Imperfect Competition

Economic Costs and Market Structures

Marginal, Average, and Fixed Costs

  • Definitions:

    • Marginal Cost (MC): The cost of producing one additional unit of a good or service.

    • Average Cost (AC): The total cost divided by the number of units produced.

    • Variable Cost per Unit (VC): The variable costs associated with each unit of output.

    • Fixed Cost per Unit (FC): The fixed costs divided by the number of units produced (not varying with output).

Perfect Competition

  • Key Characteristics:

    • Firms are price takers: They must sell every unit at the market-determined price due to lack of market power.

    • Demand Curve:

    • A perfectly competitive firm’s demand curve is horizontal, indicating that they can sell any quantity at the market price, denoted as P*.

    • Revenue:

    • Economic Profit > $0 indicates that total revenue exceeds total costs at the equilibrium point (Q*).

  • Equilibrium in Perfect Competition:

    • Combining market demand and market supply curves establishes the equilibrium market price (P*).

    • Example Quantity (Q*): The quantity at which the market demand and supply intersect, determining the market price.

Imperfect Competition and Market Power

  • Market Power:

    • A firm with market power can change the price without losing all of its customers. The firm’s demand curve is no longer flat as it is in perfect competition.

  • Indicators of Market Power:

    • Differentiation: Slight differences in products that provide value to consumers.

    • Barriers to Entry: Legal, technological, or market forces that discourage or prevent potential competitors from entering the market, which leads to different degrees of market power, categorized as:

    • Monopoly: When a market is dominated by a single seller.

    • Oligopoly: A market dominated by a few sellers.

    • Monopolistic Competition: Many firms selling similar but not identical products, where firms have some control over their prices.

Demand Curves in Market Structures

  • Demand Curves and Market Power:

    • A firm with less competition has a steeper demand curve compared to perfectly competitive firms, which have a horizontal demand curve.

    • Comparison:

    • Monopoly Demand Curve: Steep curve due to lower competition and more pricing power.

    • Perfectly Competitive Firm’s Demand Curve: Horizontal due to high competition, where firms are price takers.

    • Monopolistically Competitive Firm’s Demand Curves: Slightly downward sloping, reflecting some degree of pricing power.

Practical Example: Market Power in Action

  • Scenario: A Girl Scout selling cookies finds her marginal revenue tricky to calculate due to market constraints.

  • Price Context: She prices her cookies at $6 regardless.

  • Marginal Revenue Calculation: Each unit sold (e.g., each box of cookies) sells for $6 but the question revolves around her ability to adjust this price given demand constraints.

  • Marginal Revenue Implications: For perfectly competitive firms, price = marginal revenue, so every additional unit sold does not affect the prevailing price.

Impact of Market Power on Prices and Quantities

  • Characteristics of Firms With Market Power:

    • Firms influencing prices lead to:

    • Higher prices (Price > MC): Consumers pay more than the marginal cost of the good.

    • Lower quantity traded compared to perfect competition where price equals marginal cost.

  • Comparative Metrics:

    • Marginal Cost = Firm’s Supply = Firm Demand

    • Price in Market Power scenarios compared to Perfect Competition (PriceImp vs Pricepc) and quantities traded (QImp vs QPC).

  • Outcome Differences:

    • Under perfect competition, the outcome results in higher quantities at a lower price compared to scenarios where firms possess market power.