Lecture 2: Perfect Competition Definition - a perfectly competitive market is where agents in the market (buyers and sellers are price takers o Price taking behavior: Agent believes that the market price is given and the agent's actions do not influence the market price o Price taking behavior implies that the demand curve facing the firm is horizontal at the market determined price Number of firms inconsequential for the assumption of competitive ehavior
1 Lecture 2: Perfect Competition Definition:- A perfectly competitive market is where agents in the market (buyers and sellers) are price takers. Price taking behavior: Agent believes that the market price is given and the agent’s actions do not influence the market price. Price taking behavior implies that the demand curve facing the firm is horizontal at the market determined price. Number of firms inconsequential for the assumption of competitive behavior
o Large just stands for enough en? o What is large number of firms th number to result in price taking b ehavior o Why use the term large? ● Two reasons o Comparing across two situations price-taking behavior seems more reasonable if there are more firms an less Imperfect competition models in the limit(i.e. as number of firms grows very big: mathematically infinity result in perfectly competitive outcome
2 What is large number of firms then? oLarge just stands for enough number to result in price taking behavior. Why use the term large? Two reasons: Comparing across two situations: price-taking behavior seems more reasonable if there are more firms than less. Imperfect competition models in the limit (i.e. as number of firms grows very big: mathematically infinity) result in perfectly competitive outcome
Technology assumption for PC ● drS or crs but not irs Firms profit maximization problem Il=pq, -TC(qu dq, dTc(u =0 First order condition P= mC Profit O*
3 Technology assumption for PC DRS or CRS but not IRS Firm’s profit maximization problem )( pq11 TC q1 0 )( 1 1 1 1 1 1 dq qdTC dq dq p dq d First order condition: P = MC
IRS→MC<AC MC pricing under irs leads to loss: Total Per unit OSS C MC
4 IRS MC <AC MC pricing under IRS leads to loss:
Perfectly Competitive equilibrium Two things characterize a perfectly competitive equilibrium o All firms maximize profit by choosing output such as price equals marginal cost o Markets clear(aggregate demand equals aggregate supply)
5 Perfectly Competitive Equilibrium: Two things characterize a perfectly competitive equilibrium oAll firms maximize profit by choosing output such as price equals marginal cost. oMarkets clear (aggregate demand equals aggregate supply)
Back to the question: Why care about perfect competition? Look at the underlying assumptions o Price taking benavior o Homogenous products o Frictionless markets(no problems with information no transaction COStS o Freedom of entry and exit Are these assumptions realistic? O No e Perfect competition has certain desirable welfare properties o Maximizes our measure of welfare Consumer surplus(CS)+ Producer Surplus(ps)added across all firms o Producer surplus same as profits 6
6 Back to the question: Why care about perfect competition? Look at the underlying assumptions oPrice taking behavior oHomogenous products oFrictionless markets (no problems with information, no transaction costs) oFreedom of entry and exit Are these assumptions realistic? oNo Perfect competition has certain desirable welfare properties. oMaximizes our measure of welfare: Consumer surplus (CS) + Producer Surplus (PS) {Added across all firms) oProducer surplus same as profits
Continued. W=CS+丌 MC Q Welfare at MC pricing: a+B+r Welfare at a higher price: a+ p Some redistribution but net loss Deadweight loss
7 Continued: n i W CS i Welfare at MC pricing: Welfare at a higher price: Some redistribution but net loss Deadweight loss
Note on zero profit condition: o If there is freedom of entry and exit then the factors of production must earn equal to normal return: (Zero profit condition e When firms make zero profit price equals average cost II=(P-AC)Q PAC Ac MC PC eqm with MC free entry PC eaim 8
8 Note on zero profit condition: If there is freedom of entry and exit then the factors of production must earn equal to normal return: (Zero profit condition) When firms make zero profit price equals average cost: P AC)( Q
Classical monopoly: Other extreme market form e Features O Single seller o Uniform price(to differentiate from price discriminating monopoly o Single plant(to differentiate from a multi plant monopoly) o Consumers still competitive o The seller has market power(is a price maker): faces a downward sloping demand curve Monopolists profit ∏=TR-TC II=PQ-TC(Q) Now price is not a constant but will vary with the output chosen by the monopolist
9 Classical Monopoly: Other extreme market form Features oSingle seller oUniform price (to differentiate from price discriminating monopoly) oSingle plant (to differentiate from a multi plant monopoly). oConsumers still competitive The seller has market power (is a price maker): faces a downward sloping demand curve. Monopolist’s profit: PQ TC Q)( TCTR Now price is not a constant but will vary with the output chosen by the monopolist
Profit maximization by the monopoly Continued o In maximizing profit the monopolist can choose either quantity or price (whichever is chosen the other follows from the demand curve we will follow the convention that monopolist chooses quantity) O FO.c 0 Q d@ o dp d 7C()=0 do d@ dQ →MR=MC Monopolist in order to maximize profits chooses an output such that marginal revenue is equal to marginal cost(makes intuitive sense, .P=100-Q, MC=10---Linear example 10
10 Profit maximization by the monopoly: Continued In maximizing profit the monopolist can choose either quantity or price (whichever is chosen the other follows from the demand curve: we will follow the convention that Monopolist chooses quantity) F.O.C. MCMR TC Q dQ d dQ dP Q dQ dQ P dQ d 0)( 0 Monopolist in order to maximize profits chooses an output such that marginal revenue is equal to marginal cost (makes intuitive sense) P = 100- Q, MC = 10 --- Linear example