11.1 The Basic Model of Perfect Competition
1. Sellers are price takers. Each supplier has a negligible impact on the market price and no impact on the collective actions of other suppliers.
2. Sellers do not behave strategically. The supplier doesn't anticipate any reaction by rival suppliers when it chooses its own actions.
3. Entry into the market is free. (A market is said to be characterized by free entry when new suppliers can enter the market without any restrictions on the process of entry. A market is said to be characterized by blocked entry when it is impossible for new suppliers to enter the market at any reasonable cost – may be legal or technological barriers.)
4. Buyers are price takers. They take the price as given.
The Appropriate Market Structure
Whether the previous assumptions are likely to be satisfied depends on the market structure – the economic environment in which buyers and sellers in an industry operate.
This is a list of the important dimensions and the conditions consistent with the assumption of perfect competition.
1. The size and number of buyers: The assumption of buyer price-taking is most appropriate when there are many buyers
2. The size and number of suppliers: The assumption both of price taking and of nonstrategic behavior by suppliers are most likely to be satisfied when there are many suppliers in the market.
3. The degree of substitutability of different sellers' products. (Homogeneous goods are perfect substitutes, and have a marginal rate of substitution of one. Homogeneous goods are considered identical by buyers.) Since perfect competition is a model of price-taking sellers, the most appropriate market structure is one in which the outputs of different suppliers are homogeneous products.
4. The extent to which buyers are informed about prices and available alternatives: For the assumption that sellers are price takers to be a sensible one, buyers must be well informed about the available alternatives.
5. The conditions of entry: No technological or legal barriers to entry is present in a perfectly competitive market.
Identifying a Competitive Market Structure
The competitive model also captures the behavior of many product and factor markets, even if it does not fit all of the assumption exactly.
Finding a Competitive Equilibrium
The equilibrium market price and quantity are found by using market demand and supply curves.
The Short Run
Market Supply by Firms
To find the short-run market supply curve, we horizontally sum the individual firm supply curves. (i.e. For a given price, we add up the number of units that each firm would be willing to supply at that price to get the total market supply.)
The assumption that buyers are price takers allows us to summarize buyer behavior in terms of a market demand curve. We horizontally sum the individual demand curves.
A competitive market is in equilibrium when: (1) buyers are choosing their optimal output levels, given the prevailing market price; (2) sellers are choosing their optimal output levels, given the prevailing price; and (3) suppliers are willing to produce as much as buyers wish to purchase, and buyers are willing to purchase as much as suppliers choose to produce. The equilibrium price and quantity is found at the intersection of the market supply and market demand curves.
The Individual Supplier's Perspective
An individual supplier bases its decisions on its firm-specific demand curve. For a price-taking firm, the demand curve (and marginal revenue curve) is represented as a horizontal line at the market price. The firm's equilibrium quantity is where the firm-specific supply curve intersects with the firm-specific demand curve.
The Role of Price
In a competitive market, there is no one person who works to bring the quantity demanded in line with the quantity supplied – this is done by the impersonal forces of the market. The buyer does not need to know about technology, factor prices, or the number of suppliers. From the buyer's point of view, market conditions can be summarized entirely in terms of their market price.
The Long Run
Over a long enough time period, new suppliers can enter the market and old suppliers can exit. As a result, the short and long-run equilibria of a market may be very different.
When entry is free, the long-run market quantity supplied is infinite for any price greater than the minimum of long-run average cost. The market quantity supplied is zero at any price less than the minimum of long-run cost. It follows that the firms collectively are willing to supply any quantity at a price of p*, the minimum of long-run average cost.
The long-run market supply curve is a horizontal line at a price equal to the minimum level of long-run average cost. An industry in which long-run average costs remain unchanged as industry output rises is said to be a constant-cost industry. The long-run average cost is p* no matter what the long-run quantity supplied is.
The market demand is likely to be more elastic in the long run, because people have more opportunities for substitution.
The equilibrium price is at the intersection of the market supply and demand curves.
The Individual Supplier's Perspective
If the long-run equilibrium price is p*, then we know that each supplier faces a firm-specific demand curve that is horizontal at a price of p*. At this price, profit is maximized by producing x* units of output. Looking at the market equilibrium, we can see that the market equilibrium output is X1. We can use this to determine the number of firms in the market: N1=X1/x*
The Long Run is the Short Run Too
A long-run equilibrium is also a short-run equilibrium: each firm in the industry is producing at a point where price is equal to marginal cost and no firm that is operating could increase its profit by shutting down. However, it is not the case that every short-run equilibrium is a long-run equilibrium. To find a long-run equilibrium, there must be the right number of firms, and all firms must earn zero economic profit.
Input Price Taking by the Firm But Not by the Industry
A short-run supply curve may be upward sloping even when input prices paid by the firms are constant. In contrast, the long-run supply curve is flat when input prices paid by the firms are the same. When all suppliers are the same, any upward slope in the long-run supply curve is due to an industry-wide price effect. An increasing cost industry is an industry in which long-run average costs rise with the industry output level. An industry in which long-run average costs fall as the industry output rises are called a decreasing cost industry.
Heterogeneous suppliers are producers of a single good who have different costs of production from one another. (e.g. There may be a limited number of 'good mines' where gold can be extracted cheaply, and a much larger number of 'bad mines' where it is more expensive to extract gold.)
Taking the horizontal sum of the individual supply curves, we find the market supply curve. The equilibrium price is given by the intersection of the industry supply and demand curves. Once we have found that price, we can use it to construct the firm-specific demand curve faced by each supplier.
When there are only four good mines and entry by a bad mine is free, the long-run industry supply curve initially is upward sloping and then becomes flat at the price equal to the minimal long-run average cost of a bad mine. Depending on the market demand curve, the equilibrium price may be equal to the minimal value of the long run average cost of a bad mine. At this price, bad mines earn zero economic profits, but good mines earn positive economic profits.
When there are ore deposits of many different qualities and there are just a few deposits of each quality, the long-run supply curve is upward sloping over a wide range. At price ps, the price of gold is so high that it is profitable to extract gold from sea water. Since the amount of gold that can be recovered this way is unlimited, this segment of the supply curve is a horizontal line.
The mineral rights for a good mine sell for more than the mineral rights to a bad ore deposit by the amount equal to the additional profit that can be made from them (the producer surplus). In this case, the owner of the mine gets the economic rents, and the operator of the mine does not.
An economic rent is what the supplier of a good or service gets paid above and beyond what is needed to induce it to supply the output.
Four Steps to Finding an Equilibrium
1. Derive individual supply and demand curves.
2. Sum up individual curves to obtain market curves.
3. Find the equilibrium price and market output levels.
4. Find the individual production and consumption levels.
11.2 Using the Competitive Model
The Effect of Taxes
The statutory incidence of a tax - the economic agent who is legally responsible for the payment of the tax – is not always the same as the economic incidence of a tax – the change in the distribution of income brought about by the imposition of the tax. To determine who really pays the tax, we must look at the economic incidence of the tax.
Ad Valorem Tax: A tax whose amount depends on the value of the transaction being taxed. (e.g. 5% sales tax on clothing)
Unit Tax: A tax that is levied as a fixed amount per unit of the item subject to taxation. (e.g. 5 cents per gallon of gasoline, or $1 per pack of cigarettes)
The imposition of a unit tax paid by suppliers raises the supply schedule as perceived by consumers by exactly the amount of the tax. The economic incidence of the tax falls on both producers and consumers. The price paid by consumers rises (so it’s more expensive for consumers), but the price net of the tax falls (so producers make less than before the tax).
If the imposition of the tax is on the buyers, then from the perspective of the sellers, the after-tax demand curve, D' is equivalent to the before-tax demand curve shifted downward by exactly the amount of the tax. In this case, the price paid by consumers rises (so it’s more expensive for consumers), but the price net of the tax falls (so producers make less than before the tax).
In a competitive market, the economic incidence of a unit tax is independent of whether it is levied on consumers or producers.
Elasticities and Incidence
If demand is perfectly inelastic (demand curve is a vertical line), then the entire tax burden is borne by consumers. In general, the greater the elasticity of demand, the less the tax burden is borne by buyers, all else equal.
If supply is perfectly elastic (supply curve is a horizontal line), then the entire tax burden falls on consumers. In general, the greater the elasticity of supply (the percentage change in the quantity supplied divided by the percentage change in price), the less the tax burden is borne by suppliers, all else equal.
Who Pays for Social Security?
The payroll tax used to fund Social Security is a flat percentage of the employees’ gross wages up to some fixed amount. Half of the tax is paid by employers and half by employees. However, we may assume that the supply of labor is perfectly inelastic. (Empirically this is close to the truth.)
In this case, the employer tax shifts the effective demand curve downward. The employee tax shifts the effective supply curve upward by the amount of the tax (but if supply is perfectly inelastic, then this shift results in the same vertical line). After the imposition of the tax, the wage paid by employers to workers falls, while the full price for labor paid by employers (including wages and the tax payments) stays constant.
The Elasticity of Demand
There are a number of determinants of the price elasticity of demand.
1. The Elasticity of Demand for the Final Product: The demand for inputs by firms is derived from the demand for their output. The total output effect on factor demand increases as price elasticity of demand for the final product increases. (e.g. If the demand for cigarettes were perfectly inelastic, there would be no effect on the quantity of final output demanded when the cigarette suppliers raise their prices
2. The closeness of substitutes. The size of factor substitution effect clearly depends on the extent to which substitute factors are available.
3. The Time Frame Considered: The log-run price elasticity of market demand for the final product is likely to be greater than the short-run price elasticity. The longer the time frame, the more powerful the output effect on derived demand. Also, when the output effect (induced by the substitution made by the buyers of an output) and the factor substitution effect work in the same direction, the longer the time frame, the more elastic is the input demand.
4. The Importance of the Factor in Total Costs of Production: When a factor accounts for only a tiny fraction of the total cost of the output, a firm is unlikely to make a large adjustment in its level of output solely because the price of that factor has risen.
Steps to do comparative statics with the competitive market model
1. Sketch the original equilibrium that holds before there are any changes in the underlying market conditions.
2. Given a change in underlying market conditions, such as the imposition of a tax, figure out whether the supply curve or the demand curve is affected.
3. Determine the direction of the shift in the affected curve.
4. Find the new equilibrium at the intersection of the new supply and demand curves.
11.3 Normative Analysis of Perfect Competition
Total Surplus as a Measure of Performance
Total Surplus is the sum of consumer and producer surplus. Total surplus is the greatest when the total output is at the competitive level.
Are Value Judgments Being Made
Maximizing total surplus leads to an outcome that is efficient, but not necessarily “fair.” The justification for this approach is that once total surplus is maximized, it can be redistributed later in accord with the communities notions of fairness – make the pie as big as possible, and then worry about dividing it.
Prices versus Quantities and Their roles in Attaining Efficiency
We have been comparing the level of total surplus under competitive equilibrium with the surplus levels that would arise at different market quantities, but we have said nothing about prices. In competitive markets, prices affect quantity decision and thus (indirectly) affect total surplus. For a given quantity, a change in the price merely results in a transfer of surplus, not a net creation or loss of surplus.
Evaluating Rent Control
In the absence of rent control, the equilibrium point is at the competitive level. With the imposition of a rent ceiling equal to a price lower than the competitive equilibrium price, the quantity of housing supplied is lowered, and the total surplus falls.
Producers are worse off with rent control because they have to rent apartments at a lower price. Some households are better off because of rent control – in particular, those who obtain apartments under rent control are better off by the amount equal to the reduction in rent times the number of units rented. Some households lose from rent control – in particular, those people who would have been willing to pay the competitive price, and who would have gotten an apartment in a free market, but who do not get apartments when rent control is imposed and the quantity of housing falls.
Normative Analysis of a Sales Tax
From the buyers' perspective, the tax on wine shifts the supply curve up by $3. The equilibrium shifts as well. As a result of the tax, the surplus falls – the loss is referred to as the excess burden of the tax.
The excess burden of a tax is the amount by which the loss of surplus suffered by consumers and producers exceeds the tax revenue collected. (aka Deadweight loss)