Chapter 08 _Efficiency of Perfect Competition_

Chapter 08 _Efficiency of Perfect Competition_ - Chapter 8...

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1 Chapter 8 Efficiency of Perfect Competition Introduction and Review The last chapter focused on the short run behavior of perfectly competitive markets. This is the period of time that is too short for the existing firms to be able to change their capital stock and for new firms to enter the industry. We saw that the forces of supply and demand for a product determine the equilibrium price and quantity of that product. At this price consumers buy the amount they are willing and able to buy and producers sell the amount they are willing and able to sell. Moreover, each consumer maximizes satisfaction by consuming up to the point where the marginal benefit from the last unit of the good equals its marginal cost, which is the price of the product. Each firm produces up to the point where the marginal cost of that last unit equals its marginal revenue, which is the price of the product. As a result the producer’s profit is maximized or loss minimized. A lot of times economists and policymakers are interested in the long run equilibrium behavior of industries. This is the period of time over which firms can adjust their capital stock, existing firms can exit, and new firms can enter the industry. In the long run equilibrium, all such adjustments are made and the industry reaches a state of rest. Since, as we will see in this chapter, perfectly competitive industries move towards long run equilibrium, it is useful to study the firm and industry behavior in the long run. We want to know if, left alone, the industry would produce economically desirable outcomes over a long span of time, even though the outcome may not be desirable over the next year or two. Efficiency of Perfect Competition As you remember from Chapter 3, allocative efficiency can be defined in three equivalent ways: 1. Production of the mix of goods and services that results in the greatest amount of satisfaction for the members of the society. 2. Production of goods and services up to the point where the marginal social benefit of the last unit produced just equals its marginal social cost. 3. Production of the mix of goods and services that is Pareto efficient. No reallocation of resources to change the output mix would make anyone better off without making someone else worse off. In this chapter we will see if these conditions hold in a perfectly-competitive market. a. Maximum Total Satisfaction Consider Figure 1 that shows a perfectly competitive market in a state of equilibrium. The equilibrium price is $25 per unit. Consumer and producer surpluses are the gains from trade enjoyed by these two groups. As Figure 1 shows, at the level of output where demand equals supply the sum of consumer and producer surpluses—the total surplus
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2 is maximized. This results in the highest total amount of satisfaction for consumers and producers. Therefore, the allocatively efficient amount of production is 10,000,000 units. Figure 1
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This note was uploaded on 11/08/2010 for the course ECN ECN 001A taught by Professor Scottcarrell during the Spring '10 term at UC Davis.

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Chapter 08 _Efficiency of Perfect Competition_ - Chapter 8...

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