Perfect competition is our benchmark. What are the conditions required for a well-functioning competitive market?

Describe a competitive equilibrium, and why is it efficient?

Pareto optimality: Can the equilibrium be replaced by another that would increase the welfare of some without reducing the welfare of others?

But what about distributive justice? The above view of social welfare is based on the notion that value is revealed through willingness-to-pay along a demand curve. But people who value goods/services but lack ability to pay are omitted….

Describe consumer and producer surplus in a competitive market. How is it that they are maximized (assuming a well-functioning competitive market) in a competitive equilibrium?

Maximizing total surplus yields a welfare maximum in a market setting. We say that this outcome results in allocative efficiency because one could not re-allocate (i.e., produce either more or less) production and increase total surplus.

Why does the allocatively efficient market outcome imply P = MC at the level of the perfectly competitive firm? Draw diagram….

Market Failure: Monopoly/cartel….

Deadweight loss as inefficiency….

But what about situations that feature large economies of scale (define…)? Relate to Natural Monopoly…. Public utilities and regulation (later)….

Economies of scale can and do also lead to oligopoly structures, which may feature interfirm rivalry but may not generate P = MC outcomes. Examples: Cournot….

What about efficiency under conditions of product differentiation? The assumption in a perfectly competitive market is that products are essentially identical…. Link to monopolistic competition equilibrium, which is not economically efficient (production does not occur at minimum cost).

Estimates of the Welfare Loss from Monopoly:

How do we compute the area of deadweight loss (assume linearity for simplicity…), which illustrates allocative inefficiency?

Another source of inefficiency: The resources expended in bidding for and competing for the opportunity to be a monopolist with market power created by government, or in general to get $ or valuable resources from government. Bribes, political contributions, etc. Called rent-seeking behavior. Examples: Telecommunications Act of 1996; logging road subsidies; grazing subsidies; protection of 1872 mining act. One might also view much of image advertising as a form of wasteful rent-seeking behavior….

Harberger: Welfare losses are less than 1 percent of GNP.

Cowling and Mueller: DWL is approximately equal to 0.5*profit, where profit is

(P-AC)*Q. Generated DWL estimate of 4 percent of GNP.

Technical Progress: The overwhelming source of productivity gains in the US economy has been technological progress. Increases in productivity (more output for a given amount of input) is the key source of increases in wealth in an economy.

Schumpeter Hypothesis: Excess profit (P > MC) helps firms afford socially desirable R&D in productivity-enhancing technology.

Alternative Hypotheis: Rivalry and competition creates an incentive to find product-enhancing or cost-lowering innovations. Rewards to winner position (licensing income, first mover advantage).

Terminology: basic research (not directed toward particular profit opportunity); applied research (basic research findings directed toward potentially profitable products or services or cost-reducing process changes); development leads to commercial application of applied research finding, which eventually diffuses through the economy by way of licensing or imitation or theft (e.g., Hong Kong).