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 Output 7. 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. 2. 3. 4. 5. Zero economic profits Pareto efficiency impossible to make someone better off w/o hurting others Allocative efficiency (P=MC) Productive efficiency producing at min (AC) 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

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 demand not 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).

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) ii) iii) Some of these activities may be pro-competitive and not just anti-competitive. Some of these activities may lead to efficiency gains May reduce incentives to enter

Are the following pro- or ant-competitive? 1. Licensing requirements (CPA, ABA, AMA) 2. Patent

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 not the 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