THE ANALYSIS OF COMPETITIVE MARKETS

CHAPTER OUTLINE
• Evaluating gains and losses from government policies-
CS and PS
• The efficiency of a competitive market.
• Minimum prices
• Price supports and production quotas
• Import quotas and tariffs.
• The impact of a tax or subsidy.
 Evaluating the gains and losses from
government policies
• Consumer surplus: measures the aggregate net benefit that consumers
obtain from a competitive market.
• Producer surplus: measures the aggregate net benefit to producers.
• Suppose the market price is R5 per unit.
• Some consumer value the good highly and are willing to
pay higher price.
• Consumer A e.g is willing to pay R10 – enjoys a net
benefit of R5.
• Consumer B e.g. is willing to pay R7 – net benefit of R2.
 Application of CS & PS
• Government usually intervene in the market through price controls in the
case of market failures.
• With CS and PS we can evaluate the welfare effects of government
intervention in the market.
• We can determine who gains and who loses from the intervention and by
much.
• Figure 9.2 shows changes in CS and PS that result from government price-
control policy.
Change in CS and PS from price control
The figure government show the effect of government
intervention conducted through price control – price ceiling.
• Change in CS: - Some consumers are worse off while
others are better off.
– The worse off are those who are rationed out of the market
because of the reduction in production and sales from Q0 to Q1.
– Others benefit as they will buy good at a lower price (Pmax
rather P0).
– Those who still buy the product, enjoy increase in CS given by
rectangle A
– Those who no longer buy the product loss surplus given by
green shaded triangle B.
– Net change between rectangle A and triangle B is positive.
• Change in PS: - some producers will stay in the market but will receive
a lower price.
– Other producer will leave the market.
– Producers who remain in the market loss PS given by rectangle A.
– Triangle C measure the Additional loss of PS for those producers
who left the market.
– Total change in PS is –A-C, producer clearly loss.

• Deadweight loss: is the loss to producers from price controls offset by

the gain to consumers.

• Deadweight loss = (A-B) - (-A-C) + -B-C.

Effects of price controls when the demand is
inelastic
 The Efficiency of competitive market
Economic efficiency: - maximization of CS and PS.
However, to achieve CS PS we usually incur market failure.

• Market failure is the situation in which an unregulated market is inefficient because prices fail to provide proper
signals to consumers and producers.

• Causes of market failure:

– Externalities

– Lack of information

– Public goods.

• In the absence of externalities or a lack information, an unregulated competitive market does lead to the economically
efficient output level.
 Welfare loss of Minimum prices
What is minimum price (price floor)?
• The initial price is P0 and quantity is Q0.
• Price Pmin denotes a minimum price set the government.
• With Pmin, the quantity supplied is Q2 and quantity
demanded Q3 and the difference between Q2 and Q3
represent excess supply.
• Change in CS: consumer who continue to buy the good
now pay higher price and suffer a loss of Surplus given by
rectangle A.
– consumers who no longer buys the product loss surplus shown
by triangle B.
– Total change in CS =
• Change in producer surplus: They receive higher price for the
units they sell, which results in an increase of surplus. Given by
rectangle A (transfer of money from consumers to producers).
– Drop in Sales from Q0 to Q1 results in loss of surplus given by triangle C.

– The shaded trapezoid D measure the cost of excess surplus (the difference Q3-Q2).

– The change in PS is denoted by: -

• Total deadweight loss is given by: (A-C-D) – (-A-B) = -C-D-B.

 The minimum wage
• The other way to impose minimum price through the implementation of minimum wage.
• The effect of this policy is reflected in the figure below:
• The initial market-clearing is W0.
• The minimum wage is set at Wmin at a higher level than
the market-clearing wage W0.
• Those who can find, will receive a higher wage.
• However, some people will be unable to find job.
• The policy results in unemployment, which in the figure is
denoted by L2 – L1 .
• Higher wage rate will bid up cost of production and
subsequently higher price above the market-clearing
price.
 Price Supports and Production Quotas
Besides imposing minimum price, the government
can increase the price of a good/product:
• Price support : - is the price sets by the government above
free-market level and maintained by the government purchases
of excess supply.
• Production quotas: - The government may also cause price of
a good to rise by reducing supply or placing a limit on the on
the quantity of the product.
• Price support
• Under a price support programme, the government sets a support price Ps
and the n buys up whatever output is needed to keep the market price at this
level.
• Figure 9,10 illustrates the social welfare cost/deadweight loss of a price
support.
– Consumers: at price Ps, the quantity that consumers demand falls to Q1, but the quantity supplied
increases to Q2.
– To maintain this price and avoid having inventories pile up in producer warehouses, the
government must buy the quantity Qg = Q2-Q1.
– Because the government adds its demand Dg to the demand of consumers, producers can sell all
they want at price Ps.
– Now consumers purchase the good at higher price, (Ps instead of P0) they suffer a loss of CS
given by rectangle A.
– Because of higher price, some consumers no longer buy the product of buy less of it, and their loss
is represented by triangle B.
– Consumer loss amount to
• Producers: - Producers are now selling a larger quantity
Q2 instead of Q0 and at a higher price Ps.
– The total CS amount to
• The government: - there is also cost to the government.
– The cost is represented by (Q2-Q1)Ps, which is what the Government
has to pay for output it purchases.
– In the figure, the loss is depicted by rectangle D.
– This cost may be reduced if the government can “dumb” some of its
purchases.

• Welfare cost: - is given by

Production Quotas
• The government can also restrict supply in order to
increase the price of the product.
• With appropriate quotas, the price of the can be bid
up to any arbitrary level.
• The government restricts the quantity to Q1.
• The supply become vertical line S` at Q1.
• CS is reduced by rectangle A plus triangle C.
• Once again, there is deadweight loss given by
tringles B and C
Import quotas and Tariffs
• Without import and tariffs, the country will import a good when its world price
is below the price that would prevail locally were there no imports.
• S and D are the domestic supply and demand curves denoted by price P0
and Q0.
• The World price is Pw i.e. consumers have incentives to import.
• Suppose Govt impose import quota of Zero, the price will rise to Po.
• Consumers who still buy the product will pay a higher price and will lose an
amount surplus given by trapezoid A and triangle B.
• In addition, given this high price , some consumers will no longer buy the
good.
• So ther is additional loss of CS, given by triangle C.
• Total change in CS is
The impact of a Tax or Subsidy
– Specific tax: - tax of a certain amount of per unit sold.
– P0 and Q0 represents the market price and quantity
before the tax is imposed.
– PB is the price that the buyer pay and PS is the net
price that the seller receive after the tax is imposed.
– Pb-Ps is the tax.
– Here the burden of the tax is split or shared evenly
between buyers and sellers.
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 Take home task
Suppose that demand and supply for wine are given by the following equations:

– Calculate both equilibrium quantity and price.

– Determine the value of consumer surplus and producer surplus.
– Assuming that government impose a specific tax of R2, calculate the new equilibrium
quantity and Supply after imposition of the tax. Further explain how will the burden of this
specific tax will be shared between consumer and seller .i.e. quote relevant figures.
GENERAL EQUILIBRIUM AND ECONOMIC EFFICIENCY
 CHAPTER OUTLINE
• General Equilibrium analysis
• Efficiency in Exchange
• Equity and Efficiency
• Efficiency in production
• The gains from free trade
• An overview – the efficiency of competitive markets.
• Why markets fail.
 General Equilibrium
• What is Equilibrium?

• Partial equilibrium analysis: - Determination of equilibrium prices and

quantities in a market independence of effects from other markets.

• General equilibrium analysis: - simultaneous determination of the prices

and quantities in all relevant markets, taking feedback effects into account.
• Feedback effect: is a price or quantity adjustment in related markets.
• Figure 16,1 shows the supply and demand curves for DVD and movies.

• In part A, the price of movie tickets is initially R6.00; the market is in

equilibrium at the intersection of Dm and Sm.

• In part B, the market for DVD is also in equilibrium with a price of R3.00.

• Suppose government places a tax of R1.00 on each movie ticket.

• On the basis of partial equilibrium analysis, the supply curve will shift upward
from Sm to S*m in part A.

• Initially, this shift causes the prices of movies to increase to R6,35 and the
quantity of movie tickets to fall from Qm to Qm` .
• We go further with general equilibrium analysis, by:

– Looking at the effects of movie tax from the DVD market and,

– Seeing whether there are any feedback effects from the DVD market to the movie market.

• The movie tax affects the market for DVDs because movies and DVDs are substitutes.

• A higher movie price shifts the demand for DVDs from Dv to D`v in figure 16,1 B.

• In turn, this shift the demand the rental price of DVDs to increase from R3 to R3,50.

• Because the price is now R3.50, the demand for movies will shift upward from Dm to D`m in figure 16,1 A

• The new equilibrium price of movies is R6,75 instead of R6,35, and the quantity of movies tickets purchased has
increased from Q`m to Q``m.

• Analysis is not yet complete, the change in market of movies will generate a feedback effect on the price of DVDs
that, in turn, will affect the price of movies and so on.
 Economic Efficiency
• Economic efficiency: refers to the maximization of CS and PS.

• Efficiency in exchange – exchange economy: - market in which

two or more consumers trade two goods among themselves.

• Pareto efficient allocation: Allocation of goods in which no one

can be made better off unless someone else is made worse off.
 The Advantages of Trade
As a rule, voluntary trade between two people or two countries is mutually
beneficial.
 The Edgeworth box diagram
Edgeworth box: diagram showing all possible allocations of either two goods

between two people or of two inputs between two production processes.

 Efficient allocation
• A trade from A to B made both Karen and James better off. But is B an efficient allocation?
• The answer depends on whether James and Karen MRSs are the same at B, which depends on the shape of their
indifference curves.
• FIGURE 16,5 shows several indifference curves for both James and Karen.

• Both James and Karen MRSs give the slope of their indifference curve.

• The shaded area between these 2 indifference curves represents all possible allocation
of food and clothing that would make both James and Karen better off than at A.

• Starting at A, any trade that moved the allocation of goods outside the shaded area would
make one of the two consumers worse off and should not occur.

• The move from A to B was mutually beneficial but in the figure, B is not an efficient
because point because indifference curve Uj2 and Uk2 intersect.

• Starting at B, James would prefer to give up some food to obtain additional clothing.

• Karen on the other hand, would be willing to give up some clothing to obtain more food
and there are many such trade that would make her better off.
• This situation illustrate an important point.
• Even if a trade from an inefficient allocation makes both
people better off, the new allocation is not necessarily
efficient.
• At C the MRSs of both people are identical because at
point C the indifference curves are tangent.
• Trading food for clothing and thereby moving from point B
to point C has allowed James and Karen to achieve a
Pareto efficient outcome and they will both be better off.
• point C represent an efficient allocation.
• The government can also restrict supply in order to
increase the price of the product.
• With appropriate quotas, the price of the can be bid
up to any arbitrary level.
• The government restricts the quantity to Q1.
• The supply become vertical line S` at Q1.
• CS is reduced by rectangle A plus triangle C.
• Once again, there is deadweight loss given by
tringles B and C
 The Contract Curve

• The Contract curve: - is the curve showing all efficient allocations of goods between two consumers, or of two
inputs between two production functions.
– To find all possible efficient allocations of food and
clothing between Karen and James, we look for all
points of tangency between each of their indifference
curves.
– Figure 16,6 shows the contract curve drawn through all
efficient allocation's points.
– Three allocations labelled E,F and G are Pareto
efficient, although each involves a different distribution
of food and clothing, because one person could not be
made better off without someone else worse off.
 Consumer Equilibrium in a competitive market
• In a two-person exchange, the outcome can depend on the bargaining power
of the two parties.
• Competitive markets, however, have many buyers and sellers.
• As a results, each buyer and seller takes the price of the goods as fixed and
decides how much to buy and sell at those prices.
• We can show how competitive markets lead to efficient exchange by using
the Edgeworth box to mimic a competitive market.
• E.G, suppose there are many Jameses and Karens.
• This allows us to think of each individual James and Karen as a price taker,
even though we are dealing with only a two-person box diagram.
• Figure 16,7 shows the opportunities of trade when we start at the allocation
given by point A and when the prices of both food and clothing are equal to 1.
• When the prices of food and clothing are equal, each unit of food can be
exchanged for 1 unit of clothing.
• As a result, the price line PP in the diagram , which has a slope of -1,
describes all possible allocations that exchange can achieve.
• Suppose each James decides to buy two 2 units of clothing and sell 2 units
of food in exchange.
• This would move each James from A to C and increase satisfaction from
indifference curve UJ1 to UJ2.
• Meanwhile, each Karen buys 2 units of food and sell 2 units of clothing.
• This would move each Karen from A to C as well, increasing satisfaction from
indifference curve UK1 to UK2.
• We choose prices for the two goods so that the quantity of food demanded
by each Karen is equal to the quantity of food that each James wishes to sell.
• Likewise, the quantity if clothing demanded by each James is equal to the
quantity of clothing that each Karen wishes to sell.
• As a result, the market for food and clothing are in equilibrium.
• An equilibrium is a set of prices at which the quantity demanded equals the
quantity supplied in every market.
The Economic Efficiency of competitive markets
We revealed that point C in figure 16,7 that the allocation in a competitive
equilibrium is Pareto efficient.
This is because point C occur at the tangency of two indifference curves. If it
does not, one of James or Karens will not be achieving maximum satisfaction;
he or she will be willing to trade to achieve a higher level of utility.
Whatever, ones view of government intervention, most economists consider the
invisible hand results important.
The result that a competitive equilibrium is pareto efficient is often described as
the first theorem of welfare economics, which involves the normative evaluation
of markets and economic policy.
• Formally, the first theorem states the following:
– “if everyone trades in the competitive marketplace, all
mutually beneficial trades will be completed, and the
resulting equilibrium allocation of resources will be
Pareto efficient”
• To summarize competitive equilibrium from consumer
perspective:
• Because the indifference curve are tangent, all MRS between
consumers are equal.
• Because each indifference curve is tangent to the price line, each
persons MRS of clothing for food is equal to ratio of the price of the
two goods.
 Equity and Efficiency
• Competitive markets seek to achieve pareto
efficiency.
• However, some pareto efficiency are likely not to be
fair.
• Thus, how do we decide what is the most equitable
allocation?
• We, therefore, seek to analyze how to achieve
equality in this section
 The utility possibility frontier
Utility possibility frontier is the curve which show all efficient allocation of
resources measured in terms of the utility levels of two individuals.
 Social welfare function
Social welfare function: is the measure describing the well-being of society
as a whole in terms of the utilities of individual members.
 WHY MARKET FAILS

• Competitive market fail :-

–Market power
–Incomplete information
–Externalities
–Public goods
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PROFIT MAXIMIZATION & PERFECTLY COMPETITIVE MARKET
 CHAPTER OUTLINE

• Perfectly Competitive markets

• Profit maximization
• Marginal revenue, marginal cost, and profit maximization.
• Choosing output in the short run
• The competitive firms short run supply.
• The short run market supply curve
• Choosing output in the long run
• The industry's long-run supply curve
 Overview of market structures

• Perfect competition
• Monopolistic competition
• Oligopoly
• Monopoly
 Perfectly competitive market
The model of perfect competition lies on three basic
assumptions:

• Price taking
• Product homogeneity
• Free entry and exit
 Price taking
• Firm faces intense direct competition

• Firms sell small proportion of the market inputs

• Thus, firms decisions have no significant impact on the mart price.

• This assumption applies to consumers as well

 Product homogeneity
• Price taking is only possible if products are homogenous in
nature.

• No firm can raise the price of its product above the stated market
price

• More agricultural products are homogenous.

• Their quality is relatively similar.

 Free entry and exit

• This means that there are no special costs to block new

entrants.
• Buyers and sellers can easily enter or exit the market.
• The only costs are those which firm incur to initiate their
business.
If these assumptions hold, market demand and supply can
be used to analyze the behaviour of market price
 Profit maximization
• The assumption of profit maximization for private firms is important because it predict business
behaviour more accurately in microeconomics.

• The following types of business organization do pay regards to profit maximization

 Sole proprietorship

 Partnership

 Cooperative

 Condominium

 But NGO are exception to this principle

 Marginal Revenue, Marginal cost and Profit
maximization
To assess profit maximization point, it is important to define the following concepts:

• Marginal revenue: additional revenue obtained from selling one additional unit of the product

• Marginal cost: change in revenue resulting from a one unit increase in output

• Profit : the difference between total revenue and total cost.

To maximize profit, the firm selects the output for which the difference between revenue and costs is the greatest.
Profit maximization in the short run
 Demand and marginal revenue for a
competitive firm

• The quantity of output that the firm sells have no effect on

the market price of the product.
• Thus, decisions of an individual firm does not affect the
operation of the market.
• The figure below shows the demand and MR for a
perfectly competitive market.
 Choosing output in the short run
In the short run, a firm operates with a fixed amount of capital and must choose the levels of its
variable inputs to maximize profits. The figure below shows the firms short run decision.
• Profit is maximised at quantity q* =8.

• At lower output than q* MR is > than MC and profit can be increased by increasing output.

• The shaded area between q1 and q* represent loss of profit associated with producing q1.

• At higher output say q2 MC is > than MR.

• The shaded area between q* and q2 = 9 shows the lost profit associated with producing at q2.

• When output is q* =8, profit is given by the area of ABCD.

• Output rule : MR = MC
A competitive firm incurring loss
• Figure 8,4 shows that ATC is > than price of the product
that the firm sells.
• Note that the firm is losing money when its price is less
than AVTC at the profit maximizing output q*
• However, the firm should shutdown if the price is below
AVC.
 The competitive firms short run supply curve

• Supply curve reveal information about how much output a firm produce at
every possible price.

• The perfectly competitive supply curve is the portion of the MC curve for
which MC is greater than AVC.

• Figure illustrates the short run supply curve.

Short run supply curve for a competitive firm
 The short run market supply curve

• Short run market supply curve shows the amount of

output that the industry will produce in the short run for
every possible price.
• Market supply is obtained by adding the supply curves of
all the individual firms in the industry.
 Producer surplus in the short run

What is Producer surplus?

 Producer surplus vs profit
• PS is closely related to profit

• In the short run, PS =R-VC

• Profit = R-VC-FC
Choosing output in the long run
• Competitive firms takes prices as they are from the market.

• SAC and SMC are long enough for the firm to make a positive profit, given by
rectangle ABCD, by producing an output q1.

• LAC reflects economies of scale and diseconomies of scale.

• LMC cuts long LAC Q1 , at the point of minimum LAC.

• If the firm believe price will remain at $40, it will want to increase the size of
its plant to produce at output q3.

• When expansion is complete, profit will rise from AB to EF and total profit will
increase from ABCD to EFGD.
 Long run competitive equilibrium
Conditions for long run equilibrium:
- All firms in the industry are maximizing profit
- No firm has an incentive enter or exit the industry because firms are earning zero
economic profit.
- The price of the product is such that the quantity supplied by the industry is equal to
the quantity demanded by consumers.
Zero profit in the long run equilibrium
 The industry long run supply curve
Constant –Cost industry: - Industry whose long run supply is horizontal.
 The industry long run supply curve
Increasing-Cost industry: - Industry whose long run supply curve is upward sloping
- the price of some or all inputs to produce goods increase as the industry expands and the demand for the
inputs grows.
 The industry long run supply curve
Decreasing –Cost industry: - Industry whose long-run supply curve is downward sloping. Here, the
unexpected increase in demand causes industry to expand as before but as the industry is able to take
advantage of its size to obtain inputs more cheaply.

 Larger industry may allow for an improved transportation system or for a better less expensive financial networks,
 In this case, Firms AC curve shift downward and market price of the product falls.
 Lower market price and AC of production induce a new long run equilibrium with more firms, output and a lower
price.
 Therefore, in a decreasing-cost industry, the long run supply curve for the industry is downward sloping.
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