Competitive Market Equilibrium

Equilibrium Welfare Analysis Outline

General Equilibrium

Microeconomic Analysis

Lelimo Sylvester
General Equilibrium and Economic Welfare

Department of Economics
National University of Lesotho (NUL)

Lecture 4

Lelimo S (NUL), Lecture 4

 Competitive Market Equilibrium
Equilibrium Welfare Analysis Outline
General Equilibrium

Outline

Outline

1 Competitive Market Equilibrium

Competitive Market Equilibrium
Changing Conditions and Changing Equilibrium

2 Equilibrium Welfare Analysis

3 General Equilibrium
First Fundamental Theorem of Welfare Economics
Second Fundamental Theorem of Welfare Economics

Lelimo S (NUL), Lecture 4

 Competitive Market Equilibrium
Competitive Market Equilibrium
Equilibrium Welfare Analysis
Changing Conditions and Changing Equilibrium
General Equilibrium

A Mathematical Example
Suppose consumers have tastes over good x and a composite
good y that can be represented by the quasilinear utility
function
1
u(x, y ) = 50x 2 + y
Solving the utility maximization problem
1
max u(x, y ) = 50x 2 + y subject to px + y = I
x,y

we can derive individual demand for x as

625
x d (p) = 2
p
If there are 64,000 such consumers in the market then adding
their demand curves gives the market demand function as
40, 000, 000
D M (p) = 64, 000x d (p) =
p2
Lelimo S (NUL), Lecture 4
 Competitive Market Equilibrium
Competitive Market Equilibrium
Equilibrium Welfare Analysis
Changing Conditions and Changing Equilibrium
General Equilibrium

A Mathematical Example
2 2
Next, suppose firms have production functions f (l, k) = 20l 5 k 5
Solving the firm’s cost-minimization problem
2 2
min wl + rk subject to x = 20l 5 k 5
l,k

we can calculate conditional input demands and derive the cost function
1
 x 5
4
C (w , r , x) = 2(wr ) 2
20
Since this treats both labour and capital as variable, it is a long run cost
function.
We’ll furthermore assume that each firm faces a recurring fixed cost FC, which
implies that the long run cost function is
1
 x 5
4
C (w , r , x) = 2(wr ) 2 + FC (1)
20
The long run average cost (AC) function is then
1
C (w , r , x) 2(wr ) 2 1 FC
AC (w , r , x) = = 5
x4 +
x 20 4 x

Lelimo S (NUL), Lecture 4

 Competitive Market Equilibrium
Competitive Market Equilibrium
Equilibrium Welfare Analysis
Changing Conditions and Changing Equilibrium
General Equilibrium

Long Run Equilibrium

This AC curve is U-shaped – with it’s lowest point happening
where ∂AC
∂x = 0.
So, taking this derivative and solving for x, we get:
2
4FC 2 5

∗
xLR = 20
wr
Plugging this back into the AC function, we get the long run
equilibrium price:
1
(wr )2 FC 2

∗
pLR =
16, 384
When w = 20, r = 10 and FC = 1, 280, for instance, each
firm produces xLR∗ = 1, 280 and sells at p ∗ = 5. The optimal
LR
level of labour and capital can be calculated from conditional
input demands as 128 and 256 respectively.
Lelimo S (NUL), Lecture 4
 Competitive Market Equilibrium
Competitive Market Equilibrium
Equilibrium Welfare Analysis
Changing Conditions and Changing Equilibrium
General Equilibrium

Short Run Firm Output

In the short run, the firms’ production function is
h 2
i 2
f (l) = 20(k̄) 5 l 5 (2)

where the term in square brackets is fixed and can be treated like a
single parameter A.
Profit-maximizing firms then solve the short-run problem
max px − wl subject to x = Al a
x,l
h 2
i
where A = 20(k̄) 5
In the short run analysis, we solved such a problem to get the
 a
 a−1
w
(short-run) output supply function x(w , p) = A aAp . Plugging
in our values for A and a, we get the short run supply
h 2
i  2p  32
xSR (w , p) = 20(k̄) 5
5w
Lelimo S (NUL), Lecture 4
 Competitive Market Equilibrium
Competitive Market Equilibrium
Equilibrium Welfare Analysis
Changing Conditions and Changing Equilibrium
General Equilibrium

Suppose SR fixed capital is k̄ = 256 previously identified as the

long-run equilibrium level of capital hired by the firm when w = 20,
r = 10 and FC = 1, 280.
The short run firm supply function (given w = 20 and k̄ = 256)
then becomes
2
s
xSR (w , p) = 437.75p 3

At w = 20, r = 10 and FC = 1, 280, we also calculated the LR

∗
equilibrium price to be pLR =5
To find the short run equilibrium within this LR equilibrium, we
s
evaluate xSR at p = 5 to get firm output level of 1,280 units per
firm.
Demand at the price of 5 is D = 40,000,000
52 = 1, 000, 000– implying
there are 1,250 firms (given that each produces 1,280).
Adding the firm SR supply function across 1,250 firms, we get a
short run market supply function of
2 2
S M (p) = 1, 250(437.75p 3 ) = 547, 192p 3

Lelimo S (NUL), Lecture 4

 Competitive Market Equilibrium
Competitive Market Equilibrium
Equilibrium Welfare Analysis
Changing Conditions and Changing Equilibrium
General Equilibrium

Changing Conditions and Changing Equilibrium

Suppose from 1, w = 20 and r = 10 and there is an

additional recurring fixed cost of 1, 280, this implies a
long-run cost function for the production process in eqn 2
of
5
C (x) = 0.66874x 4 + 1, 280 (3)
This further implies an AC function (when w = 20 and
r = 10) of
1 1, 280
A(x) = 0.66874x 4 + (4)
x

Lelimo S (NUL), Lecture 4

 Competitive Market Equilibrium
Competitive Market Equilibrium
Equilibrium Welfare Analysis
Changing Conditions and Changing Equilibrium
General Equilibrium

Changing Conditions and Changing Equilibrium

Short-Run Industry Supply

To see at what output price profits will be zero, we have to see where the new
lowest point of each producer’s long-run AC curve lies. Instead of the AC in eqn
4, an increase in license fee of M960 causes the new long-run AC 0 curve to be:
1 2, 240
AC 0 (x) = 0.66874x 4 +
x

An Increase in the Cost of Capital

Plugging in the wage w = 20 and the new rental rate r 0 = 15 into the general
cost function equation 3 we get cost as a function of output given by
5
C (x) = 0.819036x 4 + 1, 280

with accompanying average cost given by

1 1, 280
A(x) = 0.819036x 4 +
x

Lelimo S (NUL), Lecture 4

 Competitive Market Equilibrium
Equilibrium Welfare Analysis
General Equilibrium

Economic Surplus
Economic surplus represents the net gains to society from all trades that are made in a
particular market, and it consists of two components: consumer and producer
surpluses.

1. Consumer Surplus
The benefit that consumers derive from consuming a good, above and beyond
the price they paid for the good.
area below demand curve and above market price.
represent the consumer’s willingness to pay for that quantity.
CS is determined by two factors: the market equilibrium price and the
elasticity of demand

2. Producer Surplus
The benefit producers derive from selling a good, above and beyond the cost of
producing that good.
area above supply curve and below market price.
is represented graphically by the area above the supply (marginal cost)
curve and below the equilibrium price

Lelimo S (NUL), Lecture 4

 Competitive Market Equilibrium
Equilibrium Welfare Analysis
General Equilibrium

Consumer Surplus
The are consumers who are willing to pay more than P ∗ per unit.The total
amount saved by all such consumers is called the Consumer Surplus.
For those who are wiling to buy the commodity at P ∗ or higher, the total
amount they are willing to pay is the total areea below the demand curve over
R ∗
the interval [0, Q ∗ ],that is 0Q f (Q)dQ. If all consumers together buy Q ∗ units
of the commodity, the total cost is P ∗ Q ∗ (which represents the area of the
rectangle with the base Q ∗ and height P ∗ ).
The consumer surplus is;
Z Q∗
CS = [f (Q) − P ∗ ]dQ
0

which equals the total amount consumers are willing to pay for Q ∗ minus what they
actually pay.
The total revenue the producers actually receive minus what makes them willing to
supply Q ∗ .
Z Q∗
PS = [P ∗ − g (Q)]dQ
0

Lelimo S (NUL), Lecture 4

 Competitive Market Equilibrium
Equilibrium Welfare Analysis
General Equilibrium

Exercise on CS and PS

Exercise
Suppose the demand curve is P = f (Q) = 50 − 0.1Q and the
supply curve is P = g (Q) = 0.2Q + 20. Find the equilibrium
and compute the consumer and producer surplus.

Hint and Solution

Find Q ∗ and P ∗ solving f (Q) = g (Q), hence compute CS and
PS.

Q ∗ = 40, P ∗ = 40 CS = 500 and PS = 1000

Lelimo S (NUL), Lecture 4

 Competitive Market Equilibrium
Equilibrium Welfare Analysis
General Equilibrium

Economic Surplus (Cont...)

3. Social Surplus (Social efficiency)
is the total surplus received by consumers and producers in a market
the sum of consumer surplus and producer surplus
It is the area above the supply curve and below demand curve

Lelimo S (NUL), Lecture 4

 Competitive Market Equilibrium
Equilibrium Welfare Analysis
General Equilibrium

Economic Surplus (Cont...)

4. Dead Weight Loss

It is the net reduction in Social Welfare from the trades
that are not made.
That is, every trade that makes at least one party better
off without making the other party worse off is actually a
good trade to do.

Example
If you want to buy a computer from SHA computers that you
believe worth more than M7000 but you actually get it for
M7000, anything that stops you from buying it is bad because
you are losing surplus. Therefore, DWL is an inefficiency

Lelimo S (NUL), Lecture 4

 Competitive Market Equilibrium
First Fundamental Theorem of Welfare Economics
Equilibrium Welfare Analysis
Second Fundamental Theorem of Welfare Economics
General Equilibrium

First Fundamental Theorem of Welfare Economics

Assumptions
1 No externalities
2 Perfect competition [individuals and firms are price takers]
3 Perfect information
4 Agents are rational.

Under these assumptions, the First Fundamental Theorem of Welfare

Economics states that a Pareto efficient allocation of resources emerges, the
competitive equilibrium, where supply equals demand, maximizes social
efficiency. In other words, so as long as we have a competitive market, our
markets left all to themselves will be efficient.
The essence of competition is that all people face the same prices-each
consumer and producer is so small relative to the market that his or her
actions alone cannot affect prices.

Lelimo S (NUL), Lecture 4

 Competitive Market Equilibrium
First Fundamental Theorem of Welfare Economics
Equilibrium Welfare Analysis
Second Fundamental Theorem of Welfare Economics
General Equilibrium

Limitations of the First Theorem

1 Few markets are perfectly competitive. Most economies

contain a collection of imperfectly competitive markets.
And in some sectors , the are no markets at all. ˜ market
failure.
2 The first theorem deals only with the efficient allocation
of resources and says nothing about their fair distribution.
3 Human capital and technology are taken as given but a
perfectly competitive system may not explain causes of
economic growth

Lelimo S (NUL), Lecture 4

 Competitive Market Equilibrium
First Fundamental Theorem of Welfare Economics
Equilibrium Welfare Analysis
Second Fundamental Theorem of Welfare Economics
General Equilibrium

Second Fundamental Theorem of Welfare

Economics
The assumptions under the first fundamental theorem constitute an
inseparable set, and therefore they must all be satisfied for Pareto
optimality.
Thus, when there are market failures or assumptions of the
first welfare theorem fails, the government intervention can
potentially improve everybody’s welfare.

According to the Second Fundamental Theorem of Welfare

Economics:
Society can attain any Pareto efficient allocation of resources by
making a suitable assignment of initial endowments and then
letting people freely trade with each other.
That is, society can attain any efficient outcome by a suitable
redistribution of resources and free trade.
Lelimo S (NUL), Lecture 4