Lecture 16 Taking Issue with Perfect Competition

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Lecture 16Taking Issue with Perfect Competition
Relax Assumptions about Perfect Competition

1. large number of buyers and sellers in the market.
2. firms have identical costs.
3. firms produce a homogeneous output.
4. perfect information about market prices and
   profits is available.
5. entry into and exit from the industry is easy.

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• Cost differences among firms arise because of
• resource quality
• production technology
• entrepreneurial opportunity cost

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• In LR equilibrium
• type 1 firms earn a normal profit
• type 2 firms earn economic rent
• type 1 firms economic rents exist because there
  the shortage at P2

ECONOMIC RENT Economic rent is defined as the
payment to a factor of production in excess of
its opportunity cost. Most often it arises from
the fact that some resources are superior in
quality but limited in availability. The presence
of economic rent means that a resource allocation
can be efficient even though some resources earn
more than their opportunity cost. This is because
some resources have values for their next best
alternative that are substantially lower than
what they are earning in their present
occupation. Consider an example. Derek Jeter,
outfielder for the New York Yankees, earns 18.9
million per year but could earn only 100,000
working at his next best alternative, modeling
for GQ. Because of the particular features of his
resource -baseball skills- he can earn an
economic rent of 18.8 million. The Yankees pay
Derek this economic rent because the revenue
generated from ticket sales- Derek is a drawing
card-outweighs the cost of paying the extra 18.8
million. If the Yankees would not pay this rent,
Derek would play out his option and sign with a
team that would pay the 18.8 million. Derek
would continue to play ball even if his rent
fell. He leaves baseball only if his salary falls
below his opportunity cost of 100,000. Rent
could fall if the demand for baseball falls,
decreasing the demand for tickets and the
Yankees willingness and ability to pay the rent.
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Taking Issue with Perfect Competition
Relax Assumptions about Perfect Competition

1. large number of buyers and sellers in the market.
2. firms have identical costs.
3. firms produce a homogeneous output.
4. perfect information about market prices and
   profits is available.
5. entry into and exit from the industry is easy.

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Monopolistic CompetitionIndustrial Organization
Characterized by

• large number of buyers and sellers in the market.
• firms have similar costs.
• firms produce a heterogeneous output.
• ample information about the market is available.
• entry into and exit from the industry is easy.

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The Role of Heterogeneous Output

• The sources of product differences for
  monopolistically competitive firms include
• different conditions of sale
• objective differences in product characteristics
• subjective differences in product characteristics
• Each firm has some market power because
• each firm sells a different product.
• raising price will reduce but not totally
  eliminate sales.

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The Role of Large Number of Sellers

• Because there are many good close substitutes for
  a firms output
• the amount of market power is minimal
• product demand is very elastic

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Important Features of Firms with Market Power

1. MR lt P because to increase sales price must be
   lowered on all output sold not just the marginal
   unit.

Q P TR MR
0 10
1 9
2 8
3 7
4 6
5 5
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Important Features of Firms with Market Power

1. The firm operates in the elastic range of a
   linear demand curve.

Q P TR MR
0 10 0
1 9 9 9
2 8 16 7
3 7 21 5
4 6 24 3
5 5 25 1
6 4 24 -1
7 3 21 -3
8 2 16 -5
9 1 9 -7
10 0 0 -9
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• Short run decision making for the a
  monopolistically competitive firm
• produce if P gt min. AVC
• if 1., produce where MR MC
• determine P based on demand

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Case 1 earn economic profits p gt 0 ? TR gt TC ? P
gt ATC
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Case 2 break even p 0 ? TR TC ? P ATC
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Case 3 min. losses by producing p lt 0 ? TVC lt TR
lt TC ? AVC lt P lt ATC
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Case 4 min. losses by shut down p 0 ? TR lt TVC
lt TC ? P lt AVC lt ATC

• SR equilibrium conditions for the firm
• produce if P gt AVC
• if 1., produce where MR MC
• p gtlt 0

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Long Run Decision Making With Monopolistic
Competition
Will profits or losses be sustained in the long
run?
Case 1
SR p gt 0 ?
firms enter industry
? existing firms lose sales to new entrants
? ?D until p 0
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Long Run Decision Making With Monopolistic
Competition
Will profits or losses be sustained in the long
run?
Case 3
SR p lt 0 ?
firms exit industry
? remaining firms gain sales
? ?D until p 0
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Long Run Equilibrium Conditions for Monopolistic
Competition

1. P gt MC
2. MR MC
3. P ATC ? p 0 (although some firms may earn
   economic rent)
4. P gt min. ATC
5. P gt min. LRAC

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Welfare Comparison of Perfect Competition and
Monopolistic Competition
Perfect Competition
Monopolistic Competition

1. P MC value output equals value of resources
   used to produce it.
2. MR MC all firms are maximizing profits.
3. P ATC all firms earn a normal profit ? all
   resources earn exactly their opportunity cost.
4. P min. ATC all firms are fully utilizing their
   plant capacity
5. P min. LRAC all firms build the optimal plant
   size.

1. P gt MC too little output at too high of price ?
   misallocation of resources
2. MR MC all firms are maximizing profits.
3. P ATC all firms earn a normal profit ? all
   resources earn exactly their opportunity cost.
4. P gt min. ATC firms are under utilizing their
   plant capacity ? excess capacity.
5. P gt min. LRAC firms do not build the optimal
   plant size.

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Welfare Criticism of Monopolistic
Competition Resources are wasted because there
are too many firms producing too little output at
inflated prices.
Alternative View of Monopolistic Competition

• Consumers prefer what monopolistic competition
  offer over that of perfect competition.
• Consumers are willing to pay a higher price
  because the benefits of a diversified choice of
  products outweighs the cost associated with the
  under allocation of resources.
• Consumers are willing to pay a higher price
  because the benefit of the travel time saved when
  shopping outweighs the cost associated with too
  many firms underutilizing capacity.

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End Point Assignment

1. What is economic rent?
2. Why does economic rent exist?
3. When a firm has some market power, why is MR lt P?
4. What is the misallocation of resources of
   monopolist competition?
5. Can anything good be said about monopolistic
   competition?