MNE-Session 5 & 6-Chap 7-Perfect Competition

Microeconomics
Second Edition, Global Edition
Chapter 7
Perfect Competition
and the
Invisible Hand
Copyright © 2018 Pearson Education, Ltd. All Rights Reserved.

Learning Objective
7.1 Perfect Competition and Efficiency

7.2 Extending the Reach of the Invisible
Hand: From the Individual to the Firm
7.3 Extending the Reach of the Invisible
Hand: Allocation of Resources across
Industries
7.4 Prices Guide the Invisible Hand
7.5 Equity and Efficiency
Copyright © 2018 Pearson Education, Ltd. All Rights Reserved
Key Ideas (1 of 2)
1. The invisible hand efficiently allocates goods and

services to buyers and sellers.
2. The invisible hand leads to efficient production

within an industry.
3. The invisible hand efficiently allocates resources

across industries.

Key Ideas (2 of 2)
4. Prices direct the invisible hand.
5. There are trade-offs between making the

economic pie as big as possible and
dividing the pieces equally (efficiency vs
equity)

Perfect Competition and the Invisible Hand (3 of 5)
Adam Smith, The Wealth of Nations (1776)
“It is not from the benevolence of the butcher, the

brewer, or the baker, that we expect our dinner, but
from their regard to their own interest.”
But isn’t all of the chaos we observe in markets

driven by market participants simply looking out
for #1—themselves?
Perfect Competition and the Invisible Hand
(5 of 5)
Efficiency is about getting the most out of

scare resources
Making the “pie” as big as possible

We are ignoring fairness (equity) at this
point BUT we will revisit the topic

Perfect Competition and Efficiency (1 of 4)
Reservation Values of Buyers and Sellers in the iPhone Market

Res. Value Res. Value
Buyers ($) Cum. Q Sellers ($) Cum. Q
Madeline $70 1 Tom $10 1
Katie $60 2 Mary $20 2
Sean $50 3 Jeff $30 3
Dave $40 4 Phil $40 4
Ian $30 5 Adam $50 5
Kim $20 6 Matt $60 6
Ty $10 7 Fiona $70 7

Sean $50 3 Jeff $30 3
Dave $40 4 Phil $40 4
Ian $30 5 Adam $50 5
Kim $20 6 Matt $60 6
Ty $10 7 Fiona $70 7
Madeline, Katie, Sean, Dave, Ian, Tom, Mary, Jeff, Phil, Adam, Matt
Kim and Ty are Buyers. and Fiona are sellers.


Sean $50 3 Jeff $30 3
Dave $40 4 At $40 Phil
Market is $40 4
Ian $30 5 in Equilibrium
Adam $50 5
Kim $20 6 Matt $60 6
Ty $10 7 Fiona $70 7

Exhibit 7.2 Demand and Supply Curves in the iPod Market

Perfect Competition and Efficiency
Social Surplus (1 of 12)
Consumer
Buyers Res. Value ($) Surplus Cum. Q
Madeline $70 $30 1
Katie $60 $20 2
Sean $50 $10 3
Dave $40 $0 4
Ian $30 Blank 5
Kim $20 6
Ty $10 Blank 7
Total Blank $60 Blank

Perfect Competition and Efficiency Social
Surplus (2 of 12)
Reservation Values
At an equilibrium ofofBuyers
price $40 and Sellers in the iPod Market
Madeline was WTP $70

Consumer Cumulative Total
Buyers
She has $30 in surplusRes. Valueshe
because ($)was Surplus Quantity
willing to pay more than
Madeline $70 market
- $40price
= $30 1
At an equilibrium
Katie $60 $20 2
price of $40
Sean $50 $10 3
Individual
Dave $40 $0 4
Consumer
Ian $30 Blank 5 surplus
Kim $20 6
Ty $10 Blank 7

Market
Consumer
surplus
Buyers Res. Value ($) Consumer Surplus Cum. Q

Madeline $70 $30 1
Katie $60 $20 2
Sean $50 $10 3
Dave $40 $0 4
Ian $30 Blank 5
Kim $20 6
Ty $10 Blank 7

At an equilibrium price of $40
Tom was WTA $10
Reservation Values of Buyers and Sellers in the iPod Market
He has $30 in surplus because he
was willing to accept less than
market price
Producer Cumulative Total
Sellers Res. Value ($) Surplus Q
At an equilibrium
Tom $40 - $10 = $30 1
price of $40
Mary $20 $20 2
Jeff $30 $10 3
Phil $40 $0 4 Individual
Adam $50 Blank 5 Producer surplus
Matt $60 6
Fiona $70 Blank 7
Market Producer
surplus

Social surplus
The sum of consumer and producer surplus
60 CS + 60 PS = $120 Social Surplus

Buyers Res. Value ($) Consumer Surplus Cum. Q

Madeline $70 $30 1
Katie $60 $20 2
Sean $50 Blank 3
Dave $40 Blank 4
Ian $30 Blank 5
Kim $20 Blank 6
Ty $10 Blank 7

Why are Madeline and Katie the 2
2 highest value market highest value consumers?
Reservation
participants would Values of Buyers and Sellers in the iPod Market
exchange units
Buyers Res. Value ($) Consumer Surplus Total. Q
Madeline $70 $30 1
Katie $60 $20 2

Highest willingness to pay
Sean $50 Blank (WTP)!
3
Dave $40 4
What if (for some reason)
Ian $30 quantity was restricted at 2 5
units?
Kim $20 6
Maybe the production of
Ty $10 this product causes 7
pollution?

Sellers Res. Value ($) Producer Surplus Cum. Q

Tom $10 $30 1
Mary $20 $20 2
Jeff $30 Blank 3
Phil $40 Blank 4
Adam $50 Blank 5
Matt $60 Blank 6
Fiona $70 Blank 7

Why are Tom and Mary the 2 highest
2 highest value market
Reservation Values of Buyers andvalue
Sellers in the iPod Market
sellers?
participants would
exchange units
Sellers Res. Value ($) Producer Surplus Total. Q

Tom $10 $30 1
Lowest willingness to
accept (WTA)!
Mary $20 $20 2
Jeff $30 Blank 3
Phil $40 4
What if (for some reason)
Adam $50 quantity was restricted at 2
Blank 5
units?
Matt $60 6
Maybe the production of
Fiona $70 this product causes 7
pollution?

Social surplus
= $100
Madeline ($70) – Tom ($10) and Katie ($60) – Mary

($20) or $60 + $40 = 100

Exhibit 7.3 Maximizing Social Surplus

Exhibit 7.3 Maximizing Social Surplus
Market in
Equilibrium
Restrict
We cannot improve the outcome Force Adam to sell at
Quantity by forcing the price or the quantity price $30 (his WTA
higher or lower. $50)
Lose this area Lose this area
Pareto Efficiency (1 of 3)
Pareto efficiency
When no one can be made better off without

making someone else worse off
Example: When price was set at $20, consumers

were made better off, but producers were made
worse off

The invisible hand directs consumers and
producers to maximize their surplus…

And leads to the highest level of social
welfare.

If the competitive market is Pareto

efficient…
then government intervention cannot be

justified based on efficiency
though perhaps it could be justified based on
equity (later in chapter)

Extending the Reach of the Invisible
(1 of 14)
You’re the new CEO of a company that operates two

manufacturing plants.
Old Plant New Plant
50 years old 4 years old
Old machinery New technology
The old plant has higher MC at every level of production

than the new plant.
(2 of 14)
Exhibit 7.4 Marginal Costs for Two Manufacturing Plants

(3 of 14)
In the past, each plant has been run independently,
and each plant manager is charged with maximizing
profit at his/her plant.

Extending the Reach of the Invisible Hand:
From the Individual to the Firm with P=$ 10
(4 of 14)
Exhibit 7.5 Optimal Production Quantity at the Old manufacturing Plant

From the Individual to the Firm (5 of 14)
Exhibit 7.5 Optimal Production Quantity at the Old Manufacturing Plant
Output set where:

Remember - Competitive
market MR = MC
firm should set: Profit-Maximizing condition!
MR = MC MR>MC: expand output
where P = MR MR<MC: contract output
Manager sets Quantity
Q = 20,000 units
Notice Costs are equal to the
area of the rectangle:
20,000 × $10 = $200,000

(6 of 14)
Total revenue for old plant:

$10 × 20,000 = $200,000
Total costs for old plant:

20,000 × $10 (ATC) = $200,000
Economic profit = $0

(7 of 14)
Exhibit 7.6 Optimal Production Quantity at the New Manufacturing Plant

(8 of 14)
Exhibit 7.6 Optimal Production Quantity at the New Manufacturing Plant
Economic Profits:
Remember - Competitive 50,000 × $2.5 = $125,000
market
firm should set:
MR = MC
where P = MR
ATC = $7.50 Output set where:
MR = MC
Notice Costs are equal to the
Profit-Maximizing condition!
area of the rectangle:
Q = 50,000 units
50,000 × $7.5 = $375,000

(9 of 14)
Total revenue for new plant:
$10 × 50,000 = $500,000
Total costs for new plant:
50,000 × $7.50 (ATC) = $375,000
Economic profit = $125,000

As the CEO, should you close the old plant and shift
production to the new plant?
The new plant:

Let’s assume the CEO says
“Yes”
1. Earns more profit Shut down Old plant
Produce all 70,000 units at

2. Has lower costs the New plant
3. Has newer technology

One year later…
Old Plant:
Output = 0
Profit = $0
New Plant: Ouch!
Output = 70,000 What happened?
Profit = -$875,000
What?
Exhibit 7.7 The Impact of Enforced Production Schedules

Competitive market Original -
results in most Competitive market
efficient (least cost)
production BOTH plants set
production where:
MR = MC
where P = MR
At Q = 70,000 New Plant Only –

ATC = $22.50
All production in
MC for the New Plant
70,000th unit = $30
MR = P = $10 Quantity = 70,000
MR<MC MR < MC
Reduce Production
in New Plant!
The invisible hand directs managers to pursue their

own self-interest…
And results in the most efficient (least cost)

production allocation.

Allocation of Resources across Industries (1 of 5)
What if industries are different?
Short-run economic profits in one industry will attract

profit-seeking producers in industries experiencing
economic losses.
In this way, free entry and exit allows reallocation of
assets to their greatest valued uses, even across
industries.
Exhibit 7.9 Economic Profits in the Paper Delivery Business

Exhibit 7.11 Economic Losses in the Trucking Market

Pretend Corn Market Remember:
Pretend Cotton Market
In a free and competitive market we
have free entry and exit
Short-run profit in one sector combined with a

short-run loss in another will cause a reallocation
of resources across sectors
The invisible hand directs firms to seek out profits…
And results in resources being allocated to

their highest value of use.

Prices Guide the Invisible Hand Deadweight
Loss (1 of 3)
Exhibit 7.15 Deadweight Loss from Price Controls

Loss (2 of 3)
Exhibit 7.15 Deadweight Loss from Price Controls
Society loses area D
Deadweight Loss
What if a Price Ceiling is set at P1?
Price decreases, firms set MR=MC and

decrease production
Quantity decreases to Q1

Loss (3 of 3)
Deadweight Loss
The reduction in social surplus resulting from a
market intervention

Equity and Efficiency (1 of 4)
Equity
Addresses the issue of a “fair” distribution of

resources across society

Equity and Efficiency (2 of 4)
Perfectly Competitive Markets are efficient
One of the roles of government in our economy is to
address efficient outcomes that we may not
consider to be equitable

MNE-Session 5 &amp; 6-Chap 7-Perfect Competition

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Microeconomics

Second Edition, Global Edition

Copyright © 2018 Pearson Education, Ltd. All Rights Reserved.

7.1 Perfect Competition and Efficiency

1. The invisible hand efficiently allocates goods and

2. The invisible hand leads to efficient production

3. The invisible hand efficiently allocates resources

Copyright © 2018 Pearson Education, Ltd. All Rights Reserved

4. Prices direct the invisible hand.

5. There are trade-offs between making the

Copyright © 2018 Pearson Education, Ltd. All Rights Reserved

Adam Smith, The Wealth of Nations (1776)

“It is not from the benevolence of the butcher, the

But isn’t all of the chaos we observe in markets

Efficiency is about getting the most out of

Making the “pie” as big as possible

Copyright © 2018 Pearson Education, Ltd. All Rights Reserved

Reservation Values of Buyers and Sellers in the iPhone Market

Copyright © 2018 Pearson Education, Ltd. All Rights Reserved

Copyright © 2018 Pearson Education, Ltd. All Rights Reserved

Reservation Values of Buyers and Sellers in the iPhone Market

Copyright © 2018 Pearson Education, Ltd. All Rights Reserved

Exhibit 7.2 Demand and Supply Curves in the iPod Market

Copyright © 2018 Pearson Education, Ltd. All Rights Reserved

Katie $60 $20 2

Sean $50 $10 3

Ian $30 Blank 5

Total Blank $60 Blank

Copyright © 2018 Pearson Education, Ltd. All Rights Reserved

Madeline was WTP $70

Total Blank $60 Blank

Buyers Res. Value ($) Consumer Surplus Cum. Q

Katie $60 $20 2

Sean $50 $10 3

Ian $30 Blank 5

Total Blank $60 Blank

Copyright © 2018 Pearson Education, Ltd. All Rights Reserved

Copyright © 2018 Pearson Education, Ltd. All Rights Reserved

The sum of consumer and producer surplus

60 CS + 60 PS = $120 Social Surplus

Copyright © 2018 Pearson Education, Ltd. All Rights Reserved

Buyers Res. Value ($) Consumer Surplus Cum. Q

Katie $60 $20 2

Sean $50 Blank 3

Dave $40 Blank 4

Ian $30 Blank 5

Kim $20 Blank 6

Total Blank $100 Blank

Copyright © 2018 Pearson Education, Ltd. All Rights Reserved

Katie $60 $20 2

Copyright © 2018 Pearson Education, Ltd. All Rights Reserved

Sellers Res. Value ($) Producer Surplus Cum. Q

Mary $20 $20 2

Jeff $30 Blank 3

Phil $40 Blank 4

Adam $50 Blank 5

Matt $60 Blank 6

Fiona $70 Blank 7

Total Blank $100 Blank

Copyright © 2018 Pearson Education, Ltd. All Rights Reserved

Sellers Res. Value ($) Producer Surplus Total. Q

Jeff $30 Blank 3

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Madeline ($70) – Tom ($10) and Katie ($60) – Mary

MNE-Session 5 & 6-Chap 7-Perfect Competition

MNE-Session 5 & 6-Chap 7-Perfect Competition