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CHAPTER 3: ECONOMICS OF PERFECT COMPETITION

Assumptions:

1. Homogeneous good

2. Price taking

3. No transaction costs

4. No externalities

5. Free entry and exit

6. Perfect divisibility of Output7. Perfect knowledge or information

While perfect competition does not exist in the real world, it is an extremely useful benchmark

with desirable properties. Some assumptions may not be needed (e.g. 5) or may be relaxed and

still obtain similar or identical results.

A single firm will produce so as to maximize profits in S-R equilibrium.

Produce where P = MC (marginal cost pricing)

Shutdown if P < min (AVC) the shutdown price

Firms supply curve is MC above AVC

Shutdown Decision:

Shutdown if: Profit (Loss) < - Sunk Costs

Revenue < Avoidable Costs

Quasi-rents = Revenue Avoidable Costs

= Payments above min. to operate

Hold-up problem:

Opportunistic behavior with incomplete contracts whereby quasi-rents are extracted from

agents with large unavoidable costs.

Market Supply Curve:

S-R: Horizontal sum of MC above AVC

L-R: Flat at the breakeven price (min AC) unless

Expansion of output causes prices of inputs to rise or fall

Properties in L-R Competitive Equilibrium

1. Zero economic profits

2. Pareto efficiency impossible to make someone better off w/o hurting others3. Allocative efficiency (P=MC)

4. Productive efficiency producing at min (AC)

5. Welfare, in a static sense, is maximized, where:

Welfare = Consumer Surplus + Producer Surplus

Welfare = CS + PS

Difficulties:

Welfare will not be maximized when:

There are economies of scale

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Large firms are more innovative (Schumpeter hypothesis)

ELASTICITY

For price elasticity of demand the minus sign is not used and may be ignored.

= ( Q / Q ) / ( P / P )

If is close to zero, demand is said to be inelastic.

If is far from zero, demand is said to be elastic.

In perfect competition, demand will be perfectly elastic and price-cost margins will be zero.

Firms with market power will have positive price-cost margins and demands that are relatively

inelastic.

RESIDUAL DEMAND

The residual demand curve is the demand curve that an individual firm faces and is the demandnot met by other firms in the market. It is the excess demand and the elasticity will depend on

the elasticity of market demand and elasticity of supply of the other firms.

For firms with small market share with face a demand curve that is much more elastic than the

market demand curve (i.e., a price taker).

EFFICIENCY AND WELFARE

Competitive equilibrium yields two desirable efficiency properties:

1. Production is performed with the least cost method.

2. Consumption takes place where P = MC.

Both production and consumption are Pareto efficient.

A common measure of welfare is CS + PS. Competitive equilibrium maximizes CS + PS (static).

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ENTRY & EXIT

Competitive process functions well when

Firms adjust well to changes in the economic environment

The process pressures firms to operate efficiently

Innovation is rewarded

Inefficiency is punished

This requires

Ability to enter (or potential to enter contestability)

Incentives and signals to enter

Easy exit, otherwise reluctant to enter if the probability of failure is high

The competitive process will not function well when there are barriers to entry.

Barrier to Entry: Advantage to an incumbent. Cost that must be incurred by a new entrant that

incumbents do not bear. (asymmetric)

Structural or Static Barriers to Entry (Exogenous):1. Economies of Scale intrinsically not a barrier unless the extent of the market is limited.

Large scale production may that requires large capital expenditures (with

imperfect capital markets)

Large sunk costs (threats of strategic behavior prevent entry)

2. Absolute Cost Advantage

Control a crucial input

Patent

Location

3. Product Differentiation

Brand name recognition

First-mover advantage Advertising

Strategic Barriers to Entry (Endogenous):

1. Pricing Strategies

Pre-emptive (before entry)

Retaliatory (after entry)

2. Commitments

Excess capacity

Advertising

3. Patents

4. Product Differentiation

Note:

i) Some of these activities may be pro-competitive and not just anti-competitive.

ii) Some of these activities may lead to efficiency gains

iii) May reduce incentives to enter

Are the following pro- or ant-competitive?

1. Licensing requirements (CPA, ABA, AMA)

2. Patent

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Welfare loss in LR Equilibrium with Entry Restrictions

(graph here)

Competition with Few Firms Contestability

Contestability is a situation with few firms, but no entry barriers. The moral being that it is notthe number of incumbent firms, but the entry/exit conditions that matter.

Perfectly Contestable: Markets with free entry and exit (no sunk costs) not dependent on the

number of firms. No sunk costs allows for hit-and-run tactics by outside firms.

Examples:

1. Residential garbage collection

Economies of scale in small town (natural monopoly)

Easy entry and exit

Competitive bidding allows for lowest possible cost

2. Airlines

Appear to have low costs of entry between city pairs for airlines already in operation

hence contestable

Empirical evidence says it is not contestable (concentration between city pairs does

influence the price)

Problems

1) Capacity constraints (pre-9/11)

2) Obtaining gates

3) Obtaining landing/departure slots

4) Advertising (entry barrier)

EXTERNALITIES

Third party or spillover effects can be positive or negative. Occur when property rights are

not clearly defined.

Lead to (private) market failures.

Public Goods (positive externality)

1. Information

2. National defense

3. Highways

Public Bads (negative externality)

4. Pollution (poorly defined property rights over the air and water)

5. Congestion