Lecture 6 Part I. Markets without market power: Perfect competition

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1 Lecture 6 Part I Markets without market power: Perfect competition

2 Market power Market power: Ability to control, or at least affect, the terms and conditions of the exchanges in which one participates According to traditional neoclassical view: Market power is considered to be bad: It can create inefficiency Competition is considered to be good: the image of a self-regulating, harmonious, «free» competitive market is at the core of this view

3 Perfect competition Assumptions of the traditional neoclassical model which we had so far are still valid. PLUS some additional assumptions: There are numerous small sellers and buyers, so small that no individual seller or buyer can affect the market price. Only one kind of good or service is traded. All units of this good or service are identical, therefore, buyers don t care from which seller they buy. Producers can freely enter or exit the industry. Buyers and sellers have perfect information: They know where the good is available, at what prices it is offered, and whether profits are being made.

4 Perfect competition Further assumptions (cont d): Firms have smooth curves with short-run diminishing returns (convexity and marginal thinking) Long-run minimum efficient scale of each producer is fairly small (relative to the demand for the output of the industry): constant returns to scale The market is assumed to operate in the following manner: Everyone (hypothetically) gathers together. Someone compiles all the offers to buy and to sell and based on that he/she determines the market-clearing price (a hypothetical «auctioneer») The price is announced, everyone who wants to exchange at this price does so.

5 So, Perfect competition Every individual seller is price-taker Each individual seller faces a horizontal (perfectly elastic) demand curve: he/she can sell as many units as she wants, as long as he/she charges the market price (BUT NOTE THAT market supply and market demand may have various other slopes!)

6 Perfect competition Any examples? Agricultural products, for instance, wheat?? Financial resale markets, for instance, for shares of certain companies Some labor markets

7 Profit maximization under perfect competition Competitive equilibrium: The equilibrium in a market where all buyers and sellers are pricetakers, unable individually to influence the price they pay or charge How much will each producer sell? It depends on demand for the product and on the firm s cost structure

8 Profit maximization under perfect competition How much economic profit will the profit-maximizing competitive firm make? Zero!! Zero economic profit (or normal profit): Revenues are just sufficient to compensate for the use of labor, materials, and other physical inputs, financial and physical capital, and the time inputs all evaluated at their opportunity costs Positive economic profit (or above-normal or supernormal profit) The amount by which revenues exceed all economic costs (incl. opportunity costs) BUT WHY ZERO?

9 Profit maximization under perfect competition The profit-maximizing firm in case of perfect competition will make zero economic profits in the long-run, because of the free entry and exit of firms into the industry!

10 Efficiency and equity in case of perfect competition Perfectly competitive markets are efficient and lead to the best possible outcomes, if: There are no production and consumption externalities (neither positive nor negative) There are no public goods All cost and effects are captured in this static model (i.e., there are no effects spread out over time) Society is not concerned about distribution (i.e., the current distribution of ability to pay is considered acceptable) THEN; Market supply curve reflects social marginal cost of production, and market demand curve reflects social marginal benefit of consumption: allocative efficiency

11 Perfect competition and long-run efficiency No competitive firm will operate on the downward-sloping or upward-sloping part of the LAC curve. WHY?

12 Perfect competition and long-run efficiency

13 Consumer and producer surplus Consumer surplus: The excess (summed over all buyers in a market) of the amounts that buyers would be willing to pay for a good or service, over the amounts that they actually pay

14 Consumer and producer surplus Producer surplus: The excess (summed over all sellers in the market) of the amounts that sellers actually receive, over the amounts that would make them just willing to supply the good or service

15 Deadweight loss Deadweight loss: The loss in efficiency (measured in terms of consumer and producer surplus) that arises if market transactions take place at other than the competitive market equilibrium level

16 Policy analysis: Taxation

17 Policy analysis: Taxation Tax with rather elastic demand

18 Policy analysis: Taxation

19 Policy analysis: Rent control Rent control with moderately elastic supply

20 Policy analysis: Rent control Rent control with perfectly inelastic supply

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