, the market price fell dramatically to the point that IBM started making a loss in 1990. It was charging a much higher price than the price of the clones and its unit costs were too high. After a restructuring and a substantial cut in its price to match the lower prices of the new competitors, IBM returned to profitability. However, competition from new entrants in Asia forced IBM to sell its business of laptop computers to a new much smaller Asian competitor. Conclusions The focus of this chapter has been on the efficiency of perfectly competitive markets. In his famous book, A. Smith proclaimed that driven by self-interest, private economic agents promote the public interest as if guided by an invisible hand. That is, private economic agents while promoting their respective self-interests and operating in perfectly competitive markets will together allocate resources efficiently if we guarantee freedom of movements of resources. In general, the amount produced of every product is equal to the amount demanded so that perfectly competitive markets do not lead to chaos. We call this situation market equilibrium. At the market equilibrium, the intersection of the supply and demand curves determines the equilibrium price and the equilibrium quantity. The height of the supply curve of a given supplier or producer at a given quantity supplied is the Deleted: At a given quantity supplied, t marginal cost or the minimum cost of producing an additional unit of the product. It is also the minimum price that a producer would accept in order to supply an additional unit of the product. The marginal cost increases as the quantity supplied increases because of diminishing returns and the use of overtime. The market supply curve of a product is the horizontal sum of the supply curves of each producer of the product. The market supply curve is upward sloping. The height of the market supply curve at a given quantity supplied is the marginal social cost. At a given quantity demanded by a single demander or consumer, the height of her/his demand curve is the marginal benefit he/she gets from consuming an additional unit of the product. Because as we consume more of a product, we get less marginal benefit from an additional unit of the product, (e.g. water), the demand curve of a single consumer is downward sloping. The height of the demand curve of a single demander or consumer at any given quantity demanded represents also the maximum amount of money he/she is willing to pay for acquiring and consuming an additional unit of the product. The market demand curve of a product is the horizontal sum of the demand curves of all the demanders or consumers of the product. The market demand curve is downward sloping. The height of the market demand curve at a given total quantity demanded by all demanders is equal to the marginal social benefit from producing an additional unit of the product. At the intersection point of the market demand curve and the market supply curve, the market achieves equilibrium. At equilibrium, the marginal social cost is equal to the marginal social benefit, Chapter 2 Competitive Markets and Efficiency, Chapter 2 Prefect Competition Markets Intro econ Sep 2024, 9/3/2024 4:27 PM 2-27 and both are equal to the market equilibrium price. At equilibrium, the sum of the quantities demanded by all the demanders or consumers is equal to the sum of the quantities supplied by all producers and/or suppliers at the equilibrium price. At the equilibrium of a perfectly competitive market, the equality of the total quantity demand by all demanders or consumers and the quantity supplied by all producers and/or suppliers imply that perfectly competitive markets produce all those units for which the marginal social benefit is greater or equal to the marginal social cost. When the marginal social cost is equal to the marginal social benefit, a market has achieved an efficient allocation of resources. We have an efficient allocation of resources when the quantity demanded and supplied maximizes total net social benefit. Total net social benefit at a given quantity demanded and produced is equal to the difference between total benefit from consuming the given quantity of the product and the total cost of producing it. The consumer surplus is equal to the difference between the total benefit demanders or consumers get from consuming a given quantity and the total amount demanders or consumers pay to purchase the given quantity at a given price. The producer surplus or the total economic profit is equal to the difference between the total revenue the producers and/or sellers get from producing and selling a given quantity of a product at a given price and the total cost of producing the given quantity. At equilibrium, the maximum total net social benefit is equal to the sum of the consumer surplus and the producer surplus at the equilibrium quantity and price. The invisible hand is the information about prices and profits. Whenever the price of a product is higher than the marginal cost of producing and/or supplying some units of the product, economic profits appear. Markets under perfect competition provide this information “free of charge” to all market participants. Those who can produce an/or supply additional units of the product at a marginal cost lower than the market price would flock into this line of production. This would lower the market price of the product and attract demanders or consumers, all leading to an increase in social welfare helping the economy achieve an efficient allocation of resources. Whenever the market (as distinct from the equilibrium) price of a product is lower than the marginal cost of producing some units of the product, economic losses appear. Competitive markets provide this information to all (existing and/or potential) market participants (on the demand and supply sides of the market). Some of the producers and/or sellers would quit. This would increase the market price and reduce the quantity demanded by some demanders or consumers, including poor people) leading to an increase in social welfare helping the economy achieve an efficient allocation of resources. We have illustrated the operation of the invisible hand by studying how perfectly competitive markets react to changes in many parameters of the economic environment. A rise in the average income raises the marginal benefit from the consumption of an additional unit of a normal good and the willingness to pay of the demanders or consumers for an additional unit of the product. Competing with each other, the demanders or consumers would push the price above the current marginal cost creating an opportunity for producers and/or suppliers to make an additional economic profit. As a result, more producers and/or sellers will flock into this line of production provided there is free entry. The invisible hand would work to insure an increase in the production of this product at the cost of a rise of the equilibrium price of the product or because of it. An increase in wages raises the marginal cost of producing an additional unit of the product at any given quantity produced and shifts the supply curve upwards. If the equilibrium price remains Chapter 2 Competitive Markets and Efficiency, Chapter 2 Prefect Competition Markets Intro econ Sep 2024, 9/3/2024 4:27 PM 2-28 unchanged, the last units produced would become unprofitable. Some producers and/or sellers would withdraw their capital and lay off workers in order to reduce output and reduce their losses. Some of them will actually shift their capital to other countries where the wages are unchanged, produce more there and, export their output back to their own country if there is free trade. The invisible hand allocates capital resources away from the country. An improvement in technology does the opposite. Perfectly competitive markets perform well in terms of directing resources and insuring harmony and efficiency in the allocation of resources provided they do not encounter obstructions (such as some market participants on the supply side or on the demand side erecting barriers with the help of the financial sector and/or government officials). Perfectly competitive markets are admittedly ideal, but they provide a good approximation to many real world markets. Furthermore, they cannot function properly without an appropriate infrastructure as provided by society at the hands of non-corrupted government officials. Unfortunately, even if we admit that the required information is complete and freely available to everyone, it is clear that perfectly competitive markets do not care about who suffers from poverty, and they are like many democratic processes prone to manipulation from within and without. They also do not work well if some of the resources used in the production process are naturally and freely available, but