Econ 1, Foldvary, Mankiw Chapter 14, Competition

Market structure means the conditions of competition.
Competition: two meanings.
1) rivalry; 2) The degree of the absence of pricing power by firms.
Pricing power is also called "market power" (p. 289).

The meaning of "competition" in chapter 14 is pricing power.

You as a customer usually have no pricing power when you buy goods.

Market structure is measured by the concentration of the firms in an industry.

Concentration: the number and relative sizes of firms in an industry.

Measured by Herfindahl index. Sum of squares of shares.

Atomistic competition: many small firms producing the same thing with the same technology, with unrestricted entry and exit. H is close to zero.

The market is totally unconcentrated.

Examples: grains, large stock and commodity markets.

The ultimate in atomistic competition is an infinite number of tiny firms.

This is called "perfect competition" because it is a complete absence of pricing power.

It is as far from monopoly as possible.

It is not real-world, but as a pure case, it serves as a model that shows the main features, which also apply to real-world atomistic competition.

Necessary conditions of atomistic competition:

1) No barriers to entry. Firms can enter easily at low cost.

No legal barriers (patents, copyrights, permits, restrictions).

The fixed costs are relatively small.

2) the product is homogenous (identical)

The product includes the location and service.

3) The information required is readily available.

4) Economies of scale exhausted at small output.

The consequence: atomistic competition.

1) number of firms is large. Thousands.

How large: large enough so that firms have horizontal demand.

Are retail firms in atomistic competition?

2) no firm is large relative to the industry.

No firm is large enough to have pricing power.

Examples: wheat, corn farming. Large stock markets.

A firm can sell all it can produce at the prevailing market price,

just as you can buy 1000 shares of a widely-traded stock you want at the market price.

The short run supply and demand curves:

Demand: buyers and sellers are price takers (p. 290).

A consequence of many firms and identical product.

Therefore, a horizontal demand curve. Infinitely elastic.

Revenue = price * quantity.

Marginal revenue = price. Average revenue = price for Q 0.

If Q=0, AR= TR/Q= 0/0, or effectively zero. (At 0, ATC = TC/0 = infinity.)

Demand curve is the marginal-revenue curve.

We assume that the firm seeks to maximize profit.

So it will not sell below the market price.

Industry demand slopes down; firm demand perfectly elastic.

If firm can't affect price, how does price change?

The price at some moment is set at the commodity exchanges.

- Table 14.1, p. 291 - revenues

Supply curve: short run. (Draw graph.)

Marginal cost tends to increase because marginal product decreases.

Suppose the MC is U-shaped.

What is the supply curve?

The upward sloping part of the marginal cost curve.

If the marginal cost is decreasing, the profit-maximizing firm will increase output.

What quantity will the firm produce?

Profit = revenue minus cost.

If MR>MC, there is more profit with greater output.

If MR<MC, there is more profit with less output.

Profit maximized MC = MR, hence where MC=P.

At that Q, for continuous quantity, marginal profit = 0.

Calculus proof:

MR = p

= R - C = PQ-C, max where d/dQ = 0

d /dQ = dPQ/dQ - dC/dQ = MR - MC = 0


C = bQ + cQQ

MC = b + 2cQ

MR = p

p = b + 2cQ; 2cQ = p-b

Q = (p-b)/2c

Suppose C = 10Q + 2QQ

MC = 10 + 4Q

If P=50, 10+4Q=50


Q = (50-10)/2*2 = 40/4

Accounting profit uses explicit costs, money transactions.

Normal profit = implicit opportunity costs.

Economic profit = accounting profit minus normal profit.

Table 14-2 (p. 293) illustrating prices, costs, profits.

Maximum profit where TR-TC is maximized at Q = 4 or 5.

Or where MC=MR, marginal analysis.

Graphs of profit and loss, Figure 1, p. 294.

Profit = P - ATC

Figure 2, p. 295, the supply curve.

Because P=MC, rising MC is the quantity supplied at each price.

The short-run supply curve is rising MC above AVC.

When should a firm stay in business?

Shut-down means Q=0 even if the firm still exits. The output shuts down.

In the long run, the firm exists the industry and ceases to exit in that industry.

Only variable costs should be considered - future costs that vary with output.

Shutdown point: where P < AVC.

Can't do anything about fixed cost in short run.

You have fixed costs even if you shut down.

If there is MR > AVC, continue in the short run.

Figure 3, p. 297, short-run supply.

Sunk costs: past costs that cannot be recovered.

If you go fishing and the bucket of lures falls overboard into the lake, it is a sunk cost!

Is a sunk cost an opportunity cost? No. It is not really an economic cost any more!

It is really a sunk loss. It once was a cost. It is not a current cost.

Rational decisions ignore sunk losses.

If you buy a ticket for a show for $6, and your willingness to pay is $10, but you lose the ticket, should you buy a new one?

Market long run: equilibrium.

All costs are now variable.

The firm exits the industry if the price is less than the long-run average cost or ATC.

Figure 4, p. 299.

Profit implies total profit. Profit = (P-ATC)*Q.

Figure 5, p. 300.

Profit can be negative, a loss, if ATC>P.

Economic losses cause firms to exit, industry supply shifts in.

If the number of firms is fixed, the market supply is the sum of individual supplies.

Fig. 6. p. 302. But in atomistic competition, firms can enter.

All firms use the same technology and quality of inputs.

Economic profits attract new firms.

Owners can make better than the normal profits they get in other industries.

The industry supply curve shifts out.

The market price falls until the profits are squeezed out.

At equilibrium: Economic Profit = 0. ATC=P.

Why be in business if economic profit is zero?

Normal profits. Normal wage, return on assets.

Firms operate at the most efficient long-run scale.

Fig. 7, p. 303, long-run industry supply horizontal if costs do not change.

But, p. 304+, costs can and usually do rise with greater output.

The supply of suitable land is limited.

If a firm has lower costs than other firms, the firm does not get an economic profit.

Mankiw p. 307 is incorrect in saying there are economic profits.

The factors get an economic rent;

these are still wages, land rents, returns to capital goods.

The price will be bid up, so the input is a cost to the firm.

If the long-run supply curve rises and the costs of labor and capital goods are the same for all firms, the difference a lower cost is a locational advantage that goes to land rent.

Technological improvement.

Reduces costs. Short run economic profits. New firms enter. Supply shifts out.

Decrease in demand. Output falls. Firms leave.

With atomistic competition, we get max efficiency.

Firms produce at minimum cost.

When price equals marginal cost, social benefits equal social costs.

Supply is the marginal cost to society, and demand is the marginal benefit to society.

When output is restricted, costs are artificially increased.

Quantity is artificially decreased.

Less is produced than what society wants.

An economic distortion and economic waste of resources.

Real-world deviations from free-market competition constitutes a welfare loss to society.

At the optimal, consumers and producers have a maximum surplus of benefit.

An economy with perfect competition is socially optimal.

In 1959, Kenneth Arrow proved that a perfectly competitive economy is Pareto optimal.

You cannot improve the well being of one person without reducing that of another.

It is a theoretical benchmark.

Real-world markets exhibit many of the effects of perfect competition,

as an approximation.

Problem: if a lump-sum subsidy is given to all firms in an industry with atomistic competition, what happens to the output of the individual original firms?