Chapter 13

Perfectly Competitive
Markets
 Overview
• Perfectly competitive markets
– Many firms, all with very small market shares
– Free entry and exit (no barriers to entry)
– Firms produce the same product (homogeneous
product)
– Perfect factor mobility / e.g. capital and labor flow freely:
all firms face same factor prices
– Perfect and symmetric information
• This Chapter
– How do firms in perfectly competitive market choose q?
– What forces drive the market price and quantity?
• Long run vs short-run
– Welfare properties of perfectly competitive markets
 Roadmap

– Competitive markets in the short run

• The quantity chosen by the firm
• Aggregating individual supply curves to market
supply curve
• The market equilibrium
• Application: policy analysis
– Competitive markets in the long run
– Welfare in competitive markets
 Competitive markets, the short run
Short run:
• # firms is fixed (no entry or exit)
• Amount of capital held is fixed
(a) The short-run quantity decision
– Firms take price as given
– Firms face short-run cost curves (as capital is fixed)
– Problem of the competitive firm:
max pq  C(q)
q

– Necessary condition:
p  C ' (q)  0, that is p  MC (q)
Figure 13.1 Cost and Demand for a Competitive
Gadget Firm

At each price, what is the optimal

quantity produced?
 Competitive markets, the short run

(b) Short-run firm supply

Obtained directly from the output decision. Supply
curve coincides with the part of MC curve that
exceeds average variable costs p>AVC(q).
(c) Short-run market supply
Add up supply of all the firms
(d) Market equilibrium in the short run
– Short-run market equilibrium (definition)
• Firms maximize profits
• Consumers maximize utility given budget restriction
• No excess demand or supply (demand =supply)
Figure 13.2 A Short-Run Supply Curve for a
Competitive Firm

MC

minAVC
Eg. A competitive firm’s cost function
is c(q)=5q-4q2+q3.
What is its supply function?
 Figure 13.3 Deriving a Market Supply Curve for a
Competitive Gadget Industry

Example: 2 firms with cost functions:

c(q1)=2q1+q12, c(q2)=5q2+2.5q22.
Question: what is the market supply if they are perfect competitive?
Figure 13.4 Equilibrium Price and Quantity
 Short-Run Industry Equilibrium

• In a short-run, neither entry nor exit can

occur.
• Consequently, in a short-run equilibrium,
some firms may earn positive economics
profits, others may suffer economic losses,
and still others may earn zero economic
profit.
 Figure 13.5 The Short-Run Equilibrium for a
Competitive Industry

Given the market price, which firms make profits?

 Understanding market equilibrium

The manager of an internet flea market does a job matching

buyers and sellers to close all transactions.
Buyer buyer price seller seller price
1 $90 1 $20
2 $80 2 $40
3 $70 3 $50
4 $60 4 $70
5 $50 5 $90
6 $40 6 $100
Question:
1)If you are the manager, what will you do?
2) What’ll be the competitive market equilibrium $,#,and TS?
3) If he maximize the # of transactions, what’s the new TS?
 Competitive markets, the short run

(e) Application of competitive market model:

policy analysis
– Methodology
• Comparative statics (here): How does certain change
affect the equilibrium in the market
• Dynamic analysis (less often used) focuses on transition
path from one equilibrium to the new equilibrium
– Comparative statics in action: some examples
• The market for illegal drugs  [see Figures 13.6 + 13.7]
• The impact of taxes and subsidies  [see Figure 13.8]
• Price floors and price ceilings
– Example: the minimum wage  [see Figures 13.9 + 13.10]
Figure 13.6 The Market for Illegal Drugs

What’s the effect of gov’t

new effort on reducing
Illegal drug dealings?
Figure 13.7 The Decision about Whom to Prosecute

Which’s more effective: gov’t new

effort on reducing illegal drug
dealings by punishing dealers or
users?
Figure 13.8(a) The Incidence of a Tax and the
Elasticity of Demand

Inelastic demand  full

Tax burden on consumers,
No effect on quantity
Figure 13.8(b) The Incidence of a Tax and the
Elasticity of Demand

elastic demand  no
effect on market price
Figure 13.8(c) The Incidence of a Tax and the
Elasticity of Demand

Qd=100-0.5P
Qs=P
Tax: $2 per unit sold.
Find out a, b, bd, dc.
 Quantity Taxes & Market Equilibrium

Market Market
p
demand supply
Tax paid by
buyers
pb
p*
ps Tax paid by
sellers

qt q* D(p), S(p)
 The Incidence of Taxes & Market Equilibrium

• The incidence of a quantity tax depends upon the

own-price elasticities of demand and supply.
pb  p* S
  .
p*  ps D
• E.g. suppose the market demand and supply curves
are linear.
D ( pb )  a  bpb S( ps )  c  dps
With the tax, the market equilibrium satisfies

pb  ps  t and D ( pb )  S( ps ) so
 Quantity Taxes & Market Equilibrium

a  c  bt a  c  dt
ps  pb 
bd bd
t ad  bc  bdt
q 
bd
The tax paid per unit by the buyer is
* a  c  dt a  c dt
pb  p    .
bd bd bd
The tax paid per unit by the seller is
* a  c a  c  bt bt
p  ps    .
bd bd bd
Figure 13.9 The Labor Market and the Minimum Wage

We concern workers welfare.

The devil makes work for idle hands.
Figure 13.11 Subsidizing Youth Employment

Subsidize or not?
Suppose for each
idle hour the harm
to the city is wv-wa.
 Long-Run Industry Supply

• In the long-run every firm now in the industry is free

to exit and firms now outside the industry are free to
enter.
• Economic profit is positive when the market price pse
is higher than a firm’s minimum av. total cost; pse >
min AC(y). Positive economic profit induces entry.
• Entry increases industry supply, causing pse to fall.
The long-run number of firms in the industry is the
largest number for which the market price is at least
as large as min AC(y).
• As each firm gets “smaller” relative to the industry,
the long-run industry supply curve approaches a
horizontal line at the height of min AC(y).
 Competitive markets, the long run
Long-run market equilibrium (definition)
• Firms choose output optimally
• Consumers maximize utility given budget restriction
• Firms choose inputs optimally
• There are no incentives to enter or exit from the market,
that is: no extra-normal profits or losses
• No excess demand or supply (demand = supply)
Thus, LR market equilibrium
• SR equilibrium
• No incentives for entry or exit
• Optimal choices in the input market

– [See Figure 13.20]

 Figure 13.20 The Adjustment to a Long-Run
Equilibrium

Given a price P, produce at a quantity where LRMC=P; then find out the
corresponding capital/operating size where SRAC=LRAC.
All n firms has identical cost function c(q)=5q-4q2+q3. Market demand is
Qd=101-p. What’s LR p*, q*, n*.
 Welfare in competitive markets

• Welfare result 1: Total welfare (total surplus) is

maximized
– Result makes sense because, by and large, supply
curve = “Marginal cost curve of industry” [see Figure
13.3]
• Welfare result 2: price is set at marginal cost
• Welfare result 3: Goods are produced at the
lowest possible cost and in the most efficient
way [Capacity choices of firms minimize average
cost. Thus, we even get p=MC(q)=ATC(q) in the LR
equilibrium]
max pq  C1 (q1 )  C2 (q2 )  ...  Cn (qn )
q1 ,..., qn
Figure 13.24 A Competitive Equilibrium Maximizes
Consumer and Producer Surpluses
 Economic Rent

The long-run equilibrium for heterogeneous

firms: some firms have lower costs due to
some special factors.
The return (the extra normal profit) from such a
special factor is called economic rent.

In general, economic rent is a payment to a

factor of production or input in excess of that
which is needed to keep it employed in its
current use.
Figure 13.21 Rent and Long-Run Competitive
Equilibria
 An Example: Taxi Cab License

Each cab has cost function for rides:

C(q)=100+0.01q2
The demand for taxi rides per day is
D(p)=10000-100p
Questions: 1) when anyone can become a taxi driver,
what is the equilibrium # of taxi rides and # of taxi
cabs operating?
2) Suppose the city issues only 48 licenses for cabs.
What are the new equilibrium # and $ of taxi rides?
What would be the price for a license for a day’s
usage? What’s the daily economic rent of a license?