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Chapter 7
Perfect Competition and the Invisible
Hand
Questions
1. All else equal, does a steep or flat demand curve result in higher social surplus? How does steepness
of supply affect social surplus?
Answer: Everything else equal, a steep demand curve will result in higher social surplus. As can be seen
in the following figures, social surplus (shown by the triangles A and B) is higher in the market with a
steep demand curve.

Similarly, other things remaining the same, social surplus (shown by the triangles A and B) is higher in a
market with a steeper supply curve.

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 Chapter 7 | Perfect Competition and the Invisible Hand 70

2. How do economic profits and losses allocate resources in an economy?

Answer: When positive economic profits exist in an industry, resources flow to that industry because of
the profits available. This behavior causes resources to flow from less productive uses to more productive
uses. That is, businesses seek to improve their profits and in so doing, they move resources into the
production of goods and services that society values the highest. Similarly, when firms face economic
losses, they exit the industry and put their resources to more profitable uses. Again, this allocates
resources to industries that produce goods and services that society values the highest.
3. How will the invisible hand move corn prices in response to:
a. a flood that destroys a great deal of the corn crop?
b. a rise in the price of wheat (a substitute for corn)?
c. a change in consumer tastes away from corn dogs toward hot dogs?
d. an increase in the number of people with access to the corn market?
Answer:
a. Since a great deal of the corn crop has been destroyed by the flood, the supply curve for corn will
shift leftwards and the price of corn will increase.
b. When the price of a substitute such as wheat increases, the demand for corn will increase. The
demand curve will shift rightwards and the price of corn will increase.
c. Corn (not surprisingly) is an important input in the production of corn dogs. If consumers prefer
fewer corn dogs, the demand curve for corn will shift leftwards and the price of corn will fall.
d. As more buyers enter the market, the demand for corn will increase. The demand curve will shift
rightwards and the price of corn will increase.

4. Hardware stores charge higher prices for snow shovels after a big snowstorm. What role do prices
play in the snow shovel market? Should the government step in and keep the prices low? Show your
reasoning with a supply and demand exhibit. Be sure to discuss deadweight loss.

Answer: Prices allocate scarce resources such as snow shovels after a big snow storm. The market price
ensures that those with the highest willingness-to-pay get a snow shovel. The price also ensures that the
low-cost suppliers provide these snow shovels. During a storm, a high price induces new suppliers to

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 Chapter 7 | Perfect Competition and the Invisible Hand 71

enter the market, and it also encourages some low-value buyers to forego the use of snow shovels. The
social surplus is the area between the supply and demand curves. The government will lower surplus (by
the deadweight loss triangle shown, at minimum) if it forces the price to be artificially low. Fewer
suppliers will sell snow shovels; this unambiguously lowers producer surplus. At best, a few high value
buyers get snow shovels; in this case the effect on consumer surplus is ambiguous as there are fewer
buyers, though these buyers do pay a lower price. Also, it may be that some low value buyers are able to
purchase, in which case the deadweight loss (DWL) is even larger than what is shown in the diagram.
5. The market for economics textbooks is in equilibrium. The government decides to relax export
restrictions on paper, leading to an increase in the demand for paper. How does social surplus in the
market for textbooks change? Why? Present a diagram as part of your explanation.
Answer: An increase in the demand for paper would also lead to an increase in the price of paper. As the
price of paper increases, the cost of producing a textbook will increase. This will shift the supply curve
for textbooks to the left. The equilibrium price of a textbook will increase while the equilibrium quantity
will fall. Consumer surplus and social surplus must fall; it is not clear if producer surplus will rise or fall.

The diagram above shows demand and supply in the textbook market. The increase in the price of paper
shifts the supply curve for textbooks from S1 to S2. At the old price of paper consumer surplus was A + B
+ C + E, producer surplus was F + G + H, and social surplus was A + B + C + E + F + G + H. At the new
higher price for paper consumer surplus is A, producer surplus is B + F, and social surplus is A + B + F.
Therefore, consumer surplus and social surplus both fell; the impact on producer surplus is ambiguous.
6. What could explain why South Korea’s gross domestic product (GDP) per capita increased so much
faster since the 1970s than North Korea’s GDP per capita?
Answer: One of the factors that could explain the divergence between South Korea’s and North Korea’s
per capita GDP is the fact that South Korea is a market economy while North Korea is a command
economy. The price mechanism allocates resources in market economies to their most efficient use. It
also aligns the incentives of sellers and buyers. Central planners in command economies, however, face
coordination and incentive problems. The central planner does not fully understand consumer wants and
the production capabilities of every sector of the economy, and it is difficult to provide workers with
appropriate incentives.

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 Chapter 7 | Perfect Competition and the Invisible Hand 72

7. In a command economy, a planning agency sets prices for various inputs and final goods. In a market
economy, supply and demand decide the prices of various goods. In both cases, there is a set of prices
operating in the economy. Then why are market economies considered more efficient than planned
economies?
Answer: Although planning agencies set prices, they cannot always accurately align the interests of
buyers and sellers or solve the coordination problem of bringing agents together to trade. Any individual
can only know a small fraction of all that is known collectively and so a planning agency cannot replicate
the work of the invisible hand. In a market economy on the other hand, the price mechanism ensures that
economic agents make trades that are in their best interest and maximize social surplus.
8. If your professor decided to give all of his students the highest grade in the class, would that affect
your classmates’ incentives to study?
Answer: If every student were given the same grade irrespective of how he or she did on an exam,
students’ incentive to study. Even without studying, a student would be ‘guaranteed’ a higher grade than
he would have received otherwise. Eventually, one can expect students in the class to stop studying
altogether.
9. Sofia, a political science student, thinks that the government should intervene to revive declining
industries like video rentals and print newspapers. The government, she reasons, can resolve the
coordination problem of getting the agents in these markets to trade. Do you agree with her? Explain
your answer.
Answer: Sofia’s reasoning is flawed because declining industries do not face a coordination problem. A
coordination problem results when economic agents with coinciding interests cannot be brought together
to trade. However, in this case, falling demand is responsible for the decline of industries like video
rentals and print newspapers. Even if the government attempted to bring together economic agents in
these industries, it is unlikely that demand for rented videos and newspapers will increase.
10. Are all efficient outcomes also equitable? Explain.
Answer: Equity is concerned with the distribution of resources across society. An efficient outcome is one
that maximizes social surplus. However, maximizing social surplus is not always consistent with equity
considerations. An economy can make the most efficient use of the resources that it has but at the same
time, these resources may not be equally distributed in society.
11. Are there real-world markets that resemble double oral auctions? Suppose you had to organize a
double oral auction for a good that has perfectly elastic demand. Do you expect prices to approach the
competitive equilibrium?
Answer: Double oral auctions are similar to how trading actually works on stock exchanges—traders
announce bids and asks and if they match, a trade is executed.
Double oral auction experiments with many different market variants - including varying the elasticity of
supply and demand and the numbers of buyers and sellers - have shown that the equilibrium price in the
market will be very close to where the supply and demand curves intersect. So, the price in a double oral
auction for a good with perfectly elastic demand is also expected to approach the equilibrium price.
12. Imagine you are a buyer in a double oral auction with a reservation value of $10 and there is a seller
asking $8.
a. How much will you gain from accepting this offer?
b. If you are the only buyer, and you know that the lowest ask price is $2, should you accept this
offer?
Answers:

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 Chapter 7 | Perfect Competition and the Invisible Hand 73

a. By accepting this offer, you will gain $2 ($10 – $8).

b. Yes. By accepting this offer, you will gain $8 ($10 – $2). If you choose to accept an offer from a
different seller, your surplus will be lower. By accepting the lowest ask price of $2, you will
maximize your surplus from this trade.

Problems
1. The following diagram shows the market demand and market supply for sweaters. Calculate
consumer surplus, producer surplus, and social surplus in this market.

Answer: Producer surplus is the area of triangle I and is equal to ½ x 100 x (60 – 20) = 2000. Consumer
surplus is the area of triangle II and is equal to ½ x 100 x (90 - 60) = 1500. Social surplus is the sum of
consumer surplus and producer surplus and is equal to 1500 + 2000 = 3500.

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 Chapter 7 | Perfect Competition and the Invisible Hand 74

2. Consider the supply and demand shown in section 7.1 of the textbook (graphed in exhibit 7.2).
Suppose the price were limited to $55 at minimum (a “price floor”).
a. At the price of $55, which people buy? What is the consumer surplus?
b. At the price of $55, two iPhones will be purchased, but there are 5 willing sellers. What is the
highest possible producer surplus? What is the lowest possible producer surplus?
Answers:
a. Madeline and Katie will buy. Surplus is $70-$55 = $15 for Madeline and $60-$55 = $5 for Katie,
for a total consumer surplus of $20.
b. The highest possible producer surplus would be achieved when Tom and Mary sell, for a total of
$45 + $35 = $80; surplus for an individual is $55 minus the reservation value. The lowest
possible producer surplus would be achieved when Phil and Adam sell, for a total of $15 + $5 =
$20.

3. There are four consumers willing to pay the following amounts for an electric car:
Consumer 1: $70,000 Consumer 2: $20,000 Consumer 3: $80,000 Consumer 4: $40,000
There are four firms that can produce electric cars. Each can produce one car at the following costs:
Firm A: $30,000 Firm B: $60,000 Firm C: $40,000 Firm D: $20,000
Each firm can produce at most one car. Suppose we wanted to maximize the difference between
consumers’ willingness to pay for electric cars and the cost of producing those cars; that is, we wanted
to maximize social surplus.
a. How many electric cars should we produce?
b. Which firms should produce those cars?
c. Which consumers should purchase those cars?

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 Chapter 7 | Perfect Competition and the Invisible Hand 75

d. Find the maximum social surplus in the electric car market.

Answers:
a. We should produce three cars. The value of the fourth car would be just $20,000 and would cost
$60,000 to produce.

Consumers Firms

(I) (II)

$80,000 3 $20,000 D

$70,000 1 $30,000 A

$40,000 4 $40,000 C

$20,000 2 $60,000 B

b. The three lowest cost firms should produce: Firms A, C, and D

c. The three consumers who value electric cars the highest should own electric cars: Consumers 1,
3, and 4.
d. Willingness to pay of the consumers = $80,000 + $70,000 + $40,000 = $190,000
Total Cost = $20,000 + $30,000 + $40,000 = $90,000
Social surplus = $190,000 – $90,000 = $100,000
4. Let us continue with the electric car example from problem 3. Suppose the market for electric cars is
competitive.
a. Show that the equilibrium price in this market is $40,000.
b. Which firms will produce an electric car if the price is $40,000?
c. Which consumers will buy an electric car when the price is $40,000?
d. Calculate consumer, producer surplus, and social surplus when the price is $40,000.
e. Compare your answers to those for problem 3.
Answers:
a. When the price is $40,000, three consumers (all except 2) are willing to buy an electric car
because their willingness to pay is greater than or equal to price. Three firms (all except B) are
willing to sell an electric car since their cost is less than or equal to the price. Therefore supply
equals demand when the price is $40,000.
b. Firms A,C, and D
c. Consumers 1,3 and 4
d. Consumers 1, 3, and 4 are willing to pay a total of $80,000 + $70,000 + $40,000 = $190,000 for
three cars. At a price of $40,000 they will pay 3 x $40,000 = $120,000 for those cars. Therefore
consumer surplus equals $190,000 - $120,000 = $70,000. It will cost Firms D, A, and C a total of
$20,000 + $30,000 + $40,000 = $90,000 to produce those cars. At a price of $40,000 their
revenues equal 3 x $40,000 = $120,000 Therefore producer surplus equals $120,000 - $90,000 =

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 Chapter 7 | Perfect Competition and the Invisible Hand 76

$30,000. Social surplus is the sum of consumer and producer surplus. Therefore, social surplus
equals $70,000 + $30,000 = $100,000.
e. The point here is that competitive markets lead to efficiency. The market outcome here leads to
the maximum social surplus we found in problem 3.
5. Sara and Jim are going to lunch together and rank the restaurant options in the following way. Which
restaurants are Pareto efficient?

Sara’s Preferences Jim’s Preferences

Chipotle 4th 3rd

Naf Naf 1st 4th

Panera 2nd 5th

Potbelly 3rd 2nd

Blaze 5th 1st

Answer: Naf Naf, Potbelly, and Blaze are Pareto efficient. Chipotle is not Pareto efficient since both Sara
and Jim are better off going to Potbelly. Naf Naf is Pareto efficient since Sara is worse off anywhere else.
Panera is not Pareto efficient since both Sara and Jim are better off at at Naf Naf. Potbelly is Pareto
efficient since Chipotle and Blaze are worse for Sara, yet Naf Naf and Panera are worse for Jim. Finally,
Blaze is Pareto efficient since Jim is worse off anywhere else.

6. The market for electric drills in a certain country is characterized by a large number of buyers and
sellers and every buyer who wants a drill and can afford one has bought one. In other words, the
market for drills is in equilibrium.
a. Does this also mean that it is Pareto efficient? Explain your answer.
b. If some of the buyers in this market are now willing to pay more than they did earlier, would your
answer change?
Answers:
a. An outcome is Pareto efficient if no individual can be made better off without making someone
else worse off. A competitive market maximizes social surplus which means there are no further
gains from trade. A gain from trade would imply that two people (a buyer and a seller) are made
better off (while all others are not affected). This means that if there were a gain from trade, the
market would not be Pareto efficient. However, since there are no such gains from trade, the
market is Pareto efficient.
b. Initially the market may not be efficient if the price has not had time to adjust upward. However,
once a new equilibrium price is achieved, the market will be Pareto efficient as before.

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 Chapter 7 | Perfect Competition and the Invisible Hand 77

7. Compared to the market for cars, the market for vintage buttons has fewer buyers and sellers. Social
surplus is likely to be higher in the market for cars than in the vintage button market. Is it then correct
to assume that the outcome in the car market is Pareto efficient while in the vintage button market it is
not? Explain.

Answer: No. The outcome in both markets are Pareto efficient. Pareto efficiency is not a concept meant to
judge whether one market is better than another market. Instead, it is intended to judge whether an
outcome is acceptable, relative what else could have happened within a particular market.

8. The following tables show a small firm’s long-run average cost of manufacturing a good at two
different plants:
Plant 1
Quantity Total Average Cost Marginal Cost
Cost
1 50
2 106
3 164
4 224
5 287
6 355
7 430
8 520
9 618

Plant 2
Quantity Total Cost Average Cost Marginal Cost
1 20
2 52
3 90
4 130
5 175
6 227
7 285
8 345
9 407

a. Complete the third and fourth columns of each table.

b. Suppose the price of the good is $60. How much should the firm produce in each plant in order to
maximize the firm’s profit? Find the firm’s profit.
c. A new manager is assigned to the production department. He thinks that the firm can profitably
move all production to Plant 2 since the average cost of production is lower in Plant 2 than in

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 Chapter 7 | Perfect Competition and the Invisible Hand 78

Plant 1. If the firm only uses Plant 2, how much should it produce in order to maximize profits?
Find the firm’s profit. Assume zero fixed cost.
Answer:
a.
Plant 1
Quantity Total Cost Average Cost Marginal Cost
1 50 50.00 50
2 106 53.00 56
3 164 54.67 58
4 224 56.00 60
5 287 57.40 63
6 355 59.17 68
7 430 61.43 75
8 520 65.00 90
9 618 68.67 98

Plant 2
Quantity Total Cost Average Cost Marginal Cost
1 20 20.00 20
2 52 26.00 32
3 90 30.00 38
4 130 32.50 40
5 175 35.00 45
6 227 37.83 52
7 285 40.71 58
8 345 43.13 60
9 407 45.22 62
b. Since the price of the good is $60, profits are maximized when marginal cost of production is
equal to $60 at both plants. This occurs when 4 units are produced at Plant 1 and 8 units are
produced at Plant 2. The firm’s revenue will be 12 x $60 = $720, its total costs will be $224 +
$345 = $569, and it will earn a profit of $720 - $569 = $151.
c. If the firm uses just Plant 2 it would maximize profits by producing just 8 units (since price
equals marginal cost in Plant 2 at 8 units). Its revenue will be 8 x $60 = $480, its cost will be
$345, and its profit will be $480 - $345 = $135.
9. You run a small classroom market experiment with only three buyers and three sellers. The
willingness to pay (reservation value) for buyer A is $7; for buyer B it is $5; and for buyer C it is $3.
The willingness to accept (reservation value) for seller X is $2; for seller Y it is $4; and for seller Z it
is $6.
a. Sketch the supply and demand in this market.
b. What is the equilibrium quantity?

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 Chapter 7 | Perfect Competition and the Invisible Hand 79

c. What is the social surplus given this outcome?

d. What if in your experiment, seller X and buyer C agree to a price of $2.50, seller Y and buyer B
agree to a price of $4.50, and seller Z and buyer A agree to a price of $6.50. All participants have
managed to find a trade that benefits them individual, and yet this is not an efficient outcome. In
terms of social surplus, why not?
Answer:

a. See diagram.

b. Q = 2, where supply and demand intersect.

c. The area between the two curves is ($7-$2) + ($5-$4) = $6. This is the maximum possible social
surplus. It could be achieved with any price from $4 to $5, so long as A and B buy (total benefit
of $7 + $5 = $12), while X and Y sell (total cost of $2 + $4 = $6) for a surplus of $12 - $6 = $6.

d. The total surplus would be total benefit minus total cost, or ($7+$5+$3)-($6+$4+$2)=$3; this is
less than the $6 social surplus from before. Fortunately, in practice this sort of outcome is rare
since either buyer A would be unlikely to pay such a high price ($6.50) or seller X would be
unlikely to agree to accept such a low price ($2.50); most likely they would match up with each
other and agree to a better price for both. This would squeeze buyer C and seller Z out of the
market, which is a good thing in terms of social surplus.

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 Chapter 7 | Perfect Competition and the Invisible Hand 80

10. Suppose a market for cheap sunglasses is in a long-run competitive equilibrium and that the price is
$10. Every producer of sunglasses sells 5,000. A cloudy summer decreases the demand for
sunglasses, which causes the market price to change. As a consequence, in the short run, will each
firm sell more sunglasses, fewer sunglasses, or the same number of sunglasses? Also, describe what
will happen in the long run?
Answers: Market demand shifts in, which causes the market price to drop. In the short run, each
individual firm will produce fewer than 5,000 sunglasses (they will slide down and to the left along the
marginal cost curve). In the long run, some firms will exit, which will shift the supply curve to the left,
until the price rises back to $10. Each firm will return to producing 5,000 sunglasses.
11. The equilibrium rent in a town is $500 per month and the equilibrium number of apartments is 100.
The city now passes a rent control law that sets the maximum rent at $400. The diagram below
summarizes the supply and demand for apartments in this city.

a. Use the figure to complete the table below

Before Rent After Rent Control Change
Control
Consumer Surplus

Producer Surplus

Social Surplus

b. Use your answers to part (a) of this problem to answer the following questions:
i. Did consumer surplus definitely rise, definitely remain constant, definitely fall, or is the
direction of the change in consumer surplus unclear?

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 Chapter 7 | Perfect Competition and the Invisible Hand 81

ii. Did producer surplus definitely rise, definitely remain constant, definitely fall, or is the
direction of the change in producer surplus unclear?
iii. Did social surplus definitely rise, definitely remain constant, definitely fall, or is the
direction of the change in social surplus unclear?
Answer:
a. The completed table is as follows:
Before Rent After Rent Control Change
Control
Consumer Surplus I + II I + III III – II

Producer Surplus III + IV + V V – III – IV

Social Surplus I + II + III + IV + V I + III + V – II – IV

b. As shown in the table:

i. The change in consumer surplus is III – II and so it is not clear if consumer surplus rose
or fell. The consumers who rent those 60 apartments that are available under rent control
are better off because they now pay $400 per month instead of $500; this benefit is area
III. But the people who cannot find an apartment under rent control are worse off. They
lose the consumer surplus they realized from the 40 apartments that are no longer
available as a result of rent control; this loss is area II.
ii. Suppliers are unambiguously worse off as a result of price controls. They receive $400
per month instead of $500 per month for each of the 60 apartments they continue to offer
under rent control (area III) and they lose the producer surplus they realized from the 40
apartments they no longer offer (area IV).
iii. Total surplus falls by the sum of II (lost consumer surplus from the 40 apartments that are
no longer offered) and IV (lost producer surplus from those 40 apartments).
12. According to reports in the Chinese media, commuters in Beijing are facing a somewhat paradoxical
situation: they find it difficult to get a cab while hundreds of cabs lie idle during rush hour. The
demand for taxis in Beijing has increased as average incomes have risen. Government-determined
gasoline prices have also increased. But the government, worried about rising prices, has left the fares
cabs can charge their customers unchanged.
a. Use supply and demand curves to explain what has happened in the market for cabs in Beijing.
b. Based on your understanding of how the invisible hand works, what do you think should be done
to correct this problem?
Answers:
a. The following diagram shows the demand and supply curves for cabs in Beijing. The increase in
demand causes the demand curve to shift to the right. Since gasoline prices have increased, the
cost of running a cab in Beijing has also increased. This will shift the supply curve to the left. The
equilibrium quantity may or may not change depending on the degree to which both curves shift
but the equilibrium price in the market will increase. However, since the government does not
allow cab fares to increase, the number of cabs demanded exceeds the supply. This explains why
commuters are unable to find a cab when they need one.

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 Chapter 7 | Perfect Competition and the Invisible Hand 82

As can be seen in the figure, the increase in demand and decrease in supply have actually
increased the equilibrium price from P to P’. The equilibrium quantity should also have increased
from Q to Q’. The distance between Q0 and Q1 shows the extent by which demand exceeds supply
as a result of the price control.

Market for Cab Rides

b. An increase in demand combined with a decrease in supply implies an increase in price.

Therefore, to fix this problem, the cab fare must be allowed to increase. For the market to be in
equilibrium, fares must be allowed to increase to P’. At this price, quantity supplied will equal
demand at the quantity demanded.
See http://www.economist.com/node/21551537 and
http://www.theatlantic.com/international/archive/2013/01/its-harder-than-ever-to-catch-a-cab-in-
beijing/267239/
13. Ashley is willing to pay $7, Bill is willing to pay $5, and Carrie is willing to pay $1.
a. Sketch demand.
b. Write out the demand schedule for each integer price up to $8 ($0, $1, $2, …$8)
c. Find Consumer Surplus if price is $2.
d. What if another buyer shows up who is “willing to pay any amount” for one unit. If we take her
word at face value, what does the new demand look like?
Answers:
a. See diagram.

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 Chapter 7 | Perfect Competition and the Invisible Hand 83

b. To fill out the table, you can pick numbers off the graph, or ask yourself: Given those
willingness-to-pay values, how many people (between Ashley, Bill, and Carrie) would want to
buy? Finally, when the price is exactly equal to a person’s willingness to pay, by definition this
person is indifferent between buying and not buying. Thus, there is more than one right answer to
the question “what is quantity demanded?”
Price (P) Quantity (Q)

$0 3

$1 2 to 3

$2 2

$3 2

$4 2

$5 1 to 2

$6 1

$7 0 to 1

$8 0

c. Consumer surplus can either be viewed as an area or as the sum of some numbers. In this case it
is the surplus that Ashley enjoys ($7 - $2 = $5) and the surplus that Bill enjoys ($5 - $2 = $3), or
$8 total.
d. This shifts the entire demand one unit to the right:

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 Chapter 7 | Perfect Competition and the Invisible Hand 84

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