Perfect Competition 10-26-2010 Econ 100 Lecture 5.1 Perfect Competition 10-26-2010

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.

Basic Assumptions Atomicity Homogeneity 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 subject to a budget/income constraint Producers aim to maximize profits by minimizing costs of production

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 what happens to the new equilibrium price? price falls if there are economies-of-scale price is unchanged if constant-returns-to-scale price rises if increasing-returns-to-scale

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)

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

How Can There Be Short-run Profitability? Unexpected increase in demand Or in the short-run, different firms may have different scale/technology Operate in different parts of the LRAC In the long-run - all will adopt least cost

Dynamics Industry costs (LRAC) determines the supply-expansion path

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

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

Dynamics After the fact: Expansion path tells us in which portion of the cost curve the industry operates in

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

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.

What Do Economist Like About Perfect Competition? Perfectly Competitive Markets Allocative efficient and productive efficient

Pareto Efficiency Allocative Efficiency: Productive Efficiency When price is equal to its marginal costs 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