LECTURE

5
Compe--ve Firm
Efficiency in Par-al Equilibrium
Externality

7/10 September, 2021
 Part 1
COMPETITIVE FIRM

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 Profit and Revenue
•  Firm chooses Q to maximize profit
•  Profit=total revenue-total cost
π (Q) = TR(Q) − TC(Q)
•  Total revenue
TR(Q) = P(Q)Q
•  Marginal revenue is the rate at which total revenue changes
with output
dTR(Q)
MR(Q) =
dQ
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 How to maximize profit?
•  Marginal cost is the rate at which total cost changes with
output dTC(Q)
MC(Q) =
dQ
•  To maximize profit, we solve
max TR(Q) − TC(Q)
Q

•  The first-order condi-on is

MR(Q) − MC(Q) = 0
•  Rearranging, we have
MR(Q) = MC(Q)

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 Profit-Maximizing Condi-on in Perfect Compe--on
•  Firms take market price P as given
•  Total revenue is linear in output
TR(Q) = PQ
•  Thus
MR(Q) = P
•  To maximize profit
P = MC(Q)

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 Second-Order Condi-on
•  The necessary second-order condi-on is
π ''(Q) ≤ 0
•  This implies
dMR(Q) dMC(Q)
− ≤0
dQ dQ

•  Since MR(Q)=P
dMC(Q)
≥0
dQ
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 Firm’s Supply Curve
P The supply curve tells us how the profit-
maximizing quan-ty of output changes with
the market price
P1 MC

P2
Pshut

0 Q
Q2 Q1
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 Defini-on of Producer Surplus
•  Producer surplus (PS) is the difference between the amount
producers actually receive by producing and selling a certain
units and the amount producers have to receive to produce a
certain units
•  PS is the area below the price and above the supply curve

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 Producer Surplus in Graph
P
MC
20 PS=0.5*30*(20-10)=150

10

0 Q
30

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 Part 2
EFFICIENCY IN PARTIAL EQUILIBRIUM

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 How to measure welfare?
•  Total welfare consumers receive
–  Measured by consumer surplus
•  Total welfare producers receive
–  Measured by producer surplus
•  Total welfare for the market as a whole
–  Total surplus = consumer surplus + producer surplus
•  If there is government interven-on
–  Total surplus = consumer surplus + producer surplus + government
revenue/expenditure
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 Total surplus=total benefit-total avoidable
costs
P
C
S(P)
CS
B
*
P
PS

A
D(P)
0 *
Q
Q
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 Economic Efficiency and Deadweight Loss
•  In par-al equilibrium, an output level (quan-ty) is efficient if at
that output level, the total surplus in the market is maximized
•  If the output level is not efficient, the market suffers from
deadweight loss
–  Total surplus is not maximized
–  Deadweight loss is the net loss in total surplus

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 Efficiency in Perfectly Compe--ve Markets
P S(P)
C
CS
P * B

PS
D(P)

A
0 *
Q
Q
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 Underproduc-on
P S(P)
C

P* B

D(P)

A
0 *
Q
Q0 Q
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 Overproduc-on
P S(P)
C
B
P*

D(P)

A
0 *
Q
Q Q0
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 Example of Underproduc-on: Excise Tax
•  Suppose the government imposes a $4 per unit tax on producers
•  Suppose in the absence of tax, the market supply curve is
"$ if
−5 + 5P P ≥1
S(P) = #
$% 0 if P <1
•  With the tax, for any market price P, producers only receive P-4
"$ if
−5 + 5(P − 4) = −25 + 5P P≥5
S1 (P) = #
$% 0 if P<5

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 How does tax change market equilibrium?
P
9 S1 (P)
New equilibrium Y
price for
consumers
7 S(P)
X
5
Price producers
actually receive
in new 3
equilibrium
D(P) = 45 − 5P
1
0 Q
10 20
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 Total surplus when there is no tax
P
9
A S(P)
7
B C X CS=A+B+C
5 PS=D+E+F
D E TS=A+B+C+D+E+F
3
F
D(P)
1
0 Q
10 20
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 Total surplus when there is tax
P
9 S1 (P)
Price for A Y S(P)
consumers=7
B X CS=A
C PS=F
5
E Tax=B+D
Price for D
TS=A+B+D+F
producers=3
F
D(P)
1
0 Q
10 20
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 Deadweight Loss with Tax
P S1 (P)
9
Price for CS Y S(P)
consumers=7
X Deadweight
C
5 Tax loss=C+E
E
Price for
producers=3
PS
D(P)
1
0 Q
10 20
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 Example of Overproduc-on: Subsidy
•  Suppose now government gives $2 per unit subsidy to
producers
•  The actual supply curve is
"$ if
−5 + 5P P ≥1
S(P) = #
$% 0 if P <1
•  With the subsidy, for any market price P, producers receive
P+2 S (P) = −5 + 5(P + 2) = 5 + 5P
1

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 Total surplus when there is no subsidy
P9
X S(P)
CS=A+B
A
PS=C+D
B TS=A+B+C+D
5
C
D
D(P)
1
0 Q
20
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 Total surplus when there is subsidy
P9
S(P)
X CS=A+B+C+E
A PS=B+C+D+F
Price for
producers=6 S1 (P)
B F
5 G
Price for C E
consumers=4 Y
D
D(P)
1
0 Q
5 20 25
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 Deadweight Loss due to Subsidy
P9
S(P)
X
A
Price for DWL=G
producers=6 S1 (P)
B F
5 G
Price for C E
consumers=4 Y
D
D(P)
1
0 Q
5 20 25
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 Source of Deadweight Loss
•  With tax, the consump-on and produc-on of the good is too
lijle
•  With subsidy, the consump-on and produc-on of the good is
too much
•  In both cases, we have quan:ty distor:on
–  Quan-ty consumed and produced is different from the efficient
quan-ty

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 Part 3
EXTERNALITY

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 Externality
•  Externality occurs when ac-ons taken by producers or consumers affect
other producers or consumers in a way not accounted for by the market
price
•  An externality imposing cost is a nega:ve externality
•  E.g. pollu-on, traffic conges-on, loud neighbors, smoking
•  An externality imposing benefit is a posi:ve externality
•  E.g. scien-fic advancement, good driving habits, good health

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Nega-ve Externality: Market for a Chemical Product
•  Suppose produc-on of the chemical product results in water
pollu-on
•  The produc-on process creates nega-ve externali-es
•  Suppose the market is perfectly compe--ve otherwise

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 Marginal Costs with Nega-ve Externality
•  Marginal private cost (MPC)
–  The marginal cost of produc-on
•  Marginal external cost (MEC)
–  Addi-onal cost of pollu-on on others associated with each addi-onal
unit of output
•  Marginal social cost (MSC)
–  MPC+MEC
•  If the producer does not take the external cost into account
–  Its marginal cost is MPC not MSC

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 Social Op-mum vs. Market Equilibrium
P X: market equilibrium
Y: social op-mum
MSC
Z
A S(P) = MPC
Y
8 H
B C D
5 G X
E F

D(P)
0 Q
80 100
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 Inefficiency in Free Market
•  Social op-mum (efficient outcome)
–  CS=A
–  PS=B+C+E+F
–  External cost=-C-F
–  TS=A+B+E
•  Free market equilibrium
–  CS=A+B+C+D
–  PS=E+F+G
–  External cost=-C-D-F-G-H
–  TS=A+B+E-H
–  DWL=H
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 Overproduc-on in Free Market
•  Social op-mum (efficient outcome)
–  Produc-on is 80
•  Market equilibrium
–  Produc-on is 100
•  Nega-ve externality leads to overproduc-on
•  The addi-onal 20 units under free market are inefficient
–  Marginal social cost higher than marginal benefit

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 Posi-ve Externality: Market for Hepa--s Vaccine
•  If a consumer buys hepa--s vaccine
–  It benefits the consumer
–  It also benefits people around the consumer
•  The vaccine creates posi-ve externality
•  Suppose the market is perfectly compe--ve otherwise

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 Marginal Benefits with Posi-ve Externality
•  Marginal private benefit (MPB)
–  The marginal benefit for the consumer
•  Marginal external benefit (MEB)
–  Addi-onal benefit for the society associated with each addi-onal unit
of purchase
•  Marginal social benefit (MSB)
–  MPB+MEB

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 Social Op-mum vs. Market Equilibrium
P X: market equilibrium
Y: social op-mum

A Z S(P)
B C Y
25
20 D E F
H MSB
G X
D(P) = MPB
0 Q
160 200
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 Inefficiency in Free Market
•  Social op-mum (efficient outcome)
–  CS=
–  PS=D+E+F+G
–  External benefit=A+C+E+F+H
–  TS=A+B+C+D+E+F+G
•  Free market equilibrium
–  CS=B+D
–  PS=G
–  External benefit=A+E
–  TS=A+B+D+E+G
–  DWL=C+F
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 Underproduc-on in Free Market
•  Social op-mum (efficient outcome)
–  Produc-on is 200
•  Market equilibrium
–  Produc-on is 160
•  Posi-ve externality leads to underproduc-on
•  The addi-onal 40 units under social op-mum are efficient
–  Marginal social benefit higher than marginal cost

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 Market Failure
•  Both posi-ve and nega-ve externali-es result in inefficiency
–  Nega-ve externality: too much resources allocated
–  Posi-ve externality: too lijle resources allocated
•  Externality is a form of market failure
–  Market fails when it does not allocate resources efficiently
–  Total surplus is not maximized in free market equilibrium

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 Solu-ons to Externality
•  How to correct for externali-es?
•  Possible solu-ons
–  Government interven-ons
•  Tax produc-on with nega-ve externality
•  Subsidize produc-on with posi-ve externality
–  Coase theorem
•  Property rights
–  Merger
•  Internalize the externality

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 Solu-on 1: Pollu-on Tax
•  Going back to the example of chemical product
•  Suppose the government imposes a pollu-on tax on the
producer
•  How much should the government tax?
–  Tax should correct for externality
–  With tax, the producer’s marginal cost should be MSC not MPC

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 Op-mal Pollu-on Tax
P Op-mal tax=MEC at the efficient Q
MSC
MPC + Tax
A S(P) = MPC
Y
8
5 B C
D E X
4
F G
D(P)
0 Q
80 100
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 Tax Improves Efficiency
•  At the equilibrium with tax
–  CS=A
–  PS=F+G
–  External cost=-C-E-G
–  Tax=B+C+D+E
–  TS=A+B+D+F
–  DWL=0
•  Equilibrium with tax=social op-mum

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 Solu-on 2: Coase Theorem
•  Ronald Coase argues that externality leads to inefficiency
because no one owns the water being polluted
•  Coase Theorem
–  If the property right to the water is clearly defined
•  Either the chemical producer or other people/firms affected by the pollu-on
own the water
–  And if there is no transac-on cost
–  Alloca-on of resources will be efficient no majer how property right
is ini-ally assigned
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 Chemical Firm vs. Fishery
•  Suppose the chemical firm produces chemical (c) and pollu-on
(x) jointly
•  The pollu-on adversely affects a nearby fishery which
produces fish (f)
•  Both firms are price takers
•  The market price of the chemical is Pc
•  The market price of fish is Pf

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 Chemical Firm’s Problem
•  Suppose the (private) cost of produc-on is
Cc (c, x)
•  The firm chooses c and x to maximize profit
max Pc c − Cc (c, x)
c,x
•  The first-order condi-ons are
∂Cc (c, x)
Pc − =0
∂c
∂Cc (c, x)
=0
∂x
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 Chemical Firm’s Op-mal Choices
•  Suppose the cost func-on is
Cc (c, x) = c 2 + (x − 4)2
•  Suppose the market price is Pc=12
•  The first-order condi-ons are
12 − 2c = 0
2x − 8 = 0
•  The op-mal choices are c=6 and x=4
•  The firm’s profit is 36

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 Fishery’s Problem
•  Suppose the cost of produc-on is
C f ( f , x)
•  The cost of the fishery is affected by x, the pollu-on level,
implying externality
•  The firm chooses f to maximize profit
max Pf f − C f ( f , x)
f
•  The first-order condi-on is
∂C f ( f , x)
Pf − =0
∂f
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 Fishery’s Op-mal Choice
•  Suppose the cost func-on is
2
C f ( f , x) = f + xf
•  Suppose the market price is Pf=10
•  The first-order condi-on is
10 − 2 f − x = 0
•  The op-mal choice is
f = 5 − 0.5x
•  Since x=4, we have f=3, the fishery’s profit is 9

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 Externality and Joint Profit
•  The joint profit of the two firms is 36+9=45
•  The total external cost to the fishery is
xf = 12
•  When the chemical firm chooses x, it does not take the
external cost into considera-on
•  What is the efficient outcome in this case?
–  When the joint profit of the two firms are maximized

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 Efficient Outcome
•  Suppose there is a benevolent social planner who maximizes
the joint profit of the two firms
max Pc c + Pf f − Cc (c, x) − C f ( f , x)
c, f ,x

•  The first-order condi-ons are

∂Cc (c, x)
Pc − =0
∂c
∂C ( f , x)
Pf − f =0
∂f
∂Cc (c, x) ∂C f ( f , x)
+ =0
∂x ∂x

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 Efficient Outcome Cont’
•  Using the prices and cost func-ons we have
12 − 2c = 0
10 − 2 f − x = 0
2x − 8 + f = 0
•  The efficient outcome is c=6, f=4, x=2
•  The joint profit of the two firms is 48
•  Compared to the market equilibrium
–  Pollu-on decreases from 4 to 2
•  How to achieve the efficient outcome?
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 Property Right
•  Suppose the fishery owns the water being polluted
•  To pollute the water, chemical firm needs the fishery’s permission
–  Chemical firm can pay the fishery to pollute the water
•  As long as there is no transac-on cost, the two firms can always
nego-ate a price such that the efficient outcome is achieved
–  Because the joint profit is higher at the efficient outcome
•  An example of how this can be done
–  Suppose the fishery can sell pollu-on rights at the market price Px per unit
of pollu-on
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 Firms’ Profit Func-ons with Property Right
•  The fishery now chooses f and xs (how many pollu-on rights to
sell) to maximize profit
max Pf f + Px xs − C f ( f , xs )
f ,xs

•  The chemical firm chooses c and xd (how many pollu-on rights

to buy) to maximize profit
max Pc c − Px xd − C c (c, xd )
c,xd

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 First-Order Condi-ons for Both Firms
•  The first-order condi-ons for the fishery are
∂C f ( f , xs )
Pf − =0
∂f
∂C f ( f , xs )
Px − =0
∂xs
•  The first-order condi-ons for the chemical firm are
∂Cc (c, xd )
Pc − =0
∂c
∂Cc (c, xd )
Px + =0
∂xd
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 Op-mal Choices with Property Rights
•  Using the cost func-ons
Pf − 2 f − xs = 0
Px − f = 0
Pc − 2c = 0
Px + 2xd − 8 = 0

•  Recall Pf=10 and Pc=12

•  If Px is such that the demand of pollu-on rights equals to the
supply of pollu-on rights
•  We have c=6, f=4, xd=xs=2, Px=4
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 The Efficient Outcome is Reached
•  This outcome is efficient
–  The 4 first-order condi-ons on slide 55 are the same as the 3 first-
order condi-ons on slide 51
•  What if the chemical firm has the property right?
–  The same!
•  Is there any other way to achieve the efficient outcome?
–  Yes! Solu-on 3: merge the two firms

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