Econ 200 Econ 201 Lecture

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					   Econ 201
   Lecture 19

Perfect Competition
• market structure describes the state of a market with respect to
• 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.
                      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
•   Behavioral assumptions of perfect competition are that:
     –   Consumers aim to maximize utility subject to a budget/income constraint
     –   Producers aim to maximize profits by minimizing costs of production
  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
  – Economic profits cause new firms to enter the market.
  – As new firms enter what happens to the new
    equilibrium price?
     • price falls if there are economies-of-scale
     • price is unchanged if constant-returns-to-scale
     • price rises if increasing-returns-to-scale
        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)
                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
          How Can There Be
         Short-run Profitability?
• Unexpected increase in demand
• Or 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
• Industry costs (LRAC) determines the
  supply-expansion path
The Long-Run Supply Curve in a
    Constant-Cost Industry
 The Long-Run Supply Curve in
Increasing- and Decreasing-Cost
• After the fact: Expansion path tells us in
  which portion of the cost curve the industry
  operates in
           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

• Price-taker -> can’t affect market price
   – No control over it’s (firm’s) demand
            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.
      What Do Economist Like
     About Perfect Competition?
• Perfectly Competitive Markets
  – Allocative efficient and productive efficient
               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
• Economic welfare is maximized
   – Sum of consumer and producer surplus

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