Prof. Bryan Caplan

Econ 370


Week 1:  Varieties and Benefits of Competition

I.                     "Industrial Organization"

A.                 Narrow definition (not mine): economic analysis of the competitiveness of markets, with a strong focus on the use of antitrust policy to improve market performance

B.                 Broad definition (mine): economic analysis of the production and sale of economic goods

C.                Preview of the semester:

1.                  "Competition and Monopoly"

2.                  "Special Markets"

3.                  "Markets, Regulation, Socialism, and Privatization"

II.                   Some Remarks on Competition

A.                 Common economic sophism: "They can charge whatever they want."

B.                 Reality: Businesses are constrained by the presence of alternative suppliers.

C.                Remember that economists use the word "profit" somewhat differently than most people do.  When economists calculate "profit," they subtract out the "average" or "market" rate of interest from the return on investment.  The idea is that making 5% when the market rate of interest is 10% is not really a profit - you actually earned 5% less than you could be expected to earn.

D.                Competition tends to push the rate of return on investment to the "average" or "market" rate.  Given economists' definition of "profit," we can therefore also say that competition tends to drive profits to zero.

III.                  Competition with Lots of Firms ("Perfect competition")

A.                 Just draw supply and demand curves.

B.                 Intersection gives competitive equilibrium price.

C.                Higher-cost producers can't earn a normal rate of return, so they leave the industry.

D.                Note: An individual consumer's willingness to pay does not affect the price actually paid.  Man dying of thirst pays the same for a glass of water as anyone else.  Why?

E.                 Another important insight: Even if supply is vertical, prices serve the socially valuable function of rationing available quantities to the highest-value users.

IV.               Competition with A Few Firms ("Imperfect Competition")

A.                 The perfect competition model assumes that there are numerous suppliers, so "the market" sets the price firms can get.  Is a market with fewer sellers, each picking their own price, necessarily less competitive?

B.                 Consider a market with only TWO sellers.  The firm that sets the lower price gets the whole market; if their prices are equal they split the market 50/50.

C.                Suppose you are one of the firms.  What is your best response to your competitors' offered price?  What is his best response to your offered price?  Notice that cutting your price slightly almost DOUBLES your profits.

D.                Conclusion: So long as the two firms are competing, this two-firm market where firms set their prices is just as competitive as if there were thousands of firms taking the market price.

E.                 Caveat: What if one firm has lower costs than the other?

V.                 Competition with One Firm ("Contestable Markets")

A.                 Suppose there is only one supplier in an industry.  Many people are inclined to call this a "monopoly."  But is this situation necessarily less competitive than the earlier cases?

B.                 Suppose there are other firms that could potentially enter the market if they want.  If they enter, competition basically works as in the 2-firm case discussed above.  Whoever prices lower gets the whole market; equal prices split the market 50/50.

C.                If you are the current monopolist, what would your best pricing decision be?  What if you are the potential entrant?

D.                Conclusion: As long as there are potential competitors, the so-called "monopolist" behaves just as competitively as anyone else.

E.                 What if there are fixed costs?  Then potential competition does not force you down to MC, but Average Cost.

F.                 What happens if there are cost differences (fixed or marginal) between the incumbent and potential competitors?

VI.               Cost Curves and Market Structure

A.                 Cost curve just shows a firm's AVERAGE COST of producing a given quantity of output.

B.                 The AC curve will normally decline initially, reach a minimum (often called the "minimum efficient scale"), and then eventually start increasing.  Why?

1.                  Ex: Transporting bags of groceries from your car to your house

C.                In the three cases discussed above, the number of firms in an industry was simply assumed.  But in reality, the shape of the AC curve strongly determines the number of firms in an industry.

D.                Combine the INDUSTRY demand curve with the AC curve of one firm.  If this demand curve intersects the AC curve in the declining region, you are likely to have just one firm in the market.  (Recall that this is not necessarily a bad thing).

E.                 If the demand curve intersects the AC curve in the rising or flat region, there is probably "room" in the market for additional firms.

F.                 How many firms can ultimately "fit" in a market?  This depends on the size of the market compared to the size of the minimum efficient scale. 

G.                Specifically: Let q be the quantity at which a firm reaches its minimum AC.  Let Q be the total quantity demanded by consumers when P equals that AC.  The number of firms that fits equals Q/q, rounding down.

1.                  Question: Why round down?

VII.              Allocative and Productive Efficiency

A.                 Allocative efficiency, by definition, requires that price=marginal cost.  Why?  Otherwise, one could potentially increase consumer welfare without reducing producer profits.

B.                 Productive efficiency, by definition, requires production at the minimum possible AC (given the level of production).

C.                Important implication: There can be a trade-off between allocative and productive efficiency.  Is it better to have a high-cost producer set P=MC, or a low-cost producer with P>MC?  It depends.  One efficient but un-competitive producer may actually be better for consumers than thousands of inefficient producers.

D.                A high-cost producer with P>MC is the worst of both worlds.  As the lectures from week 2 will show, this is usually what you get when the government deliberately restricts competition.

E.                 Application: "Why Taxes Are Bad."