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Perfectly Absurd

Lynne Kiesling’s post on the perils of the model of “perfect” competition is spot-on.

This semester I’m teaching an introductory economics course to first-year law students at George Mason University. While I run through with them the mechanics of the perfect-competition model, I warn my students that this model is neither descriptive (this much is obvious) nor prescriptive (this much is less obvious, given this model’s appallingly inappropriate name).

In textbook models of markets, a firm that differentiates its product from those offered by its rivals will generate inefficiencies. The alleged reason is that the differentiated product gives the firm the power to raise price without losing all of its market. (In econ-speak, the firm offering the differentiated product now faces a demand curve that now is less than infinitely elastic.) The intuition is this: now that the firm’s product differs from those of its rivals, some consumers will suffer paying a higher price for this differentiated product because no other supplier offers a product exactly like this newly differentiated one, so the pressure on the producer of this differentiated product to keep its price as low as possible (in econ-speak, equal to marginal cost) is less intense than it is when all producers offer products that are indistinguishable from each other.

Product differentiation creates inefficiency relative to the state of the market in “perfect” competition. QED. In other words, markets less than “perfectly competitive” are wasteful. This conclusion is tossed before students routinely.

This conclusion is perfectly absurd.

This conclusion is perfectly absurd for a variety of reasons. Here’s my favorite.

The only reason the newly differentiated product sells at a price higher than the price charged when the market was “perfectly competitive” is that the consumers who buy this differentiated product value it more highly than they value the undifferentiated product – the one still sold by the many firms remaining in the “perfectly competitive” part of the industry. Because, by assumption, many firms make up a “perfectly competitive” industry, any consumer who does not want to pay the higher price for the differentiated product can satisfy all of his demands for this industry’s output by buying as much as he wants of the undifferentiated product from the other firms, all at the lower price.

In short, the only reason product differentiation leads to higher prices and less-elastic demand curves is because it appeals to consumers – it makes them better off compared to how they were before the differentiation occurred.

A useful, although academic, book on this subject is Perfect Competition and the Transformation of Economics (1995), by Frank M. Machovec.


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