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Econ 201
Lecture 19
Perfect Competition
10-23-2008
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
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There is a large number of small producers and consumers on a given market,
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Any firm may enter or exit the market as it wishes (no barriers to entry).
Individual buyers and sellers act independently
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All firms have access to production technologies, and resources are perfectly mobile.
Free entry
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All firms and consumers know the prices set by all firms
Equal access
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Goods and services are perfect substitutes; that is, there is no product differentiation. (All
firms sell an identical product)
Perfect and complete information
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Firms are price takers, meaning that the market sets the price that they must choose.
Homogeneity
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each so small that its actions have no significant impact on others.
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:
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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:
– 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