Lecture 4(a) Competition and Monopoly

Why Bother? The first part of this course looked at the motivation and calculation of individual consumers and producers. Now we need to examine how these groups interact in a marketplace. The actual models are so unrealistic as to border on the absurd, but they provide a kind of a benchmark against which we can judge markets in the real world.

What Would a Perfectly Competitive Market Look Like? Many Buyers and Sellers, of more or less the same size. Many Buyers and Sellers, of more or less the same size. No Walmarts or Dept. of Defense No Walmarts or Dept. of Defense Homogenous Product Homogenous Product Meaning the output of one firm is indistinguishable from that of another (i.e., a commodity) Meaning the output of one firm is indistinguishable from that of another (i.e., a commodity) Perfect Information (about prices and costs) Perfect Information (about prices and costs) No Entry Barriers (we’ll have to think more carefully about exactly what this means later). No Entry Barriers (we’ll have to think more carefully about exactly what this means later).

Firm Demand is Perfectly Elastic (that is, firms are price takers) Market Demand P Q Firm Demand

All This Really Means Is That MR=P This makes perfect sense: the firm doesn’t have to cut price in order to sell more. Thus, every added unit sold increases revenue by the price of the good. This makes perfect sense: the firm doesn’t have to cut price in order to sell more. Thus, every added unit sold increases revenue by the price of the good. Of course if you like calculus: Of course if you like calculus: R = Pq and so MR = dR/dq = P

The Next Step is Describe What an Equilibrium Will Look Like in a Competitive Market An “equilibrium” is defined in economics (and most other sciences) as a state of the world in which none of the relevant variables will have a tendency to change. An “equilibrium” is defined in economics (and most other sciences) as a state of the world in which none of the relevant variables will have a tendency to change. In analyzing markets it is useful to distinguish between “short run” equilibrium and “long run” equilibrium. In analyzing markets it is useful to distinguish between “short run” equilibrium and “long run” equilibrium. The short run describes a period of time that is too short for new firms to enter the market or for existing firms to make significant adjustments to their productive capacity. (Think about how that fits in with the discussion of fixed costs and time from the previous lecture.) The short run describes a period of time that is too short for new firms to enter the market or for existing firms to make significant adjustments to their productive capacity. (Think about how that fits in with the discussion of fixed costs and time from the previous lecture.) The long run refers to a time period sufficiently long to permit new entry (or exit) and maybe capacity adjustment. The long run refers to a time period sufficiently long to permit new entry (or exit) and maybe capacity adjustment.

Short Run Equilibrium Part I: How Much Does a Typical Firm Produce? (Obvious Answer: The q such that MC=MR=P Firm Demand P MC q

Short Run Equilibrium Part II: Short Run Supply MC PoPo Firm Demand qoqo Market Supply With N Firms Nq o q1q1 P1P1 Nq 1 The “supply curve” is really just a reflection of MC

Short Run Equilibrium Part III: Putting It All Together MC PoPo Firm Demand qoqo Market Supply With N Firms Nq o Supply Demand Think About Why This is Equilibrium

Short Run Equilibrium IV: Summing Up A Short Run Equilibrium is Characterized by P=MR=MC P=MR=MC “Market Clearing Prices” (i.e., Quantity Demanded = Quantity Supplied “Market Clearing Prices” (i.e., Quantity Demanded = Quantity Supplied

Long Run Equilibrium I: What Does it Mean Since the defining characteristic of the “short run” was the assumption of no entry, the “long run” will be defined as the period of time long enough for firms to enter (or change scale). Since the defining characteristic of the “short run” was the assumption of no entry, the “long run” will be defined as the period of time long enough for firms to enter (or change scale). This means we need to ask about profits. This means we need to ask about profits.

This Can’t Happen in the Long Run MC PoPo Firm Demand qoqo Market Supply With N Firms Nq o Supply Demand AC Positive Profits

So What Would Happen in the Long Run With Positive Profits? MC PoPo Firm Demand qoqo Market Supply With N Firms Nq o Supply Demand AC Positive Profits Entry and Lower Price

What Would Happen in the Long Run If There Were Negative Profits? MC PoPo Firm Demand qoqo Market Supply With N Firms Nq o Supply Demand AC Exit and Higher Price Loss

The Long Run Equilibrium MC PoPo Firm Demand qoqo Market Supply With N Firms Nq o Supply Demand AC No (economic) profit or loss

Long Run Equilibrium: Summing Up A Short Run Equilibrium is Characterized by P=MR=MC P=MR=MC “Market Clearing Prices” (i.e., Quantity Demanded = Quantity Supplied) “Market Clearing Prices” (i.e., Quantity Demanded = Quantity Supplied) No (economic) profits or loss (P=AC min ) No (economic) profits or loss (P=AC min )

Issue: Can You Make Money (i.e., earn positive economic profits) In a Competitive Market The model says no but…. The model says no but….

A note on “stability” and competitive equilibrium An equilibrium may exist but not be “stable” An equilibrium may exist but not be “stable” Think about the “cattle cycle” or “bubbles”. Think about the “cattle cycle” or “bubbles”.

Applying the Model: SR Equilibrium and the Burden of a Tax Consider a “per unit” tax on some good (like the tax on a pack of cigarettes). Consider a “per unit” tax on some good (like the tax on a pack of cigarettes). Does it matter whether the tax is imposed on the buyer or seller? Does it matter whether the tax is imposed on the buyer or seller?

Suppose the Producer Must Pay $5 Tax Supply (no tax) Demand P no tax Supply (tax) Tax shifts the Supply by $5 P tax P net

Suppose the Consumer Must Pay $5 Tax Supply Demand (no tax) P no tax Tax shifts the demand by $5 P tax P net Demand (tax)