Perfect Competition
Price takers are firms with perfectly elastic demand curves - can sell everything at market price, but if they go higher, they sell nothing. Market price is a given. This is equivalent to perfect competition.
Assumptions:
- All firms in market produce identical products
- Large number of independent firms
- Each seller small relative to size of total market
- No barriers to entry/exit
Firms increase production until MR=MC, thus maximizing economic profit. For a price taker, MR = Price = demand curve = horizontal line.
- Economic loss occurs for any units sold where MR < MC
- To find economic profit, total revenue less total costs
- Equal to a rectangle at Q with horizontal line at ATC
- In equilibrium, firms will not earn economic profits for any significant time
- Firms enter and price decreases to ATC
- All firms just produce at the minimum of the ATC curve
Firm should still operate if P < ATC but still greater than AVC - as long as you are covering some of your fixed costs, operate
- If P = AVC, this is the shutdown point - if P < AVC, losses will be greater than fixed costs
- Shutting down will limit losses to fixed costs
Long run equilibrium output level for perfect competition is MR = MC = ATC
Short run supply curve is the MC line above the AVC. Market is the sum of these curves.
Changes in Demand, Entry/Exit, Plant Size
- Increase in mkt demand - increase P and Q in short run
- Firms expand production and enter
- Decrease does opposite
- Firms either decrease production (downsizing) or shut down in long run
- If an industry is characterized by economic profits, firms enter and drive down price by shifting supply curve outward
- Individual firms produce less though, because price is lower - move along its own supply curve
- Therefore, total revenue and economic profit will decrease
- If industry characterized by economic losses, firms exit and drive up price, firms produce more, and total revenue will increase and economic loss will decrease
Permanent changes in demand/tech
- Permanent change in demand - leads to entry or exit of firms from industry
- Demand shifts out
- Price increases, Q increases
- Firms realize economic profit
- New firms enter
- Supply curve shifts out
- Come back to initial price
- Firms produce more in aggregate, but each go back to same production
- Long run eq price might be higher or lower after increase in demand
- Depends on effect of demand for inputs
- External economies of scale - input prices fall because of greater demand
- Negative sloping industry supply curve
- External diseconomies of scale - increase demand leads to greater prices
- Positive sloping industry supply curve
- Technological changes
- Take some time to set in - costly
- Supply curves shift to the right and supply more product at lower price
- First movers will earn economic profits
- New firms will be attracted
- Existing firms will experience economic losses - adopt new tech or exit
Monopoly
Characterized by one seller of a specific, well defined product with no good substitutes. Barriers to entry are high.
- Legal barriers - e.g. patents, copyrights, and govt franchises (USPS), utilities
- Natural barriers - large economies of scale, e.g. electric utility.
- Downward demand curve - unlike price takers, monopoly must set price so that P and Q maximize profits (assuming no price discrimination)
To maximize profit, expand output so MR = MC
- Does not attract other market entrants due to barriers - thus economic profits exist
- Demand must lie above ATC in order to make profit
- Profit = (P - ATC) * Q
- Monopolists are price searchers and have imperfect information regarding demand
- Must experiment to find profit max'ing quantity
Price discrimination - charging different customers different prices for same product
- To work, must have downward demand curve and at least two groups of customers with different price elasticities of demand
- Must also be able to prevent sellers from reselling the product
- Compared to perfect competition, monopoly reduces consumer surplus by DWL triangle
- Less than efficient quantities are being produced
- Price discrimination reduces DWL and gain accrues to firm
- With perfect price discrimination, there would be no DWL - would all go to monopolist
Note there is still consumer surplus in a monopoly with single price. But both PS and CS are lower in monopoly than in perfect competition. Further loss from monopoly is rent seeking - producers spend time/resources trying to make a monopoly
Gains from Monopolies
- Natural Monopoly: Economy where scale benefits are so pronounced that ATC is minimized when only one firm operates
- Given economies of scale, having a second firm would increase ATC significantly
- Economies of scope can also lead to natural monopoly
- Expand product range so ATC decreases
- Regulators might aim to improve resource allocation
- Average Cost Pricing - force monopolist to price where ATC meets demand
- Monopolist gets 'normal' profit
- Marginal Cost Pricing - aka efficient regulation - force monopolist to reduce to where firm MC meets market demand
- This requires a subsidy because now price is below ATC and otherwise firm would leave the market
- Lack of information - ATC, MC, market demand unknown
- Cost shifting - firm has no incentive to reduce costs, since regulators will reduce price. Firm can just allow costs to rise and regulator will allow prices to increase
- Quality - easier to regulate price than quality - firm may reduce quality in a profit squeeze
- Special interest - firm might influence through regulatory board/lobbying
Monopolistic Competition and Oligopoly
Monopolistic Competition
- Large number of independent sellers, each relatively small, no power over price; firms pay attention to average mkt price, not individual competitors' price, and too many firms to collude
- Differentiated products, but close substitutes
- Firms compete on price, quality, and marketing. Can set price, but usually strong correlation between quality and price you can charge. Marketing informs about differentiations of products.
- Low barriers to entry - if there are economic profits, firms expected to enter.
Demand curves are highly elastic bc of substitutes. E.g. toothpaste market.
Oligopoly
- Small number of sellers
- Interdependence among competitors (decisions made by one firm affect the other)
- Significant barriers, often large economies of scale
- Products may be similar OR differentiated
Highly dependent on actions of rivals. E.g. the automobile mfg market.
Under monop comp, you still go where MR = MC to max profits
- P is greater than MC, so this is inefficient - but remember, there is product diff.
- Question becomes, is there an economically efficient level of product diff
- Efficiency is unclear in monop comp
- Important aspects
- Product innovation - can earn profits, but then subs come in, so must spend more to innovate again - MR of innovation should equal the MC of innovation
- Advertising - expenses are high for monop comp. Greater than for perfect comp or monopolies. Increases ATC curve. But can also increase revenue and might be worth it and decrease ATC. (not sure on this last point - increases profit but doesn't ATC still increase?)
- Brand names - provide signals about quality. Valuable to firm.
Oligopoly - Kinked Demand Curve Model
- Assumes an increase in product price will not be followed by competitors, but a decrease will
- Each firm believes demand curve is flatter above a given price, and steeper beneath
- Above the kink, firm will lose market share; below, the price decrease cost will swamp the quantity increase benefit
- Thus you should produce at the kink to maximize profit
Oligopoly - Dominant Firm Model (alternative to Kinked Demand model)
- One of the firms has a cost advantage - produces relatively large portion of industry output
- Dominant firm basically acts as a monopolist and others are price takers
Oligopoly Games / Prisoners' Dilemma
- Profit maximized when both firms agree to hold up a higher price - act as a monopoly together
- MR for industry = MC for industry
- If one firm cheats on the agreement, he will make even more but industry profit will not be as high
- If both firms cheat, they are back to the perfect competition result
- Both firms' dominant strategy is to cheat no matter what the other firm does
- Probability of collusion is greater when cheating is easy to detect, when there are fewer firms, when threat of new entrants is lower, and when laws enforcing anti-colluding laws are weaker
End of reading
3:00 pm
1.75 hours
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