Competitive `Market Equilibrium

Assumptions

Every agent is small compared to the market (producers and consumers)

What do we assume agents can not change?

Price, they are price-takers (firms cannot affect the equilibrium price by increasing or decreasing the quantity they supply)

What do we assume consumers cannot change?

Equilibrium, they cannot change price by changing the quantity they demand

What are goods in a competitive market?

Homogeneous (identical, consumers are totally indifferent to buying a good from one producer to another, perfect substitutes)

What do we assume about transaction costs in competitive markets?

There are not transaction costs, therefore it is very easy to switch from one producer to another one.

Why do we want to compare all other markets to perfectly competitive markets?

Because they are a benchmark of efficient markets/

Steps to find the market demand curve

1. Take individual demand found by solving the consumer problem Q_i D

2. Assume that we have n consumers in the market

3. Market demand QD = n x QiD

Individual demand curve vs Market demand curve

An individual demand curve shows the quantity a single consumer buys at different prices, while a market demand curve shows the total quantity all consumers buy by adding individual demands

Differences in market demand curve and individual demand curve

• Individual: Steeper slope.

• Market: Flatter slope due to aggregated quantities

Adherence of the law demand (always true for market demand, not always for individual)

Describes how strongly consumer purchasing behavior follows the foundational economic principle that, ceteris paribus (all else being equal), as the price of a good or service increases, the quantity demanded decreases, and vice versa.

Constructing market supply curve steps

1. Take individual supply found by solving QiS

2. Assume that we have n firms on the market

3. Market supply QS = n x QiS

For what prices do we find the market supply?

Long run for p ≥ min AVC

Short run for p ≥ min AC

Differences between market supply and individual supply curves

Individual supply: Usually steeper and closer to the origin

Market supply: Flatter and farther from the origin.

Short-run vs Long-run FC

FC sunk

FC avoidable

Free entry

n = infinity, so potential entrants into the market are infinite. this implies that QS = infinity x QiS if p geq min AC

The market supply becomes a horizontal flat line where price is constant

Short-runv free entry

In the short-run. the number of firms is fixed, we cannot assume free entry. Existing firms cannot adjust output or temporarily shut down, but firms do not enter or permanently exit the market.

Free entry Long-run

Firms can enter if they expect positive economic profits and exit if they are making losses.

Long-run free entry effect on supply curve

The greater the number of firms, the flatter the supply curve. If the supply curve is completely flat, then price cannot be changed by quantity - price-takers assumption.

Total surplus

Measures in monetary terms the total welfare generated in a market

Sum of surpluses of all participants

total surplus in competitive markets without interventions

consumer surplus + producer surplus

Efficiency

A competitive market equilibrium is efficient if it maximises total welfare, it is not possible to increase welfare for one agent without decreasing welfare for another agent.

Deadweight Loss

Measures, in monetary terms, the inefficiency generated in the market

Deadweight loss due to underproduction

For the units between Q_1 and Q^* buyers are willing to pay more than it costs sellers to produce them, so trading those units would create additional surplus. Because those trades do not happen, that surplus is lost—the blue triangle.

DWL>0

Deadweight loss due to overproduction

For every extra unit between \(Q^*\) and \(Q_2\):

• The supply curve shows the cost of producing it.

• The demand curve shows how much buyers value it.

• Supply is above demand, so cost exceeds benefit—producing that unit reduces total surplus.

The red triangle adds up these losses.

When DWL = 0?

When Q = Q*

At this quantity, total surplus is maximised: all beneficial trades take place, and no extra units whose cost exceeds their benefit are produced.

Why is producer surplus = 0 in the long-run?

Because producers receive exactly enough to cover all their economic costs, with nothing extra left over.

In the long-run the supply curve is horizontal as n = infinity.

Is economic profit driven to zero in the long run in a perfectly competitive market?

Yes, in the short run, firms can earn extra profit because competitors haven’t entered yet.

In the long run, firms have had time to enter, increase supply and push prices down until that extra profit is zero.

Why is long-run competitive equilibrium efficient?

• Each firm produces as cheaply as possible: it operates at its efficient scale, where average cost is lowest.

• The market produces the right total quantity: buyers’ willingness to pay for the last unit equals its marginal cost, \(P=MC\). Producing less would miss beneficial trades; producing more would cost more than the extra units are worth.

Efficient scale of production

• Short run: a firm chooses output where P=MC, which may not be at minimum average cost.

• Long-run competitive equilibrium: entry and exit push price to \(P=MC=min AC), so firms do produce at the efficient scale.

competitive market price long-run v short-run

The firm chooses P=MC in both periods to maximise profit:

• If P>MC, producing another unit adds more revenue than cost, so it should produce more.

• If P<MC, that unit costs more than it earns, so it should produce less.

In the long run, entry and exit add another condition: P=min AC. Positive profits attract firms and push price down; losses cause firms to exit and push price up.

What is the efficient scale of production q?

The quantity where average cost is lowest—each unit costs as little as possible to produce.

P=min AC

Does efficient scale of production apply to short-run?

Yes. Efficient scale is where \(MC=AC=\min AC\), in both the short run and the long run. It is the quantity that gives the lowest cost per unit. However, in the short run, firms do not necessarily produce at the efficient scale.

Why does MC tend to increase in the short-run?

MC increases in this example because the factory has limited capacity. As production rises, workers and machines become stretched, so each additional unit becomes more expensive to produce.

Does an increasing MC increase average cost?

An increasing MC raises average cost only when MC is above average cost If the next unit costs more than the current average, it pulls average cost up. If it costs less than the current average, it pulls average cost down.

Do short-run firms produce at efficient scale of production?

Short run: firms produce where P=MC. This may or may not be at minimum average cost.

Long-run competitive equilibrium: firms produce where P=MC=min AC, so they do produce at the efficient scale.

What is a non-competitive market?

When firms have some power to influence the price (we study where the supply side has market power / producers).