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Home , Perfect competition

6/24/2009

Outline

• Understanding Perfect – Differences Between Short Run and Long‐Run Perfect Competition – Elasticities • CttblContestable MMktarkets K. Graddy • Sources of • First Theorem of

Perfect Competition 1 Perfect Competition 2

Intuition of Perfect Competition Graphs of Perfect Competition

Basic Assumptions Industry S • Homogeneous Perfectly Divisible Output Curve • • No Transaction Costs P* • Taking Firm curve Industry • No Demand D Curve

Perfect Competition 3 Perfect Competition 4

Perfect Competition Perfect Competition

price MC

Consumer Surplus AC

Pc MC= AC MR=AR=p

Q* quantity Perfect Competition 5 Perfect Competition 6 Qc

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SHORT‐RUN EQUILIBRIUM OF THE FIRM Math of Perfect Competition P,C MC Profits = Revenue - Costs

π = R - C AC FOC : MR = MC P3 π = pq − C(q) SUPER‐NORMAL

P2 maxπ = pq − C(q) LOSS q P1 p − C'(q) = 0 p = C'(q)

q1 q2 q3 q

Perfect Competition 7 Perfect Competition 8

SHORT‐RUN SUPPLY CURVE OF THE FIRM P,C Short‐run Supply Curve of the Industry MC SRS is the MC curve above SRS AVC • In the short run the number of firms is fixed – (No entry or exit) AC • Therefore Industry SRS is simply the horizontal P3 sum of all the current Firms’ SRS curves AVC P2

P1

q1 q2 q3 q

Perfect Competition 9 Perfect Competition 10

THEREFORE, WITH IDENTICAL FIRMS, HORIZONTAL LONG‐RUN ADJUSTMENT TOWARDS LONG‐RUN EQUILIBRIUM INDUSTRY SUPPLY CURVE P,C P P,C P MC MC D2 D2 FIRM INDUSTRY FIRM INDUSTRY

D1 D1 AC AC

P2 P2 P P 1 P1 1 P1 LRS

SRS1 SRS1 SRS SRS2 2

q q q q q 1 2 Q1 Q2 Q3 Q 1 Q1 Q3 Q

Perfect Competition 11 Perfect Competition 12

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What happens if firms aren’t Efficiency of Perfect Competition identical? • Output is produced at Minimum Average • Can positive economic profits be consistent Cost with long‐run ? • Price is equal to Minimum • What is the of the last unit sold if firms are not identical and one firm is • Supernormal Profit competed away capacity constrained (ie is it the MC of the – Zero Economic Profit remains high cost firm or the low cost firm)? • Price is equal to Marginal Cost • How much profit do the less efficient firms earn? • In the long‐run competitive equilibrium, must Perfect Competition 13 the profit of the marginalPerfect Competition entrant be zero? 14

Elasticity of demand: • is not the same as the slope Percentage change in output resulting from a 1% change in price. More elastic Higher slope η = ΔQ/Q ΔP/P Lower slope slope normalization Less elastic η= ΔQ P ΔP Q Elasticity is units free

Constant Slope Constant Elasticity Perfect Competition 15 Perfect Competition 16

Why elasticity declines down the . • However, we often say:

slope = Q1 - Q0 = Q3 - Q2 (elastic) (inelastic) Po P1 -P0 P3 -P2 P1

P2

P3 D

perfectly Q0 Q1 Q2 Q3 perfectly elastic inelastic

Po/Qo > P2/Q2

Elasticity at Po , P1: (Q1 -Q0)*P0 Elasticity at P2 , P3:(Q3 -Q2)* P2 (P1 -P0)*Q0 (P3 -P2)* Q2 Perfect Competition 17 Perfect Competition 18

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Discussion: Is a Fish Perfectly Elasticities and Revenue Competitive? • If η < ‐1, demand is elastic – i.e. |ΔQ/Q| > |ΔP/P| – quantity effect is greater than price effect – P Q R (Luxury domestic cars, η=1 .91) • If ‐1 < η < 0, demand is inelastic – i.e. |ΔQ/Q| < |ΔP/P| – P R – (Cigarettes, η=.75)

Perfect Competition 19 Perfect Competition 20

Ultra : Contestable Markets • Results: With increasing the (Baumol 1982) following conclusions are predicted – There is a unique operating firm in the industry • Assumptions – This firm makes zero profits – Homogeneous – Average‐cost pricing prevails – Firms set • In the absence of competition, potential entry is – No sunk costs very effective in disciplining incumbent firms ‐‐ this theory presents a strong argument against – Free entry and exit regulation or nationalization of – Entrant may enter and undercut rival before • Criticism: Generally believed that prices adjust incumbent is able to respond more rapidly than decisions about quantity or entry

Perfect Competition 21 Perfect Competition 22

Problems with Perfect Competition: Barriers to Entry Barriers to Entry – – – Bain defined a BTE as anything which allows Absolute cost advantages • Scarce resources incumbent firms to earn supernormal profits • Legal barriers without the threat of entry. He asserted that • Patents there are four elements of which • Learning give rise to barriers to entry: – • Location • Switching costs • Complementary goods – Capital Raising Requirements

Perfect Competition 23 Perfect Competition 24

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In Conclusion: First Theorem of Conclusion • Markets in Competitive Equilibrium are • Perfect Competition in the Long‐Run and “Pareto Efficient” Short Run • Contestable Markets • Sources of Barriers to Entry • First Theorem of Welfare Economics

Perfect Competition 25 Perfect Competition 26

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