Perfect Competition, Price discrimination and Olygopoly (Main Concepts)

Competitive equilibrium & efficiency: perfectly competitive market

The perfectly competitive market has three main characteristics:

• Absence of transaction costs -> perfect information among buyers and sellers.
• Products homogeneity -> markets consist of only one homogeneous product, so buyers don't perceive any differentiated product such as substitutes to the existing ones.
• No entry barriers -> it implies a large number of buyers and sellers, who can increase or decrease the quantity sold without affecting the market price (price takers).

Over time, the number of firms that operate in a market can change because new entrants may begin producing if it is profitable for them. Whereas in the short run, the active firms remain fixed and are the only ones who can produce output. Therefore:

Short-run and long-run curves

Short-run curve: is the horizontal sum of the individual supply curve of all currently active firms.

Long-run curve: is the horizontal sum of the individual supply curves of all the potential entrants. Indeed, the long-run curve is represented as a horizontal, infinitely elastic supply curve, due to the free entry.

In a perfectly competitive market, there is free entry, which means that any potential firm who wishes to enter a certain market has the possibility to achieve the same technology as all others. In this case, the number of potential firms is unlimited. Free entry is a basic assumption given by the fact that technological knowledge diffuses over time and some patents may expire, making technology available to anyone who wishes to enter a market.

Efficient scale of production

In the long-run supply curve, all firms will produce at the efficient scale of production, which is the amount of output where the AC reaches its minimum (AC = MC), denoted as Q_e. As a consequence, their profit will be zero.

Why at the efficient scale of production? The efficient scale of production doesn’t mean that firms should produce at this amount, however. Rather, it tells us that if we want to produce a large amount of output with the least cost production, we should try to divide it up among all Q_e the current firm, each of which will produce at Q_e. When P = AC = MC, firms will be indifferent between producing Q_min or nothing. Under AC_min, firms will produce zero and make negative profits. Whereas, if they produce above AC_min, they can produce an infinite number of outputs.

Competitive equilibrium

As this explanation shows, we can better understand the concept of competitive equilibrium in the long run and its implications. Firstly, we must clarify that we refer to the competitive equilibrium because we are in a perfectly competitive market. At this point, the market clears (D = S). Moreover, there are two basic assumptions:

• There are no sunk costs in the long run.
• Free exit.

The free entry has three implications for the market equilibrium, due to the reasons previously given:

• P = AC because the market supply with free entry is a horizontal line at price AC_min.
• Firms earn zero profits.
• All firms produce at Q_e in order to achieve a large production of output at the least cost.

Furthermore, it is important to know the number of active firms in the long run: N_e = Q* / Q. Whereas, in the short run, the number of firms is fixed.

When do firms enter the market?

Potential firms will enter the market in response to the profit opportunity that emerges when short-run equilibrium prices rise above AC_min. Consider first the long-run competitive equilibrium:

• P = AC -> substitute P* into Q to find the quantity produced in the long run;
• Profits are zero;
• N_e = Q* / Q for finding the number of active firms, each of which produces at the efficient scale of production.

Short-run competitive equilibrium

Determine the supply curve S(P):

• Quantity rule: P = MC
• Shut down rule: Profits > 0 ? P > AC_min ? In case there are sunk costs, you have to take the average avoidable costs (AAC) into account and equate it to MC -> AAC = MC.
• After having found the supply curve, multiply it by the number of active firms and set D = S.
• The price will be above P* > AC_min, hence firms will register positive profits.
• Therefore, we expect many firms to enter the market, so the price will be drawn down to AC_min again.

Aggregate surplus

Why do we talk about aggregate surplus? The aggregate surplus measures the efficiency of an economy. In other words, a market is economically efficient if it maximizes the social surplus. The latter equals the sum of the CS (consumer surplus) and the PS (producer surplus).

Aggregate Surplus = Total Willingness To Pay - Total avoidable costs of production.

How do we measure them?

The total WTP equals the area under the market demand curve up to the quantity consumed.