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Chapter 8 The Theory of Perfect Competition

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A Competitive Model of exchange


In

an Exchange Economy, goods are exchanged but not produced. Reservation price is the maximum amount a person is willing to pay for a good. Market demand & supply functions give the total number of units demanded & supplied at a given price.
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Figure 8.1 Demand and supply

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From Figure 8.1


All

individuals supply/demand only one unit of the good, and their individual demand/supply curves are given by their reservation willingness to pay for a good. The decision to be in or out of the market is called the extensive margin.
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Figure 8.2 Competitive equilibrium in an exchange economy

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From Figure 8.2


Imagine there is a Walrasian auctioneer who acts as a price setter. If quantity demanded/supplied at the announced price exceeds quantity supplied/demanded there is excess demand/supply. The auction ends in a competitive equilibrium only when quantity demanded equals quantity supplied. This competitive allocation is Paretooptimal or efficient.

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The Assumptions of Perfect Competition


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2.

3. 4. 5.

Large Numbers: No individual demander or supplier produces a significant proportion of the total output. Perfect Information: All participants have perfect knowledge of all relevant prices and technology. Product Homogeneity: In any given market, all firms products are identical. Perfect Mobility of Resources (Inputs). Independence: Individual consumption and production decisions are independent of all other consumption/production decisions.
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Firms Short-run Supply Decision


A

firms profit () is its total revenue (TR) minus short-run total costs (STC). The profit function is expressed as: (y) = TR(y)-STC(y) Profit is maximized at Y*, as a function of the exogenous variable price (p). The slope of the profit function with respect to output is zero at Y*.
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Figure 8.4 Profit maximization

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Marginal Revenue and Marginal Cost


The

slope of the total revenue function is marginal revenue (MR). The slope of the total cost function is marginal cost (MC). The firm will maximize profits by equating MR & MC: Notationally: SMC(y*)=MR=p

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Figure 8.5 The competitive firms supply function

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From Figure 8.5

1. 2.

Short-run profit maximization requires SMC(y*)=MR=p, subject to two qualifications: SMC is rising. p>minimum value of AVC.

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Profit Maximization
Profit

can be expressed as: (y*) = y*[p-SAC(y)]

Where: p-SAC(y) is profit per unit of y

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Figure 8.6 The profit rectangle

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Figure 8.7 Aggregating demand

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Figure 8.8 Aggregating supply

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Figure 8.9 Short-run competitive equilibrium

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Efficiency of the Short-Run Competitive Equilibrium


The

short-run equilibrium shown in Figure 8.9 is considered to be efficient because it maximizes Consumer Surplus and Producer Surplus. The sum of Consumer Surplus and Producer Surplus, known as Total Surplus is a measure of the aggregate gains from trade realized in this market.
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Long-Run Competitive Equilibrium

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2.

There are two conditions of longrun equilibrium: No established firm wants to exit the industry. No potential firm wants to enter the industry.

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Long-Run Competitive Equilibrium

Positive profit is a signal that induces entry, or allocation of additional resources to the industry. Losses are a signal that induces exit, or the allocation of fewer resources to the industry. In long-run equilibrium, price equals the minimum average cost.
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Figure 8.10 Exit, entry, and long-run competitive equilibrium

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Figure 8.11 The firm in long-run competitive equilibrium

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Long-Run Supply Function


The

long-run competitive equilibrium is determined by the intersection of LRS and the demand function. Deriving LRS incorporates changes in input prices that arise as industry-wide output expands. These changes determine whether the industry is a constant, increasing, or decreasing cost industry.
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Figure 8.12 LRS in the constant-cost case

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Figure 8.13 LRS in the increasing-cost case

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