Perfect CompetitionThe Firm’s ProblemEquilibriumSlide 4Welfare AnalysisSocial Optimality of Perfect CompetitionA Simple Example of Maximizing WelfareSlide 8Departures from Perfect CompetitionSlide 10Slide 11Slide 12Other Barriers to EntryGetting around Entry BarriersMonopolyThe Monopolist’s ProblemThe Monopolist’s MarkupEquilibrium ProfitsSlide 19Benefits of MonopolyOligopolyMost Real-World Industries are OligopoliesIndustry ConcentrationStatic vs. Dynamic Views of ConcentrationImplications of Differential EfficiencyPerfect CompetitionPerfectly Competitive Industries have the following features:1. There are many firms and each one is small relative to the size of the market2. There are no entry or exit barriers3. Each firm produces an identical product: no differences in appearance, location, brand names, or other attributes4. Everyone in the economy knows the production technology and market price5. All firms are price takersThe Firm’s ProblemEach firm in the market chooses its output to maximize its profit taking the market price as given: maxq  = pq – c(q) – fp is the market pricec(q) is the firm’s variable cost functionf is the firm’s fixed cost At the optimal output choice, price equals the marginal cost of production p = c’(q) = mcEquilibriumEquilibrium in perfectly competitive markets occurs through entry and exit In equilibrium,  = 0 If  > 0, entry occurs; if  < 0, exit occursIf the industry is initially in equilibrium and a shock occurs, entry and exit occur instantly to restore the zero-profit condition Entry and exit occur instantly because there are no entry or exit barriers Examples of shocks: The demand curve shiftsThe variable cost function changesFixed costs changeNo real-world industry satisfies all of the conditions of the perfect competition model. All models are simplified representations of reality designed to provide us with intuition. If the five conditions are close to being satisfied, the model has important implications for analyzing industries, particularly in the long run: 1. Economic profits above or below zero do not persist for long. Entry and exit occurs to eliminate non-zero profits. 2. Positive demand shocks lead to entry, while negative demand shocks lead to exit. Long run effects on market price and firm size are negligible. 3. If fixed costs fall, market price and firm size fall, while market quantity and the number of firms rise4. If the marginal cost curve shifts down, market price falls, while firm size and the market quantity rise. The effect on the number of firms is ambiguousWelfare Analysis Economists typically assess social benefits or costs using “total surplus,” which is a measure of value added or gains from trade Calculating surplus: Suppose that a consumer is willing to pay $10 for a good Suppose a firm can produce the good for $6 Suppose the market price of the good is $7 Then total surplus is 10 – 6 = 4, the difference between the consumer’s willingness to pay and the firm’s cost Producer surplus is 7 – 6 = 1, which is equal to firm profits if there are no fixed costs Consumer surplus is 10 – 7 = 3Social Optimality of Perfect Competition Under some conditions, perfect competition yields socially optimal outcomes Condition 1: Ignore technological progress and consider only current output Firms may require the prospect of positive profits in order to invest in technological progress, which is one of the main drivers of economic growth Condition 2: Assume there are no externalities An externality: a cost or benefit generated by an agent’s action where the agent does not pay the cost or receive the benefit Example: when a child cleans his room he may not benefit but his mom doesA Simple Example of Maximizing Welfare 1. A good can be produced at a constant marginal cost of $12. Each consumer is willing to buy at most one unit of the good3. Each consumer’s willingness to pay for a unit of the good is in between $0 and $10 Recall that maximizing total welfare requires maximizing total surplus Maximizing total surplus requires that if a consumer’s willingness to pay exceeds the marginal cost, the consumer should receive a unit of the good, because total surplus rises If willingness to pay is less than the marginal cost, the consumer should not receive a unit, because total surplus would fallPerfect Competition uses the price system to achieve socially optimal outcomes In a perfectly competitive equilibrium, the price equals the marginal cost Every consumer whose willingness to pay exceeds the price buys a unit of the good Thus, if willingness to pay exceeds marginal cost, the consumer obtains a unit; otherwise he does not Welfare is maximizedDepartures from Perfect Competition 1. Market Power Large firms exist in most markets Often at least one firm is large enough to influence the market price by adjusting output Large firms may also have cost advantages due to economies of scale Economies of scale exist when average cost falls as output rises Large firms can often price above marginal cost and earn positive economic profits In a static setting, this ability (referred to as market power) tends to reduce welfare In a dynamic setting, the prospect of obtaining market power encourages innovation2. Product Differentiation Most firms differentiate their products Differentiation has social benefits because consumers have more choices Differentiation also has social costs: It is costly to differentiate products Differentiation may allow firms to obtain market power Differentiation and product proliferation may create entry barriers Thus, the welfare effect of product differentiation cannot be determined without putting further structure on the environment3. Barriers to Entry Typically, entry is costly (exit may be too) In perfect competition, entry and exit is critical; if it cannot occur then the equilibrium changes Definition: A barrier to entry is a cost of producing which is borne by new entrants but not by established firms Determining whether something is a barrier to entry can be tricky Assessing the welfare implications of a particular barrier is even more tricky Consider patents, for exampleExamples of Barriers to Entry: Absolute Cost or Quality Advantages Firms in the market might have superior knowledge, resources, and capabilities that are hard to duplicate Trade secrets: the formula for Coca-Cola Location: a mining company sitting on gold Learning