Market power and barriers to entry

A third important condition in the invisible hand result is that both consumers and producers are assumed to take prices as given, so that neither have any market power. This means that neither producers nor consumers can profitably move prices away from the prevailing market price. If firms use their market power, however, then the market outcome can fail to be efficient (although sometimes only a single firm in the industry can be enough to guarantee an efficient outcome). The basic idea is that if a firm has market power, it may be willing to increase price (and lose some - but not all - of its customers), thereby lowering revenue but also lowering costs, which could increase the firm's profit. But if price no long equals marginal cost, then some gains from trade have been left unexploited, which means that the outcome cannot be efficient. As Chapter 10 shows, the connections between the number of firms in an industry, the extent of market power, and the ensuing efficiency losses can often be tenuous.

Finally, the invisible hand result assumes that there are no barriers to entry or exit. The importance of this can be seen in our analysis of long- run competitive equilibrium explored earlier. If there are barriers to entry, then the long-run market supply curve is effectively just the short-run supply curve, which is the sum of individual short-run marginal cost curves and is generally upward sloping. If demand increases for some reason, then in the presence of barriers to entry, new firms will not be able to enter the market, and greater demand will be rationed with higher prices. Firms will be able to earn economic profits in the short run. However, these profits may eventually be dissipated away as the prices of scarce inputs rise and profits are bid down to zero. In this case, the owners of those scarce factors of production would earn economic rents. Relative to a situation without entry barriers, overall welfare would be lower.

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