Microeconomic Mondays-Perfect Competition, Producer Surplus

Economists like to look at things in extremes.  Perfect competition is one of those extremes. But, looking at a market in terms of perfect competition is extremely useful because it gives you insight into how markets react given certain changes in stimuli, and how human behavior changes.

There are some perfectly competitive markets in the world.  Traders in a trading pit are in one of the most perfectly competitive marketplaces ever constructed.  Here are the characteristics of a perfectly competitive market.

1. All firms sell an identical product.
2. All firms are price takers.
3. All firms have a relatively small market share.
4. Buyers know the nature of the product being sold and the prices
charged by each firm.
5. The industry is characterized by freedom of entry and exit.

In perfect competition, it’s critical to know the elasticity of supply.  Supply contains things that a firm can control and take variance out of.  Demand is trickier.  That’s why firms focus on supply chain management.  Here is the formula for supply elasticity.

The determinants of elasticity are:

• the extent to which production methods are flexible
• the relative importance of Fixed Costs and Variable Costs
• Availability of substitute inputs
• extent of industry competition
• short vs long run

Once you know your supply curve, you can figure out where you can attempt to price your good in the market.  Every entity is rational and tries to profit maximize.  This is also called maximizing producer surplus.  Producer surplus is defined as the difference between what the firm is willing to sell the good for, and what it actually sells it for.  Graphically, it looks like this:

For the math geeks out there, the Producer Surplus equation hinges on the marginal cost of producing one more. ∑MC=TC-FC=VC [∫MC=VC]; which is the formula for the area under the supply curve. Thus PS=TR-VC=Profit+FC=SR Profit  or,

Knowing how to calculate producer surplus will affect your strategy in the market. It will affect decisions to enter, exit, expand, and how to target the marketplace. Next week we will discuss accounting versus economic profits.

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