HE2001 Intermediate Microeconomics

Lecture 3: Perfect Competition and Welfare

Pak Hung Au

Division of Economics, Nanyang Technological University, Singapore

Jan 2020

Pak Hung Au (NTU) Competition & Welfare Jan 2020 1 / 26

Introduction

We have seen that in a quasi-linear environment, utilitarianism is a

desirable welfare standard.
Today we will look into the model of perfect competition in a
quasi-linear environment and discuss its welfare properties. In
particular, we will

1 explain common concepts used in welfare evaluation, such as producer

surplus and consumer surplus, are closely linked to utilitarianism;
2 explain why perfect competition maximizes total welfare, thus
achieving Pareto e¢ ciency;
3 state and derive the two fundamental theorems of welfare economics.

Pak Hung Au (NTU) Competition & Welfare Jan 2020 2 / 26

Consumer Surplus

Given consumer i’s inverse demand function δi (x ) for some goods,

his marginal willingness to pay for
the 1st unit is δi (1);
the 2nd unit is δi (2);
the 3rd unit is δi (3), and so on.
Given a price p for the goods, the consumer will buy xi units, such
that
δi (xi + 1) < p < δi (xi ) .
In the case of continuous quantity, he buys until p = δi (xi ).
1
Consumer i’s demand at price p is thus Di (p ) = (δi ) (p ).

Pak Hung Au (NTU) Competition & Welfare Jan 2020 3 / 26

Consumer Surplus

His consumer surplus is the di¤erence between his willingness to pay

for the xi units and the actual amount he pays:
CSi = δi (1) + δi (2) + ... + δi (xi ) pxi .
In the case of continuous quantity, his consumer surplus is
Z xi
CSi = δi (t ) dt pxi .
0
Pak Hung Au (NTU) Competition & Welfare Jan 2020 4 / 26
Consumer Surplus

In what sense is consumer surplus a welfare measure?

Suppose consumer i has a quasi-linear utility function:

Ui (x, t ) = vi (x ) + t.

Here vi (x ) is increasing and concave in the quantity x of goods (with

vi (0) = 0), and t is interpreted as the money the consumer holds (for
other consumption).
Given a price p of the goods, the consumer would choose x and t to
maximize Ui (x, t ) subject to budget constraint

px + t I,

where I is the consumer’s income.

Pak Hung Au (NTU) Competition & Welfare Jan 2020 5 / 26

Consumer Surplus

As utility is increasing in both x and t, it is clear that the budget

constraint holds with equality at the solution.
Rearranging the budget constraint into t = I px and substituting
into the utility function, the problem becomes one of choosing x to
maximize vi (x ) px + I .
FOC implies that p = vi0 (x ).
Consumption of the goods does not depend on income I . Thus, a
consumer with quasi-linear utility function has no "income e¤ect".

Pak Hung Au (NTU) Competition & Welfare Jan 2020 6 / 26

Consumer Surplus

By calculation above, the inverse demand function δi is actually vi0 .

Consumer i’s inverse demand function δi (x ), can therefore be
interpreted as his marginal utility of consuming the x-th unit of
goods.
Therefore, his consumer surplus is
Z xi
CSi = vi0 (s ) ds pxi = vi (xi ) pxi .
0

Consequently, the consumer surplus is his utility gain derived from the
transaction:

CSi = (vi (xi ) + I pxi ) I

|{z}
| {z }
consumer’s utility after the purchase consumer’s utility before the purchase

Pak Hung Au (NTU) Competition & Welfare Jan 2020 7 / 26

Market Demand
Recall the market demand function is obtained from adding up
individual consumers’demand curves horizontally.
Suppose there are N consumers in the market. The market demand is
N
Dmkt (p ) = D1 (p ) + D2 (p ) + .... + DN (p ) = ∑ Di ( p ) .
i =1

Pak Hung Au (NTU) Competition & Welfare Jan 2020 8 / 26

Market Demand
1
The inverse market demand is δmkt (Q ) Dmkt (Q ).
δmkt (Q ) can be viewed as the marginal social utility brought
about by the "society’s" consumption of the Q-th unit of
goods.

Pak Hung Au (NTU) Competition & Welfare Jan 2020 9 / 26

Market Consumer Surplus
If the total quantity consumed by all consumers is Q at market price
p, then the market consumer surplus is
Z Q
CSmkt = δmkt (s ) ds pQ.
0
It is also the sum of all consumers’utility gain from transaction.
N
CSmkt = CS1 + CS2 + .... + CSN = ∑ vi (xi ) pQ,
i =1
Here, Q = x1 + x2 + ... + xN .

Pak Hung Au (NTU) Competition & Welfare Jan 2020 10/ 26

Producer Surplus

We have seen from HE 1001 that

each …rm is characterized by a production technology, from which we
can derive its cost function;
a …rm’s supply curve is determined by the portion of its marginal cost
curve above the (short-run) average cost curve.
Given …rm j’s marginal cost function MCj (q ), its cost of producing
the 1st unit is MCj (1);
the 2nd unit is MCj (2);
the 3rd unit is MCj (3), and so on.
Given a price p for the goods, …rm j will produce qj units such that

MCj (qj ) < p < MCj (qj + 1) .

Pak Hung Au (NTU) Competition & Welfare Jan 2020 11/ 26

Producer Surplus
In the case of continuous quantity, it produces until p = MCj (q ).
Firm j’s supply curve is thus
(MCj ) 1 (p ) if p > minimum SR average cost
Sj ( p ) = .
0 otherwise

Pak Hung Au (NTU) Competition & Welfare Jan 2020 12/ 26

Producer Surplus

Its producer surplus is the di¤erence between the amount it receives

for producing the qj units and the cost that it incurs to produce them:

PSj = pqj [MCj (1) + MCj (2) + .... + MCj (qj ) + F ] .

where F is the avoidable …xed cost in the short run.

In the case of continuous quantity, its producer surplus is
Z qj
PSj = pqj MCj (s ) ds + F = pqj Cj (qj ) ,
0

where Cj (qj ) is …rm j’s avoidable cost of producing qj units.

Pak Hung Au (NTU) Competition & Welfare Jan 2020 13/ 26

Market Supply
Recall the market supply function is obtained from adding up
individual …rms’supply curves horizontally.
Suppose there are M …rms in the market. The market supply is
M
Smkt (p ) = S1 (p ) + S2 (p ) + .... + SM (p ) = ∑ Sj ( p ) .
j =1

Pak Hung Au (NTU) Competition & Welfare Jan 2020 14/ 26

Market Supply
Using market supply Smkt (p ), we can derive the inverse market
1
supply function Smkt (Q ).
1
Smkt (Q ) can be viewed as the marginal industry cost that the
"industry" incurs in the production of the Q-th unit of goods.

Pak Hung Au (NTU) Competition & Welfare Jan 2020 15/ 26

Market Producer Surplus

If the total quantity produced by all …rms is Q at market price p, then

the market producer surplus is
Z Q
1
PSmkt = pQ Smkt (s ) ds
0

The market producer surplus is the sum of all …rms’pro…ts (net of

sunk …xed costs).
M
PSmkt = PS1 + PS2 + .... + PSM = pQ ∑ Cj (qj ) .
j =1

(Here Q = q1 + q2 + ... + qM .)

Pak Hung Au (NTU) Competition & Welfare Jan 2020 16/ 26

Competitive Equilibrium

In the equilibrium of a perfectly competitive market, there is a market

price such that
each consumer chooses xi that maximizes his utility;
each …rm chooses qj that maximizes its pro…t; and
the market clears, i.e., quantity demanded equals quantity supplied.
In notation, market price p and allocation
(x1 , x2 , ..., xN ; q1 , q2 , ..., qM ) is a competitive equilibrium if
for each consumer i, p = vi0 xi ;
for each …rm j, p = MCj qj ; and
x1 + x2 + ... + xN = q1 + q2 + ... + qM (i.e., ∑N M
i =1 xi = ∑j =1 qj ).

Pak Hung Au (NTU) Competition & Welfare Jan 2020 17/ 26

Competitive Equilibrium

Pak Hung Au (NTU) Competition & Welfare Jan 2020 18/ 26

Welfare Maximization
Imagine a benevolent social planner could mandate production and
consumption of each consumer and …rm.
How should this social planner decide the production and
consumption plans?
Recall we have shown that in a quasi-linear environment, an allocation
is Pareto e¢ cient if and only if it maximizes the society’s total utility.
Hence the social planner would like to choose
(x1 , x2 , ..., xN ; q1 , q2 , ..., qM ) to maximize
N M
∑ vi (xi ) ∑ Cj (qj )
i =1 j =1

subject to the constraint

N M
∑ xi = ∑ qj .
i =1 j =1

Pak Hung Au (NTU) Competition & Welfare Jan 2020 19/ 26

Welfare Maximization

The Lagrangian is
" #
N M M N
L= ∑ vi (xi ) ∑ Cj (qj ) + λ ∑ qj ∑ xi .
i =1 j =1 j =1 i =1

The FOC for xi :

vi0 (xi ) λ = 0.
The FOC for qj :
Cj0 (qj ) + λ = 0.

Pak Hung Au (NTU) Competition & Welfare Jan 2020 20/ 26

Welfare Maximization

Therefore, the social planner’s optimal allocation

(x1 , x2 , ..., xN ; q1 , q2 , ..., qM ) would satisfy the following equations:

vi0 (xi ) = λ for each consumer i;

Cj0 (qj ) = λ for each …rm j;
N M
∑ xi = ∑ qj ,
i =1 j =1

for some Lagrange multiplier λ.

Consequently, every Pareto e¢ cient allocation satis…es these
equations.
We have seen these equations, with λ = p !

Pak Hung Au (NTU) Competition & Welfare Jan 2020 21/ 26

First Fundamental Theorem of Welfare Economics

Theorem
A competitive equilibrium is Pareto e¢ cient.

It holds beyond the quasi-linear environment considered here.

Given any combination of (not-too-crazy) utility functions of
consumers, and (not-too-crazy) cost functions of …rms, the resulting
competitive equilibrium is Pareto e¢ cient.

Pak Hung Au (NTU) Competition & Welfare Jan 2020 22/ 26

First Fundamental Theorem of Welfare Economics

Pak Hung Au (NTU) Competition & Welfare Jan 2020 23/ 26

Second Fundamental Theorem of Welfare Economics

The second welfare theorem considers the converse of the …rst welfare
theorem.
There are multiple Pareto e¢ cient allocations, each di¤ering in the
money held by the consumers.
Take an arbitrary Pareto e¢ cient allocation, can it be achieved as a
competitive equilibrium, perhaps through some redistribution of
endowments among the consumers?
Yes! Redistribution of endowments would not a¤ect any consumption
and production decision.

Pak Hung Au (NTU) Competition & Welfare Jan 2020 24/ 26

Second Fundamental Theorem of Welfare Economics

Theorem
For any Pareto e¢ cient allocation, the social planner can come up with a
budget-balanced monetary transfer scheme (t1 , t2 , ..., tN ) such that a
competitive equilibrium with initial endowments
(I1 + t1 , I2 + t2 , ..., IN + tN ) yields precisely the targeted Pareto e¢ cient
allocation.

The second welfare theorem says that a benevolent social planner can
implement any Pareto e¢ cient allocation by appropriately
redistributing incomes, and then "letting the market work freely".
The second welfare theorem holds much more generally, beyond the
quasi-linear environment considered here.

Pak Hung Au (NTU) Competition & Welfare Jan 2020 25/ 26

Summary

Under a quasi-linear environment, we can view the market demand

curve as the society’s marginal utility curve.
Similarly, we can view the market supply curve as the industry’s
marginal cost curve.
By the First Welfare Theorem, perfect competition leads to an
allocation that maximizes the sum of the utilities of all consumers and
…rms, and is thus Pareto e¢ cient.
By the Second Welfare Theorem, any Pareto e¢ cient allocation can
be achieved by redistributing endowments, and then letting the
market run free.

Pak Hung Au (NTU) Competition & Welfare Jan 2020 26/ 26