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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