Perfect Competition in Economics

Jason Moore

These are my notes and thoughts on perfect competition in Economics.

The invisible hand efficiently allocates goods and services to buyers and sellers. The invisible hand leads to efficient production and industry. The invisible hand allocates resources efficiently across industries. Prices direct the invisible hand. There are trade-offs between making the economic pie as possible and dividing the pieces equally. 

 

A reservation value is the price at which a person is indifferent between making the trade and not doing so. 

 

When we plot the demand and supply schedules, we end up with stepwise curves because each individual only demands or supplies one unit. 

 

The equilibrium price is determined by the intersection of the market demand and market supply curves. 

 

Social surplus is the sum of consumer surplus and producer surplus. It represents the total value from trade in the market. For social surplus to be maximized, the highest-value buyers are making a purchase and the lowest-cost sellers are selling. In this way, buyers and sellers as distinct groups are doing as well as they possibly can, they are optimizing.

 

We now know that the competitive market equilibrium is efficient in the sense that mutually advantageous trades take place. In this way, there are no unexploited gains to trade. Accordingly, the competitive market equilibrium maximizes social surplus.

 

The pareto efficient asks if we can make any individual better off without harming someone else, and the answer is no. An outcome is pareto efficient if no individual can be made better off without making someone else worse off. As it turns out, besides maximizing social surplus, the competitive market equilibrium is also pareto efficient.

 

So we can say that in a perfectly competitive market, the first distinct function of the equilibrium price is that it efficiently allocates goods and services to buyers and sellers.

 

So, we can say that in a competitive market, the second distinct function of the equilibrium price is that it efficiently allocates the production of goods in an industry. 

 

Entry in a market stops when the market price decreases all the way down to where the marginal cost curve intersects the average total cost curve. Once the price reaches the minimum of the average total cost curve, we are in equilibrium because p=mc=atc, which means that there is zero economic profit and therefore no reason for more firms to enter.

 

This example shows what happens when positive economic profits exist in an industry, resources flow to that industry because of the profits available, This behavior causes resources to flow from less productive uses to more productive uses. 

 

Such shifting of resources leads to a very important outcome, in a perfectly competitive market equilibrium, production occurs at the point of minimum average total cost. Because resources leave those industries in which price cannot cover their costs of production and enter those industries where price can cover their costs of production, the total value of production is maximized in equilibrium. 

 

This reasoning leads to a third distinct function of equilibrium prices in a competitive market, they allocate scarce resources across industries in an optimal manner. This is because the industry equilibrium is where p=atc=mc, and this happens only at the minimum point of the average total cost curve. 

 

What we know so far is that when the right market conditions are in place, self-interest and social interest, as measured by special surplus, are perfectly aligned. Price incentives lead economic agents to act in this manner. Market prices act as the most important piece of information, leading high-value buyers to buy and low-cost-sellers to sell. The flow of labor and physical capital to sectors with the highest rewards cause the production to be at just the right level in a competitive market equilibrium. 

 

A price control is a government restriction on the price a firm can charge for a good or service. 

 

Economists call the decrease in social surplus that results from a market distortion a deadweight loss. 

 

The coordination problem of bringing agents together to trade is a difficult one for central planners. After you have solved the coordination problem, you need to think about how to tackle the incentive problem, or aligning the interests of the economic agents. 

 

A market economy has features that are remarkable at providing price signals that guide resources in a way that maximizes social surplus and makes the economy efficient. Market forces tend to eliminate waste. 

 

Equity is concerned with how the economic pie is allocated to the various economic agents. 

 

In a double oral auction, both bids and asks are orally stated. 

Bilateral negotiations are when a single buyer and a single seller confront each other with bids and asks, rather than yelling out the offers to a group. 

 

When the strong assumptions of a perfectly competitive market are in place, markets align the interests of self-interested agents and society as a whole. In this way, the market harmonizes individuals and society so that in their pursuit of individual gain, self-interested people promote the well-being of society as a whole.

 

The remarkable tendency of individual self-interest to promote the well-being of society as a whole is orchestrated by the invisible hand.

 

The invisible hand efficiently allocates goods and services to buyers and sellers, leads to efficient production within an industry, and allocates resources efficiently across industries.

 

The invisible hand is guided by prices. Prices incentivize buyers and sellers, who in turn maximize social surplus, the sum of consumer surplus and producer surplus, by simply looking out for themselves.

 

We can measure the progress of an economy by measuring social surplus, or how big the economic pie is. But we can also measure progress by considering questions of equity, or how the economic pie is distributed among economic agents. 

 

The diagram on the right shows the demand and supply for jeans. Calculate consumer surplus, producer surplus, and social surplus in the market.

Consumer surplus is measured by the area under the demand curve and above the equilibrium price line.

Producer surplus is above the supply line and below the equilibrium line.

Social surplus is the sum of consumer and producer surplus.

Consumer surplus is:

  1. (20*140) / 2 = 1400

Producer surplus is:

  1. (30*140) / 2 = 2100

Social surplus is:

  1. 1400 + 2100 = 3500



 There are four consumers willing to pay the following amounts for an electric car: 60000, 40000, 80000, 20000

There are four firms that can produce electric cars at the following costs: 20000, 80000, 30000, 40000

Each firm can produce at most one car. Suppose the market for electric cars is competitive.

Why is the equilibrium price in this market 40000?

  1. All of the above
  2. At this price,, the quantity demanded(three cars) equals the quantity supplied(three cars)
  3. At this price, three consumers are willing to buy an electric car and three firms are willing to sell an electric car
  4. At 40000, three consumers have reservation values equal to or above 40000 and three firms have reservation values equal to or below 40000

Which firms will produce an electric car if the price is 40000?

  1. A,C, D

Which consumers will buy an electric car when the price is 40000?

  1. 1, 2, 3

Complete the table by calculating consumer surplus, producer surplus, and social surplus when the market price is 40000.

Consumer surplus is the difference between the buyers reservation values and what the buyers actually pay.

Producer surplus is the difference between the price and the seller’s reservation values.

Social surplus is the sum of the consumer and producer surplus

  1. Consumer surplus = 60000
  2. Producer surplus = 30000
  3. Social surplus = 90000

 

Sara and Jim are going to lunch together and rank the restaurant options in the following way.

An outcome is pareto efficient if no individual can be made better off without making someone else worse off.

Which of the following restaurant choices are pareto efficient for Sara and Jim?

  1. In this scenario, the pareto efficient outcomes occur when both Sara and Jim choose Naf Naf and Blaze. As there is no other allocation or bundle of restaurants which is preferred over Naf Naf and Blaze, both are ranked the highest.

 

Social surplus is the 

  1. Total value from trade in a market

Social surplus is maximized when the

  1. All of the above
  2. Buyers and sellers as distinct groups are doing as well as they possibly can
  3. Competitive market is in equilibrium
  4. Highest value buyers are making a purchase and the lowest-cost sellers are selling

 

The figure on the right displays the market for video game consoles where nine buyers are interacting with nine sellers.

According to this figure the equilibrium price is:

  1. 500

The equilibrium quantity is:

  1. 5

When the market is in equilibrium, social surplus is:

  1. (900-100)+(800-200)+(700-300)+(600-400) = 2000

If the number of consoles is restricted to two less than the equilibrium quantity, social surplus is:

  1. (900-100)+(800-200)+(700-300) = 1800

Alternatively, if the government mandated that one more video game console than the equilibrium be transacted, social surplus is now:

  1. 1800

From this analysis, it can be concluded that a market in competitive equilibrium:

  1. Maximizes social surplus

 

The diagrams shown below depict the cost curves of two plants owned by a firm producing video games.

From the positions the curves hold in each graph, it can be deduced that the older, less efficient facility is:

  1. Beta(atc is higher)

If video games are produced in a competitive market and the current price is 70, production in Alpha is:

  1. 70 thousand and production in beta is 60 thousand units. (See where mc line crosses required price to get quantity)

If management sought to transfer 10 thousand units of Beta’s production to Alpha, the firm;s overall profits would:

  1. Decrease, since for those 10 thousand units mc_beta<mc_alpha

 

The figure on the right shows the typical firm in a perfectly competitive industry. Equilibrium in the market is currently yielding a price of 30.

At this price, the typical firm earns a:

  1. Negative economic profit (equilibrium price is less than average total cost)

As a consequence of the current short run conditions in this industry, it may be expected that firms will:

  1. Leave this market

As this movement occurs, economic profits for the typical firm will:

  1. Approach zero

 

How will the invisible hand move corn prices in response to each of the following:

A weather pattern that produces a bumper corn crop:

  1. Decrease corn prices by shifting the supply curve for corn rightward

A rise in the price of wheat(substitute for corn):

  1. This will increase corn prices by shifting the demand curve for corn rightward

A change in consumer tastes away from corn dogs toward hot dogs:

  1. This will decrease corn prices by shifting the demand curve for corn leftward

A decrease in the number of demanders in the corn market:

  1. This will decrease corn prices by shifting the demand curve for corn leftward

 

The tables below show the reservation values of buyers and sellers in the market for used iphones.

Suppose the minimum price is given as 55, which of the following is true in the market for used iphones?

  1. Madeline and Katie will each be willing to buy an iphone. (their reservation values are both above 55)

At a price of 55 per iphone, the consumer surplus is:

  1. 20. (70-55)+(60-55) = 20

At the price of 55, two iphones will be purchased, but there are five willing sellers.

Based on this information, the highest possible producer surplus is:

  1. Producer surplus will be maxed if tom and mary are able to sell the iphones. The highest possible producer surplus will be 45+35=80

At a price of 55 per iphone, the lowest possible producer surplus is:

  1. Producer surplus will be at a minimum if Phil and Adam are able to sell the iphones. The lowest possible producer surplus will be 5+15=20 (or sellers that are closest to 55 but under)



The equilibrium rent in a town is 500 per month and the equilibrium number of apartments is 100. The city now passes a rent control law that sets the maximum rent at 400. Complete the table:

Consumer surplus is measured by the area below the demand curve and above the equilibrium price line.

Producer surplus is found as the area above the supply curve and below the equilibrium price line.

Social surplus is simply the sum of both.

Before rent control:

  1. Consumer surplus = A+B
  2. Producer surplus = C+D+F
  3. Social surplus = A+B+C+D+F

 

After rent control:

  1. Consumer surplus = A+C
  2. Producer surplus = F
  3. Social surplus = A+C+F

 

Now show the change in consumer surplus, producer surplus, and social surplus.

  1. Consumer surplus = c-b
  2. Producer surplus = -(c+d)
  3. Social surplus = -(d+b)

 

Assess each change from the before value to after value as positive, negative, or unclear

  1. Consumer surplus = unclear
  2. Producer surplus = negative
  3. Social surplus = negative



A non-market price imposition is a:

  1. Price control

In the figure on the right, the imposition of price p_c results in a:

  1. Surplus (price control line is above the equilibrium line)

If the imposed price p_c were removed, market forces would rectify the mismatch between the quantity demanded and quantity supplied by pushing the price:

  1. Downward (the existence of a surplus causes downward pressure on price)

This price adjustment would eliminate the mismatch by:

  1. Incentivizing

 

When economists speak of a deadweight loss, they are referring to:

  1. Decrease in social surplus

Consider the figure on the right that shows a market with a government-imposed price control at P_c

At this price, the transacted level of the product is:

  1. Q2 (When the government imposes a price at P_c, the quantity demanded determines the amount actually transacted in the market. Since the price control line is above the equilibrium line, we know we will have a surplus and a surplus will lower the price. Thats why it has to be Q2)

Since this market is prevented from attaining equilibrium, the result is a deadweight loss, which is measured by area;

  1. C+e

 

Imagine you are a buyer in a double oral auction with a reservation value of 17 and there is a seller asking for 12. If you accept this offer, you will gain:

  1. 5

If you are the only buyer, and you know that the lowest ask price is 2, should you accept this offer?

  1. Both a and c are correct
  2. Yes, accepting an offer from any other seller will reduce your surplus
  3. Yes, since you will gain 15

 

Assume there are two industries in our economy, the production of pizza and the production of calzones. Each of these products is produced in a similar way with similar ingredients and requires similar skills.

If the market price of pizza in this competitive market is below the average total cost curve and the price of calzones is above the average total cost curve:

  1. Firms currently making pizza will switch to making calzones

When firms switch from making pizza to calzones, the price of pizza will:

  1. Increase

The price of calzones will:

  1. Decrease

 

Social surplus is the:

  1. Total value from trade in a market

Social surplus is maximized when the:

  1. All of the above
  2. Buyers and sellers as distinct groups are doing as well as they possibly can
  3. Highest-value buyers are making a purchase and the lowest cost sellers are selling
  4. Competitive markets is in equilibrium

 

Two manufacturing plants operate at acme corp, plant a and plant b

If plant a uses older technology than plant b, it is likely to have:

  1. Higher marginal cost than plant b

In this case, plant a requires a market price that is:

  1. Higher than plant b to produce

At the market price, plant a will produce:

  1. Less than plant b

Will earn:

  1. Lower economic profit

 

When economists speak of a deadweight loss, they are referring to:

  1. Decrease in social surplus caused by a market distortion

Consider the figure on the right that shows a market with a government-imposed price control lower than the market equilibrium

At this price, the transacted level of the products is:

  1. Q1

Since this market is prevented from attaining equilibrium, the result is a deadweight loss, which is measures by area:

  1. B+D

 

Imagine you are a buyer in a double oral auction with a reservation value of 14 and there is a seller asking for 8.

If you accept this offer,m you will gain:

  1. 6

If you are the only buyer, and you know that the lowest asking price is 2, should you accept this offer?

  1. Both are correct
  2. Yes, since you will gain 12
  3. Yes, accepting an offer from any other seller will reduce your surplus



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