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IDE 3r

IDE 3r

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Published by Arina Farihan Azhar

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Published by: Arina Farihan Azhar on Dec 08, 2011
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CHAPTER 3: ECONOMICS OF PERFECT COMPETITIONAssumptions:1.Homogeneous good2.Price taking3.No transaction costs4.No externalities5.Free entry and exit6.Perfect divisibility of Output7.Perfect knowledge or informationWhile perfect competition does not exist in the real world, it is an extremely useful benchmark with desirable properties. Some assumptions may not be needed (e.g. 5) or may be relaxed andstill obtain similar or identical results.A single firm will produce so as to maximize profits in S-R equilibrium.
Produce where P = MC (marginal cost pricing)
Shutdown if P < min (AVC) theshutdown price
Firm’ssupply curveis MC above AVCShutdown Decision:Shutdown if: Profit (Loss) < - Sunk CostsRevenue< Avoidable CostsQuasi-rents = Revenue Avoidable Costs= Payments above min. to operateHold-up problem:Opportunistic behavior with incomplete contracts whereby quasi-rents are extracted fromagents with large unavoidable costs.Market Supply Curve:S-R: Horizontal sum of MC above AVCL-R: Flat at the breakeven price (min AC) unless
Expansion of output causes prices of inputs to rise or fallProperties in L-R Competitive Equilibrium1.Zero economic profits2.Pareto efficiency – impossible to make someone better off w/o hurting others3.Allocative efficiency (P=MC)4.Productive efficiency – producing at min (AC)5.Welfare, in a static sense, is maximized, where:
Welfare = Consumer Surplus + Producer Surplus
Welfare = CS + PSDifficulties:Welfare will not be maximized when:
There are economies of scale
Large firms are more innovative (Schumpeter hypothesis)ELASTICITYFor priceelasticityof demand the minus sign is not used and may be ignored.ε = ( Δ Q / Q ) / ( Δ P / P )If ε is close to zero, demand is said to be inelastic.If ε is far from zero, demand is said to be elastic.In perfect competition, demand will be perfectly elastic and price-cost margins will be zero.Firms with market power will have positive price-cost margins and demands that are relativelyinelastic.RESIDUAL DEMANDThe residual demand curve is the demand curve that an individual firm faces and is the demandnot met by other firms in the market. It is the excess demand and the elasticity will depend onthe elasticity of market demand and elasticity of supply of the other firms.For firms with small market share with face a demand curve that is much more elastic than themarket demand curve (i.e., a price taker).EFFICIENCY AND WELFARECompetitive equilibrium yields two desirable efficiency properties:1.Production is performed with the least cost method.2.Consumption takes place where P = MC.Both production and consumption are Pareto efficient.A common measure of welfare is CS + PS. Competitive equilibrium maximizes CS + PS (static).
ENTRY & EXITCompetitive process functions well when
Firms adjust well to changes in the economic environment
The process pressures firms to operate efficiently
Innovation is rewarded
Inefficiency is punishedThis requires
Ability to enter (or potential to enter – contestability)
Incentives and signals to enter
Easy exit, otherwise reluctant to enter if the probability of failure is highThe competitive process will not function well when there are barriers to entry.Barrier to Entry:Advantage to an incumbent. Cost that must be incurred by a new entrant thatincumbents do not bear. (asymmetric)Structural or Static Barriers to Entry (Exogenous):
Economies of Scale– intrinsically not a barrier unless the extent of the market is limited.
Large scale production may that requires
large capital expenditures
(withimperfect capital markets)
Large sunk costs (threats of strategic behavior prevent entry)2.Absolute Cost Advantage
Control a crucial input
 Product Differentiation
Brand name recognition
First-mover advantage
AdvertisingStrategic Barriers to Entry (Endogenous):1.Pricing Strategies
Pre-emptive (before entry)
Retaliatory (after entry)2.Commitments
Excess capacity
Product DifferentiationNote:i)Some of these activities may be pro-competitive and not just anti-competitive.ii)Some of these activities may lead to efficiency gainsiii)May reduce incentives to enterAre the following pro- or ant-competitive?1.Licensing requirements (CPA, ABA, AMA)2.Patent

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