Chapter 5

Question 1

Assumptions of Perfect Competition

Answer 1

○ A homogenous commodity (i.e. no product differentiation)
○ A large number of relatively small buyers and sellers
○ Free entry and exit into and out of the market
○ Perfect information
○ Perfect factor mobility
○ Zero transaction costs

Question 2

2 Forms of Market Efficiency

Answer 2

Allocative

Productive

Question 3

Allocative Efficiency

Answer 3

i. If the goods are homogenous, there will be a wide availability of substitutes.
ii. Bid down the market-clearing price until price (p) equals marginal cost (mc).
iii. Implies that the value customers place on good is equal to cost of resources used to produce it.

Question 4

Productive Efficiency

Answer 4

i. Free entry means if firms are making profit (AR>AC) there will be new entrants, which raises AC for all firms and competes away the profit
ii. Any losses (AR < AC) will result in firms leaving the industry, reducing AC.
iii. In equilibrium, firms make zero profit (AR=AC) and will produce minimum of the average cost curve.
1) Occurs when goods are made at lowest possible cost. Puts the economy on outer limit of ‘production possibility frontier’ (PPF).

Question 5

○ Assumptions of imperfect competition

Answer 5

§ A clearly defined heterogeneous product with no close substitutes
§ A single seller
Prohibitive barriers to entry and exit.

Question 6

Absent market competition firms may

Answer 6

restrict output and increase prices so that they divert consumer surplus into profit.

Question 7

Definition of perfect competition and monopoly are

Answer 7

imaginary constraints; hypothetical tools that economists use to benchmark reality. Economists and policymakers use this framework as means to regulate real markets.

Question 8

If you have a narrow definition (single seller) then

Answer 8

there are no monopolies, but if you have a broad definition (the seller of a heterogeneous product) then every good would count.

Question 9

If an individual firm has > 25% of market share

Answer 9

it’s considered a monopoly.

Question 10

Herfindahl Index

Answer 10

○ Perfectly competitive industry would have index of 0
○ Monopoly have index of 1
Higher the number, the more concentrated the market. Competition is defined by market concentration

Question 11

Natural monopoly

Answer 11

refers to a situation where the economies of scale are so large that the optimal number of firms in the market is one.
○ Cannot tell if it’s a natural monopoly unless we see how competitive it is.
○ Some cases natural monopolies rely on barriers to entry, and not economies of scale, and how in other cases natural monopolies are beneficial for consumers.

Question 12

Collusion is inherently

Answer 12

unstable

Question 13

Factors of Collusion

Answer 13

○ Number of firms - the bigger the cartel, the harder it is to maintain agreement
○ Detection of price cuts - it’s often difficult to tell if members are cheating
○ Low entry barriers - its not easy to prevent non-cartel members from competing
○ Unstable demand conditions - firms may have different outlooks for future demand and disagree on how they should respond
○ Difference in costs - if some firms are more efficient than others they would prefer to capture more market share

Question 14

Biggest downside to regulation

Answer 14

a homogenizing effect on market behavior overall

○ It is the nature of markets for firms to compete on different margins and to experiment

Question 15

In equilibrium perfectly competitive firms make

Answer 15

The existence of profit could also imply that the market is in disequilibrium.

Question 16

static approach

Answer 16

The static approach is to assume we’re in equilibrium and therefore we view profit as a sign of inefficiency.

Question 17

dynamic approach

Answer 17

The dynamic approach is to conclude that the market is simply in disequilibrium.

Question 18

Profit serves two functions:

Answer 18

1. Profit provides an incentive - a reward for entrepreneurial discovery
   Profit provides knowledge - a signal to mobilize resources

Question 19

Dynamic

Answer 19

Profit derives from entrepreneurial exposure to uncertainty - ‘residual earnings after all contractual claims have been met’.

Question 20

Static

Answer 20

profit is ‘passive or accidental earnings as a consequence of deviations from perfect competition’ aka ‘rents’ and imply that profits are regrettable and the only thing they signal is inefficiency and waste

Question 21

Monopolies can only persist if

Answer 21

legally protected. Since the barriers to entry and exit are due to government regulations, their only responsibility in providing a ‘competitive market’ is refraining from restrictions on businesses.

Question 22

Regulation and competition policy are not ways to control monopolies

Answer 22

they’re the reason monopolies exist.
§ Regulations can be counterproductive since they raise the cost of doing business, offering an advantage to existing firms or larger ones who can afford legal advice and regulatory expertise.
§ When entry is free we get the good results regardless of the situation with market share.