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Perfect Competition
Perfectly Competitive Industries have the following features:
1.
2.
3.
4.
5.
There are many firms and each one is small relative to the size of the
market
There are no entry or exit barriers
Each firm produces an identical product: no differences in appearance,
location, brand names, or other attributes
Everyone in the economy knows the production technology and market
price
All firms are price takers
The Firm’s Problem
Each firm in the market chooses its output to maximize its profit taking the market
price as given:
maxq p = pq – c(q) – f
p is the market price
c(q) is the firm’s variable cost function
f is the firm’s fixed cost
At the optimal output choice, price equals the marginal cost of production
p = c’(q) = mc
Equilibrium
Equilibrium in perfectly competitive markets occurs through entry and exit
In equilibrium, p = 0
If p > 0, entry occurs; if p < 0, exit occurs
If the industry is initially in equilibrium and a shock occurs, entry and exit occur
instantly to restore the zero-profit condition
Entry and exit occur instantly because there are no entry or exit barriers
Examples of shocks:
The demand curve shifts
The variable cost function changes
Fixed costs change
No real-world industry satisfies all of the conditions of the perfect competition
model. All models are simplified representations of reality designed to provide
us with intuition. If the five conditions are close to being satisfied, the model
has important implications for analyzing industries, particularly in the long
run:
1.
Economic profits above or below zero do not persist for long. Entry and exit
occurs to eliminate non-zero profits.
2.
Positive demand shocks lead to entry, while negative demand shocks lead to
exit. Long run effects on market price and firm size are negligible.
3.
If fixed costs fall, market price and firm size fall, while market quantity and
the number of firms rise
4. If the marginal cost curve shifts down, market price falls, while firm size and
the market quantity rise. The effect on the number of firms is ambiguous
Welfare Analysis
Economists typically assess social benefits or costs using “total surplus,” which is
a measure of value added or gains from trade
Calculating surplus:
Suppose that a consumer is willing to pay $10 for a good
Suppose a firm can produce the good for $6
Suppose the market price of the good is $7
Then total surplus is 10 – 6 = 4, the difference between the consumer’s willingness
to pay and the firm’s cost
Producer surplus is 7 – 6 = 1, which is equal to firm profits if there are no fixed
costs
Consumer surplus is 10 – 7 = 3
Social Optimality of Perfect Competition
Under some conditions, perfect competition yields socially optimal outcomes
Condition 1: Ignore technological progress and consider only current output
Firms may require the prospect of positive profits in order to invest in
technological progress, which is one of the main drivers of economic growth
Condition 2: Assume there are no externalities
An externality: a cost or benefit generated by an agent’s action where the agent
does not pay the cost or receive the benefit
Example: when a child cleans his room he may not benefit but his mom does
A Simple Example of Maximizing Welfare
1. A good can be produced at a constant marginal cost of $1
2. Each consumer is willing to buy at most one unit of the good
3. Each consumer’s willingness to pay for a unit of the good is in between $0 and
$10
Recall that maximizing total welfare requires maximizing total surplus
Maximizing total surplus requires that if a consumer’s willingness to pay exceeds
the marginal cost, the consumer should receive a unit of the good, because
total surplus rises
If willingness to pay is less than the marginal cost, the consumer should not
receive a unit, because total surplus would fall
Perfect Competition uses the price system to achieve socially optimal outcomes
In a perfectly competitive equilibrium, the price equals the marginal cost
Every consumer whose willingness to pay exceeds the price buys a unit of the
good
Thus, if willingness to pay exceeds marginal cost, the consumer obtains a unit;
otherwise he does not
Welfare is maximized
Departures from Perfect Competition
1.
Market Power
Large firms exist in most markets
Often at least one firm is large enough to influence the market price by adjusting
output
Large firms may also have cost advantages due to economies of scale
Economies of scale exist when average cost falls as output rises
Large firms can often price above marginal cost and earn positive economic
profits
In a static setting, this ability (referred to as market power) tends to reduce welfare
In a dynamic setting, the prospect of obtaining market power encourages
innovation
2. Product Differentiation
Most firms differentiate their products
Differentiation has social benefits because consumers have more choices
Differentiation also has social costs:
It is costly to differentiate products
Differentiation may allow firms to obtain market power
Differentiation and product proliferation may create entry barriers
Thus, the welfare effect of product differentiation cannot be determined without
putting further structure on the environment
3. Barriers to Entry
Typically, entry is costly (exit may be too)
In perfect competition, entry and exit is critical; if it cannot occur then the
equilibrium changes
Definition: A barrier to entry is a cost of producing which is borne by new
entrants but not by established firms
Determining whether something is a barrier to entry can be tricky
Assessing the welfare implications of a particular barrier is even more tricky
Consider patents, for example
Examples of Barriers to Entry:
Absolute Cost or Quality Advantages
Firms in the market might have superior knowledge, resources, and capabilities
that are hard to duplicate
Trade secrets: the formula for Coca-Cola
Location: a mining company sitting on gold
Learning curves: cost advantages may be obtainable only with production
experience
Advantages associated with scope: IBM produces many electronics products. If its
scope is important for its success, a potential entrant may have to produce
many products. This could cause coordination problems and increase
management costs for the entrant.
Other Barriers to Entry
Capital Requirements
Economies of Scale
Product Differentiation and Brand Names
Government-created and Legal Barriers, such as patents and copyrights
Getting around Entry Barriers
Entry barriers protect firms that are earning positive economic profits
The prospect of earning positive economic profits provides potential entrants with
an incentive to try to get around entry barriers
Two ways to get around entry barriers:
1. Innovate: In the late 1980’s, the rise of Drexel Burnham Lambert in
investment banking was mainly due to new approaches to financing
2. Differentiate: When Japanese firms entered the motorbike industry they did so
with small dirtbikes
Monopoly
Monopolized Industries have the following features:
1.
There is a single firm, the monopolist
2.
There are high entry barriers
3.
The monopolist produces a unique product with no close substitutes
4.
The monopolist often has private information about its production
technology and costs
5.
The monopolist faces the entire market demand curve and can
influence the market price
The Monopolist’s Problem
The monopolist chooses its output to maximize its profit taking the market
demand curve as given:
maxq p = p(q)q – c(q) – f
p(q) is the market inverse demand curve
c(q) is the firm’s variable cost function
f is the firm’s fixed cost
At the optimal output choice, marginal revenue equals the marginal cost
mr = p’(q)q + p(q) = c’(q) = mc
The Monopolist’s Markup
Rearranging the monopolist’s first-order condition,
p ( 1 + p’(q)q/p ) = c’(q)
p ( 1 + 1/e ) = c’(q)
where e = q’(p)p/q, the price elasticity of demand (which is negative,
because demand is downward sloping)
Clearly, price exceeds marginal cost:
p – c’(q) = – p/e
Equilibrium Profits
Recall that in perfectly competitive markets, entry drives economic profits
down to zero
Monopolists are protected by high entry barriers
Thus, they can sustain economic profits greater than zero
If the industry is initially in equilibrium and a shock occurs, it is possible
that no entry occurs in response
The monopolist may adjust its output in response to a shock
Welfare Analysis
Industry profits are maximized under monopoly
However, because the monopolist prices above marginal cost, some
potential gains from trade are unrealized. Thus, monopoly does not
maximize total welfare.
The unrealized potential gains from trade are referred to as “deadweight
losses”: they are an unambiguous loss, not a transfer from one
economic agent to another
One qualification: in the presence of negative externalities, monopoly may
lead to higher total welfare than perfect competition, because the
monopolist restricts output
Benefits of Monopoly
The prospect of obtaining monopoly profits can encourage socially
beneficial activities, not just rent seeking
For example, innovations may lead to new products, improve existing
ones, or lower production costs
Without the incentive of monopoly profits, firms might innovate less
This is the main argument for having a patent system – a patent assigns
the property right on an invention
Property rights on inventions are particularly critical when inventing
requires large sunk costs but imitating requires relatively small sunk
costs
For example, pharmaceuticals
Oligopoly
Oligopolies have the following features:
1. There are a few large firms and there may be many small firms
2. There may be high or low entry barriers, but it is typically not easy to
become large
3. The firms typically produce differentiated products
4. Production processes may be differentiated and the firms may possess
private information about their production technologies and costs
5. The oligopolists (the large firms) are engaged in strategic interaction:
they all have some market power, and a given oligopolist’s optimal
strategy depends on the other oligopolists’ strategies
Most Real-World Industries are Oligopolies
It is unusual to observe an industry with no large firms or only one large
firm
Typically some firms are larger and more profitable than most of their
competitors
Firms differ along many dimensions: products, production processes,
organizational forms, brand names, location, distribution networks, etc.
Those that are able to sustain profits above the norm in their industry are
said to have a “competitive advantage”
The source of a competitive advantage is typically some resource or
capability that is difficult to imitate (particular technologies, trade
secrets, brand names, etc.)
Industry Concentration
Concentration ratios measure the number and relative size of the large
firms in the market
Generally, the higher the concentration ratio, the closer the industry
structure is to the monopoly extreme
The lower the concentration ratio, the closer the industry structure is to the
perfectly competitive extreme
We expect that deadweight losses are higher in more concentrated
industries
Mergers in highly concentrated industries tend to attract more attention
from antitrust authorities than those in less concentrated industries
Static vs. Dynamic Views of Concentration
In a static (one-period) framework, high concentration is bad, because it
creates deadweight welfare losses
Policy makers may be tempted to break up firms to create smaller ones,
with the goal of approximating perfect competition
The differential efficiency hypothesis is that large firms are large and
profitable because they are more efficient – they have cost advantages
or better products
Thus, high concentration and high profits are observed together because
differential efficiency causes some firms to become large and
profitable
Implications of Differential Efficiency
If the differential efficiency hypothesis is correct, breaking up firms in
highly concentrated industries is not a good idea
Breaking up these firms would punish them for being efficient and
discourage investments that improve efficiency
Empirical tests strongly support the differential efficiency hypothesis: a
firm’s profit is strongly correlated with its market share
In contrast, there is typically only a weak positive association between
industry profit and concentration