1. Perfect Competition 2-5-2008
Econ 100 Lecture 5.4
Perfect Competition

2. 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.

3. 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

4. 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

5. 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)

6. 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

7. 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

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

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

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

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

12. 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

13. 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.

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

15. 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