Microeconomics: Perfect Competition and the Invisible Hand

Microeconomics Third Edition - Chapter 7: Perfect Competition and the Invisible Hand

Learning Objectives

  • 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

Key Ideas

  • The invisible hand efficiently allocates goods and services to buyers and sellers.

  • The invisible hand leads to efficient production within an industry.

  • The invisible hand efficiently allocates resources across industries.

  • Prices direct the invisible hand.

  • There are trade-offs between making the economic pie as big as possible and dividing the pieces equally.

Perfect Competition and the Invisible Hand (1)

  • Adam Smith's concept presented in 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."

    • This raises the question: Is market chaos driven by participants solely looking out for their interests?

Perfect Competition and the Invisible Hand (2)

  • The examination focuses on how efficient markets can lead to the maximum level of well-being, noting that maximum well-being doesn’t equate to fairness.

Perfect Competition and Efficiency (1)

  • Exhibit 7.1: Reservation Values of Buyers and Sellers in the iPhone Market (data shown will cover next 18 slides):

    • Buyers' Reservation Values (in dollars) and Cumulative Quantity:

    • Madeline: $70 - 1

    • Katie: $60 - 2

    • Sean: $50 - 3

    • Dave: $40 - 4

    • Phil: $40 - 4

    • Ian: $30 - 5

    • Adam: $50 - 5

    • Kim: $20 - 6

    • Matt: $60 - 6

    • Fiona: $70 - 7

    • Sellers' Reservation Values (in dollars) and Cumulative Quantity:

    • Tom: $10 - 1

    • Mary: $20 - 2

    • Jeff: $30 - 3

    • Ian: $30 - 5

    • Kim: $20 - 6

    • Ty: $10 - 7

Perfect Competition and Efficiency (2)

  • The same data is repeated for clarity - ensuring it's captured distinctly for analysis purposes, useful for graph plotting and further insights.

Perfect Competition and Efficiency (3)

  • Each set of data in Exhibit 7.1 enhances understanding of buyer and seller dynamics in the market.

Perfect Competition and Efficiency (4)

  • Analysis at a specific price point ($10):

    • Buyers' Reservation Values and Cumulative Quantities remain constant until they fail to match the sellers.

Perfect Competition and Efficiency (5)

  • Analysis at the price point of $60 shows limited transactions as the producers do not find the price viable enough for supply.

Perfect Competition and Efficiency (6)

  • Critical point occurs at $40: Quantities are equal, thus reflecting market clearing price.

Perfect Competition and Efficiency (7)

  • Exhibit 7.2: Demand and Supply Curves in the iPhone Market further illustrates these dynamics visually.

Perfect Competition and Efficiency (8)

  • Reservation values with subsequent illustration of Consumer Surplus calculated from buyers' reservation values minus selling price.

Perfect Competition and Efficiency (9)

  • Illustrates further how consumer surplus is built upon reservation values defining maximum willingness to pay.

Perfect Competition and Efficiency (10)

  • Similar calculations are provided to demonstrate Producer Surplus among sellers with given values comparing each seller's reservation against market rates.

Perfect Competition and Efficiency (11)

  • Clarifies how Producer Surplus is derived by comparing sellers' reservation price against actual selling price with results.

Perfect Competition and Efficiency (12)

  • Social Surplus: Overview given with numerical examples illustrating the sum of consumer and producer surplus.

    • Total: CS + PS = $60 + $60 = $120 Social Surplus.

Perfect Competition and Efficiency (13)

  • Analyzing restrictions on quantity (2 units) affects buyer reservation values and thus consumer surplus.

    • Showing diminishing return for consumers.

Perfect Competition and Efficiency (16)

  • Reiterates the results from market disturbances confirming surplus efficiencies.

Perfect Competition and Efficiency (17)

  • Highlighting social surplus is reduced when quantities are forcibly restricted, moving to $100 in our example case.

Perfect Competition and Efficiency (19)

  • Pareto Efficiency: Defined as the state in which one’s position cannot be improved without worsening another’s—highlighted with examples of price adjustments.

Perfect Competition and Efficiency (20)

  • As per the invisible hand, efficiencies lead to maximizing societal surplus and welfare responding to market pricing adjustments.

Perfect Competition and Efficiency (21)

  • Since competitive markets are deemed Pareto Efficient, this restricts justifiable government intervention strictly on grounds relating to equity.

Allocation of Resources across Industries (1)

  • Discussion on economic profits in one industry attracting producers from sectors with losses, confirming fluidity in market resource allocation due to competitive forces.

Allocation of Resources across Industries (2)

  • Steps to calculating profit thus fall in following order:

    1. Find optimal output where MR = MC (marginal revenue equals marginal cost).

    2. Derive Average Total Cost (ATC) at found quantity.

    3. Establish whether:

      • If P > ATC, firms experience economic profits.

      • If P < ATC, firms incur economic losses.

      • If P = ATC, it results in breakeven for the firm.

Allocation of Resources across Industries (4-6)

  • Discuss further market adjustments as firms enter or exit due to changing economic conditions demonstrating adaptability and refinement of resources over time.

Pricing Power and Coordination (5)

  • Pricing mechanisms identified as the core to the invisible hand, directing flows of resources effectively and responding to consumer signals through supply and demand trends.

Market Coordination vs Command Economy (6)

  • Outlined the essential differences between market-directed resources through price systems and command economies where central agency decides outcomes, stressing the effectiveness of a competitive framework over centralized control.

Equity and Efficiency (1)

  • The government’s role defined as a mediator to correct perceived inequities in resource distribution, where perfect competition leads to efficient but not necessarily equitable outcomes.

Evidence-Based Economics (1)

  • Confirmation that markets of self-interested individuals can indeed maximize overall societal well-being, provided conditions like no externalities are met and there’s perfect competition.