Transcript Industrial Organization and Competition

Industrial Organization &
Perfect Competition
1
Perfectly Competitive Markets
Structure Assumptions
 Many
buyers and sellers
 Homogeneous product or output
– Note: these first two assumptions imply that the
perfectly competitive firm is a price taker.
– P(x) = P* =  where  is the demand for the
individual firm’s output.
– Also note that if P(x) is just P*, then mr=P*, too.
 “Free”
entry and exit
 Full and symmetric information
2
Perfectly Competitive Markets
 Every
demander is a price-taker (no
buyer can influence the price).
 Every supplier is a price-taker (no seller
can influence the price).
 The market price is known to all
potential buyers and sellers and anyone
who wishes to trade at that price can do
so.
3
An Example
 Jonathan’s
farm
is perfectly
competitive and
uses the inputs
shown to
produce the
quantities of
apples indicated
on the table.
Jonathan's Apple Farm Production Function
Apples
Land
Labor Proprietor's
(tons/year)
(acres)
(hired) time (hours)
0
100
0
1,100
50
100
2,500
1,100
100
100
3,700
1,100
150
100
5,000
1,100
200
100
6,800
1,100
250
100
10,000
1,100
300
100
15,000
1,100
350
100
27,000
1,100
4
Production Detail

Here is some
finer detail
regarding the
apple farm.
Apple Farm Production Function (detail)
Apples
Land
Labor Proprietor's
(tons/year)
(acres)
(hired) time (hours)
200
100
6,800
1,100
210
100
7,320
1,100
220
100
7,900
1,100
230
100
8,530
1,100
240
100
9,220
1,100
250
100
10,000
1,100
260
100
10,800
1,100
5
Factor Prices
 Jonathan
is a
factor price
taker.
 Use these
factor prices to
build the cost
tables.
Prices
Labor's time
Owner's time
Rent
$8.00 per hour
$12.00 per hour
$124.00 per acre
6
Costs
Jonathan's Apple Farm Costs
Apples
(tons/year)
0
50
100
150
200
250
300
350
Land
12,400
12,400
12,400
12,400
12,400
12,400
12,400
12,400
Hired
Labor
0
20,000
29,600
40,000
54,400
80,000
120,000
216,000
Proprietor's
Average
time
Total Cost
Cost
13,200
25,600
13,200
45,600
912
13,200
55,200
552
13,200
65,600
437
13,200
80,000
400
13,200
105,600
422
13,200
145,600
485
13,200
241,600
690
Marginal
Cost
(midpoint
formula)
296
200
248
400
656
1,360
7
Finer Cost Details
Jonathan's Apple Farm Costs (detail)
Apples
(tons/year)
200
210
220
230
240
250
260
Land
12,400
12,400
12,400
12,400
12,400
12,400
12,400
Hired
Proprietor's
Average
Labor
time
Total Cost
Cost
54,400
13,200
80,000
400
58,560
13,200
84,160
401
63,200
13,200
88,800
404
68,240
13,200
93,840
408
73,760
13,200
99,360
414
80,000
13,200
105,600
422
86,400
13,200
112,000
431
Marginal
Cost
(midpoint
formula)
440
484
528
588
632
8
Graph of Jonathan’s Cost
Curves


The marginal cost of
each ton of apples is
shown as the red line.
The average cost is
shown as the blue
line.
Notice that the
marginal cost =
average cost at
average cost’s
minimum.
Jonathan's Cost Functions
$/ton

1,000
900
800
700
600
500
400
300
200
100
0
0
100
200
300
400
Apples (tons/year)
Average Cost
Marginal Cost (midpoint formula)
9
Profit Maximization
 Profit
() = total revenue(tr) - total cost(tc).
 Profit depends on the firm’s output level (x).
 So…  (x) = tr(x) - tc(x)
 Define
– marginal revenue (mr) = tr/x
– marginal cost (mc) = tc/x
 NOTE:
Since we have a perfectly
competitive firm P=mr for all levels of
production.
10
Profit Maximization
 General
rules for profit maximization:
 If x* maximizes  , then
– mr = mc at x*
– x* is a profit max and not a profit min
– at x* it’s worth operating
 Reminder:
since the firm is perfectly
competitive, P=mr for all values of x.
11
Jonathan’s Profit and Loss


Suppose the market
price is $600/ton.
The vertical
difference between
Jonathan’s total
revenue and total
cost curve is his
profit.
The profit maximum
occurs at 240
tons/year.
Total Cost and Revenue
300,000
250,000
Maximum
Profit,
market
price=
marginal
cost
200,000
$

150,000
100,000
Total Revenue,
slope=market
price
Total Cost,
slope=marginal
cost
50,000
0
0
50
100
150
200
Apples (tons/year)
250
300
350
400
Total Cost
Total Revenue
12
Finding Profit Maximizing Points
Using The Marginal Cost Curve



Jonathan will supply apples
to the market in increasing
quantities as the price
rises.
The points on the marginal
cost curve correspond to
profit maximizing quantities
at two different market
prices.
The quantity supplied at a
market price of $600/ton is
(about) 240 (black dot).
Consider another market
price, P=1,200 and note
that x* increases.
Marginal Cost of Apples
1,600
mc
1,400
Price ($/ton)

mr when P=1,200
1,200
1,000
800
mr when P=600
600
400
200
0
0
100
200
300
400
Apples (tons/year)
13
Finding the Value of Profit - Case A
P
A
B
O
mc
atc
C
P* = mr

If market price is P*,
then the firm supplies x*
where mr=mc.

Total Revenue=OACQ*

Total Cost=OBDQ*
Note: use the atc curve
to get the value of total
costs by multiplying atc
by x*

Profit = tr-tc=BACD
D
x*
Quantity
14
Finding the Value of Profit - Case B
P
B
O
mc
atc
P* = mr
D
x*

If market price is P*, then
the firm supplies x* where
mr=mc.

Total Revenue=OBDQ*

Total Cost=OBDQ*

Profit = tr-tc=0

Note: economic profit = 0
Quantity
15
Finding the Value of Profit - Case C
P
mc
atc
avc



D
B
A
O
P* = mr

C
x*
Quantity

If market price is P*, then the
firm supplies x* where mr=mc.
Total Revenue=OACQ*
Total Cost=OBDQ*
Profit = tr-tc = -ABDC
Note: Profits are negative.
They are loses.
Should firm continue to
operate? Good question.
Now need to look at where
the average variable cost
curve is. Recall: produce at a
loss provided tr  vc or
p  avc
Since P>avc at x*, firm should
produce x*.
16
The Firm’s Supply Curve
 An
individual perfectly competitive firm’s
supply curve (the srsfirm) is its marginal cost
curve above its average variable cost curve.
 For a perfectly competitive firm, choosing the
output at which market price equals marginal
cost maximizes profits.
– Remember, it’s really mr=mc at x*, but since the
firm is a price taker, P=mr all the time, so P=mc at
x*.
17
Jonathan’s Supply Curve

At the market price
indicated on the vertical
axis, profit maximizing
apple production is given
by the marginal cost
curve, which is Jonathan’s
supply of apples curve.
The supply curve is the
the marginal cost curve
above average variable
cost because profit
maximizing behavior
means increasing
production until marginal
cost = market price.
Single Farm Supply of Apples
1,600
1,400
Price ($/ton)

1,200
1,000
800
600
400
200
0
0
100
200
300
400
Apples (tons/year)
18
Total Costs and Economic
Profits
 Total
costs include fixed costs, variable
costs (at market prices) and the
opportunity cost of owned factors (such
as the owner’s time, land, and
equipment owned by the business).
 Economic profits are the difference
between total revenue from sales and
total costs, as defined above.
19
Back to Jonathan’s Farm...
 The
apple market is competitive.
 Jonathan cannot control the price of
apples.
 Consider, for the moment, a price of say
$528/ton now
 To profit maximize Jonathan produces
until P (=mr) = mc
20
Jonathan’s Economic Profit
and Loss
Apples
(tons/year)
200
210
220
230
240
250
260

Apple Farm Profits (detail)
Marginal
Revenue
Total
Marginal = Market Economic
Total Cost Revenue
Cost
Price
Profits
80,000 105,600
25,600
84,160 110,880
440
528
26,720
88,800 116,160
484
528
27,360
93,840 121,440
528
528
27,600
99,360 126,720
588
528
27,360
105,600 132,000
632
528
26,400
112,000 137,280
25,280
At the market price of $528, the profit maximizing apple
production is the highlighted line.
21
Graph of Jonathan’s
Revenue and Cost

The vertical difference
between Jonathan’s total
revenue and total cost
curves is his economic
profits.
The slope of the total cost
line (marginal cost) is
equal to the slope of the
total revenue line
(marginal revenue =
market price)
Total Cost and Revenue
250,000
200,000
Maximum
Profit,
market
price=
marginal
cost
150,000
$

100,000
Total Revenue,
slope=market
price
Total Cost,
slope=marginal
cost
50,000
0
0
50 100 150 200 250 300 350 400
Apples (tons/year)
Total Cost
Total Revenue
22
Graph of Jonathan’s
Economic Profits


The chart at the right shows
that Jonathan’s economic
profits are maximized at
apple production where the
market price is equal to the
marginal cost (230
tons/year).
Profits are maximized when
marginal cost is as close as
possible to market price,
without exceeding it.
The slope of economic profits
= zero at the profit maximum.
Economic Profits (detail)
28,000
27,500
27,000
$

26,500
26,000
25,500
25,000
200
210
220
230
240
250
260
Apples (tons/year)
23
Accounting Profits
 Accounting
profits are defined as total sales
revenue (the same as total revenue in the
economic profits definition) minus operating
costs (costs of goods sold + administrative
and sales costs for those who know some
accounting).
 Accounting Profits = Sales Revenue Accounting Costs
24
Did Jonathan Make
Accounting Profits?
Apples
(tons/year)
200
210
220
230
240
250
260

Accounting Profits vs. Economic Profits (detail)
Total
Accounting
Accounting
Economic
Revenue
Costs
Profits
Total Costs Profits
105,600
66,800
38,800
80,000
25,600
110,880
70,960
39,920
84,160
26,720
116,160
75,600
40,560
88,800
27,360
121,440
80,640
40,800
93,840
27,600
126,720
86,160
40,560
99,360
27,360
132,000
92,400
39,600
105,600
26,400
137,280
98,800
38,480
112,000
25,280
The blue line in the table illustrates that Jonathan makes an accounting
profit of $40,800 when the apple price is $528/ton.
25
Economic Profits
 Economic
profits are the difference
between total revenue and total costs.
 Economic total costs include the
opportunity costs of all inputs to the
production process–in particular, the
opportunity costs of the owner’s time
and physical capital (equipment and
space).
26
Reconciling Economic and
Accounting Profits


The table to the right
shows that
Jonathan’s economic
profits equal his
accounting profits
minus the
opportunity cost of
his time.
Thus, when the price
of apples is $528/ton
and 230 tons/year
are sold, economic
profits = $27,600
Reconciling Accounting and Economic Profits (detail)
- Opportunity
Cost of
Apples
Accounting Jonathan's
= Economic
(tons/year)
Profits
Time
Profits
200
38,800
13,200
25,600
210
39,920
13,200
26,720
220
40,560
13,200
27,360
230
40,800
13,200
27,600
240
40,560
13,200
27,360
250
39,600
13,200
26,400
260
38,480
13,200
25,280
27
Question 1
 At
a market price of $440/ton for
apples, what is the optimal annual
production of apples?
 Use the data on your handout to
answer this question.
28
Answer 1
 Marginal
cost = market price = $440/ton
at a production level of 210 tons/year.
 This is the profit maximizing level of
output when the market price is
$440/ton.
29
Question 2
 At
a market price of $440/ton for
apples, what are Jonathan’s accounting
and economic profits?
30
Answer 2
 Total
revenue = $440 x 210 = $92,400.
 Total costs = $124 x 100 (land) + $8.00
x 7,320 (labor) + $12.00 x 1,100
(proprietor’s time) = $84,160 .
 Economic profits = total revenue - total
costs = $92,400 - $84,160 = $8,240.
31
Answer 2 (continued)
 Total
revenue = $440 x 210 = $92,400.
 Accounting costs = $124 x 100 (land) + $8.00
x 7,320 (labor) = $70,960.
 Accounting profits = total revenue accounting costs = $92,400 - $70,960 =
$21,440.
 Economic profits = accounting profits opportunity cost of owner’s time = $21,440 $13,200 = $8,240.
32
Question 3
 At
a market price of $400/ton for
apples, what are Jonathan’s accounting
and economic profits?
33
Answer 3
 Optimal
production = 200 tons/year.
 Total revenue = $400 x 200 = $80,000.
 Economic profits = total revenue - total
costs = $80,000 - $80,000 = 0.
 Accounting profits = total revenue accounting costs = $80,000 - 66,800 =
13,200.
34
Question 4
 Should
Jonathan continue to operate
the apple farm if the market price of
apples is $400/ton?
35
Answer 4
 Jonathan’s
economic profits are zero when
the market price of apples is $400/ton
($0.20/pound, about the current price
wholesale price for first quality fresh apples).
 Jonathan just recovers the opportunity cost of
his time ($13,200), so he is indifferent
between producing apples and taking a job at
$12/hour.
36
Producers Surplus Revisited




Producers surplus measures the gain to the firm from
selling all units at the market price.
Producers surplus is the supply-side equivalent of
consumers surplus.
Total producers surplus = the area above the marginal
cost curve and below the market price = economic profits
+ fixed costs.
Incremental producers surplus = the difference between
the market price and the marginal cost of the given unit
of production.
37
Jonathan’s Producers Surplus
 Jonathan’s
total
producers
surplus, when the
market price is
$528, is the sum
of his economic
profits ($27,600)
and his fixed
costs ($25,600) =
$53,200.
38
Producers Surplus and
Economic Profits
 Producers
surplus is not equal to
economic profits.
 Producers surplus includes fixed costs.
 Economic profits = producers surplus fixed costs.
 Producers surplus = economic profits +
fixed costs.
39
The Market Supply Curve
 The
market supply curve is the sum of
the quantities supplied by each seller at
each market price.
 Market supply, thus reflects the
marginal costs of each of the producers
in the market.
 This is Short Run Market Supply (SRS)
40
Supply Curve for a New York
Apple Farm


The data used to construct
Jonathan’s supply curve
were representative of the
typical New York State
apple farm.
The supply curve for a
single apple farm is shown
to the right.
It is the same as the supply
curve we have been using,
based on the marginal cost
curve of a single farm.
Single Farm Supply of Apples
1,600
1,400
Price ($/ton)

1,200
1,000
800
600
400
200
0
0
100
200
300
400
Apples (tons/year)
41
Market Supply Curve:
Horizontal Summation
Farm B’s Supply of Apples
1,600
1,600
1,400
1,400
Price ($/ton)
Price ($/ton)
Farm A’s Supply of Apples
1,200
1,000
800
600
400
200
800
600
400
0
0
100
200
300
Apples (tons/year)

1,000
200
0

1,200
400
0
100
200
300
400
Apples (tons/year)
At a price of $1000/ton, add Farm A’s supply to Farm B’s supply to
get market supply (about 560 tons/year). Add over all farms.
The market supply curve is the horizontal summation of the firms’
supply curves.
42
Short Run Equilibrium Summary
 The
firm is profit maximizing - no desire at
current market price to change the quantity
supplied.
– Firm is on its short run supply curve
 Market
Demand = Short run Market Supply
– No tendency for market price to change
 Note:
number of firms fixed, technology
given and firm’s capital fixed.
 Get: (P*, X*, x*)
 Firms can have +/0/- profit.
43
Profit Signal
 When
profit in the short run is positive there
are firms at the margin that want to enter the
market and it is assumed that they can.
 When profit in the short run is negative there
are firms at the margin that want to exit the
market and it is assumed that they will.
44
Long Run Equilibrium
 All
the short run equilibrium properties.
 But also…no firms wish to exit the
market nor do firms want to enter.
 Get: (P*, X*, x*, N*)
 Note:
For there to be neither entry or exit,
need economic profit to be zero. This is a
long run equilibrium requirement. Otherwise
the number of firms in the market will still be
in flux.
45
Long Run Equilibrium Position








Profit max implies that mr=lrmc at x*.
Zero profit implies P=lratc at x*.
Since the firm is perfectly competitive, P=mr at all
values of x.
By substitution, P=lratc at x* and P=lratc at x*.
Therefore lrmc=lratc at x*.
This implies that x* is at the minimum of the typical
firm’s lratc. x* is at MES.
P* must be the price consistent with the minimum
value on the lratc curve.
N* and X* determined by position of market demand.
46
Long Run Equilibrium Picture
SRS w/N*
lratc
A
P*
P*
a
mr
D
X*
market
X
x*
x
typical firm
47
Steps to Draw The Picture?
 Doesn’t
matter how you draw it, as long
as you draw it correctly in the end.
 Draw-a-person test.
48
What’s not ok...
49
Increases in Demand
 When
demand increases and is expected to
remain at the increased level, the short run
response is to move along the short run
supply curve--higher price and greater
quantity supplied.
 The long run response is to have entry in the
market, movement along the long run supply
curve--price returns to the minimum average
total cost and quantity supplied increases.
50
Long Run Adjustment Picture
srmc
D new
SRS w/N*
P’
B
sratc
lratc
b
P’
A
P*
P*
mr’
a
mr
D
X*
market
X’
X
x* x’
x
typical firm
51
Long Run Equilibrium Picture
srmc
D new
SRS w/N*
A
P*
lratc
SRS
w/N**
B
P’
sratc
b
P’
C
P*
mr’
a
mr
LRS
D
X*
market
X’
X** Q
x* x’
x
typical firm
52
Long Run Supply in the
Market



Both points A and C in
the previous picture
are long run
equilibrium points.
Point B is a temporary
short run equilibrium
point.
If you connect all
points like A and C
you get the market
long run supply curve
in a perfectly
competitive market.
D new
SRS w/N*
SRS
w/N**
B
P’
A
P*
C
LRS
D
X*
X’
X** X
53
Long Run Supply in the
Market




The long run supply curve in
the market is horizontal at the
long run equilibrium price P*.
P* is sometimes called the
“normal price.”
P* is the price consistent with
the typical firm’s minimum long
run average total cost.
Note: important assumption is
that the position of the firm’s
cost curve is unaffected by
entry (or exit) of firms in the
market.
D new
SRS w/N*
SRS
w/N**
B
P’
A
P*
C
LRS
D
X*
X’
X** X
54
Example: Long Run Supply in
the System-fixer Market



The market demand for system
installations is shown by the blue
line in the graph.
The market is very much larger than
firm’s at the efficient scale, so we
expect competitive conditions to
prevail.
The long run supply (in red) reflects
the technological and competitive
conditions in the market: surviving
firms must operate at the scale of
firm B at a minimum average total
cost of $26/installation.
Short run supply is shown in brown.
Market for System Installations
50
45
40
Price ($/installation)

35
30
25
20
15
Demand
10
Long Run Supply
5
Short Run Supply
0
0
2,000
4,000
6,000
8,000 10,000 12,000 14,000 16,000
Quantity (Installations/week)
55
Question
 How
many firms are there in the long
run in the system-fixer market?
56
Answer
 Firms
with the efficient scale do 8
installations per week at an average
total cost of $26/installation.
 At $26/installation the market demand
is 8,000 installations per week.
 Therefore, there are 1,000 firms in the
market.
57
Increase in Demand in the
System-fixer Market


Demand increases in the market as
indicated by the new (black)
demand curve.
The short run response is an
increase in price with not much
additional quantity supplied (point
A), movement along the short run
supply curve.
The long run response is a return to
the original price of $26/installation
and an expansion of quantity
supplied along the long run supply
curve (point B).
Increase in Demand
50
45
40
Price ($/installation)

A
35
B
30
25
20
15
Demand
Long Run Supply
10
Short Run Supply
5
New Demand
0
0
2,000
4,000
6,000
8,000 10,000 12,000 14,000 16,000
Quantity (Installations/week)
58
Question
 What
would be the long run result of a
fall in demand for system installations
when the quantity demanded at
$26/installation is 4,000.
59
Answer
 Now,
only 500 firms operating at the
minimum efficient scale will survive.
 The industry will shrink by exit of some
system fixer firms. Of the original 1,000
firms, only 500 survive.
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External Economies and
Diseconomies of Scale



If the industry exhibits no external economies or diseconomies
of scale, then the industry long run supply curve is perfectly
elastic (horizontal). The industry grows by replicating firms at
the efficient scale. Entry and exit leaves the position of cost
curves intact. This is called a constant cost industry.
If the industry exhibits external diseconomies of scale, then the
industry long run supply curve is upward sloping. The minimum
average total cost of all firms in the industry rises as the size of
the market grows. This is called an increasing cost industry.
If the industry exhibits external economies of scale, then the
industry long run supply curve is downward sloping. The
minimum average total cost falls as the size of the industry
grows. This is called a decreasing cost industry.
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Constant Cost Industry
 When
we draw the long run supply curve as
a horizontal line, we are asserting that there
are no external economies or diseconomies
of scale.
 Lack of economies or diseconomies of scale
means that growth of the industry doesn’t
foster technological improvements and
doesn’t change the prices of inputs.
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


When an industry long run
supply curve slopes upward,
the industry exhibits external
diseconomies of scale.
This can occur because the
prices of the inputs rise as
the industry expands.
This can also occur because
the industry becomes
“congested” and the minimum
average total cost at the
efficient scale rises.
Price
External Diseconomies of
Scale
Long run supply with
external diseconomies of
scale in the industry
Quantity
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Examples of Long Run Supply
Curves that Slope Up




As a competitive industry grows its demand for certain
specialized factors increases (information systems specialists
in the accounting service industry, fabrication equipment in
the microprocessor industry).
Increased demand for specialized factors means that the
equilibrium price of these factors will increase (movement
along a factor supply curve--increased quantity and increased
price of the factor).
So as the industry (not the firm) grows, the price of these
specialized factors increases and the minimum average total
cost rises.
Thus, the long run supply curve slopes upward.
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Long Run Competitive
Equilibrium - Reviewed

The firms in a perfectly competitive market are in
long run equilibrium when
– Quantity supplied = Quantity demanded at the
current market price.
– Firm’s are profit maximizing so that marginal
revenue (= Price) = marginal cost for all firms in
the market.
– Price = minimum average total cost for all firms in
the market, implying zero economic profit.
– No firm wants to enter the market.
– No firm currently in the market wants to exit.
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Why are there zero economic
profits in the long run?





Zero economic profits means that all factors used in
production make exactly their opportunity cost.
Purchased factors receive their market price, which is
equal to their opportunity cost.
Owned factors receive the same compensation that they
would receive in their next best use, which is also equal to
their opportunity cost.
Thus, no firm wants to enter the market because it cannot
make any more money than it is currently making.
Similarly, no firm wants to leave the market because it
cannot make any more money in any other business.
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Performance
 Efficiency:
– Allocative efficiency: (look at market) The level of
output traded is allocatively efficient if it
maximizes net social surplus.
– Productive efficiency: (look at the firm) The firm’s
output level is productively efficient if it is at the
minimum of the firm’s long run average total cost
curve, that is, if it is at least as large as minimum
efficient scale of production.
 Equity:
– Is the outcome of the allocatoin process fair?
Equitable? Just?
67
Long Run Competitive
Equilibrium - Performance

Efficiency:
– The market equilibrium is allocatively efficient. That is, at
X*, net social surplus is maximized.
– Each firm is productively efficient. That is each firm
operates at, at least, minimum efficient scale. Each firm
operates at the minimum of its long run average total cost
curve.

Equity: Is the outcome of the competitive process
fair? Equitable? Just?
– Good questions that we do not answer here and now.
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Allocative Efficiency - Proof
 If
X* is allocatively efficient, then net social
surplus should be as high as it can feasibly
be.
 Net Social Surplus = $TBsociety - $TCsociety
 When net social surplus is as high as it can
be, $MBsociety = $MCsociety
 Question: Is the outcome of the competitive
process allocatively efficient?
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Answer
Demand=Supply at X*.
 Demand represents $marginal benefit.
 Supply represents $marginal cost.
 So…marginal benefit equals marginal cost at
X*.
 So…net social surplus is maximized at X*.
 There is no transaction among the buyers
and sellers that improves the welfare of at
least one person without reducing the welfare
of at least one person.

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Productive Efficiency - Proof







Profit max implies that mr=lrmc at x*.
Zero profit implies P=lratc at x*.
Since the firm is perfectly competitive, P=mr at all
values of x.
By substitution, P=lratc at x* and P=lratc at x*.
Therefore lrmc=lratc at x*.
This implies that x* is at the minimum of the typical
firm’s lratc. x* is at MES.
P* must be the price consistent with the minimum
value on the lratc curve.
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