Chapter 14

Chapter 14 - Part III: Competitive Markets and the...

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Part III: Competitive Markets and the “In- visible Hand” In Part I, we derived demand curves (and functions) for goods, supply curves (and functions) for labor and both demand and supply functions for capital — all from an underlying model of individual choice aimed at maximizing happiness. In Part II, we similarly derived supply curves (and functions) for goods, as well as demand curves (and functions) for labor and capital — all from an underlying model of Frm choice aimed at maximizing proFt. We thus have built both demand and supply relationships in both output and input markets and are now ready to combine them to analyze an entire market. This will allow us to talk about the concept of equilibrium for the Frst time, and it will enable us to analyze how prices form rather than taking prices as given (as we have thus far.) And it will allow us to illustrate more fully some insights we have only been able to hint at thus far: namely that, under certain conditions, competitive markets lead to a spontaneous order in which millions of individual choices combine to form prices that guide behavior in such a way as to allocate resources e±ciently. We will refer to this result as the Frst welfare theorem . Chapter 14 begins by combining supply and demand curves in a single industry. Again, we will distinguish between the short run and the long run , but this distinction arises for reasons somewhat di²erent than it did in Chapter 13 for Frms (where the short run was deFned as the time period during which some input is Fxed.) In competitive industries that are characterized by the presence of many small Frms , the short run is the period over which it is not easily possible for Frms to enter or exit the industry, while the long run arises when Frms can freely enter and exit. Given our deFnition of economic proFt (with its implication that a producer is doing the best she can by being in an industry so long as she makes at least zero proFt) 6 , we can be conFdent that long run proFts in any competitive industry will always be zero for the last Frm that entered (or the next Frm that would exit) the industry. Thus, while short run supply in an industry is determined by the individual supply curves of the Frms that already exist in this industry, long run supply is determined by the entry and exit decisions of Frms that will drive price to a level at which proFts will be zero for the marginal Frm in the industry. In either case, we will see the logic behind the fact that market prices will settle at the intersection of market demand and supply — and the logic behind the process by which a “spontaneous order” emerges from the interaction of many individuals in the market. 6 If this statement does not make sense to you, re-read the introduction to Part II of the text.
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Chapter 14 - Part III: Competitive Markets and the...

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