Perfect Competition

Perfectly Competitive Industries have the following features:

1. There are many firms and each one is small relative to the size of the market

2. There are no entry or exit barriers

3. Each firm produces an identical product: no differences in appearance, location, brand names, or other attributes

4. Everyone in the economy knows the production technology and market price

5. 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 = 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

EquilibriumEquilibrium in perfectly competitive markets occurs through entry and exit In equilibrium, = 0 If > 0, entry occurs; if < 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 shiftsThe variable cost function changesFixed 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(q)q – c(q) – f

p(q) is the market inverse demand curvec(q) is the firm’s variable cost functionf 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