Chapter 10 · Microeconomics
Performance of Firms in Imperfect Competition
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Efficiency and welfare
Allocative efficiency
- Imperfect competitors set P above MC and restrict output to Qm at price Pm.
- More market power means greater allocative inefficiency.
Productive efficiency
- Perfect competitors produce at minimum AC (Qpc).
- Imperfect competitors leave excess capacity because output falls short of minimum AC.
- The monopolist is the most productively inefficient.
Dynamic efficiency
- Supernormal profit funds R&D and innovation.
- Greater contestability raises the willingness to innovate.
- Process innovation lowers average cost.
Consumer welfare
- Weighed up by price, quantity, economies of scale, quality and variety.
- Advertising may create imaginary differences rather than real ones.
Equity
- Supernormal profit can worsen income inequality.
- Price discrimination can help, for example discounted medical fees for lower-income patients.
- Natural monopolies supplying basic goods fall heavily on lower-income budgets.
Impact on other firms
- Dominant firms reduce the contestability that rivals would otherwise face.
Government intervention
Regulatory pricing
- Used mainly for natural monopolies whose average cost declines.
- MC pricing (P = MC): maximises welfare but yields subnormal profit wherever MC is below AC.
- MC pricing under nationalisation runs persistent losses funded by tax; bureaucrats lack a profit incentive and produce inefficiently.
- AC pricing (P = AC): earns normal profit and lowers price, reducing allocative inefficiency, but removes the incentive to innovate.
Regulatory standards
- Performance targets with penalties, for example LTA standards for bus services.
- Effective but costly to monitor.
Competition policy
- Lowers barriers to entry so new firms enter.
- Incumbent demand falls and allocative efficiency improves.
Lump-sum tax
- Shifts AC up without affecting MC or output, leaving normal+ area profit.
- Revenue can fund transfer payments.
- May limit the firm's capacity for R&D.
Government Contracting Model
- Firms bid competitively on price to run the service.
- Contracts may become so detailed that the government effectively runs the firm.
Evaluation Points
- The efficiency of a firm is a trade-off between static inefficiency (P above MC) and dynamic gains from innovation.
- Regulation can trade allocative gains against lost incentives to cut cost and innovate.
- There is no single best remedy; the choice depends on how deep the market failure runs and how contestable the market is.