Econ 12, Foldvary, Mankiw Chapter 14, Competition

Market structure: the conditions of competition.

Competition: two meanings.

1) rivalry; 2) The absence of pricing power.

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. 1, (.4,.6), etc.

Atomistic competition: many small firms producing the same thing with the same technology, with unrestricted entry and exit. H = 0.

The market is totally unconcentrated.

Atomistic markets are real-world.

Examples: grains, large stock and commodity markets.

"Perfect" because as far from monopoly as one can get.

But not real-world.

A model that serves as a benchmark.

Perfect competition: An absence of long-run market power by firms in an industry, an outcome of atomistic competition.

1) buyers and sellers are price takers.

Not a conditition, but a *consequence* of atomistic structure and identical product.

A firm has no control over price: price taker.

Horiz demand curve. Elastic.

Marginal revenue: = p.

Retail stores: price takers or makers? Why?

Limited number of stores & not identical product. Location.

Atomistic firm: can't sell above competitors.

Can sell all it wants at the one market price.

2) number of firms is large. No collusion.

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

Wheat, corn farming. Large stock and commodity markets.

3) no barriers to entry. No legal barriers (permits, restrictions), and the fixed costs are relatively small.

4) firms' products are homogenous (identical)

Includes location, service.

5) Exit and entry are instantaneous and costless.

For ideal perfection, but not needed for real world competition.

part of #3. Long run exit and entry sufficient.

6) Complete information.

Ideal. Real world: enough information to do business.

No patents in the field. Information is public.

7) Firms try to maximize profits. Only some need to be.

Those who don't get squeezed out.

Also 8) Economies of scale exhausted at small output.

Consequence is #2.

Short run supply curve:

Upward sloping part of the marginal cost curve.

Industry demand slopes down; firm demand perfectly elastic.

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

Commodity markets (illustrated bottom, page 241).

Profit maximized or cost minimized when MC = MR = P.

Profit = revenue minus cost.

Accounting profit uses explicit costs, money transactions.

Normal profit = implicit opportunity costs.

Economic profit = accounting profit minus normal profit.

Generally, benefits maximized when MC = Marginal Benefits.

Revenue = p*q. P always the same. MR thus = P.

If MR > MC, can profit by selling more.

If MR < MC, extra unit sells at a loss; sell less.

So profit maximized where MC = MR = P.

(Calculus proof)

Table illustrating prices, costs, profits.

Max profit at Q = 8.

Graphs of profit and loss.

Using total profit: greatest distance between TR & TC.

MC is slope of TC curve

When should a firm stay in business?

Only variable costs should be considered

- future costs that vary with output.

Shutdown point: where MC < AVC.

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

You have fixed costs even if you shut down.

Market long run: equilibrium.

Economic profits attract new firms.

Owners can make better than normal profits.

Supply curve shifts out.

Economic losess cause firms to exit, supply to shift in.

At equilibrium:

AC = MC = P. Economic Profit = 0.

Why be in business if economic profit is zero?

Normal profits. Normal wage, return on assets.

Can temporarily have entrepreneurial profits.

If a firm has below-average costs, the factors earn an economic rent; still wages, land rents, returns to capital goods.

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

Market supply: sum of invididual firms' supply.

If demand goes up: short term economic profit,

but supply up, zero profit.

Technological improvement.

Reduces costs. Economic profits. New firms enter.

Supply shifts out.

Decrease in demand.

Output falls. Firms leave.

With atomistic competition, 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.

Consumer surplus: the maximum a consumer is willing to pay minus the market cost.

Producer surplus: Market price minus the minimum a producer is willing to sell at.

The triangle representing welfare losses.

Taxes, arbitrary restrictions, create such losses.

An economy with perfect competition is Pareto optimal.

We can't make somone better off without making another worse off.

Operating at maximum efficiency.

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

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

as an approximation.