2. Insights on competitive structures

Question 1

Basics of competitive markets: market power

Answer 1

extra: There are different market forms: we can compare them looking at the market power. The market power is the capability of a firm to set a price above the cost. Therefore, the profit achieved by a company depends on the market structure, which means barriers, number of firms and so on (it is not an internal characteristic). The monopoly (or firm with a dominant position) is characterized by the highest level of market power.
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We can classify the market structures considering the number of firms:
perfect competition (theoretical) N-> infinity
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Oligopoly
| (more realistic) N= 1
Monopoly
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PERFECT COMPETITION consists of infinite companies producing homogeneous products.
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Question 2

Competitive markets

Answer 2

In competitive markets, it is easier to achieve an efficient allocation because price is a vehicle of information about scarcity of resources and may involve different behaviors of economic agents. For example, if price rises, it means the offer is much lower than demand. If every relevant good is traded in a market at publicly known prices (i.e. if there is a complete set of markets), and if households and firms act perfectly competitive (i.e. as price takers), then the market outcome is Pareto optimal. Therefore, when markets are complete, any competitive equilibrium is necessarily Pareto optimal. Competitive markets are efficient: there are no market failures and it is possible to reach Pareto efficiency.
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There are some ASSUMPTIONS:

Question 3

Competitive market mechanism

Answer 3

The competitive market mechanism always achieves an efficient allocation but it is not the only mechanism able to achieve it. Nevertheless, this mechanism is a very simple one: every individual simply maximizes its own utility while only knowing its own preferences and the market prices. Other allocation mechanisms require much more information, especially in a large economy with several markets and agents.

Question 4

Classification of market structures

Answer 4

Market power increases as we go across:
- Perfect competition
- Potential competition
- Monopolistic competition & Competitive selection
- Oligopoly
- Dominant firm
- Monopoly

Question 5

Perfect competition: definition and 5 central assumptions

Answer 5

Definition: A perfectly competitive market is a market where firms are price-taker, i.e. they do not determine the price to which sell their products, price is settled by the market, i.e. by the interaction of demand and supply. Firms do not realize any extra-profit (in the long-run).
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5 central assumptions:
1. atomicity
2. product homogeneity.
3. perfect information (every agent, firms and consumers) know the price charged by every firm.
4. Firms have access to all production technologies (for simplicity one can assume the extreme form of technology symmetry, but it’s not necessary).
5. No entry and exit barriers (free entry and exit)
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EXTRA:
Perfect competition is the market structure with the highest production efficiency because costs are minimized and the highest allocative efficiency, because the price is the lowest possible.
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Since the maximum social welfare is the sum of the consumers’ surplus and the producers’ surplus, this is an ideal situation for the policy makers.
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Firms do not gain any extra profits. Therefore, this is the worst possible situation for firms.
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A perfectly competitive market is a market where firms are price-taker, i.e. they do not determine their selling price since it is settled by the market, i.e. by the interaction of demand and supply.
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The perfect competition refers to five central assumptions:

Question 6

Perfect competition dynamics: 2 questions

Answer 6

1. WHY ARE COMPANIES PRICE-TAKER?
   - Products are homogenous, so if a company raises the price, consumers will buy the products from competitors and the demand for that company is null (perfect information). Therefore no (rational) firm will raise the price.
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   - If the company reduces the price, consumers will try to buy all the products from that company. But the company is not able to serve the entire market due to its limited production capacity (atomicity)
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   - Firms can not collude, given their high number (atomicity)
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2. WHY NO EXTRA-PROFITS?
   - If a firm makes extra-profit, this extra-profit will attract other firms to acquire the technology required (equal access to technology) and enter into the market (no barriers).
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   - This induced competition will erode in the long-run any possibility of extra-profits for the firms with the adoption of the best technologies possible by firms

Question 7

extra: Competitive markets are an example of perfect competition in every market:

Answer 7

Competitive markets are an example of perfect competition in every market:
- every consumer will consume a quantity of any good n produced in the economy until the marginal utility he/she gets from the consumption equals the price he/she pays for obtaining it (MUn=Pn). Furthermore, any good n produced is traded at a price equal to its marginal cost (MCn=Pn).
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Each individual is maximizing his/her utility by acquiring/selling products/services at the minimum price possible given costs (allocative efficiency), and products/services are produced at the minimum cost possible given the price of the factors (productive and technical efficiency). No Pareto improvements are possible in the economic system by moving resources from one production to another one.
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MU1/MU2=P1/P2=MC1/MC2
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Perfect competition is the best social solution and a point of reference in order to maximize the social welfare. Nowadays there are hybrid solutions between the two extreme: the first extreme refers to transactions between separate individuals and the second to the elimination of the price system with a regime of central planning within a single organization. These hybrid solutions involve the interaction among firms through the markets but within which activities are explicitly coordinated by plans and hierarchical structures. They are an effective mechanism for achieving coordination.
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Competitive markets are the ultimate goal but there are three main market imperfections not allowing the perfect competition:

Question 8

Perfect competition equilibrium:
p = MC = AC min (v imp)

Answer 8

p = MC = AC min
price= marginal cost = AC= average cost
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The maximum quantity of the good produced at the lowest possible cost = Max Productive efficiency.
(A more efficient than B if A has less input cost than B OR if at the same input cost, the production quantity is more in A than B)
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The maximum quantity of the good sold at the lowest price= Max Allocative efficiency.
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On the blackboard: In order to understand the dynamics, we look at the Demand (DD) and Supply (SS) curves.
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(Marginal cost curve and average cost curve intersection)
Point where AC curve is called minimum efficient scale (MES)
Each firm produces at the min efficient scale. (Firms don’t gain any profit)
pi (extra profit)= TR (total revenue) - TC (total cost)
AC= TC/p ; TC= AC * p (profit)
Aggregate supply and aggregate demand (graph)
If aggregate demand increases,
pi (extra profit)= TR (total revenue) - TC (total cost)
When competitors see this, no entry barriers, they enter the space and compete which brings the AS to the minimum efficient scale again.
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EXTRA: the lowest possible cost. Furthermore, this is the maximum allocative efficiency, since the firms sell the maximum quantity of the good at the lowest price.
From an economic perspective, we consider explicit and implicit costs that are the total opportunity costs. Therefore, in perfect competition, the firms realize “normal”􏰝 profits, but they􏰔 should not realize extra-profits over the long run.

Question 9

(Static) Social Welfare in terms of Surplus

Answer 9

(Fixed costs not taken into consideration)
CONSUMER’S SURPLUS:
Difference between the price an individual is willing to pay to have a certain good or service and the market price for the same good or service
It measures the consumers’ welfare’
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PRODUCER’S SURPLUS:
Difference between the price of a certain good or service paid to the producer and the price the producer is willing to accept for selling the same good or service
It measures producers’ welfare
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SOCIAL WELFARE:
consumer’s surplus + producer’s surplus
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Formula:
W= S^c + S^p = (integration of v * pi)
W =
S =
v =

Question 10

Surplus in perfectly competitive markets (see MOOC Week 4 - Competition - Part 2)

Answer 10

Figure:
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- Consumer’s surplus (red)
- Supplier’s surplus (green)
- Social welfare or total surplus (red + green)
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(Short-run) Supply curve in p.c. equal to the horizontal sum of marginal costs of individual firms (which number is fixed in the short run)

Question 11

Consumer’s surplus, producer’s surplus, social welfare

Answer 11

extra: Consumer’s surplus is the difference between the prices an individual is willing to pay to have a certain good or service and the market price for the same good or service. It measures the consumers’ welfare. The total consumer’s surplus from the aggregate demand curve is the following.
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Producers’ surplus is the difference between the prices of a certain good or service paid to the producer and the price the producer is willing to accept for selling the same good or service. It measures producers’ welfare.
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Social welfare is the sum of consumer’s surplus and producer’s surplus.
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In perfect competition, we have the maximum area of surplus and welfare.

Question 12

Potential competition (contestable markets): DEFINITIONS & PRE-REQUISITES

Answer 12

Definition: A contestable market is a market where firms from other markets/sectors can perform a HIT AND RUN COMPETITION with no costs of entry and exit.
Hit and run competition means take the money and go away very fast. It looks similar to the perfect competition in terms of results.
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PRE-REQUISITES:
- No requisites on the n° of firms in the market
- No entry and exit barriers (no sunk costs and non-redeployable investments).
- Perfect information for consumers (they are able to react immediately to price differentials between companies)
- Time requested for the incumbent to retaliate to the entry of the new firms (by lowering price) is superior to the time needed for the entrant to make all the investment necessary to operate in the focal market.

Question 13

RESULTS OF THE PRE-REQUISITES

Answer 13

Results
- Incumbent Firm(s) are forced to settle a price near to the average cost in order not to “turn on” the signal of extra-profits.
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- As a matter of fact, every extra-profits will be captured and exploited by new entrants with a hit and run competition
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- If the market is contestable, the n° of firm is a poor predictor of the market power, and even a market with only 1 firm may behave more similarly to perfect competition rather than monopoly
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The assumptions of perfect competition and contestable markets are difficult to observe in the real world. They are not so realistic but they are useful as benchmarking models for comparing results (in terms of efficiency and social welfare) of more realistic market structures, where firms have market power (oligopoly, monopoly).

Question 14

Assumptions underlying PERFECT COMPETITION and CONTESTABLE MARKETS difficult to observe in the real world

Answer 14

Only useful as benchmark models for comparing results (in terms of efficiency and social welfare) of more realistic market structures, where firms do have market power (oligopoly, monopoly)

Question 15

MONOPOLY & DOMINANT POSITION
(please again refer to MOOC in Economics)

Answer 15

What a firm with no competitors does?
Now price-taking is not credible anymore
The monopolist is a price-setter
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The highest level possible of market power is the monopoly. There are no possible entrants and one single firm faces the whole demand. It is completely free to choose the price, being a price setter.

Price elasticity= % change in price, results in change in % demand of that good?
elasticity of demand

Question 16

Monopolies price-setting

Answer 16

If the monopolist is a price setter how does it choose the price
First of all note that choosing price is equivalent to choosing quantity to produce.
There is a surplus transferred from consumers to producers with respect to the perfect competition. Monopoly is inefficient in terms of social welfare and avoided by policy makers.

Question 17

Demand elasticity in monopoly (fig, formulas)

Answer 17

The demand elasticity influences the price definition: the monopolist will settle a higher price as long as it faces an inelastic demand, while the more the demand curve is elastic, the more it will fix a price close to MC, and similar to the one that would emerge under perfect competition. In the case of rigid demand, if the firm rises the price, it will lose a relatively lower number of customers. Therefore, prices are much higher.
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lecture slide: The monopolist will settle a higher price as long as it faces an inelastic demand, while the more the demand curve is elastic the more it will fix a price close to MC, and similar to the one that would emerge under perfect competition
(fig, formulas)

Question 18

Dominant firm

Answer 18

The analysis on pure monopoly we conducted so far can also be applied to the market context in which there’s only one very large firm and a set of very small firms with a limited production capacity.
If K is the total production capacity of the set of small firms, these latter typically fix a price only marginally inferior to the one fixed by the large firm and produce a quantity such as their capacity is saturated:
(smaller firms will take the price set by large firms as a limit and set a price below it)
(fig);

Question 19

Dominant firm and the double marginalization problem

Answer 19

1 monopoly is better than 2:
2 monopolies (wholesaler and retailer) < 1 single monopoly active in both markets
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2 monopolies (Worse in terms of welfare for both firms and consumers)
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This is known as the “double marginalization” problem

Question 20

Example DMP: the Marginal Revenue curve for the retailer is the Demand curve for the wholesaler

Answer 20

See slides
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We have a monopoly in a retail market with p = 5 – (1/50)q, no fixed costs and use of only 1 input for each unit of output (1 engine for 1 car).
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Now suppose MC (marginal cost) for using this input is constant and under perfect competition in the wholesale market the retailer buys for 1 Euro.
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MR (marginal revenue)= 5 –(2/50)q = MC = 1 ; q (quantity) = 100 –> p (price) = 3
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Now suppose that wholesale market is not anymore in perfect competition but instead is dominated by a monopolist.
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What is the price (and quantity) that the monopolist would settle?
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The demand faced by the monopolist in the wholesale market is p = 5 –(2/50)q
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MR = 5 –(4/50)q = MC = 1 —> q = 50; p = 3
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What the monopolist in the retail market will do? Now its marginal cost is 3 and not 1 as before.
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MR = 5 –(2/50)q = MC = 3 —> q = 50; p = 4
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Imp: 1° scenario (wholesale market perfectly competitive): π = 200; SC = 100
2° scenario (wholesale market in monopoly): π wholesaler = 100; πretailer = 50; SC = 25
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