Outline. Perfect CompetitionQ * 5. Intuition of Perfect Competition. Graphs of Perfect Competition. Perfect Competition 6/24/2009

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1 Outline K. Graddy Industrial Organization Understanding ifferences Between Short Run and Long Run Elasticities Contestable t Markets Sources of Barriers to Entry First Theorem of Welfare Economics 1 Intuition of Graphs of Basic Assumptions Homogeneous Perfectly ivisible Output Perfect Information No Transaction Costs Price Taking No Externalities P * Firm demand curve Industry Supply Curve Industry emand Curve S 3 4 price Consumer Surplus MR=AR=p P c = uantity Q * 5 Q c 6 1

2 Math of Profits = Revenue - Costs π = R - C FOC : MR = π = p C( ) maxπ = p C( ) p C'( ) = 0 p = C'( ) SHORT RUN EQUILIBRIUM OF THE FIRM SUPER NORMAL PROFIT LOSS SHORT RUN SUPPLY CURVE OF THE FIRM SRS is the curve above AVC SRS AVC Short run Supply Curve of the Industry In the short run the number of firms is fixed (No entry or exit) Therefore Industry SRS is simply the horizontal sum of all the current Firms SRS curves AJUSTMENT TOWARS LONG RUN EQUILIBRIUM P FIRM INUSTRY THEREFORE, WITH IENTICAL FIRMS, HORIZONTAL LONG RUN INUSTRY SUPPLY CURVE P FIRM INUSTRY 1 1 LRS SRS 1 SRS 1 SRS SRS 1 Q 1 Q Q 3 Q 1 Q 1 Q 3 Q 11 1

3 Efficiency of Output is produced at Minimum Average Cost Price is eual to Minimum Average Cost Supernormal Profit competed away Zero Economic Profit remains Price is eual to Marginal Cost 13 What happens if firms aren t identical? Can positive economic profits be consistent with long run competitive euilibrium? What is the marginal cost of the last unit sold if firms are not identical and one firm is capacity constrained (ie is it the of the high cost firm or the low cost firm)? How much profit do the less efficient firms earn? In the long run competitive euilibrium, must 14 the profit of the marginal entrant be zero? Elasticity of demand: Percentage change in output resulting from a 1% change in price. η = ΔQ/Q ΔP/P slope η= ΔQ P ΔP Q Elasticity is units free normalization Elasticity is not the same as the slope More elastic Higher slope Lower slope Less elastic 15 Constant Slope Constant Elasticity 16 Why elasticity declines down the demand curve. However, we often say: P o slope = Q 1 - Q 0 = Q 3 - Q -P 0 - (elastic) (inelastic) Q 0 Q 1 Q Q 3 perfectly elastic perfectly inelastic P o /Q o > /Q Elasticity at P o, : (Q 1 -Q 0 )*P 0 Elasticity at, : (Q 3 -Q )* ( -P 0 )*Q 0 ( - )* Q

4 Elasticities and Revenue iscussion: Is a Fish Market Perfectly Competitive? If η < 1, demand is elastic i.e. ΔQ/Q > ΔP/P uantity effect is greater than price effect P Q R (Luxury domestic cars, η=1.91) If 1 < η < 0, demand is inelastic i.e. ΔQ/Q < ΔP/P P R (Cigarettes, η=.75) 19 0 Ultra Free Entry: Contestable Markets (Baumol 198) Assumptions Homogeneous goods Firms set prices No sunk costs Free entry and exit Entrant may enter and undercut rival before incumbent is able to respond Results: With increasing returns to scale the following conclusions are predicted There is a uniue operating firm in the industry This firm makes zero profits Average cost pricing prevails In the absence of competition, potential entry is very effective in disciplining incumbent firms this theory presents a strong argument against regulation or nationalization of utilities Criticism: Generally believed that prices adjust more rapidly than decisions about uantity or entry 1 Problems with : Barriers to Entry Bain defined a BTE as anything which allows incumbent firms to earn supernormal profits without the threat of entry. He asserted that there are four elements of market structure which give rise to barriers to entry: Barriers to Entry Economies of scale Absolute cost advantages Scarce resources Legal barriers Patents Learning Product ifferentiation Location Switching costs Complementary goods Capital Raising Reuirements 3 4 4

5 In Conclusion: First Theorem of Welfare Economics Conclusion Markets in Competitive Euilibrium are Pareto Efficient in the Long Run and Short Run Contestable Markets Sources of Barriers to Entry First Theorem of Welfare Economics 5 6 5

Managerial Economics & Business Strategy Chapter 9. Basic Oligopoly Models

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