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Lecture 9
Markets without market power:
Perfect competition
Market power
• Market power:
Ability to control, or at least affect, the terms and conditions
of the exchanges in which one participates
• According to traditional neoclassical view:
– Market power is considered to be bad: It can create
inefficiency
– Competition is considered to be good: the image of a
self-regulating, harmonious, «free» competitive market
is at the core of this view
Perfect competition
•
Assumptions of the traditional neoclassical model which we
had so far are still valid.
•
PLUS some additional assumptions:
– There are numerous small sellers and buyers, so small that
no individual seller or buyer can affect the market price.
– Only one kind of good or service is traded. All units of this
good or service are identical, therefore, buyers don’t care
from which seller they buy.
– Producers can freely enter or exit the industry.
– Buyers and sellers have perfect information: They know
where the good is available, at what prices it is offered, and
whether profits are being made.
Perfect competition
• Further assumptions (cont’d):
– Firms have smooth curves with short-run diminishing
returns (convexity and marginal thinking)
– Long-run minimum efficient scale of each producer is
fairly small (relative to the demand for the output of the
industry): constant returns to scale
– The market is assumed to operate in the following
manner:
• Everyone (hypothetically) gathers together.
• Someone compiles all the offers to buy and to sell and
based on that he/she determines the market-clearing
price (a hypothetical «auctioneer»)
• The price is announced, everyone who wants to exchange
at this price does so.
Perfect competition
• So,
– Every individual seller is price-taker
– Each individual seller faces a horizontal (perfectly elastic)
demand curve: he/she can sell as many units as she wants, as
long as he/she charges the market price
(BUT NOTE THAT market supply and market demand may have
various other slopes!)
Perfect competition
• Any examples?
– Agricultural products, for instance, wheat??
– Financial resale markets, for instance, for
shares of certain companies
– Some labor markets
Profit maximization under perfect competition
• Competitive equilibrium:
The equilibrium in a market where all buyers and sellers are pricetakers, unable individually to influence the price they pay or charge
• How much will each producer sell?
It depends on demand for the product and on the firm’s cost
structure
Profit maximization under perfect competition
How much economic profit will the profit-maximizing competitive
firm make? Zero!!
– Zero economic profit (or normal profit):
Revenues are just sufficient to compensate for the use of labor,
materials, and other physical inputs, financial and physical capital, and
the time inputs—all evaluated at their opportunity costs
– Positive economic profit (or above-normal or supernormal
profit)
The amount by which revenues exceed all economic costs (incl.
opportunity costs)
BUT WHY ZERO?
Profit maximization under perfect
competition
The profit-maximizing firm in case of perfect competition will
make zero economic profits in the long-run, because of the
free entry and exit of firms into the industry!
Efficiency and equity in case of perfect
competition
Perfectly competitive markets are efficient and lead to the best
possible outcomes, if:
– There are no production and consumption externalities
(neither positive nor negative)
– There are no public goods
– All cost and effects are captured in this static model (i.e.,
there are no effects spread out over time)
– Society is not concerned about distribution (i.e., the current
distribution of ability to pay is considered acceptable)
THEN;
Market supply curve reflects social marginal cost of production,
and market demand curve reflects social marginal benefit of
consumption: allocative efficiency
Perfect competition and long-run
efficiency
No competitive firm will operate on the downward-sloping or
upward-sloping part of the LAC curve.
WHY?
Perfect competition and long-run
efficiency
Consumer and producer surplus
Consumer surplus:
The excess (summed over all buyers
in a market) of the amounts that
buyers would be willing to pay
for a good or service, over the
amounts that they actually pay
Consumer and producer surplus
Producer surplus:
The excess (summed over all sellers in
the market) of the amounts that sellers
actually receive, over the amounts
that would make them just willing to
supply the good or service
Deadweight loss
Deadweight loss:
The loss in efficiency (measured in
terms of consumer and producer
surplus) that arises if market transactions
take place at other than the competitive
market equilibrium level
Policy analysis: Taxation
Policy analysis: Taxation
Tax with
rather elastic demand
Policy analysis: Taxation
Policy analysis: Rent control
Rent control with
moderately elastic supply
Policy analysis: Rent control
Rent control with
perfectly inelastic supply