Market structures: Perfect Competition

• Perfect competition, monopoly, monopolistic competition, and oligopoly are market structures that differ in their efficiency, barriers to entry, and potential outcomes.
• Efficiency in this context relates to how well resources are allocated to maximize societal welfare

Perfect Competition

• Assumptions: Large number of buyers and sellers, homogeneous products, free entry and exit, perfect information.

• Firms are price takers

• Efficiency:

  • Allocatively efficient: Price (P) = Marginal Cost (MC). Resources are allocated to their most valued use from society's perspective.
  • Productively efficient: Production occurs at the minimum point of the average cost (AC) curve. P=MC=min AC

• Graph: The firm's demand curve is perfectly elastic (horizontal) at the market price. The MC curve intersects the AC curve at its minimum.

• Achieved equality: MC = AR (Average Revenue), MC = AC

• Barriers to Entry: No barriers. Free entry and exit ensure that firms cannot sustain long-run economic profits

Monopoly

• Assumptions: Single seller, unique product, high barriers to entry.

• The firm is a price maker

• Efficiency:

  • Allocatively inefficient: Price (P) > Marginal Cost (MC). The monopolist restricts output to raise prices, leading to a deadweight loss.
  • Productively inefficient: Production does not occur at the minimum point of the average cost (AC) curve.

• Graph: The firm faces a downward-sloping demand curve. Marginal revenue (MR) is below the demand curve. Profit is maximized where MR = MC

• Achieved equality: MC = MR (profit maximization)

• Barriers to Entry: High barriers, such as patents, control of essential resources, or government regulations, prevent other firms from entering the market.

Monopolistic Competition

• Assumptions: Many buyers and sellers, differentiated products, low barriers to entry.

• Firms have some control over price due to product differentiation.

• Efficiency:

  • Allocatively inefficient: Price (P) > Marginal Cost (MC). Firms restrict output to maintain higher prices.
  • Productively inefficient: Production does not occur at the minimum point of the average cost (AC) curve. Excess capacity exists

• Graph: The firm faces a downward-sloping demand curve that is more elastic than a monopolist's. MR is below the demand curve.

• Achieved equality: MC = MR (profit maximization)

• Barriers to Entry: Low barriers to entry. New firms can enter the market with similar, but differentiated, products.

• In the long run, entry of new firms drives economic profit to zero.

Oligopoly

• Assumptions: Few sellers, homogeneous or differentiated products, significant barriers to entry.

• Firms are interdependent; decisions of one firm affect others.

• Efficiency:

  • Efficiency depends on the specific behavior of firms. Outcomes can range from near-competitive to near-monopoly.
  • If firms collude, the outcome is similar to a monopoly, with high prices and low output (allocatively inefficient).
  • If firms compete aggressively, the outcome might be closer to perfect competition.
  • Usually not productively efficient.

• Graph: No single, definitive graph. Models include the kinked demand curve model (which explains price rigidity) and game theory models (which analyze strategic interactions).

• Achieved equality: MC = MR (profit maximization), but where MR depends on the actions of rivals.

• Barriers to Entry: Significant barriers, such as high capital costs, patents, or strategic actions by existing firms.

Comparisons and Achievable Equalities

• MC = AR (or Price): Achieved in perfect competition where firms are price takers and economic profit is zero in the long run.

• MC = AC: Achieved in perfect competition in long-run equilibrium, ensuring productive efficiency.

• MC = MR: Achieved by all firms (perfect competition, monopoly, monopolistic competition, and oligopoly) when maximizing profit.

• Allocative efficiency (P = MC) is only achieved in perfect competition. In other market structures, firms have some market power and restrict output to raise prices above marginal cost.

• Productive efficiency (production at minimum AC) is only achieved in perfect competition in the long run.

• Barriers to entry protect firms from competition. Perfect competition has no barriers and monopoly has the highest.

• The number of firms decreases from perfect competition to monopoly. Perfect competition has many, while a monopoly has only one.

Perfect competition, a market structure characterized by numerous buyers and sellers, homogeneous products, and free entry and exit, ensures allocative and productive efficiency. Firms are price takers, leading to resource allocation that maximizes societal welfare. No barriers to entry.