HON 1302 Lecture 10: Chapter 12: General Equilibrium and the Efficiency of Perfect Competition

What valuable company is nobody building? This question is harder than it looks, because your company could create a lot of value without becoming very valuable itself. Creating value isn't enough -- you also need to capture some of the value you create. This means that even very big businesses can be bad businesses. For example, U.S. airline companies serve millions of passengers and create hundreds of billions of dollars of value each year. But in 2012, when the average airfare each way was $178, the airlines made only 37 cents per passenger trip. Compare them to Google, which creates less value but captures far more. Google brought in $50 billion in 2012 (versus $160 billion for the airlines), but it kept 21% of those revenues as profits -- more than 100 times the airline industry's profit margin that year. Google makes so much money that it is now worth three times more than every U.S. airline combined. The airlines compete with each other, but Google stands alone. Economists use two simplified models to explain the difference: perfect competition and monopoly. "Perfect competition" is considered both the ideal and the default state in Economics 101. So-called perfectly competitive markets achieve equilibrium when producer supply meets consumer demand. Every firm in a competitive market is undifferentiated and sells the same homogeneous products. Since no firm has any market power, they must all sell at whatever price the market determines. If there is money to be made, new firms will enter the market, increase supply, drive prices down and thereby eliminate the profits that attracted them in the first place. If too many firms enter the market, they'll suffer losses, some will fold, and prices will rise back to sustainable levels. Under perfect competition, in the long run no company makes an economic profit. The opposite of perfect competition is monopoly. Whereas a competitive firm must sell at the market price, a monopoly owns its market, so it can set its own prices. Since it has no competition, it produces at the quantity and price combination that maximizes its profits. To an economist, every monopoly looks the same, whether it deviously eliminates rivals, secures a license from the state or innovates its way to the top. I'm not interested in illegal bullies or government favorites: By "monopoly," I mean the kind of company that is so good at what it does that no other firm can offer a close substitute. Google is a good example of a company that went from 0 to 1: It hasn't competed in search since the early 2000s, when it definitively distanced itself from Microsoft and Yahoo! Americans mythologize competition and credit it with saving us from socialist bread lines. Actually, capitalism and competition are opposites. Capitalism is premised on the accumulation of capital, but under perfect competition, all profits get competed away. The lesson for entrepreneurs is clear: If you want to create and capture lasting value, don't build an undifferentiated commodity business. How much of the world is actually monopolistic? How much is truly competitive? It is hard to say because our common conversation about these matters is so confused. To the outside observer, all businesses can seem reasonably alike, so it is easy to perceive only small differences between them. But the reality is much more binary than that. There is an enormous difference between perfect competition and monopoly, and most businesses are much closer to one extreme than we commonly realize. The confusion comes from a universal bias for describing market conditions in self-serving ways: Both monopolists and competitors are incentivized to bend the truth. Monopolists lie to protect themselves. They know that bragging about their great monopoly invites being audited, scrutinized and attacked. Since they very much want their monopoly profits to continue unmolested, they tend to do whatever they can to conceal their monopoly -- usually by exaggerating the power of their (nonexistent) competition. Think about how Google talks about its business. It certainly doesn't claim to be a monopoly. But is it one? Well, it depends: a monopoly in what? Let's say that Google is primarily a search engine. As of May 2014, it owns about 68% of the search market. (Its closest competitors, Microsoft and Yahoo!, have about 19% and 10%, respectively.) If that doesn't seem dominant enough, consider the fact that the word "google" is now an official entry in the Oxford English Dictionary -- as a verb. Don't hold your breath waiting for that to happen to Bing. But suppose we say that Google is primarily an advertising company. That changes things. The U.S. search-engine advertising market is $17 billion annually. Online advertising is $37 billion annually. The entire U.S. advertising market is $150 billion. And global advertising is a $495 billion market. So even if Google completely monopolized U.S. search-engine advertising, it would own just 3.4% of the global advertising market. From this angle, Google looks like a small player in a competitive world. What if we frame Google as a multifaceted technology company instead? This seems reasonable enough; in addition to its search engine, Google makes dozens of other software products, not to mention robotic cars, Android phones and wearable computers. But 95% of Google's revenue comes from search advertising; its other products generated just $2.35 billion in 2012 and its consumer-tech products a mere fraction of that. Since consumer tech is a $964 billion market globally, Google owns less than 0.24% of it -- a far cry from relevance, let alone monopoly. Framing itself as just another tech company allows Google to escape all sorts of unwanted attention. Non-monopolists tell the opposite lie: "We're in a league of our own." Entrepreneurs are always biased to understate the scale of competition, but that is the biggest mistake a startup can make. The fatal temptation is to describe your market extremely narrowly so that you dominate it by definition. Suppose you want to start a restaurant in Palo Alto that serves British food. "No one else is doing it," you might reason. "We'll own the entire market." But that is only true if the relevant market is the market for British food specifically. What if the actual market is the Palo Alto restaurant market in general? And what if all the restaurants in nearby towns are part of the relevant market as well? These are hard questions, but the bigger problem is that you have an incentive not to ask them at all. When you hear that most new restaurants fail within one or two years, your instinct will be to come up with a story about how yours is different. You'll spend time trying to convince people that you are exceptional instead of seriously considering whether that is true. It would be better to pause and consider whether there are people in Palo Alto who would rather eat British food above all else. They may well not exist. In 2001, my co-workers at PayPal and I would often get lunch on Castro Street in Mountain View, Calif. We had our pick of restaurants, starting with obvious categories like Indian, sushi and burgers. There were more options once we settled on a type: North Indian or South Indian, cheaper or fancier, and so on. In contrast to the competitive local restaurant market, PayPal was then the only email-based payments company in the world. We employed fewer people than the restaurants on Castro Street did, but our business was much more valuable than all those restaurants combined. Starting a new South Indian restaurant is a really hard way to make money. If you lose sight of competitive reality and focus on trivial differentiating factors -- maybe you think your naan is superior because of your great-grandmother's recipe -- your business is unlikely to survive. The problem with a competitive business goes beyond lack of profits. Imagine you're running one of those restaurants in Mountain View. You're not that different from dozens of your competitors, so you've got to fight hard to survive. If you offer affordable food with low margins, you can probably pay employees only minimum wage. And you'll need to squeeze out every efficiency: That is why small restaurants put Grandma to work at the register and make the kids wash dishes in the back. A monopoly like Google is different. Since it doesn't have to worry about competing with anyone, it has wider latitude to care about its workers, its products and its impact on the wider world. Google's motto -- "Don't be evil" -- is in part a branding ploy, but it is also characteristic of a kind of business that is successful enough to take ethics seriously without jeopardizing its own existence. In business, money is either an important thing or it is everything. Monopolists can afford to think about things other than making money; non-monopolists can't. In perfect competition, a business is so focused on today's margins that it can't possibly plan for a long-term future. Only one thing can allow a business to transcend the daily brute struggle for survival: monopoly profits. So a monopoly is good for everyone on the inside, but what about everyone on the outside? Do outsize profits come at the expense of the rest of society? Actually, yes: Profits come out of customers' wallets, and monopolies deserve their bad reputation -- but only in a world where nothing changes. In a static world, a monopolist is just a rent collector. If you corner the market for something, you can jack up the price; others will have no choice but to buy from you. Think of the famous board game: Deeds are shuffled around from player to player, but the board never changes. There is no way to win by inventing a better kind of real-estate development. The relative values of the properties are fixed for all time, so all you can do is try to buy them up. But the world we live in is dynamic: We can invent new and better things. Creative monopolists give customers more choices by adding entirely new categories of abundance to the world. Creative monopolies aren't just good for the rest of society; they're powerful engines for making it better. Even the government knows this: That is why one of its departments works hard to create monopolies (by granting patents to new inventions) even though another part hunts them down (by prosecuting antitrust cases). It is possible to question whether anyone should really be awarded a monopoly simply for having been the first to think of something like a mobile software design. But something like Apple's monopoly profits from designing, producing and marketing the iPhone were clearly the reward for creating greater abundance, not artificial scarcity: Customers were happy to finally have the choice of paying high prices to get a smartphone that actually works. The dynamism of new monopolies itself explains why old monopolies don't strangle innovation. With Apple's iOS at the forefront, the rise of mobile computing has dramatically reduced Microsoft's decadeslong operating system dominance. Before that, IBM's hardware monopoly of the 1960s and '70s was overtaken by Microsoft's software monopoly. AT&T had a monopoly on telephone service for most of the 20th century, but now anyone can get a cheap cellphone plan from any number of providers. If the tendency of monopoly businesses was to hold back progress, they would be dangerous, and we'd be right to oppose them. But the history of progress is a history of better monopoly businesses replacing incumbents. Monopolies drive progress because the promise of years or even decades of monopoly profits provides a powerful incentive to innovate. Then monopolies can keep innovating because profits enable them to make the long-term plans and finance the ambitious research projects that firms locked in competition can't dream of. So why are economists obsessed with competition as an ideal state? It is a relic of history. Economists copied their mathematics from the work of 19th-century physicists: They see individuals and businesses as interchangeable atoms, not as unique creators. Their theories describe an equilibrium state of perfect competition because that is what's easy to model, not because it represents the best of business. But the long-run equilibrium predicted by 19th-century physics was a state in which all energy is evenly distributed and everything comes to rest -- also known as the heat death of the universe. Whatever your views on thermodynamics, it is a powerful metaphor. In business, equilibrium means stasis, and stasis means death. If your industry is in a competitive equilibrium, the death of your business won't matter to the world; some other undifferentiated competitor will always be ready to take your place. Perfect equilibrium may describe the void that is most of the universe. It may even characterize many businesses. But every new creation takes place far from equilibrium. In the real world outside economic theory, every business is successful exactly to the extent that it does something others cannot. Monopoly is therefore not a pathology or an exception. Monopoly is the condition of every successful business. Tolstoy famously opens "Anna Karenina" by observing: "All happy families are alike; each unhappy family is unhappy in its own way." Business is the opposite. All happy companies are different: Each one earns a monopoly by solving a unique problem. All failed companies are the same: They failed to escape competition.

According to the article above by Peter Thiel do you think perfect competition is best for the economy and for consumers? Why or why not? What does Peter Thiel think about perfect competition versus monopolies?

See the question and two answers, give brief your own opinion for each answer( are you agree on disagree with the answer, why?)

Q:This week, we are discussing market types. In this forum, please pick one of the market types that are presented in your textbook and provide your own definition (use your own words) and example. What do you think are the benefits vs. deficiencies of your chosen market type?

Answer 1)

Perfect Competition

This kind of market type stipulates the overall advantage that a market has. In this market, there are many sellers and buyers.These players do not control the price of commodities or services but the prices are controlled by the demand and supply of goods and services. As a result of this, no one can determine the market price of commodities because customers will switch to the next best alternative. All the market players in this sense are price takers and the customers that subscribe to these goods have a lot of experience about the goods offered. It means therefore that they have adequate information about the goods available, which means, therefore, they are aware of the prices that are being charged. All the firms that exist in this kind of market type have a relatively small market share because of the existence of so many of them. The market is also characterized by free entry and exit of firms. New firms can enter the market if they so wish and create competition to the existing firms. Due to this nature of many firms, most of them only earn enough to keep them on the market and nothing more for these firms (Makowski & Ostroy, 2001).

Answer 2)

The Oligopoly; best recognized by few sellers, identical (or similar) products, and its difficult entryinto the market. A good way to determine if a market has an oligopoly is if the change in one seller, causes its "competition" to change likewise. Automotive, cell phone industries, and aviation are some examples of markets that have an oligopoly. In the automotive industry, if one vehicle producer (lets say Chevrolet) changes the body style of its line up, other "completion" is soon to follow. Notice how cars these days are getting nicer and nicer for the base model? Research and Development is greatly valued in an industry that has an oligopoly. This is because if a seller lowers prices, they understand that its competitors will soon follow with ease. But, if they develop a better improvement over its last model in technology, it is much harder to follow than just a reduction in price.

The advantage of an oiligolpoly is that the leaders can set prices instead of take them. Which leads to those that are in charge having the ability to increase profit margins above what they would be in a truly free market.

The disadvantage is that for those looking to try to get into the market will have much difficulty because of the common huge capitol expenditures required to actually compete with the big boys.

Please If you can highlight or mark the correct answer

Activity : 2 point(s)

If P = $8 and MC = $5 + 0. 2Q, the competitive firm's profit-maximizing level of output is:

5

0.2

8

15

Activity : 2 point(s)

In the long run, firms will exit a perfectly competitive industry if:

excess profits exceed zero.

excess profits are less than zero.

total profit equals zero.

excess profits equal zero.

Activity : 2 point(s)

In long-run equilibrium, monopoly prices are set at a level where:

price exceeds marginal revenue.

industry demand equals industry supply.

industry demand is less than industry supply.

price exceeds average revenue.

Activity : 1 point(s)

The kinked demand curve theory of oligopoly assumes that rival firms:

react to price increases.

react to price increases and decreases.

do not react to price changes.

react to price decreases.

Activity : 1 point(s)

In oligopoly markets, the market demand curve is:

upward sloping.

downward sloping.

horizontal.

vertical.

Activity : 2 point(s)

The level of competition in a given market tends to increase if:

minimum efficient scale of firms increases.

the number of substitutes increases.

significant barriers to exit are imposed.

the number of potential entrants decreases.

Activity : 2 point(s)

In the short run, the:

firm has complete flexibility with respect to input use.

availability of all inputs is fixed.

operating period is longer than the planning period.

availability of at least one input is fixed.

Activity : 1 point(s)

In both monopolistic competition and oligopoly markets:

there is easy entry and exit.

consumers perceive differences among the products of various competitors.

economic profits may be earned in the long run.

there are many sellers.

Activity : 1 point(s)

In oligopoly equilibrium:

MC = AC

MC > AC

MR = MC

MC < AC

Activity : 2 point(s)

A firm will earn normal profits when price:

equals average total cost.

equals average variable cost.

equals marginal cost.

exceeds minimum average total cost.

Activity : 2 point(s)

Economic costs include both explicit and implicit cost. When analyzing costs the next-best use of a given asset is called:

current cost.

replacement cost.

historical cost

opportunity cost.

Activity : 2 point(s)

In a perfectly competitive market:

sellers and buyers have perfect information.

entry and exit are difficult.

c. sellers produce similar, but not identical products.

each seller can affect the market price by changing output.

Activity : 2 point(s)

In competitive market equilibrium, the firm's:

MR = MC and P > AR

MR = MC and P > AC

AR = AC and MR > MC

P = MR = AR = AC = MC

Activity : 1 point(s)

A firm should increase advertising if the net marginal revenue derived is:

equal to the marginal cost of advertising.

greater than the marginal cost of advertising.

greater than zero.

less than the marginal cost of advertising.

Activity : 2 point(s)

For a firm in perfectly competitive market equilibrium:

a replacement cost.

an implicit cost.

an explicit cost.

an opportunity cost.

Activity : 1 point(s)

In a monopolistically competitive industry, firms:

offer products that are not perfect substitutes.

make decisions in light of expected reactions from other firms.

set price equal to marginal cost.

are price takers.

Activity : 2 point(s)

Fixed costs include:

variable labor expenses.

output-related energy costs.

output-related raw material costs.

variable interest costs for borrowed capital.

Activity : 2 point(s)

A monopolist maximizes profits by producing a level of output when:

P = AC

P > MC

P < MC

P = MC

Activity : 2 point(s)

The demand curve for a unique product without substitutes is:

upward sloping.

downward sloping.

horizontal.

vertical.

Activity : 2 point(s)

At the point of minimum Average Variable Cost:

historical cost.

incremental cost.

current cost.

Activity : 2 point(s)

In the decision process, management should ignore:

implicit costs.

historical costs.

sunk costs.

incremental costs.

Activity : 1 point(s)

At the profit maximizing level of output for a monopolist:

P = AR and AR = AC

P = MC and MR > MC

P = MR and AC = MC

P > MC and MR = MC

Activity : 2 point(s)

In perfectly competitive markets, profits are maximized when:

MC=AC

P>AC

MR=MC

MR=P

Activity : 2 point(s)

Graphically, competitive market supply is measured by the:

vertical difference of competitor demand curves.

vertical sum of competitor demand curves.

horizontal difference of competitor MC curves.

horizontal sum of competitor MC curves.

Activity : 2 point(s)

For a firm in perfectly competitive market equilibrium:

MR < AR

P > AC

P > MR

P = MC

Activity : 2 point(s)

In the long run, firms will offer supply at the point where P = MR = MC if:

MC is rising.

MC is falling.

MC is constant.

P > AC

Activity : 2 point(s)

The firm demand curve in a competitive market is:

upward sloping.

downward sloping.

horizontal.

vertical.

Activity : 1 point(s)

Monopolistic competition is characterized by:

homogeneous products.

barriers to entry and exit.

perfect dissemination of information.

few buyers and sellers.

Activity : 2 point(s)

Marginal cost equals:

average variable cost at its maximum point.

the change in total fixed cost divided by the change in quantity.

the change in total variable cost divided by the change in quantity.

total cost divided by quantity.

Activity : 2 point(s)

In the short run, a perfectly competitive firm will shut down and produce nothing if:

excess profits equal zero.

total cost exceeds total revenue.

total variable cost exceeds total revenue.

the market price falls below the minimum average total cost.

Activity : 2 point(s)

For a monopoly in equilibrium:

MR = MC

MC ≤ AC

MR ≤ AC

P ≥ AC

Activity : 2 point(s)

When profits are maximized in a competitive market, average cost is always:

rising.

falling.

constant.

none of these.

Activity : 2 point(s)

So long as P > AVC, the competitive firm's short-run supply curve is equal to:

AVC

P

MC

none of these.

Activity : 1 point(s)

The four-firm concentration ratio will rise following:

a rise in imports.

a fall in imports.

a merger between the two largest firms in the industry.

small firm entry.

Activity : 2 point(s)

In oligopoly markets, the market demand curve is:

point on the short-run marginal cost curve.

short-run average cost of production.

long-run average cost of production.

point on the short-run average cost curve.

Activity : 2 point(s)

The following market cannot be described as perfectly competitive:

the unskilled labor market.

the milk market.

discount retailing.

the agricultural grain markets.

Activity : 2 point(s)

In the long run, the:

availability of at least one input is fixed.

firm's operating decisions are typically constrained by prior capital expenditures.

availability of all but one input is fixed.

firm has complete flexibility with respect to input use.

Activity : 1 point(s)

The industry supply curve is derived through the horizontal summation of firm:

average cost curves.

marginal revenue curves.

marginal cost curves.

demand curves.

Activity : 2 point(s)

Price and product quality competition tends to be vigorous when:

entry barriers are low.

potential entrants are few.

product quality information is scarce.

the number of active sellers is few.

Activity : 1 point(s)

A perfectly functioning cartel results in:

oligopoly.

monopoly.

perfect competition.

monopolistic competition.

Activity : 1 point(s)

When prices in monopolistically competitive markets exceed those in a perfectly competitive equilibrium, this difference is the cost of:

information.

market power.

inefficiency.

product differentiation.

Activity : 1 point(s)

In the short run, a monopolist will:

shut down if price equals average total cost.

shut down if price is less than average total cost.

shut down if price is less than average variable cost.

never shut down.

Activity : 2 point(s)

In the short run, a perfectly competitive firm will shut down and produce nothing if:

typically involve multiple units of output.

do not vary across decision alternatives.

come into play when judging the costs of adding a new product line, advertising campaign, production shift, or organization structure.

play a role in determining the optimal course of action.

Activity : 2 point(s)

At the point of minimum AVC:

MC is falling.

MC is constant.

MC is rising.

MC = AVC.

Activity : 2 point(s)

A monopsony is a market with:

many sellers.

one buyer.

many buyers.

one seller.

Activity : 1 point(s)

The demand curve faced by a firm in a monopolistically competitive industry is:

the downward sloping industry demand curve.

downward sloping.

more elastic than the perfectly competitive firm's demand curve.

horizontal.

Activity : 2 point(s)

Perfect competition always prevails in markets with:

few buyers and sellers.

many buyers and sellers.

an even balance of power between sellers and buyers.

a single buyer.

Activity : 2 point(s)

If the slope of a long-run total cost function decreases as output increases, the firm's underlying production function exhibits:

constant returns to scale.

decreasing returns to scale.

decreasing returns to a factor input.

increasing returns to scale.

Activity : 2 point(s)

Average cost declines as output expands in a production process with:

constant returns to scale.

decreasing returns to scale.

decreasing returns to a factor input.

increasing returns to scale.

Activity : 2 point(s)

If the productivity of variable factors is decreasing in the short-run:

marginal cost must increase as output increases.

average cost must decrease as output increases.

average cost must increase as output increases.

marginal cost must decrease as output increases.