THE PERFECTLY COMPETITIVE MODEL
 

PERFECT COMPETITION: economic rivalry between autonomous units of capital seeking to maximize profits and avoid losses, without government intrusion.
 
 

THE PERFECT ARTICULATION OF THE INVISIBLE HAND
 
 

this does not exist in reality, but there are some approximations

Commodity & Stock Mkts. -- auction mkts.

Sports -- Free Agency

Relative to other countries the U.S. is more competitive
 
 

===================================================
 
 

Perfect Competition is based on the following ASSUMPTIONS:
 
 

1. Buyers & Sellers are price takers (Mkt. S&D=P)
 
 

2. The number of firms is large
 
 

3. There are no barriers to entry
 
 

4. Products are homogenous
 
 

5. Entry & exit are instantaneous & costless
 
 

6. There is complete information
 
 

7. Firms are profit maximizing entrepreneurial firms
 
 

*SUPPLY: a schedule of quantities of goods that will be offered to the market at various prices
 
 

PRICE TAKER--firm’s only decision is how much to produce given the mkt price. Since the firm is a profit maximizer it will produce the output that maximizes profit.

 

The FIRM’S SUPPLY CURVE will be its MC CURVE above its AVC CURVE

the firm perceives its demand curve as perfectly elastic
 
 

If there is as increase in price, firms acting in their self-interest will produce more -- even though this collectively will force P down

=============================================

TERMS: MC & MR
 
 

Profit Maximizing Condition => P = MR = MC

in other output levels will yield lower profits

 
 

CALCULATE PROFIT: TR - TC = PROFIT

not necessary to know cost to determine the level of output that maximizes profit

=============================================

ACCOUNTING PROFIT = TR - TC
 
 

ECONOMIC PROFIT = TR - (TC + implicit opportunity costs)

opportunity costs => owner’s salary

normal profit - return on owner’s capital

     => not concerned w/ profit per unit but maximizing total profit
 
 

DETERMINE PROFIT FROM A GRAPH

LR & SR CONDITION IN PERFECT COMPETITION

    SR  => zero, negative or positive
   LR => zero only

 

    => determining profit f/ TR & TC curves

 
 

    => shutdown point : the firm must pay FC whether it is operating or not -- the firm closes down if it is losing more than FC, because its cheaper to go out of business

 

SUPPLY CURVES
 

anythe Market supply curve is the horizontal sum of each firm’s MC curve

as we sum the MC curves the Mkt supply curve becomes more elastic
 
 

The Mkt supply curve is more responsive, in terms of Qs, to changes in price than the firm’s supply curve (MC curve)

WHY?

1. Increase/decrease in Qs by existing firms

2. Entry/exit of firms in the industry
 
 

    => Mkt response to an increase in demand

 

    => MKT. RESPONSE TO A DECREASE IN DEMAND

* TWO REASONS TO STUDY PERFECT COMPETITION:

1. Understand how the invisible hand works

2. As a benchmark to judge other systems
 

the Pure Theory of Monopoly assumes that there is only one firm that represents the entire industry & sells a product

with no close substitutes -- in reality firms can have local monopolies even if they are in competitive industries

Microsoft is not a Pure Monopoly, but Microsoft has Market Power 
 

Therefore, just as the market demand curve in perfect competition is downward sloping so is the monopolist’s, they both represent the entire industry
 
 

HOW ARE MONOPOLIES CREATED?

Barriers to competition

1. Legal or Political=> patents (Xerox)

2. Sociological=> ethnic bias (Jameson)

3. Unique ability=> (Microsoft & Intel)
 
 

Perfect Competition=> firm is a price taker, the firm’s output does not affect price
 
 

Monopoly=> firm is a price setter, it chooses the output level it wants to sell & that level of output affects price
 
 

SO THE MONOPOLIST TAKES THIS INTO ACCOUNT WHEN DETERMINING PRICE & OUTPUT DECISIONS
 
 

the competitive firm benefits consumers & the monopolist benefit themselves
 
 

POLAROID vs. KODAK
 
 

Perfect Competition => P = MR
 
 

where, MR = change in TR / change in Q
 
 

Monopoly => MR is NOT equal to P / except for the first unit of output
 
 

MICHAEL JACKSON vs. MADONNA
 
 

Monopoly & Profit Maximizing Output => MR = MC
 
 

Monopoly Graphically

 
 

MC curve same as perfect competition, but, it is not a Supply Curve, the Monopolist does not have a Supply Curve
 
 

Profit & the Monopolist

MR > MC increase profits by increasing Q

MR < MC increase profits by decreasing Q

MR = MC profit Max

NEGATIVE ECONOMIC PROFITS FOR THE MONOPOLIST

 

MONOPOLIST @ ZERO ECONOMIC PROFIT vs. PERFECTLY

        COMPETITIVE FIRM IN THE LONG RUN

NOTICE: PERFECT COMPETITION IN THE LR PRODUCES AT THE
                 LOWEST ATC vs. THE MONOPOLIST THAT PRODUCES
                 @ A HIGHER ATC

**************************************************************

THE NORMAL MONOPOLIST vs.

THE PRICE-DISCRIMINATING MONOPOLIST
 
 

the PRICE-DISCRIMINATING MONOPOLIST charges the highest price each consumer is willing to pay

NO CONSUMER SURPLUS

output is the same as perfect competition, but on average, charges a higher price
 

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NATURAL MONOPOLIES=> economies of scale

***************************************************
 
 

WELFARE LOSS FROM MONOPOLY

the public generally despises monopolies, because of excessive profits. Economists believe that excessive profits aren’t the problem -- welfare loss is the difficulty.
 
 

WHY? Resources are allocated inefficiently=> consumers buy less of the monopolist’s output & more of something else, relative to perfect competition.

***************************************************
 
 

PUBLIC-CHOICE ECONOMISTS => realistic critique of monopoly

Government created monopolies cause economic agent to lobby government for "monopoly rights"

RENT-SEEKING BEHAVIOR=>

rent-seeking loss=> Tullock Rectangle

Recommendation: Bid for monopoly rights

 

the expectation of guaranteed profits encourages firms to bid away profits=> so the granted monopoly will come close to zero economic profit & the government will receive the benefit, in terms of increased revenue
  ******************************************************************************************

Chapter 14

 MONOPOLISTIC COMPETITION, OLIGOPOLY &
                                   STRATEGIC PRICING

we have studied the extremes of market structure

now we will look at two market structures that are closer to reality=>
 

MONOPOLISTIC COMPETITION

&

OLIGOPOLY

***************************************************

Market Structures are based on the physical characteristics of the market where they interact

***************************************************

CLASSIFYING INDUSTRIES: a way to identify market structure
 
 

Standard Industrial Code (SIC): system of classifying mkts

Two Digit: broadly defined (general), more competitive

*furniture & fixtures    SIC => 22

Four Digit: specific type (subset) of industry within the broadly defined grouping

*steel office furniture    SIC => 2242
                                                                42 = steel office furniture
                                                                        a subset of furniture & fixtures
 

MEASURING MARKET STRUCTURE
 
 

Concentration Ratio: the percent of industry output (market share) that the top firms have
 
 

Most Common Concentration Ratio: four-firm concentration ratio

below 40% => Monopolistic Competition

40% - 60% => Oligopolistic

above 60% => Monopolistic
 
 

PROBLEM WITH CONCENTRATION RATIO

does not tell the whole story=> one firm could have 48% & the next three firms could have 1% each
 
 

HERFINDAHL INDEX: measure of competitiveness of an industry

the market share of all firms within an industry squared
 
 

For Example: 10 firms with a market share of 10% each

                    10² + 10² +...+ 10² = 1,000
 
 

ADVANTAGES:

1. Includes all firms in the industry

2. Gives extra weight to firms with a large market share
 
 

Rule of Thumb used by the Antitrust Division of the Justice Department=> mergers ok if less than 1,000
 

TWO EXAMPLES vs. CONCENTRATION RATIO

each example will have a four-firm concentration ratio of 51% but a much different showing in the Herfindahl Index
 
 

Ex. #1: 1 firm mkt share = 48%, next 3 = 1% each

four-firm concentration ratio = 51%
 
 

Let’s say the remaining 49% mkt share is shared equally by 49 firms, so they would each have 1% each
 
 

herfindahl index: 48² + 1² +...+ 1² = 2304 + 52 = 2356
 
 

Ex. #2: 3 firms with 13% mkt share & 1 firm with 12%

four-firm concentration ratio: 51%
 
 

Let’s say the remaining 49% mkt share is shared equally by 49 firms, so they would each have 1% each
 
 

herfindahl index: ( 3 x 13² )+ 12² + ( 49 x 1² ) =

( 3 x 169 ) + 144 + ( 49 x 1 ) =

507 + 144 + 49 = 700

*neither index can identify the mkt power of conglomerates

***************************************************
 

Monopolistic Competition:

1. Many sellers (competitive aspect) e.g. restaurants

collusion is difficult -- firms are independent
 
 

2. Product Differentiation (monopolistic aspect)

Soft drinks & tacos / advertising the difference

shifts the demand curve to the right, higher price
 
 

3. Multiple Dimensions of Competition: in perfect competition the only dimension is price

    a. Perceived quality, service & location

    b. Ease of entry by new firms in the LR

    c. No significant barriers to entry

    d. Zero economic profits in the LR
 
 

Monopolistic Competition has some monopoly power so it faces a downward sloping demand curve (its portion of the market demand curve)
 
 

Price, Output & Profit Max is the same as Monopoly

Comparing Monopolistic Competition with Perfect Competition
    Graphically this would be the same as comparing monopoly with perfect competition
 

perfect competition produces @ P=MR=MC, @ min ATC

monopolistic competition: P=ATC > MC=MR, where ATC is not @ a min
 
 

THEREFORE, increasing output will lower ATC for a monopolistic competitive firm
 
 

ADVERTISING & ECONOMIES OF SCALE

advertising shifts up the ATC curve, but if the firm can increase output enough, then ATC are lower
 
 

***************************************************

Edward Chamberlin=> Monopolistic Competition
 
 

Joan Robinson=> Imperfect Competition

***************************************************
 
 

Monopolistic Competition & Oligopoly

ECONOMIC THEORY CAN PREDICT PRICE, OUTPUT & LR PROFIT FOR MONOPOLISTIC COMPETITION, BUT NOT FOR OLIGOPOLY
 
 

WHY?
 
 

Monopolistic Competition has many sellers & the firms do not consider the response of rival firms in their decision making process

&

Oligopolistic firms are few and they consider the response of their rivals in their decision making -- so it is hard to predict!
 
 

STRATEGIC DECISION MAKING: taking explicit account of a rival’s expected response

***************************************************
 
 

OLIGOPOLY:

1. Small number of firms

2. Mutually Interdependent

*Must use strategic decision making to survive
 
 

NO SINGLE MODEL OF OLIGOPOLY

many possible output & pricing strategies
 
 

economists have developed 5 of 6 models of oligopolistic behavior -- we will study the two extremes
 
 

CARTEL MODEL: firms (oligopolists) act like a single firm, a monopoly
 
 

*firms are assigned quotas consistent w/ p maximization

*uniform pricing

ÄExplicit collusion is illegal in the U.S.
 
 

ÄInformal or implicit collusion is hard to prove

Leadership pricing
 
 

Problem with the Cartel Model: firms’ interests may not coincide

Prices tend to be sticky (Keynes)

1. Collusion

2. Expectations of other firms’ reactions
 
 

CONTESTABLE MARKET MODEL:

barriers to entry determine price/output decisions
 
 

high barriers=> acts like a monopolist

low barriers=> acts more competitive
 
 

Price Warsè strategic pricing gone wild

Prices<ATC=>losses

THE JAPANESE & GLOBAL DOMINATION
 
 

Game Theory=> The Prisioner’s Dilemma

choices: No one confesses -- each gets 6 months

One confesses -- the other gets 10 years

Both confess -- they each get 5 years

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