Perfectly Competitive Markets, Market Equilibrium, Welfare Economics, Efficiency, and Market Failure

Transcription

1 Perfectly Competitive Markets, Market Equilibrium, Welfare Economics, Efficiency, and Market Failure Markets--Putting Market Supply and Market Demand Together So far in this course, we have studied consumers and demand separately from producers and supply. We now allow consumers and producers to come together and interact in markets. We seek to understand (1) how consumers and producers will end up allocating resources when they interact together in markets, (2) how well off consumers and producers will be after they interact in markets. Markets are situations in which producers and consumers exchange goods and services. In a market, producers and consumers (1) negotiate over prices, (2) form contracts, and (3) exchange goods and services. Prices are measures of the relative values of various goods and services. Prices also serve as "signals" to producers and consumers about which goods and services to produce and consume. To producers, prices are signals as to which products society feels are more or less valuable and/or more or less scarce. High prices signal more valuable and/or scarcer goods and services and serve as incentive for producers to increase production of these products. To consumers, prices are signals as to which products are more or less scarce and/or more or less costly to produce. High prices signal scarcer and/or more costly products and serve as incentive for consumers to conserve on the consumption of these products. As noted by the famous early economist Adam Smith, prices act as an "Invisible Hand," indirectly guiding producers and consumers to make efficient production and consumption decisions. Contracts are formal, enforceable agreements to exchange specified quantities of goods and services at specified prices. Perfectly Competitive Markets -- A market is considered "perfectly competitive" if it meets the following criteria: (1) Many, small, competing producer/sellers, such that no firm is large enough to significantly affect the market prices of products it sells or inputs it buys, (2) Many, small, competing consumer/buyers, such that no consumer/buyer is large enough to significantly affect the market prices of products it buys. (3) There are No Barriers to Entry--i.e., it is easy for new firms to enter the industry in the long run. (4) Homogeneous Products--all firms in an industry produce exactly the same product. (5) Decreasing Marginal Benefit (Market demand curves slope downward) 1

2 (6) Increasing Marginal Cost (Market supply curves slope upward) (7) Everyone in the market has Full Information about the costs and benefits of consuming and producing the product (this ensures that each decision-maker's choices are based on the true costs and benefits of consuming\producing the product) (8) Property Rights are fully defined and fully enforced. In other words, there are No Externality "Spillover" Costs or Benefits (only the consumers who pay get the benefits of consuming a product, and only the producers who make a product bear the costs of producing itno costs of production are "pushed off" onto others) (9) There is No Coercion in the market (no one is forcing someone through the threat of violence to consume or produce something-i.e., the "no mafia condition") Market Equilibrium In a perfectly competitive market, producers and consumers negotiate over prices until agreements are reached and contracts are signed regarding the quantity of the product traded, Q, and the price per unit of the product, PQ. In our models of consumers and producers in perfectly competitive markets, we have determined the quantity of the product purchased or produced, Q, taking the price of the product, PQ, as given, fixed information. Where does this PQ come from? It comes from consumers and producers negotiating over PQ in the market. When every producer and consumer has finished negotiating and has signed all the contracts each wishes to sign regarding how much Q will be exchanged and at what price PQ, then the market is said to be in Equilibrium. When a perfectly competitive market is in equilibrium, someone is buying everything that is produced, and someone is producing everything that is bought. In equilibrium, there is neither "overproduction" nor "underproduction." In addition, when a perfectly competitive market is in equilibrium, PQ is the same for everyone, because no producer can charge a higher price, due the intense competition from many other producers wanting to sell, and no consumer can get away with paying a lower price, due the intense competition from the many other consumers wanting to buy. It turns out that we can predict the PQ to which producers and consumers will negotiate if we know the market demand and market supply curves for product Q. Because both market demand curves and market supply curves are graphed with "dollars per unit" on the vertical axis and "Qmarket" on the horizontal axis, we can put them together on the same graph, as illustrated below. 2

3 Figure 1. Model of Perfectly Competitive Market Recall from our discussion of demand that a demand curve measures the marginal benefits that consumers receive from consuming additional units of the product. (Hence, the market demand curve in the figure above is also labeled MB for "marginal benefit.") Consumers will purchase more of a good or service until the marginal benefit they receive from purchasing an additional unit falls to the price level; beyond this point the price they would have to pay would be higher than the marginal benefit they receive from consuming the additional unit of the good or service. Recall from our discussion of supply that a supply curve measures the marginal costs that producers pay when producing additional units of the product. (Hence, the market supply curve in the figure above is also labeled MC for "marginal cost.") Producers will produce more of a good or service until the marginal cost of producing an additional unit rises to the price level; beyond this point the price they would receive would be less that the marginal cost of producing the additional unit of the good or service. In a perfectly competitive market, consumers and producers will negotiate about price until a price is agreed upon that equates the consumer's marginal benefit with the producer's marginal cost; this Equilibrium Price, usually denoted PQ*, occurs where the demand and supply curves intersect, as shown in the figure above. At this price, the market is in equilibrium; the consumer wants to buy and consume the same quantity of the good or service, QD as the producer wants to produce and sell, QS. In other words, in competitive equilibrium the quantity demanded equals the quantity supplied. This Equilibrium Quantity, usually denoted, Q*, occurs where the demand and supply curves intersect. Another way to see why PQ* is the equilibrium price is to consider what would happen if the price were somewhat higher. At a higher price, producers would want to produce more, but consumers would want to buy less, creating a situation of Excess Supply, or Surplus, of the 3

4 product. To reduce the costs of storing and protecting the surplus product, producers would reduce price (put the product "on sale") to rid themselves of excess inventory. The reduction in price would move the price back toward PQ*. Figure 2. Excess Supply Puts Downward Pressure on Price Similarly, consider what would happen if the price were lower than PQ*. At a lower price, producers would want to produce less, but consumers would want to buy more, creating a situation of Excess Demand, or Shortage, of the product. Taking advantage of the shortage situation, producers would begin to raise price to increase profits. At the same time, some consumers would begin offering "bribes" to the producers to obtain some of the product in short supply. For these reasons, price would begin to move upward toward PQ*. Figure 3. Excess Demand Puts Upward Pressure on Price 4

5 The Perfectly Competitive Market As a System of Equations Figure 1 is a model of a perfectly competitive market. It is a model composed of two sub-models: the Market Demand Curve model and the Market Supply Curve model. As we have seen, the Market Demand Curve and Market Supply Curve models can be represented by equations: Market Demand Curve Equation: PQ = a - b QD, where a and b are given constants Market Supply Curve Equation: PQ = c + d QS, where c and d are given constants We know that the price is the same in the two equations above because, in market equilibrium, consumers and producers have negotiated to the same price. Also, we know that the quantity is the same in the two equations (that is, QD equals QS), because, in market equilibrium, the quantity bought is the same as the quantity sold (in equilibrium, there's no "left over" quantity). The two equations can be solved using simple algebra as follows: 1. assume that you are given numbers to plug in for model parameters a, b, c and d (these numbers come from a statistical regression analysis) 2. set the Market Demand Equation equal to the Market Supply Equation (because the PQ's are equal) 3. solve for Q (remember, QD is equal to QS, so just replace them both with "Q") 4. plug Q back into the Market Supply Equation to solve for PQ You should end up with numbers for PQ, Q. The number you get for PQ is market equilibrium price, denoted PQ *. The number you get for Q is the market equilibrium quantity, denoted Q *. Numerical Example: Question: Suppose market demand for good Q is given by PQ = QD and market supply for the good is given by PQ = QS. Calculate the equilibrium market price PQ * and equilibrium market quantity Q * that would occur in this market as a result of negotiation among consumers and producers. Answer: In a competitive market, producers and consumers will negotiate over price and quantity until they agree on a price and a quantity. Because they agree to the same price, we know that PQ is the same in both equations. Also, we know that QD is equal to QS. Use this fact to justify replacing QS and QD with just Q: Market Demand becomes: PQ = Q Market Supply becomes: PQ = Q 5

6 Set Market Demand equal to Market Supply: Q = Q, Solve for Q: Q = Q Q = Q 3000 = 2Q 1500 = Q Plugging Q back into the Market Supply Equation: PQ = Q PQ = PQ = 2500 Thus, market equilibrium quantity, Q * = 1500, and market equilibrium price, PQ * = Analyzing Shocks to the Market Recall that parameters reflect everything that we assume to be held constant in a model. Suppose one of the things that we are assuming to be constant suddenly changes. In terms of our model of a competitive market, this is called a Market Shock. A Market Shock is simply a change in a parameter affecting the market model. Because the market model is composed of demand and supply curves, the parameters in the market model are simply the parameters in demand and supply curves. Hence, because a Market Shock is a change in one of the parameters in either a demand or supply curve, a Market Shock will lead to a shift of either the market demand or the market supply curve, respectively. When one of these curves shifts, a new market equilibrium will be reached where the new curve (either new demand or new supply, depending on which curve is shifted) crosses its old market counterpart (old supply, if we have a new demand curve; old demand, if we have a new supply curve). Because there is a new market equilibrium after a shock, the market will settle on a new equilibrium market price P * and equilibrium market quantity Q *. The new equilibrium price and quantity can be determined by plugging the new parameter value into either demand or supply, as appropriate, setting the new demand or supply equal to its old market counterpart (either old supply or old demand, respectively), solving for the new Q *, and then plugging back in and solving for the new P * --a straightforward, if rather tedious, process. 6

7 Welfare Economics Welfare economics is the study of the net benefit (total benefits minus total costs) to society of allocating resources in alternative ways. Welfare economics seeks to measure these net benefits and to determine how the net benefits are distributed among various individuals and groups in society. Hence, by "welfare economics" we do NOT mean "the study of government programs to help the poor," rather we mean "the study of how well folks in society are doing, the study of their welfare." In this handout,we will consider the welfare economics of a perfectly competitive market. Later in the course, we will consider the welfare economics of some types of markets that are not perfectly competitive. We will find that many environmental problems are caused by, or at least made worse by, the lack of perfect competition in markets. Welfare Economics Analysis of the Perfectly Competitive Market Model As discussed earlier in this handout, equilibrium price in a perfectly competitive market, denoted PQ*, occurs where the market demand and market supply curves intersect. At this price, consumers want to buy and consume the same quantity of the good or service (QD) as the producers want to produce and sell (QS). This competitive equilibrium quantity is usually denoted, Q*. What are the net benefits to consumers, to producers and to society overall from producing and consuming the market equilibrium quantity Q* of a good or service in a perfectly competitive market? Typically, economic welfare is measured by Total Surplus. Total Surplus is the sum of Consumer Surplus and Producer Surplus. Recall from the handout titled "Consumers and Demand" that Consumer Surplus is simply "Consumer Profit," and it is measured by the triangular area under the demand curve and above the price line. Recall from the handout titled "Producers and Supply" that Producer Surplus is Total Revenue minus Variable Costs; it is the amount of Total Revenue left-over to pay Fixed Costs and Profits after Variable Costs are paid. (In the short-run, producers try to maximize Producer Surplus, the amount of money available to pay profits and "locked-in" fixed costs.) Because the Short-Run Marginal Cost curve measures additions to Variable Cost, the area under the Marginal Cost curve is equal to the entire Variable Cost. Producer Surplus is measured by the triangular area under the price line and above the Short-Run Marginal Cost curve. Figure 4 below shows how Total Surplus can be measured by the Consumer Surplus (CS) and Producer Surplus (PS) areas on a graph of the Perfectly Competitive Market Model. 7

8 Figure 4. Consumer Surplus, Producer Surplus and Total Surplus Areas From Consumer's Perspective: Total Benefit ("TB") = Area A + Area B + Area C Total Expenditure ("TE") = Area B + Area C Consumer Surplus ("CS") = TB - TE = Area A From Producer's Perspective: Total Revenue ("TR") = Area B + Area C Variable Cost ("VC") = Area C Producer Surplus ("PS") = TR - VC = Area B From Society's (Overall) Perspective: Total Surplus ("TS") = CS + PS = Area A + Area B 8

9 Normative Aspects of Welfare Economics-- Positive Economics seeks scientific answers to questions about how the economy works and about how individuals and groups behave in it and benefit from it. Much of the first part of this course has been an introduction to the tools of positive economic analysis. In this section of this handout, we touch on an aspect of Normative Economics. Normative Economics concerns judgments about whether a particular economic outcome is desirable or undesirable, good or bad. A common "normative yardsticks" used to measure the desirability of various economic outcomes is Efficiency. Welfare Economics uses the yardstick of efficiency to judge the relative desirability of alternative economic outcomes. Of course, other "judgmental yardsticks," such as the fairness, riskiness, or morality of alternative economic outcomes could be (and commonly are) used instead of, or in combination with, the yardstick of efficiency to judge the relative desirability of alternative outcomes. For now, however, we will focus on using efficiency as a measure of economic welfare. In this course, we will define efficiency in the following practical way: Efficiency - An economic outcome is efficient if Total Surplus is maximized. Competitive Market Equilibrium Achieves Efficiency How well does the perfectly competitive market perform when measured with the yardstick of Efficiency? Notice in Figure 1 above that when Q* is produced and consumed, the marginal benefit of production (as given by the Market Demand curve) equals the marginal cost of production (as given by the Market Supply curve). In other words, in competitive market equilibrium, MB equals MC: In a competitive market equilibrium, MB = MC. So, what's so special about MB = MC? Well, it turns out that producing and consuming where MB = MC for each good and service results in efficiency! In other words, producing and consuming where MB = MC for each good and service maximizes Total Surplus! Competitive market equilibrium achieves efficiency (maximizes Total Surplus). Why? Consider gradually increasing the level of Q produced and consumed. At first, the MB from consuming additional units of Q is much higher than the MC of producing additional units. Clearly, it adds to Total Surplus to produce and consume these units. However, as more is produced, the MB of consumption falls and the MC of production rises. As a result, the additions to Total Surplus get smaller and smaller as Q increases. At the point where MB = MC, the additional benefit of producing that particular unit of Q is just equal to the additional cost, we add nothing to Total Surplus by producing and consuming that unit. If we produce beyond the point at which MB = MC, then MC is greater than MB, and we are taking away from Total 9

10 Surplus with each additional unit produced and consumed. By producing and consuming only up to the point where MB = MC, we maximize Total Surplus. The First Theorem of Welfare Economics The result that Perfectly competitive market equilibrium achieves efficiency (maximizes Total Surplus) follows from our models of consumer and producer behavior. Because it is a result that comes from models, it is a theorem. Because it is such an important theorem, it is given a special name: The First Theorem of Welfare Economics If all conditions necessary for a perfectly competitive market hold, then negotiation over price among producers and consumers will result in the market price PQ* that causes producers and consumers to produce and consume the quantity Q*, where MB = MC. Because MB = MC at Q *, Total Surplus is maximized at Q *. Thus, Q* is the efficient level of Q. In summary, if the conditions for perfect competition hold, then the efficient amount of Q will be produced and consumed. Generalizing this idea, if all markets were perfectly competitive, then the free interaction of consumers and producers in markets would result in the production and consumption of all goods and services at precisely the levels necessary to maximize the total surplus of society, without any government coordination or regulation. The First Theorem of Welfare Economics is the foundation upon which "Conservative" arguments against "big government" and for "getting the government out of the market place" are based. The First Theorem of Welfare Economics implies that the competitive market can achieve efficiency without government involvement. The First Theorem of Welfare Economics is the foundation upon which "conservative" arguments against "big government" are based. Arguments for a "free market" and for "getting the government out of the market place" are based upon this theorem. If conditions in a particular market are "close" to those required for a competitive market, then the First Welfare Theorem provides a strong rationale for not interfering in that particular market. Market Failure It is very important to note that the First Theorem of Welfare Economics holds only if all the conditions for a perfectly competitive market hold. All of the conditions for a perfectly competitive market probably never hold completely for any real-world market. However, if conditions are "close" to those required for a competitive market in some particular market, then the First Welfare Theorem provides a strong rationale for not interfering in that particular market. On the other hand, if one or more of the conditions for a perfectly competitive market does not hold to a significant degree, then a situation of Market Failure is said to exist. Under Market 10

11 Failure conditions, market interaction between consumers and producers may not allocate resources in ways that eliminate waste and maximize Total Surplus. An important role for government can be to identify market failures and to try to develop rules and regulations that make these markets more like perfectly competitive markets. This is often referred to as "setting the rules of the game," or "leveling the playing field." "Liberal" arguments for expanded government coordination and regulatory activities are usually based on the notion of Market Failure. Correcting market failures is the rationale behind a tremendous amount of government activity, such as anti-trust regulation, cable TV regulation, pollution regulation, subsidy of public education, interstate highway construction, etc. We will return to examine the topic of market failure in more detail later in the course. Most economists don't believe that government should never be involved in the marketplace. Most economists also don't believe that government should always be involved in the marketplace. Rather, most economists say that the government should be involved in some markets and not in others, and that the decision about whether or not the government should be involved depends upon whether significant market failure exists in a particular market. 11

12 Deadweight Losses of Overproduction and Underproduction Suppose Market Failure occurs. Fundamentally, what this means is that society is "overdoing" something or "underdoing" something, relative to the efficient level. Recall that the efficient level of doing something occurs where MB=MC. Consider what would happen if we were not to produce and consume where MB = MC. For example, suppose that a quantity larger than Q * were produced and consumed. At any quantity larger than Q *, the marginal costs of production rise above the marginal benefits of consumption; although consumers gain some benefit from consuming quantities above Q *, the incremental costs of producing more than Q * are higher than the incremental benefits of consuming Q *. In other words, the opportunity cost of producing more than Q * is higher than the benefit received. This is inefficient; less should be produced. This inefficiency is called the "deadweight loss of overproduction." A measure of the deadweight loss of overproduction is given by the triangular area indicated in the figure below. Figure 5. 12

13 On the other hand, suppose that a quantity smaller than Q * were produced and consumed. At any quantity smaller than Q *, the marginal costs of production are below the marginal benefits of consumption; although it would cost more to increase production toward Q *, the incremental benefits of consuming more are higher than the incremental costs of producing more. In other words, the cost of producing more would be less than the benefit that would be received from consuming more. This is inefficient; more should be produced. This "deadweight loss of underproduction" is measured by the triangular area indicated in the figure below. Figure 6. 13