Econ 201

Chpt 14:

Perfect Competition

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Overview of Market Structures

Quick Reference to Basic Market Structures        

Market Structure Seller Entry Barriers Seller Number Buyer Entry Barriers Buyer Number

Perfect Competition No Many No Many

Monopolistic competition No Many No Many

Oligopoly Yes Few No Many

Oligopsony No Many Yes Few

Monopoly Yes One No Many

Monopsony No Many Yes One

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Overview• market structure describes the state of a market with respect to

competition.• The major market forms are:

– Perfect competition, in which the market consists of a very large number of firms producing a homogeneous product.

– Monopolistic competition, also called competitive market, where there are a large number of independent firms which have a very small proportion of the market share.

– Oligopoly, in which a market is dominated by a small number of firms which own more than 40% of the market share.

– Oligopsony, a market dominated by many sellers and a few buyers. – Monopoly, where there is only one provider of a product or service. – Natural monopoly, a monopoly in which economies of scale cause

efficiency to increase continuously with the size of the firm. – Monopsony, when there is only one buyer in a market.

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Basic Assumptions• Atomicity

– There is a large number of small producers and consumers on a given market,• each so small that its actions have no significant impact on others.

– Firms are price takers, meaning that the market sets the price that they must choose. • Homogeneity

– Goods and services are perfect substitutes; that is, there is no product differentiation. (All firms sell an identical product)

• Perfect and complete information – All firms and consumers know the prices set by all firms

• Equal access – All firms have access to production technologies, and resources are perfectly mobile.

• Free entry – Any firm may enter or exit the market as it wishes (no barriers to entry).

• Individual buyers and sellers act independently – The market is such that there is no scope for groups of buyers and/or sellers to come

together to change the market price (collusion and cartels are not possible under this market structure)

• Behavioral assumptions of perfect competition are that:– Consumers aim to maximize utility – Producers aim to maximize profits.

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Firm’s Output/Supply Decision

• In the short-run – MC curve >= min(AVC)

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The Shut-down Point (price)

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Short-run Profitability• In the short-run, it’s possible for a firm (or

firm’s) to earn above a normal rate of return (or an economic profit)

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Long-run Profitability• Positive economic profit cannot

be sustained– Entry of new firms causes:

• Market supply curve to shift to the right

• Lowering the market equilibrium price and

• Lowering each firm’s demand curve (or constant price)

– In the long run, the firm will make only normal profit (zero economic profit). Its horizontal demand curve will touch its average total cost

curve at its lowest point

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In the long-run, entry will dissipate short-run economic profits

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How Can There Be Short-run Profitability?

• In the short-run, different firms may have different scale/technology – Operate in different parts of the LRAC– In the long-run - all will adopt least cost

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Top Pot Donuts

• On April 8, Top Pot is slated to be in all company-owned Starbucks Corp. stores in 50 states, the companies said Thursday.

• "This is a big, big leap for us and something we are really proud of," said Mark Klebeck, one of Top Pot's three co-founders.

• Klebeck said Top Pot currently is in about 5,000 Starbucks locations in 25 states.

• Starbucks, at the end of last year, had 7,087 company-owned stores in the U.S., but it was not disclosed how many stores would be operating in April as the company is slowing down its growth. Starbucks had an additional 4,081 licensed stores and has more than 15,000 stores worldwide.

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Strategy and Policy

• Firms would prefer to avoid perfect competition.

– Firms become victims of their own efficiency.

– In the short-run, if one firm adopts a cost-savings technology -> short-run economic profits

– In the long-run -> others will imitate and reduce their costs

• Price-taker -> can’t affect market price

– No control over it’s (firm’s) demand

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What Do Economist LikeAbout Perfect Competition?

• Perfectly Competitive Markets – Allocative efficient and productive efficient

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Pareto Efficiency

• Allocative Efficiency:– When price is equal to its marginal costs

• Consumers’ (marginal) value of last (marginal) unit equals the resource’s marginal cost

• Opportunity costs (value) of alternative use of resource is given by marginal cost

• Productive Efficiency– Goods are produced at minimum cost

• In the long-run: competitive firms produce at minimum of LRAC

– Economic welfare is maximized• Sum of consumer and producer surplus

• Technological Innovation

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The Long-Run Supply Curve

• Consider an increase in demand:

– The increase in demand leads to an increase in price.

– The higher price causes firms to earn an economic profit.

– Economic profits cause new firms to enter the market.

– As new firms enter, the price falls.

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Long-Run Supply Curves

• Types– Constant cost -> no change in price– Decreasing cost -> price will fall– Increasing cost -> price will increase

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Dynamics

• What does the supply expansion path tell us about industry costs?

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The Long-Run Supply Curve in an Constant-Cost Industry

• An constant-cost industry is an industry in which production costs remain unchanged as the industry expands.– As a result, price is driven back down to the initial

level by the entry of new firms.

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The Long-Run Supply Curve in a Constant-Cost Industry

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The Long-Run Supply Curve in an Increasing-Cost Industry

• An increasing-cost industry is an industry in which production costs increase as the industry expands.– As a result, price cannot be driven back down to the

initial level by the entry of new firms.

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The Long-Run Supply Curve in an Decreasing-Cost Industry

• A decreasing-cost industry is an industry in which production costs decrease as the industry expands.– As a result, price will be driven below the initial level

by the entry of new firms.

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The Long-Run Supply Curve in Increasing- and Decreasing-Cost

Industries

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Dynamics

• Expansion path tells us in which portion of the cost curve the industry operates in

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Summary

• Perfect competition is the least concentrated of the four market structures.

• The model of perfect competition assumes a large number of buyers and sellers, an identical product, perfect information, and freedom of entry and exit.

• Perfectly competitive firms are price takers.

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Summary (cont’d)

• Perfectly competitive firms maximize profit by producing the level of output for which marginal revenue equals marginal cost.

• A perfectly competitive firm’s supply curve is the portion of the short-run MC curve above AVC.– The market supply curve is found by summing the

individual firms’ supply curves.

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Summary (cont’d)

• In the long run, perfectly competitive firms earn zero economic profits.

• The long-run supply curve shows the quantity that all firms are willing to supply at different prices.

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