Perfect competition and market

efficiency

Miller UN1105
Adam Smith, The Theory of Moral Sentiments
(1759)
“The produce of the soil maintains at all times nearly that number of
inhabitants which it is capable of maintaining. The rich only select from
the heap what is most precious and agreeable. They consume little
more than the poor, and in spite of their natural selfishness and
rapacity, though they mean only their own conveniency, though the
sole end which they propose from the labours of all the thousands
whom they employ, be the gratification of their own vain and insatiable
desires, they divide with the poor the produce of all their
improvements. They are led by an invisible hand to make nearly the
same distribution of the necessaries of life, which would have been
made, had the earth been divided into equal portions among all its
inhabitants, and thus without intending it, without knowing it, advance
the interest of the society, and afford means to the multiplication of
the species.”

2
Adam Smith, The Wealth of Nations (1776)
“But man has almost constant occasion for the help of his brethren,
and it is in vain for him to expect it from their benevolence only. He
will be more likely to prevail if he can interest their self-love in his
favour, and show them that it is for their own advantage to do for him
what he requires of them. Whoever offers to another a bargain of any
kind, proposes to do this. Give me that which I want, and you shall
have this which you want, is the meaning of every such offer; and it is
in this manner that we obtain from one another the far greater part of
those good offices which we stand in need of. 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.”

3
Demand and supply curves in the iPod
market
Social surplus

Social surplus or total surplus: The sum of

consumer and producer surplus

5
Total surplus in the iPod market
Social surplus
= 60 CS + 60 PS = $120 Social Surplus

7
Restrict to two units exchanged
Force five units to be exchanged
Pareto efficiency

When no one can be made better off without

making someone else worse off

10
Competitive equilibrium is Pareto
efficient
In a perfectly competitive market the competitive
equilibrium maximizes total surplus and leads to
an allocation that is Pareto efficient.
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.
Marginal costs for two plants
In the past, each plant has been run

independently, and each plant manager charged

with maximizing profit at her plant.

Optimal production at the old plant
Total revenue for old plant:

$10 x 20,000 = $200,000

Total costs for old plant:

20,000 x $10 (ATC) = $200,000

Economic profit = $0
Optimal production at the new plant
Total revenue for new plant:

$10 x 50,000 = $500,000

Total costs for new plant:

50,000 x $7.50 (ATC) = $375,000

Economic profit = $125,000

19
As the CEO, should you close the old plant and
shift production to the new plant?

The new plant:

1. Earns more profit

2. Has lower costs

3. Has newer technology

20
Shut down old plant and transfer 20,000 units of
production to the new plant
Old Plant:
Output = 0
Profit = $0
New Plant:
Output = 70,000
Profit = -$875,000
What?

21
If the plants are managed independently so as to
maximize individual profit, they also maximize total
profit.

With the plants operated independently

MCold= MCnew (=P)

Why do we need this for efficiency in production?

What if industries are different?
Short-run economic profits in one industry will
attract profit-seeking producers from industries
experiencing economic losses.

In this way, free entry and exit allows

reallocation of assets to their greatest valued uses,
even across industries.
Prices are the key to coordinating economic

activity in free markets.

25
Deadweight loss from price controls
Deadweight loss

The reduction in total surplus resulting from a

market distortion
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
Two possible solutions:

1. Market economy = prices direct flow of

resources, provide incentives for participants

2. Command economy = central agency directs

resources, provides incentives

K-Mart’s move to

a command

economy
Competitive markets do not necessarily produce
equitable outcomes, though they may produce
efficient outcomes.
Make sure to read the text on Uber and on
efficiency in experimental markets.