Econ 201

1. Econ 201 Chpt 14: Perfect Competition

2. Overview of Market Structures

3. Overview • market structure describes the state of a market with respect to competition. • The major market forms are: • Perfect competition, in which the market consists of a very large number of firms producing a homogeneous product. • Monopolistic competition, also called competitive market, where there are a large number of independent firms which have a very small proportion of the market share. • Oligopoly, in which a market is dominated by a small number of firms which own more than 40% of the market share. • Oligopsony, a market dominated by many sellers and a few buyers. • Monopoly, where there is only one provider of a product or service. • Natural monopoly, a monopoly in which economies of scale cause efficiency to increase continuously with the size of the firm. • Monopsony, when there is only one buyer in a market.

4. Basic Assumptions • Atomicity • There is a large number of small producers and consumers on a given market, • each so small that its actions have no significant impact on others. • Firms are price takers, meaning that the market sets the price that they must choose. • Homogeneity • Goods and services are perfect substitutes; that is, there is no product differentiation. (All firms sell an identical product) • Perfect and complete information • All firms and consumers know the prices set by all firms • Equal access • All firms have access to production technologies, and resources are perfectly mobile. • Free entry • Any firm may enter or exit the market as it wishes (no barriers to entry). • Individual buyers and sellers act independently • The market is such that there is no scope for groups of buyers and/or sellers to come together to change the market price (collusion and cartels are not possible under this market structure) • Behavioral assumptions of perfect competition are that: • Consumers aim to maximize utility/well-being • Producers aim to maximize profits.

5. What is a Competitive Market? • Competitive market • Market with many buyers and sellers • Trading identical products • Each buyer and seller is a price taker • Firms can freely enter or exit the market • Implying • No firm or individual has any “market power” • No ability to set or effect market equilibrium price

6. 1 Profit maximization for a competitive firm Costs and Revenue MC The firm maximizes profit by producing the quantity at which marginal cost equals marginal revenue. ATC AVC P=MR1=MR2 MC2 MC1 P=AR=MR 0 Quantity Q2 Q1 QMAX At the quantity Q1, marginal revenue MR1 exceeds marginal cost MC1, so raising production increases profit. At the quantity Q2, marginal cost MC2 is above marginal revenue MR2, so reducing production increases profit. The profit-maximizing quantity QMAX is found where the horizontal price line intersects the marginal-cost curve.

7. The Shut-down Point (price)

8. Short-run Profitability • In the short-run, it’s possible for a firm (or firm’s) to earn above a normal rate of return (or an economic profit)

9. Long-run Profitability • Positive economic profit cannot be sustained • Entry of new firms causes: • Market supply curve to shift to the right • Lowering the market equilibrium price and • Lowering each firm’s demand curve (or constant price) • In the long run, the firm will make only normal profit (zero economic profit). Its horizontal demand curve will touch its average total cost curve at its lowest point

10. In the long-run, entry will dissipate short-run economic profits

11. Strategy and Policy • Firms would prefer to avoid perfect competition. • Firms become victims of their own efficiency. • In the short-run, if one firm adopts a cost-savings technology -> short-run economic profits • In the long-run -> others will imitate and reduce their costs • Price-taker -> can’t affect market price • No control over it’s (firm’s) demand

12. Why PC Markets are EfficientWhat Economists Like About Them • Allocative Efficiency: MV=MC • Total Surplus is as large as possible • Consumers’ (marginal) value of last (marginal) unit equals the resource’s marginal cost • Opportunity costs (value) of alternative use of resource is given by marginal cost • Productive Efficiency • Goods are produced at minimum cost • In the long-run: competitive firms produce at minimum of LRAC • Economic welfare is maximized • Sum of consumer and producer surplus • Technological Innovation

13. What Do Economist LikeAbout Perfect Competition? • Allocatively efficient – way which goods are allocated to consumers results in largest gain to society • Means that Total Surplus is largest

14. 4 Productively Efficient – goods produced at least cost MC Costs 2. ...but exits if P<ATC Long run, the firm produces on the MC curve if P= min(ATC) . ATC 0 Quantity Long run: firms earn zero economic profit (opportunity costs included!)

15. In the Long Run …. • Firms choose the scale/size that minimizes costs of production for the expected level of demand

16. Incentive for Technological Innovation • Incentive is the possibility of short-run economic profits • How do PC firms earn a short-run economic profit? • “hope to get lucky” - an unexpected increase in demand • Firm has no control over that • Reduce it’s costs of production • More efficient use of resources • Better/improved technology

17. In the short-run: adopting a new/more efficient technology reduces the firm’s costs of production; allows it to earn a positive economic profit In the long-run: all surviving firms will adopt the same technology; economic profits go to zero

18. The Long-Run Supply Curve • Consider an increase in demand: • The increase in demand leads to an increase in price. • The higher price causes firms to earn an economic profit. • Economic profits cause new firms to enter the market. • As new firms enter, the price falls.

19. Long-Run Supply Curves • Types • Constant cost -> no change in price • Decreasing cost -> price will fall • Increasing cost -> price will increase

20. Dynamics • What does the supply expansion path tell us about industry costs?

21. The Long-Run Supply Curve in an Constant-Cost Industry • An constant-cost industry is an industry in which production costs remain unchanged as the industry expands. • As a result, price is driven back down to the initial level by the entry of new firms.

22. The Long-Run Supply Curve in a Constant-Cost Industry

23. The Long-Run Supply Curve in an Increasing-Cost Industry • An increasing-cost industry is an industry in which production costs increase as the industry expands. • As a result, price cannot be driven back down to the initial level by the entry of new firms.

24. The Long-Run Supply Curve in an Decreasing-Cost Industry • A decreasing-cost industry is an industry in which production costs decrease as the industry expands. • As a result, price will be driven below the initial level by the entry of new firms.

25. The Long-Run Supply Curve in Increasing- and Decreasing-Cost Industries

26. Dynamics • Expansion path tells us in which portion of the cost curve the industry operates in

27. Summary • Perfect competition is the least concentrated of the four market structures. • The model of perfect competition assumes a large number of buyers and sellers, an identical product, perfect information, and freedom of entry and exit. • Perfectly competitive firms are price takers.

28. Summary (cont’d) • Perfectly competitive firms maximize profit by producing the level of output for which marginal revenue equals marginal cost. • A perfectly competitive firm’s supply curve is the portion of the short-run MC curve above AVC. • The market supply curve is found by summing the individual firms’ supply curves.

29. Summary (cont’d) • In the long run, perfectly competitive firms earn zero economic profits. • The long-run supply curve shows the quantity that all firms are willing to supply at different prices.