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2012 | OriginalPaper | Chapter

5. Perfect Competition and Market Imperfections

Authors : Victor J. Tremblay, Carol Horton Tremblay

Published in: New Perspectives on Industrial Organization

Publisher: Springer New York

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Abstract

Competition is a fundamental concept in a market economy. We can think of competition as firm rivalry, where one firm battles to gain a strategic advantage over its competitors. For example, General Motors and Ford have been competing with one another for over a century to produce better cars at lower cost and to create more catchy marketing campaigns. We can also think of competition as a type of market structure. Both concepts are important in industrial organization. In later chapters, we analyze various forms of competitive behavior. In this chapter, we review the market structure of perfect competition.

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previous chapter Behavioral Economics

next chapter Monopoly and Monopolistic Competition

In Chap. 2 we discuss alternative firm motives.

The model also assumes that there are many buyers. Unless otherwise indicated, we will assume many buyers throughout the book.

Although q is the only variable in this example, we use ∂ instead of d to remind us that there are many other variables that are implicitly assumed to be held fixed.

Generally, we will consider long-run problems, but at this point, we are abstracting from time.

A maximum is assured because the profit equation is concave. If it were convex, this method would identify the output level that would minimize profit. See the Mathematics and Econometrics Appendix at the end of the book for more details.

These functions derive from the following total revenue, total cost, and profit functions: \( TR = 2q, \) \( TC = {q^2}, \) and \( \pi = TR - TC = 2q - {q^2}. \) The TC equation is not the usual representation of a cost equation in perfect competition, as we will see subsequently, but we use it here to provide a simple example.

In the short run, the firm must pay its fixed costs whether it shuts down or not. In this case, the firm would shut down if its losses from staying in business were less than its fixed cost, which it cannot avoid.

This differs from the short-run supply function. Recall from principles of economics that a firm’s short-run supply curve is its marginal cost curve above average variable cost. The short-run industry supply curve is the (horizontal) summation of the marginal cost curves of every firm in the industry. Thus, it reflects the industry’s marginal cost of production.

The third is the decreasing-cost case.

To see the result more clearly, we leave off the MC₁ and MC₂ curves.

The third case involves decreasing costs. That is, input prices fall as industry production increases. The usual example given to justify this possibility is the presence of economies of scale in the production of a primary input. Scale economies cause the input price to fall with increased production, and the long-run supply function has a negative slope.

For a decreasing-cost industry, \( \partial {Q_{\rm{s}}}/\partial p \,<\, 0 \) and \( {\epsilon_{\rm{s}}} \,<\, 0. \)

This would be true, for example, for commodities that are not reproducible, such as van Gogh paintings.

This means that the firm is operating on its isoquant, where an isoquant represents all minimum combinations of inputs that can just produce a given level of output. For further discussion, see Färe et al. (1985) and Varian (2010).

The economically efficient point occurs where the firm’s isoquant is tangent to its isocost function. The isocost function represents all combinations of inputs that generate a given cost. For further discussion, see Färe et al. (1985) and Varian (2010).

Here, we mean that the perfectly competitive model is statically efficient, but it need not be dynamicaly efficient as we will see in later chapters.

This is a partial equilibrium approach, which ignores the effect that a price change in this market will have on other markets. For discussion of these general equilibrium effects, see Bernheim and Whinston (2008), Pindyck and Rubenfield (2009), and Varian (2010).

When PS is positive, as it is in this example, it is called economic rent. Even when economic profit is zero, firms may earn “economic rent.” That is, an entrepreneur may enjoy owning a company so much that he or she is willing to earn only 8% on invested financial capital, even though the normal rate is 10%. If the owner does earn 10%, the 2% above the owner’s opportunity cost is rent, not profit. Note that the concept of economic rent is different from the rent you pay on an apartment.

As discussed in Chap. 1, just because markets fail to reach an ideal does not mean that government intervention can improve welfare. We ignore this issue here, but take it up more thoroughly in later chapters.

For a review of the economics of networks, see Shy (2011).

We will see that producers of high quality goods can solve this information problem by offering guarantees or warranties.

Akerlof GA (1970) The market of ‘Lemons’: quality uncertainty and the market mechanism. Quart J Econ 84(3):488–500CrossRef

Baumol WJ, Panzar JC, Willig R (1982) Contestable markets and the theory of industry structure. Harcort Brace Javonovich, Inc., New York

Färe R, Grosskopf S, Knox Lovell CA (1985) The measurement of efficiency of production. Springer, New York

Frank RH, Bernanke BS (2008) Principles of microeconomics. Irwin Publishing, Boston

Mankiw GN (2011) Principles of microeconomics. South-Western College Publishing, Cincinnati, OH

Mas-Colell A, Whinston MD, Green J (1995) Microeconomic theory. Oxford University Press, New York

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Pindyck RS, Rubenfield DL (2009) Microeconomics. Pearson Prentice Hall, Upper Saddle River, NJ

Shy O (2011) A short survey of network economics. Rev Ind Organ 38(2):119–149CrossRef

Smith A (1776) An inquiry into the nature and causes of the wealth of nations

Stiglitz J (1987) Technological change, sunk costs, and competition. Brookings Pap Econ Act 1987(3):883–937CrossRef

Varian HR (2010) Intermediate microeconomics: a modern approach. W.W. Norton, New York

Title: Perfect Competition and Market Imperfections
Authors: Victor J. Tremblay
Carol Horton Tremblay
Publisher: Springer New York
Book: New Perspectives on Industrial Organization
Print ISBN: 978-1-4614-3240-1

Electronic ISBN: 978-1-4614-3241-8

Copyright Year: 2012
DOI: https://doi.org/10.1007/978-1-4614-3241-8_5