The economics of competitive markets Rolands Irklis

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1 The economics of competitive markets Rolands Irklis www. erranet.org

2 Presentation outline 1. Introduction and motivation 2. Consumer s demand 3. Producer costs and supply decisions 4. Market equilibrium and dynamics 5. Efficiency and welfare in competitive markets 6. Short vs long run equilibrium 7. Capacity constraints on the supply side 8. Efficient markets vs market failures 2

3 Motivation Why should you be interested in the economics of competitive markets? Real-life relevance: most products and services in our lives are sold in more or less free markets Professional development: in some more or less lucky countries, electricity is/will be one of these products Intellectual curiosity: understanding economics is a nice cognitive exercise in the logical application of basic common sense 3

4 Introduction Textbook economics: many of its ideas seem to be formalizations of common sense logic no special intellect or mathematical skills are needed at this level Textbook economics is important competitive market is the ideal market to which we compare it does a good job of describing free markets it provides useful tools and thinking framework to analyze economic situations it enforces logical deduction and argumentation The outlined concepts will be used several times during this training 4

5 Assumptions Consumers are rational Firms maximize profits Products are homogeneous Transactions are costless Information is freely available In competitive markets Consumers and producers are price takers entry to and exit from the market is free Legal system is in place cheating is duly punished and therefore not worth doing Government plays no role other than providing institutional infrastructure How far these assumptions drive away from reality? 5

6 The basic concept: market equilibrium price (p) market demand curve industry supply curve equilibrium (market-clearing) price equilibrium (market-clearing) quantity quantity (q) During this lecture we will analyse the market equilibrium in the case of perfect competition 6 6 6

7 A typical electricity market equilibrium 7 7

8 Presentation outline 1. Introduction and motivation 2. Consumer s demand 3. Producer costs and supply decisions 4. Market equilibrium and dynamics 5. Efficiency and welfare in competitive markets 6. Short vs long run equilibrium 7. Capacity constraints on the supply side 8. Efficient markets vs market failures 8 8 8

9 What is demand? People have an idea how much of a product they want to consume, depending on: their needs, and the options available to satisfy these needs the time of day the weather their income the neighbors consumption the price of the product marketing and advertising how much they consumed last time We are interested in the effect of the relevant and measurable factors 9 9 9

10 What is the demand curve? price (p) light fridge hot water For any quantity, there is a maximum unit price that consumers are willing to pay For any given price, there is a A/C? maximum quantity that consumers are willing to purchase D(p) quantity (q) The law of demand: the higher the price, the lower the demanded quantity This relationship is captured by the downward-sloping demand curve With many consumers or large quantities, the demand schedule is approximated by a continuous curve

11 Shifts in demand price (p) High demand Low demand quantity (q) Consumption is influenced by many factors at the same time In two dimensions, only one effect can be displayed The other effects shift the demand curve in or out Demand shifters technological change: e.g. low energy consuming products change in substitutable products price good vs bad weather high vs low income daytime vs nighttime little vs a lot of marketing number of customers expectations

12 Demand elasticity price (p) Price elasticity of demand Low elasticity = High elasticity quantity (q) Percent change in demanded quantity Percent change in price How does consumption react to a change in price? If the same price change induces a greater fallback in consumption, demand is more elastic Demand elasticity depends on substitution possibilities e.g. lemon juice instead of lemon in tea Income elasticity can be defined similarly Other influences on demand elasticity substitutability (own price vs. cross price elasticity) good vs bad weather high vs low income daytime vs nighttime time horizon

13 Presentation outline 1. Introduction and motivation 2. Consumer demand 3. Producer costs and supply decisions 4. Market equilibrium and dynamics 5. Efficiency and welfare in competitive markets 6. Short vs long run equilibrium 7. Capacity constraints on the supply side 8. Efficient markets vs market failures

14 The simplest (meaningful) production cost structure We want to know how much expenditure the firm must incur for any level of production the cost function: C(q) Production costs can be divided into two groups: fixed costs, which do not depend on the production level [e.g.: capital equipment] sunk cost [e.g.: rental fee] Avoidable fix cost [e.g.: lighting in a factory] variable costs, which change with the level of production [e.g.: material cost] We can also divide total cost by total quantity average cost, which usually changes with the production level

15 The most important cost category in economic decisions Marginal cost (MC): how much extra money would it cost to produce one unit more of the product? Rational economic decision makers think in marginal concepts they compare marginal benefits to marginal costs they make a decision if its marginal benefits are larger than its marginal costs A company produce one unit more of its product if its marginal revenue is larger than its marginal cost

16 The cost function cost (c) Marginal cost (the slope!) Cost function Variable cost Total cost Fixed cost Average cost (the slope!) quantity (q) Quantity produced

17 General shape of the marginal and average cost functions unit cost marginal cost average cost quantity (q) Least-cost production level

18 How do companies in competitive markets decide about production levels? Firms observe the market price (P) at which they can sell a unit of the product they assume that this price does not change with their own production decisions (price-taking assumption) Firms know how much the last unit cost and how much the next one would cost they are aware of marginal cost Firms had a profit of P MC on the last unit sold if this is negative (P < MC), it s better to reduce production! Firms will have a profit of P MC on the next unit sold if this is positive (P > MC), it s better to increase production! Production level is optimal if P = MC and Total revenue>variable costs Otherwise it is better for the company not to produce at all

19 Firm-level supply functions Optimal company production decisions are governed by P = MC Marginal cost curves are, in fact, the supply functions of a pricetaking company they tell us how much the firm would produce given the market price Supply functions are upward sloping like the marginal cost If the market price is higher, companies are willing to produce more To get the industry supply function, we have to add up the firmlevel supply curves horizontally

20 Supply curve aggregation price (p) firm-level supply curves industry supply curve quantity (q)

21 Entry and exit of firms price (p) firm-level supply curves new entrant new industry supply curve industry supply curve quantity (q) If another firm enters the market, the industry supply curve moves to the right and becomes flatter. If a firm exits the market, the opposite happens

22 Presentation outline 1. Introduction and motivation 2. Consumer demand 3. Producer costs and supply decisions 4. Market equilibrium and dynamics 5. Efficiency and welfare in competitive markets 6. Short vs long run equilibrium 7. Capacity constraints on the supply side 8. Efficient markets vs market failures

23 Market equilibrium price (p) market demand curve industry supply curve equilibrium (market-clearing) price equilibrium (market-clearing) quantity quantity (q)

24 How does the market find the equilibrium? If prices are above the market-clearing level there is too much supply and not enough demand companies find that they cannot sell all production at the high price they will reduce the output to the point where they can sell everything the price will go down to the market-clearing level If prices are below the market-clearing level there is excess demand relative to supply consumers are queuing at the shops some of them are willing to buy at higher prices as well and will bid up the price to get the product the price will increase and companies produce more to close the gap between demand and supply

25 Shifts in demand and supply Demand increase Supply increase price (p) market demand curve price (p) market demand curve industry supply curve industry supply curve (e.g. higher income) quantity (q) (e. g. new firms enter) quantity (q)

26 Presentation outline 1. Introduction and motivation 2. Consumer demand 3. Producer costs and supply decisions 4. Market equilibrium and dynamics 5. Efficiency and welfare in competitive markets 6. Short vs long run equilibrium 7. Capacity constraints on the supply side 8. Efficient markets vs market failures

27 What is efficiency? General definition an economic outcome is efficient if no one can be made better-off (by some reallocation of resources) without making someone else worse-off More specific static definition given the cost and benefits of economic activity in a certain situation, all possible gains from trade are realized allocative efficiency More specific dynamic definition costs of economic activity are made as small as reasonable over time productive efficiency e.g. profitable investments are undertaken to decrease production cost

28 Welfare and efficiency Welfare is defined as a measure of overall well-being generated in a market consumer surplus is generated when people pay less money for a product than their valuation ( reservation price ) of the product producer surplus ( profit ) is generated when companies receive more money for a product than what it cost them to produce it (the marginal cost) welfare is the sum of these two An economic outcome is efficient if no one can be made better-off without harming anyone else neither consumer nor producer surplus can be increased Therefore, a market outcome is efficient if it maximizes welfare

29 Consumer and producer surplus price (p) price (p) consumer surplus market price market price producer surplus quantity (q) quantity (q)

30 Allocative efficiency requires P = MC price (p) price (p) consumer surplus producer surplus price unrealized gains from trade marginal cost consumer surplus producer surplus marginal cost producer loss efficiency loss from trade price quantity (q) If price is above marginal cost, more could be produced and sold for mutual gain, but isn t. quantity (q) If price is below marginal cost, the last units are not worth as much as they cost to produce

31 Competition and allocative efficiency Remember: price-taking firms set production to a level where P = MC they will ensure that an allocatively efficient level of output is produced, whatever the price is Also: consumers will buy the product up to the point where the last unit is worth to them exactly as much as the market price Supply-demand interaction results in the clearing of the market Therefore, the last person to buy the product will pay exactly as much as the product is worth to him, which is exactly as much as it cost the firm to produce it Neither the consumers, nor the firms can be made better-off without one party hurting the other The competitive market equilibrium is both efficient and welfare maximizing

32 Presentation outline 1. Introduction and motivation 2. Consumer demand 3. Producer costs and supply decisions 4. Market equilibrium and dynamics 5. Efficiency and welfare in competitive markets 6. Short vs long run equilibrium 7. Capacity constraints on the supply side 8. Efficient markets vs market failures

33 Short run vs long run In the short run firms cannot enter or exit the market supply is upward sloping excess profits are perfectly feasible in equilibrium losses can also happen In the long run firms can enter the market if they see excess profit firms can leave the market if they are consistently losing money supply is flat (horizontal) and corresponds to the level of least-cost production in long-run equilibrium, there are no excess profits or losses Lack of excess profit does not mean it is not worth to produce all inputs are paid at the market prices

34 Presentation outline 1. Introduction and motivation 2. Consumer demand 3. Producer costs and supply decisions 4. Market equilibrium and dynamics 5. Efficiency and welfare in competitive markets 6. Short vs long run equilibrium 7. Capacity constraints on the supply side 8. Efficient markets vs market failures

35 Capacity constraint in supply A special characteristic of electricity generation marginal costs are fairly constant and low fixed costs are fairly high there is a maximum production level, beyond which it is physically impossible to produce in the short run What happens to marginal cost? above the capacity limit MC becomes infinitely large What happens to optimal company production? below the capacity limit: P = MC left at the capacity limit: MC left P MC right

36 Industry supply with uniform, capacity constrained production technologies price several (overlapping) firm-level supply curves price industry supply curve quantity quantity Q: If P = MC, how is the fixed cost recovered?

37 Industry supply with uniform, capacity constrained production technologies price Short-run equilibrium price Long-run equilibrium P P industry supply curve industry supply curve P = MC Spare capacity exists There is no producer surplus Fixed costs are not covered All firms lose money Some firms will exit the market quantity MC left P MC right There is no spare capacity Producer surplus is positive Fixed costs recovered through shortage No firms lose money No firm enters or exits the market 37 quantity 37 37

38 Industry supply with two different, capacity constrained production technologies price firm-level supply curves High MC, Low FC price range of demand fluctuations Low MC, High FC industry supply curve quantity quantity A: To recover fixed costs with competitive pricing, capacity shortages (price spikes) must occur from time to time

39 Presentation outline 1. Introduction and motivation 2. Consumer demand 3. Producer costs and supply decisions 4. Market equilibrium and dynamics 5. Efficiency and welfare in competitive markets 6. Short vs long run equilibrium 7. Capacity constraints on the supply side 8. Efficient markets vs market failures

40 Are markets always efficient? Of course, they are not Some main reasons for market failure Market power there are too few suppliers in the market, and they realize (and take into account) the effect of their production decisions on market prices extreme case: natural monopoly Information asymmetries buyers cannot ascertain the quality of the product, and therefore may not buy it even if they value it higher than its cost e.g. private health insurance Externalities one producer may have unintended harmful effects on another firm (or consumers), which is not reflected in market prices (externalities) e.g. pollution Transaction costs, inefficient legal system, etc

41 Any remedies? The government usually steps in and applies regulation concerning prices, quantities entry, exit quality participation procedures However, an imperfect market is not necessarily a bad one Regulation also has its own failures insufficient information improper incentives costly bureaucracy political interference The relative benefits of markets vs regulation should be weighted against each other when deciding between the two forms (and their various mixtures)!

42 THANK YOU FOR YOUR ATTENTION! Rolands Irklis W Web: