1. Perfect Competition
Perfectly Competitive Industries have the following features:
There are many firms and each one is small relative to the size of the market
There are no entry or exit barriers
Each firm produces an identical product: no differences in appearance, location, brand names, or other attributes
Everyone in the economy knows the production technology and market price
All firms are price takers

2. The Firm’s Problem
Each firm in the market chooses its output to maximize its profit taking the market price as given:
maxq p = pq – c(q) – f
p is the market price
c(q) is the firm’s variable cost function
f is the firm’s fixed cost
At the optimal output choice, price equals the marginal cost of production
p = c’(q) = mc

3. Equilibrium
Equilibrium in perfectly competitive markets occurs through entry and exit
In equilibrium, p = 0
If p > 0, entry occurs; if p < 0, exit occurs
If the industry is initially in equilibrium and a shock occurs, entry and exit occur instantly to restore the zero-profit condition
Entry and exit occur instantly because there are no entry or exit barriers
Examples of shocks:
The demand curve shifts
The variable cost function changes
Fixed costs change

4. No real-world industry satisfies all of the conditions of the perfect competition model. All models are simplified representations of reality designed to provide us with intuition. If the five conditions are close to being satisfied, the model has important implications for analyzing industries, particularly in the long run:
1.    Economic profits above or below zero do not persist for long. Entry and exit occurs to eliminate non-zero profits.
2.    Positive demand shocks lead to entry, while negative demand shocks lead to exit. Long run effects on market price and firm size are negligible.
3.    If fixed costs fall, market price and firm size fall, while market quantity and the number of firms rise
4.   If the marginal cost curve shifts down, market price falls, while firm size and the market quantity rise. The effect on the number of firms is ambiguous

5. Welfare Analysis
Economists typically assess social benefits or costs using “total surplus,” which is a measure of value added or gains from trade
Calculating surplus:
Suppose that a consumer is willing to pay $10 for a good
Suppose a firm can produce the good for $6
Suppose the market price of the good is $7
Then total surplus is 10 – 6 = 4, the difference between the consumer’s willingness to pay and the firm’s cost
Producer surplus is 7 – 6 = 1, which is equal to firm profits if there are no fixed costs
Consumer surplus is 10 – 7 = 3

6. Social Optimality of Perfect Competition
Under some conditions, perfect competition yields socially optimal outcomes
Condition 1: Ignore technological progress and consider only current output
Firms may require the prospect of positive profits in order to invest in technological progress, which is one of the main drivers of economic growth
Condition 2: Assume there are no externalities
An externality: a cost or benefit generated by an agent’s action where the agent does not pay the cost or receive the benefit
Example: when a child cleans his room he may not benefit but his mom does

7. A Simple Example of Maximizing Welfare
1.   A good can be produced at a constant marginal cost of $1
2.   Each consumer is willing to buy at most one unit of the good
3.   Each consumer’s willingness to pay for a unit of the good is in between $0 and $10
Recall that maximizing total welfare requires maximizing total surplus
Maximizing total surplus requires that if a consumer’s willingness to pay exceeds the marginal cost, the consumer should receive a unit of the good, because total surplus rises
If willingness to pay is less than the marginal cost, the consumer should not receive a unit, because total surplus would fall

8. Perfect Competition uses the price system to achieve socially optimal outcomes
In a perfectly competitive equilibrium, the price equals the marginal cost
Every consumer whose willingness to pay exceeds the price buys a unit of the good
Thus, if willingness to pay exceeds marginal cost, the consumer obtains a unit; otherwise he does not
Welfare is maximized

9. Departures from Perfect Competition
1.    Market Power
Large firms exist in most markets
Often at least one firm is large enough to influence the market price by adjusting output
Large firms may also have cost advantages due to economies of scale
Economies of scale exist when average cost falls as output rises
Large firms can often price above marginal cost and earn positive economic profits
In a static setting, this ability (referred to as market power) tends to reduce welfare
In a dynamic setting, the prospect of obtaining market power encourages innovation

10. 2.   Product Differentiation
Most firms differentiate their products
Differentiation has social benefits because consumers have more choices
Differentiation also has social costs:
It is costly to differentiate products
Differentiation may allow firms to obtain market power
Differentiation and product proliferation may create entry barriers
Thus, the welfare effect of product differentiation cannot be determined without putting further structure on the environment

11. 3.   Barriers to Entry
Typically, entry is costly (exit may be too)
In perfect competition, entry and exit is critical; if it cannot occur then the equilibrium changes
Definition: A barrier to entry is a cost of producing which is borne by new entrants but not by established firms
Determining whether something is a barrier to entry can be tricky
Assessing the welfare implications of a particular barrier is even more tricky
Consider patents, for example

12. Examples of Barriers to Entry:
Absolute Cost or Quality Advantages
Firms in the market might have superior knowledge, resources, and capabilities that are hard to duplicate
Trade secrets: the formula for Coca-Cola
Location: a mining company sitting on gold
Learning curves: cost advantages may be obtainable only with production experience
Advantages associated with scope: IBM produces many electronics products. If its scope is important for its success, a potential entrant may have to produce many products. This could cause coordination problems and increase management costs for the entrant.

13. Other Barriers to Entry
Capital Requirements
Economies of Scale
Product Differentiation and Brand Names
Government-created and Legal Barriers, such as patents and copyrights

14. Getting around Entry Barriers
Entry barriers protect firms that are earning positive economic profits
The prospect of earning positive economic profits provides potential entrants with an incentive to try to get around entry barriers
Two ways to get around entry barriers:
1.   Innovate: In the late 1980’s, the rise of Drexel Burnham Lambert in investment banking was mainly due to new approaches to financing
2.   Differentiate: When Japanese firms entered the motorbike industry they did so with small dirtbikes

15. Monopoly Monopolized Industries have the following features:
There is a single firm, the monopolist
There are high entry barriers
The monopolist produces a unique product with no close substitutes
The monopolist often has private information about its production technology and costs
The monopolist faces the entire market demand curve and can influence the market price

16. The Monopolist’s Problem
The monopolist chooses its output to maximize its profit taking the market demand curve as given:
maxq p = p(q)q – c(q) – f
p(q) is the market inverse demand curve
c(q) is the firm’s variable cost function
f is the firm’s fixed cost
At the optimal output choice, marginal revenue equals the marginal cost
mr = p’(q)q + p(q) = c’(q) = mc

17. The Monopolist’s Markup
Rearranging the monopolist’s first-order condition,
p ( 1 + p’(q)q/p ) = c’(q)
p ( 1 + 1/e ) = c’(q)
where e = q’(p)p/q, the price elasticity of demand (which is negative, because demand is downward sloping)
Clearly, price exceeds marginal cost:
p – c’(q) = – p/e

18. Equilibrium Profits
Recall that in perfectly competitive markets, entry drives economic profits down to zero
Monopolists are protected by high entry barriers
Thus, they can sustain economic profits greater than zero
If the industry is initially in equilibrium and a shock occurs, it is possible that no entry occurs in response
The monopolist may adjust its output in response to a shock

19. Welfare Analysis Industry profits are maximized under monopoly
However, because the monopolist prices above marginal cost, some potential gains from trade are unrealized. Thus, monopoly does not maximize total welfare.
The unrealized potential gains from trade are referred to as “deadweight losses”: they are an unambiguous loss, not a transfer from one economic agent to another
One qualification: in the presence of negative externalities, monopoly may lead to higher total welfare than perfect competition, because the monopolist restricts output

20. Benefits of Monopoly
The prospect of obtaining monopoly profits can encourage socially beneficial activities, not just rent seeking
For example, innovations may lead to new products, improve existing ones, or lower production costs
Without the incentive of monopoly profits, firms might innovate less
This is the main argument for having a patent system – a patent assigns the property right on an invention
Property rights on inventions are particularly critical when inventing requires large sunk costs but imitating requires relatively small sunk costs
For example, pharmaceuticals

21. Oligopoly Oligopolies have the following features:
There are a few large firms and there may be many small firms
There may be high or low entry barriers, but it is typically not easy to become large
The firms typically produce differentiated products
Production processes may be differentiated and the firms may possess private information about their production technologies and costs
The oligopolists (the large firms) are engaged in strategic interaction: they all have some market power, and a given oligopolist’s optimal strategy depends on the other oligopolists’ strategies

22. Most Real-World Industries are Oligopolies
It is unusual to observe an industry with no large firms or only one large firm
Typically some firms are larger and more profitable than most of their competitors
Firms differ along many dimensions: products, production processes, organizational forms, brand names, location, distribution networks, etc.
Those that are able to sustain profits above the norm in their industry are said to have a “competitive advantage”
The source of a competitive advantage is typically some resource or capability that is difficult to imitate (particular technologies, trade secrets, brand names, etc.)

23. Industry Concentration
Concentration ratios measure the number and relative size of the large firms in the market
Generally, the higher the concentration ratio, the closer the industry structure is to the monopoly extreme
The lower the concentration ratio, the closer the industry structure is to the perfectly competitive extreme
We expect that deadweight losses are higher in more concentrated industries
Mergers in highly concentrated industries tend to attract more attention from antitrust authorities than those in less concentrated industries

24. Static vs. Dynamic Views of Concentration
In a static (one-period) framework, high concentration is bad, because it creates deadweight welfare losses
Policy makers may be tempted to break up firms to create smaller ones, with the goal of approximating perfect competition
The differential efficiency hypothesis is that large firms are large and profitable because they are more efficient – they have cost advantages or better products
Thus, high concentration and high profits are observed together because differential efficiency causes some firms to become large and profitable

25. Implications of Differential Efficiency
If the differential efficiency hypothesis is correct, breaking up firms in highly concentrated industries is not a good idea
Breaking up these firms would punish them for being efficient and discourage investments that improve efficiency
Empirical tests strongly support the differential efficiency hypothesis: a firm’s profit is strongly correlated with its market share
In contrast, there is typically only a weak positive association between industry profit and concentration