Perfect Competition, Price discrimination and Olygopoly (Main Concepts)

Competitive Equilibrium & Efficiency: Perfectly competitive market

The perfectly competitive market has 3 main characteristics:

Absence of transaction costs -> perfect information among buyers and sellers

o Products homogeneity -> markets consist of only one homogeneous product,

o 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

o increase to decrease the quantity sold without affecting the market price (price

takers)

Over time the number of firms that operates 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 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, infinitively elastic supply

curve, due to the free entry.

In a perfectly competitive market there is free entry, which means that any

potential firm who whishes to enter a certain market has the possibility to

.

achieve the same technology of 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 to whishes to enter a market. efficient scale of

Therefore, in the long-run supply curve all firms will produce at the

production - 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 e

When P = AC = MC firms will be indifferent between producing Q or nothing.

min

Under AC firms will produce 0 and make negative profits. Whereas, if they

min

produce above AC they can produce an infinitive number of outputs.

min

Therefore, as this explanation we can better understand the concept of competitive

equilibrium in the long run and its implications. competitive equilibrium

Firstly, we must clarify that we refer to the 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

o FREE EXIT

o

The free entry has 3 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

o min

min.

Firms earn 0 profits

o e

All firms produce at Q in order to achieve the a large production of output at the

o least cost production.

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 rises above AC .

min

Consider first the LONG RUN competitive equilibrium:

o P = AC -> substitute P* into Q, in order to find the quantity

 min

produced in the long run;

Profits are zero

 E

N = Q*/Q for finding the number of active firm, each of which

 produces at the efficient scale of production.

Find the SHORT RUN competitive equilibrium:

o Determine the supply curve S(P):

 1. QUANTITY RULE: P = MC

2. 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 min

 After having found the supply curve multiply it for the number of active

firms and 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.

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

o production

How do we measure them?

o The total WTP equals the area under the market demand curve up to the

 quantity consumed. This is true if the quantity of goods are consumed by

the costumers who face the highest willingness to pay (which is true

whenever all consumers face the same price)

Total avoidable cost equal the area under the supply curve up to the

 quantity of goods produced by those firms with the lowest avoidable

costs.

Consumer surplus = WTP - total

expenditure

Producer surplus = profits - sunk Revenues - total avoidable

costs costs

Being economically efficient means also that any alternative outcome that makes

someone better off it must make somebody else worse off. A particular output of

this kind is the Pareto Optimal, which is an economic output at which is

impossible to make anyone better off without making someone else worse off.

Deadweight loss: is the reduction of the aggregate surplus below its maximum

value. Perfectly competitive markets maximize the aggregate surplus,

o the price taker firms

because set their price equal to the marginal cost for

maximizing their profits. Therefore, there is no deadweight loss.

Price discrimination

Why do firms price discriminate?

Price discrimination is a economic technique to increase profits by seeking to satisfy

the needs of a larger range of customers. In fact, a monopolist could increase its

profits by: Charging more the units for those costumers that are willing to pay

o more for the output,

Reducing the charge over those units, for which costumers do not

o have such a high willingness to pay.

Naturally, in order to compute price discrimination market power is needed and also

an ability to distinguish costumers' WTP.

This process is called prefect price discrimination, when the firm is able to

determine the different levels of consumers' WTP and consequently charge different

prices for each unit it sells.

However, sometimes firms aren't able to determine such a perfect pricing for each

WTP. But, if they are clever they can use different techniques of price discrimination

based on : Observable characteristic : when a firm can distinguish, even if

o imperfectly , consumers with a high versus low WTP

Self selection: when firms offer a menu of alternatives, designed

o so that the different costumers will make their own decision based on their

perceived needs.

Quantity depended: or volume sensitive pricing plan: is the price

o that a costumer pays of each extra unit, that depend on how many units the

consumer has bought.

Perfect price discrimination MR = D = MC

Since a perfectly discriminating monopolist collects an amount equal to the

consumer WTP for each unit, its marginal revenues coincides with the demand

curve, so perfect price discrimination is similar to the perfect competition:

MR = D = MC

Production = consumption

With perfect price competition the producer produce the exact amount that the

consumer consumes. Moreover, the seller produces exactly the same quantity as