Chapter 12Perfect competition arises:When firm’s minimum efficient scale is small relative to market demand so there is room for many firms in the industryWhen each firm is perceived to produce a good or service that has no unique characteristics, so consumers don’t care which firm they buy fromIn order to maximize economic profit, the perfectly competitive firm must decide:How to produce at minimum costWhat quantity to produceWhether to enter or exit a marketAt shutdown pointAVC is at its minimumMC curve crosses AVC curveFirm is indifferent between producing and shutting downIncurs a loss equal to TFC from either actionFirms enter marketMarket supply increasesMarket price fallsFirms make zero economic profit in long runFirms exit marketMarket supply decreasesMarket price rises until firms make zero economic profitPermanent increase in demandEconomic profit induces entryIncreases short-run supplyShifts short-run market supply curve rightwardAs market supply increases, price falls and market quantity continues to increase.With falling price, each firm decreases its output as it moves along its marginal cost curve (supply curve).New long-run equilibrium occurs when price has fallen to equal minimum average total costFirms make zero economic profit, and firms have no incentive to enter the marketThe main difference between the initial and new long-run equilibrium is the number of firms. In the new equilibrium, a larger number of firms produce the equilibrium quantity.New TechnologiesAre constantly discovered that lower priceEnables firms to produce at lower average cost and lower marginal costFirm’s cost curves shift downwardFirms that adopt new technology make economic profitNew-technology firms enter, old-technology firms exit or adopt new technologyIndustry supply increases, industry supply curve shifts rightwardPrice falls and quantity increasesEventually, new long-run equilibrium emerges in which all firms use the new technology, price equals minimum average total cost, each firm makes zero economic profitChoicesConsumer’s demand curve shows how best budget allocation changes as price of a good changesConsumers get the most value out of their resources at all points along demand curvesWith no external benefits, market demand curve is the marginal social benefit curveCompetitive firm’s supply curve shows how the profit-maximizing quantity changes as the price of a good changesFirms get the most value out of their resources at all points along supply curveWith no external cost, market supply curve is marginal social cost curveIn competitive equilibrium…Resources are used efficiently – quantity demanded equals quantity supplied, so marginal social benefit = marginal social costGains from trade for consumers is measured by consumer surplusGains from trade for producers is measured by producer surplusTotal gains from trade = total surplusIn long-run equilibrium total surplus is maximizedChapter 13Three types of barriers to entry:Natural – creates Natural MonopolyOwnershipLegal – creates Legal MonopolyTwo types of monopoly price-setting strategiesSingle-price monopolyPrice discriminationIf demand is elastic,a fall in price brings an increase in total revenueIncrease in revenue from increase in quantity sold outweighs the decrease in revenue from the lower price per unitMarginal revenue is positiveAs the price falls, total revenue increases.If demand is inelastic,A fall in price brings a decrease in total revenueRise in revenue from increase in quantity sold is outweighed by the fall in revenue from lower price per unitMR is negativeAs price falls, total revenue decreases.If demand is unit elastic,Fall in price does not change total revenueRise in revenue from increase in quantity sold equals fall in revenue from lower price per unitMR=0, which means total revenue is maximizedRent seekers pursue their goals in two main ways:Buy a monopoly – transfers rent to creator of monopolyCreate a monopoly – uses resources in political activityTo be able to price discriminate, a monopoly must:Identify and separate different buyer typesSell a product that cannot be resoldA monopoly can discriminate:Among units of a good. (ex. Quantity discounts)Among groups of buyers (ex. Advance purchase on airline tickets)The more perfectly a monopoly can price discriminate, the closer its output is to the competitive output (P=MC) and the more efficient is the outcome. This outcome differs from outcome of perfect competitions:The monopoly captures the entire consumer surplusThe increase in economic profit attracts even more rent-seeking activity that leads to inefficiencyTwo theories about how regulation works are:Social interest theoryCapture theoryHow can the firm cover its costs and at the same time obey the marginal cost pricing rule?Where possible, a regulated natural monopoly might be permitted to price discriminate to cover the loss from marginal cost pricingNatural monopoly might charge a one-time fee to cover its fixed costs and then charge a price equal to marginal cost.Average cost pricing ruleGovernment might pay a subsidy equal to the monopoly’s lossRegulators use one of two practical rules:Rate of return regulationPrice cap regulationChapter 14The presence of a large number of firms in the market implies:Each firm has only a small market share and therefore has limited market power to influence the price of its productEach firm is sensitive to the average market price, but no firm pays attention to the actions of others. So no one firm’s actions directly affect the actions of others.Collusion, or conspiring to fix prices, is impossible.Product differentiation enables firms to compete in three areas:Quality – design, reliability, and servicePriceMarketingTwo key differences between monopolistic competition and perfect competition:Excess capacityMarkupDownward sloping demand curve in monopolistic competition because:Firms produce less than the efficient scaleFirms operate with positive markupPerfectly elastic demand curve for firms in perfect competition because:No excess capacityNo markupIs Monopolistic Competition efficient?Price = marginal social benefitMarginal cost = marginal social costPrice exceeds marginal cost, so marginal social benefit exceeds marginal social costIn long run produces less than efficient quantityAdvertising expenditures affect the firm’s profit in two ways:Increase costsChange demandChapter 15Chapter 12Perfect competition – an industry in
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