PERFECT COMPETITION

Chpt 12

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.

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Overview of Market Structures

Quick Reference to Basic Market Structures        

Market Structure Seller Entry Barriers # of Sellers Buyer Entry Barriers # Buyers

Perfect Competition No Many No Many

Monopolistic competition No Many No Many

Oligopoly (few firms) Yes Few No Many

Oligopsony (few buyers) No Many Yes Few

Monopoly (one firm) Yes One No Many

Monopsony (one buyer) No Many Yes One

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Basic Assumptions: Perfect Competition

Atomicity ◦ There is a large number of small producers and consumers on a given market,

◦ each so small that its actions have no significant impact on others. ◦ Firms are price takers, meaning that the market sets the price that they must choose.

Homogeneity ◦ Goods and services are perfect substitutes; that is, there is no product differentiation. (All firms sell an identical product)

Perfect and complete information ◦ All firms and consumers know the prices set by all firms

Equal access ◦ All firms have access to production technologies, and resources are perfectly mobile.

Free entry ◦ Any firm may enter or exit the market as it wishes (no barriers to entry).

Individual buyers and sellers act independently ◦ 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:◦ Consumers aim to maximize utility/well-being◦ Producers aim to maximize profits.

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What is a Competitive Market?

Competitive market◦ Market with many buyers and sellers◦ Trading identical products◦ Each buyer and seller is a price taker◦ Firms can freely enter or exit the market

Implying◦ No firm or individual has any “market power”

◦ No ability to set or effect market equilibrium price

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Profit Maximizing Rule Quantity (Q)

◦ How many driveways did Mr. Plow clear?

Price (P)◦ Price charged per driveway

Total Revenue (TR)◦ TR = P Q

Total Costs (TC)◦ Sum of all production costs at a certain level of output

Profit (π)◦ π = TR – TC

Profit Maximizing Rule Marginal Revenue (MR)

◦ MR = ΔTR ÷ ΔQ◦ Δ = change in◦ For a competitive firm, MR = P

Marginal Cost (MC)◦ MC = ΔTC ÷ ΔQ◦ Additional costs of producing additional units

Profit Maximizing Rule Change in Profit

◦ ΔProfit = MR – MC

Profit maximizing rule:◦ To maximize profits, the firm should use a marginal analysis

◦ Profit is maximized by choosing the level of output such that

MR = MC

Profit Maximizing Rule Profit is maximized by choosing the level of output such that

MR = MC

If MR > MC◦ The firm can increase profits by producing more Q

If MR < MC◦ The firm has produced “too much” Q, and profits are not

maximized