Lecture 6 - Market and competition

Government Concerns on Market Competition

  • Governments are worried about excessive market power in markets.

  • Policymakers look for ways to prevent firms from obtaining excessive market power.

Overview of Lectures

  • Previous discussions focused on the role of firms and their internal organization.

  • Current and upcoming lectures will examine market structures and their influence on firm behavior.

  • Not all market allocations lead to efficiency; the causes of inefficiency and governmental responses will be explored.

Core Topics Outline

  • Definitions and concepts discussed in the course include:

    1. What is a market?

    2. Perfect Competition

    3. Equilibrium in Perfect Competition

    4. Measuring the Degree of Competition

Market Coordination Mechanisms

  • In the Neolithic age, barter systems were used for trade.

  • The introduction of exchange units (e.g., shells, metal coins) marked the beginning of market economies.

  • Economic activities can be organized in:

    • Economic Planning: Centralized coordination by authorities based on information about production and consumption.

    • Market-based Economy: Decentralized organization where prices regulate economic activities.

Role of Markets in Economic Coordination

  • Adam Smith's "invisible hand" idea:

    • Individual actions, though aimed at personal gain, can benefit the public good.

  • Friedrich Hayek advocated that competitive markets provide the necessary information through prices for efficient resource allocation.

Competitive Markets Defined

  • Key characteristics of a competitive market include:

    1. Homogeneous goods and services.

    2. Large numbers of buyers and sellers.

    3. Independent actions of buyers and sellers.

    4. Easy access to price information.

  • Perfect competition is an ideal state that doesn't exist in reality.

Implications of Perfect Competition

  • Demand curve of a single firm in perfect competition is horizontal, thus perfectly elastic.

  • In perfect competition:

    1. Firms are price-takers.

    2. Firms have no incentive to alter prices. As a result, any attempt to raise prices above the market equilibrium will lead to a complete loss of customers to competitors.

    3. Optimal output occurs where marginal cost equals price. Cm(Q)=P, where Cm(Q) represents the marginal cost at quantity Q, indicating that firms will produce at the level where their costs of production match the prevailing market price.

Price Setting in Competitive Markets

  • Aggregate demand and supply determine market prices:

    • Aggregate supply = sum of individual firms' supply across the industry.

    • aggregate demand corresponds to the number of units sold at each price level.

    • Equilibrium price is achieved when industry demand equals total supply.

Supply and Demand Dynamics

  • Supply elasticity

    • like the demand elasticity, the supply elasticity summarizes the responsiveness of supply to changes in price

    • πœ€π‘† = (Ξ” 𝑄/𝑄)/(Ξ” 𝑃/P)

    • it affects equilibrium prices and responses to economic shocks.

  • Shifts in supply/demand impact equilibrium prices:

    • demand curve = the total quantity that the sum of consumers are to consume at each level of prices

    • supply curve: total quantity that the sum of firms produce at each price.

  • Supply shocks

    • Increase in supply decreases price if demand remains unchanged.

    • Increase in demand raises prices if supply remains unchanged.

  • shocks and elasticity

    • the size of the change after a shock to demand or supply depends on the elasticity of supply or demand

    • the higher the elasticity (the lover the change of quantities given a change of price), the smaller is the price change.

Case Studies of Market Conditions

  • Example: Fish market in Kerala highlights the effects of excess sellers and buyers leading to waste and shortage respectively.

  • Events like supply shocks affect market prices, as seen in energy and grain prices post-Ukrainian invasion.

  • example of suply shocks

    • blockage of US American ports in 1861 due to declaration of independence of confederate states

    • prices for cotton increase as American cotton can no longer be exported

    • Europe starts importing from other countries.

  • Price control

    • Rent controls in San Francisco, implemented in 1994 without prior announcements

    • price ceiling below market clearing price, hence excess demand. How are allocations affected ?

    • Results:

      • Impact on Housing Demand (People Renting Apartments)

        • Rent control protects existing tenants by keeping their rents low.

        • Because of this protection, tenants stay in their apartments longer instead of moving.

        • Tenant mobility (the number of people moving in and out) drops by 3.5 percentage points over 5–10 years.

        • This effect is even stronger for racial minorities, meaning they are even less likely to move once rent control is in place

      • Impact on Housing Supply (Landlords and Available Rentals)

        • Some landlords stop renting out apartments because rent control limits how much they can charge.

        • Instead, they convert rental apartments into condominiums (which are not affected by rent control).

        • This leads to:

          • 8% more apartments turned into condos within 5–10 years.

          • 15% fewer tenants living in rent-controlled buildings (because landlords either sell apartments or stop renting them out).

Measuring Market Power

  • a firm has market power when it can set both its price and quantity (price-maker).

    • There is a spectrum of competitive market structures varying in the number of competitors, the type of goods traded and the contestability of the market.

  • Herfindahl-Hirschman Index (HHI) is used to measure market concentration:

    • HHI=i=1βˆ‘N​si2​

    • Where N: number of firms, , 𝑠𝑖 : market share of firm i

      • Higher HHI indicates less competition.

  • Market structures range from perfect competition to monopoly.

Market Failures and Economic Efficiency

  • Competitive market equilibrium maximizes economic surplus and avoids deadweight loss.

  • Conditions for Pareto efficient markets include complete markets, complete information, and market power absence.

  • pareto efficiency = no further improvements can be made in the allocation of resources without harming at least one participant

Conditions for efficient market

  • nature of the market (perfect competition): competitors are interchangeable, they act independently and goods are homogenous. Prices are determined by the market. Opposite = market power

  • nature of the good (no missing markets); opposite = externalities/public goods

  • nature of information (perfect information); opposite = info asymmetries

  • rationality of consumers

Final Notes

  • Some economists argue competition has diminished globally, leading to increased market power for large firms.

  • Important sectors experiencing oligopoly include the US banking sector, telecommunications, and social media, reflecting reduced competition.