Markets: Perfect Competition and The Invisible Hand

Markets
Chapter 7
Perfect Competition and the
Invisible Hand
Copyright © 2018 Pearson Education, Ltd. All Rights Reserved.

Key Ideas
1. Cost of Doing Business
2. 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.
4. Prices direct the invisible hand: regulation creates deadweight loss
5. There are trade-offs between making the economic pie as big as
possible and dividing the pieces equally: the efficiency versus equity
trade-off
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Cost of Doing Business

The Cost of Doing Business: Introducing Cost Curves
•
Variable Cost (VC): The cost associated with the variable factors of production.
Variable costs change as the level of output changes (eg. Employee costs).
Fixed Cost (FC): The cost associated with the fixed factors of production. Fixed
costs do not change as output changes (eg. Rent).
Short-run: Total Cost = Variable Cost (VC) + Fixed Cost (FC)
Average Total Cost (ATC) = TC/Q, Q= total quantity produced
Average Variable cost (AVC) =VC/Q
Average Fixed cost (AFC) =FC/Q
Marginal Cost =Change in total cost per unit (

Cost of Production
(10)
(1) (8) (9)
(3) (4) (5) (6) (7) Marginal Cost
Output (2) Marginal Variable Fixed Cost Total Cost Average Total
Average Average
(MC)
# Fixed Cost Variable Cost
Per Empl
Product Cost (VC) (FC) (TC) Cost (ATC)
(AFC) (AVC)
= change in
Day = (4) + (5) = (6)/(1) (6)/ change in
= (5)/(1) = (4)/(1)
(1)
0 0 $0 $200 $200
100 1 100 $72 $200 $272 $2.72 $2.00 $0.72 $0.72
207 2 107 $144 $200 $344 $1.66 $0.97 $0.70 $0.67
321 3 114 $216 $200 $416 $1.29 $0.62 $0.67 $0.63
444 4 123 $288 $200 $488 $1.10 $0.45 $0.65 $0.59
558 5 114 $360 $200 $560 $1.00 $0.36 $0.65 $0.63
664 6 106 $432 $200 $632 $0.95 $0.30 $0.65 $0.68
762 7 99 $504 $200 $704 $0.92 $0.26 $0.66 $0.73
854 8 92 $576 $200 $776 $0.91 $0.23 $0.67 $0.79

Marginal Cost, Average Total Cost, and Average Variable Cost Curves

Putting It All Together: Using the Three Components to Do the
Best You Can
Profits = Total Revenues – Total Costs
Total Revenue = P × Q
Total Cost = ATC × Q
Profit = (P × Q) – (ATC × Q) = (P – ATC) × Q
= (P – ATC) × Q
Shutdown: The decision to stop producing in the short run—occurs if

price falls below AVC

Efficient allocation of goods across Buyers and Sellers

Perfect Competition and Efficiency
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
At $40 Market is
Ian $30 5 Adam
in Equilibrium $50 5
Kim $20 6 Matt $60 6
Ty $10 7 Fiona $70 7

Perfect Competition and Efficiency
Exhibit 7.2 Demand and Supply Curves in the iPod Market

Perfect Competition and Efficiency Social Surplus at
equilibrium Price of $40
Reservation Values of Buyers and consumer Reservation Values of Sellers and producer
surplus in the iPhone Market surplus in the iPod Market
Res. Value Consumer Cum. Res. Producer Cumulativ

Buyers ($) Surplus Q Sellers Value ($) Surplus e Total Q
Madeline $70 $30 1 Tom $10 = $30 1
$40 -
Katie $60 $20 2
Mary $20 $20 2
Sean $50 $10 3
Jeff $30 $10 3
Dave $40 $0 4
Phil $40 $0 4
Ian $30 Blank 5
Adam $50 Blank 5
Kim $20 6 Matt $60 6
Ty $10 Blank 7 Fiona $70 Blank 7
Total Blank $60 Blank Total Blank $60 Blank

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

What if we only allowed 2 units to be exchanged at
$40? Or fixed Price at $20
Social surplus
= $100
Madeline ($70) – Tom ($10) and Katie ($60) – Mary

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

Perfect Competition and Efficiency: 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
Perfect Competition and Efficiency: Pareto Efficiency
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.

Efficient resource allocation Within a Firm

Extending the Reach of the Invisible Hand: From the
Individual to the Firm
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.
Exhibit 7.4 Marginal Costs for Two Manufacturing Plants
In the past, each plant
has been run
independently, and each
plant manager is
charged with maximizing
profit at his/her plant.

Total revenue for old plant: Total revenue for new plant:
$10 × 20,000 = $200,000 $10 × 50,000 = $500,000
Total costs for old plant: Total costs for new plant:
20,000 × $10 (ATC) = $200,000
50,000 × $7.50 (ATC) = $375,000
Economic profit = $0 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

Extending the Reach of the Invisible Hand: From the Individual
to the Firm (11 of 14)
One year later…

Old Plant:
Output = 0
Profit = $0
New Plant:
Output = 70,000
Profit = -$875,000
What?

Efficiency across Industries

Extending the Reach of the Invisible Hand: Allocation of
Resources across Industries
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.

Remember:
In a free and competitive market we
Pretend Corn Market have free entry and exit
Pretend Cotton Market
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 as a guide to resource allocation

Prices Guide the Invisible Hand: Deadweight Loss
Deadweight Loss from Price Controls
What if a Price Ceiling is set at P1?
Price decreases, firms set MR=MC and

decrease production
Society loses area D
Quantity decreases to Q1
Deadweight Loss

Prices Guide the Invisible Hand Deadweight
Loss (3 of 3)
Deadweight Loss
The reduction in social surplus resulting from a
market intervention

Prices Guide the Invisible Hand: The Command
Economy
Two problems:
1. Coordination problem = bringing together self-

interested economic agents to form markets
2. Incentive problem = how to motivate agents to

participate in markets

Prices Guide the Invisible Hand The Command
Economy
Two possible solutions:
1. Market economy = prices direct flow of
resources, provide incentives for participants
2. Command economy = central agency directs
resources, provides incentives

Equity and Efficiency
Equity
Addresses the issue of a “fair” distribution of

resources across society

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

Evidence-Based Economics Example:
Yes – but only under a
strict set of conditions

Evidence-Based Economics Example:
Do companies like Uber make use of the invisible hand?

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Markets

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

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

3. The invisible hand efficiently allocates resources across industries.

4. Prices direct the invisible hand: regulation creates deadweight loss

5. There are trade-offs between making the economic pie as big as

Copyright © 2018 Pearson Education, Ltd. All Rights Reserved

Copyright © 2018 Pearson Education, Ltd. All Rights Reserved

Copyright © 2018 Pearson Education, Ltd. All Rights Reserved

Copyright © 2018 Pearson Education, Ltd. All Rights Reserved

Profits = Total Revenues – Total Costs

Total Cost = ATC × Q

Profit = (P × Q) – (ATC × Q) = (P – ATC) × Q

Shutdown: The decision to stop producing in the short run—occurs if

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

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Exhibit 7.2 Demand and Supply Curves in the iPod Market

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Res. Value Consumer Cum. Res. Producer Cumulativ

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The sum of consumer and producer surplus

60 CS + 60 PS = $120 Social Surplus

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

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When no one can be made better off without making someone

The invisible hand directs consumers and producers to maximize their

surplus…and leads to the highest level of social welfare.

Copyright © 2018 Pearson Education, Ltd. All Rights Reserved

Copyright © 2018 Pearson Education, Ltd. All Rights Reserved

You’re the new CEO of a company that operates two

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

Exhibit 7.4 Marginal Costs for Two Manufacturing Plants

In the past, each plant

has been run

independently, and each

charged with maximizing

profit at his/her plant.

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$10 × 20,000 = $200,000 $10 × 50,000 = $500,000

Economic profit = $0 Economic profit = $125,000

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The new plant:

Produce all 70,000 units at

3. Has newer technology

One year later…

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Copyright © 2018 Pearson Education, Ltd. All Rights Reserved

What if industries are different?

Short-run economic profits in one industry will attract profit-seeking

Copyright © 2018 Pearson Education, Ltd. All Rights Reserved

Short-run profit in one sector combined with a

The invisible hand directs firms to seek out profits…

And results in resources being allocated to