Unit 4: Perfect Competition
4.1: Perfect competition in the short run
Now that we have discussed the concepts of firm production and costs in general, we can study how these concepts apply to specific markets. We will study the way in which market structure impacts firm output and pricing decisions. We begin with perfectly competitive markets.
Characteristics of Perfect Competition
There are three important features of a perfectly competitive market.
• Large number of buyers and sellers: The number of buyers and sellers in a perfectly
competitive market is so large that no individual buyer or seller can exert any influence on the market price. If we take one farmer out of the thousands of farmers growing rice in India, whether he changes his output or goes out of business, his decisions are too small to impact the market price of rice.
• Sellers sell an identical (homogeneous) product: In perfect competition, there is no
differentiation among the products offered by various sellers. This rules out branded products like soap or restaurants, which are differentiated.
• Easy entry and exit: Perfectly competitive markets must feature easy entry for new firms.
For example, there can’t be huge start-up costs or legal barriers that would prevent firms from entering the market. Conversely, it must be easy for firms to leave the industry when they want to. For example, there can’t be a lot of specialized equipment that the firm has difficulty selling off.
Pricing
The diagram below shows the entire market for wheat. It describes all buyers and all sellers.
The market equilibrium is for 100,000 bushels of wheat to be traded at a price of $40 per bushel. Now, one of the conditions of perfect competition is that there are so many buyers and sellers that each seller’s own output has no influence on the price. What this means is that, from the perspective of a single firm, the selling price of wheat is $40 per bushel regardless of that firm’s output. Whether the individual firm produces no wheat or whether the individual firm produces 100 bushels of wheat, the firm is too small to impact the market price of wheat.
The diagram below shows the firm’s demand curve for wheat alongside the market for wheat. Note that 𝑄𝑄 designates the market output of wheat, while 𝑞𝑞 designates the firm’s output of wheat. The firm’s output has no impact on the price at which wheat is sold.
This makes sense. There are a large number of firms selling exactly the same product for $40. If an individual firm tried to raise its price, even to $40.01, it wouldn’t sell any wheat since there are thousands of firms selling exactly the same wheat at the market price of $40. The firm can’t raise its price at all or it loses all its business – this is what it means for demand to be perfectly elastic.
But what about prices below $40? Actually, there is no reason to consider prices lower than $40. Look at the demand curve. The firm can sell as much wheat as it wants at $40. The firm is small in relation to the overall size of the market and therefore can increase its own output with no impact on the selling price. The firm has no reason to charge a price lower than $40 because it can already sell as much wheat as it wants at $40.
Perfectly competitive firms are said to be price-takers, and we now see what this means. When the market price of wheat is $40, the firm simply accepts this price and sells as much wheat as it wants to sell at $40. The firm does not choose the price and it has no impact on the price. It accepts the market price.
The negative way to look at price taking is that the firm has no power whatsoever to raise its price. A more positive perspective is that a perfectly competitive firm can sell as much output as it wants at that market price. This is different from a firm with market power, like an airline, which would have to cut its price in order to increase its sales.
Marginal Revenue
The total revenue earned by a firm is defined as 𝑇𝑇𝑇𝑇 =𝑃𝑃×𝑞𝑞. Marginal revenue is the additional
revenue from selling one more unit. Precisely, marginal revenue is defined as follows.
𝑀𝑀𝑇𝑇= Δ𝑇𝑇𝑇𝑇Δ𝑞𝑞
q (bushels) P TR MR
0 40 0 --
1 40 40 40
2 40 80 40
3 40 120 40
4 40 160 40
5 40 200 40
6 40 240 40
7 40 280 40
The marginal revenue from selling one more bushel of wheat is always exactly equal to $40. This makes sense. Every time a firm sells one more bushel of wheat, the bushel sells for a price of $40, and so the firm’s revenue goes up by $40. For perfect competitors, marginal revenue is always equal to price. The firm’s marginal revenue curve is shown below.
Profit Maximization
q (bushels) P TR MR TC MC
0 40 0 -- 10 --
1 40 40 40 15 5
2 40 80 40 25 10
3 40 120 40 40 15
4 40 160 40 60 20
5 40 200 40 90 30
6 40 240 40 150 60
7 40 280 40 250 100
Determining the level of output that the firm should produce is a simple marginal benefit / marginal cost comparison.
Producing the first bushel adds $40 to revenue (MR) but it only adds $5 to costs (MC). Since the marginal revenue exceeds the marginal cost, the firm should produce the first bushel. The same can be said of the second, third, fourth and fifth bushel, for which the marginal revenue is also greater than the marginal cost. However, the firm should not produce the sixth bushel or the seventh bushel of wheat, because the additional cost of producing them (MC) is greater than the additional revenue (MR) that the firm earns. Producing these bushels would actually lower the firm’s profit. So the firm’s optimal level of output is 5 bushels.
• What if MR > MC? If the firm is producing at output level 𝑞𝑞1, then its revenue from selling another unit (MR) exceeds the cost of producing the unit (MC). Thus, the firm would increase its profit by producing more output. Any time MR > MC, the firm should increase its output in order to raise profit.
• What if MR < MC? If the firm is producing at output level 𝑞𝑞2, then its cost of producing
the marginal unit (MC) exceeds the revenue that it earned from that unit (MR). Thus, the firm should cut back on output in order to raise its profit. Any time MR < MC, the firm should reduce its output in order to raise profit.
Putting these two facts together, the profit-maximizing level of output for any firm is the level of output where MR = MC. This rule is so important that it is sometimes called the “golden rule” of profit maximization.
There are three points to clarify about the MR=MC rule. First, it is true that the firm should raise its output any time MR > MC, and so the rule for the profit-maximizing level of output is to produce up to the point where MR = MC. But if we are working with discrete units, like in the table, we might not be able to find a unit for which MR = MC exactly. As usual in cases like this, we go up to the last unit where the MR is greater than the MC.
Second, notice on the diagram that the highest profit on a single unit is earned when the firm produces 𝑞𝑞1 units of output. This is the greatest difference between marginal revenue and marginal cost. But if it produces one more unit beyond 𝑞𝑞1, the marginal revenue is still greater than the marginal cost. In other words, producing another unit still adds profit. It just doesn’t add as much
profit as what producing 𝑞𝑞1 added. Nevertheless, profit still rises by increasing output any time MR > MC. The firm should continue producing any output where MR > MC and stop right at the point where the two are equated: MR = MC.
Third, remember that marginal revenue is exactly equal to price for a perfect competitor. Thus, the profit maximizing rule MR = MC can be alternatively stated as P = MC, but this holds for perfectly competitive markets only. The MR = MC rule is universal for all markets, but it is not true that price and marginal revenue are equal in other markets.
Showing Profit Graphically
Now, 𝑃𝑃∗ is the price at which each unit is sold. Average total cost (ATC) is the cost per unit of production. Thus, the difference between 𝑃𝑃∗ and ATC represents the profit earned on each unit. If a product sells at a price of $10 per unit, but the cost of production is only $8 per unit, then the firm earns a profit of $2 for each unit produced.
On the other hand, if the market price 𝑃𝑃∗ is lower than the firm’s average total cost, then the firm is earning a loss. Its optimal level of output is still where MR = MC, which is described now as “loss-minimizing” rather than “profit-maximizing”. The loss per unit is the difference between the price and the per-unit cost of production ATC. And then the total loss is this per-unit loss multiplied over all units produced.
Shut Down Rule
If a firm is losing money, isn’t it better just to shut down production completely? The answer, it turns out, is not quite this simple. It sometimes can make sense for a firm to stay open even if it is losing money, at least in the short-run.
Consider Firm A and Firm B, whose daily cost and revenue data are shown in the table below.
Firm A Firm B
Total Revenue $500 $500
Total Fixed Costs $100 $600
Total Variable Costs $700 $200
Total Costs $800 $800
Now, both firms earn a loss of $300 per day as long as they are operational, since total revenue is only $500 but total costs are $800.
to be paid in the short-run regardless of output level. If a firm shuts down in the short-run, it loses its fixed costs. With this in mind, the table below shows each firm’s loss if it operates and if it shuts down.
Firm A Firm B
Total Revenue $500 $500
Total Fixed Costs $100 $600
Total Variable Costs $700 $200
Total Costs $800 $800
Loss if operating $300 $300
Loss if shut down $100 $600
Firm A is better off shutting down. It loses only the $100 fixed cost when it shuts down but it loses $300 when it operates.
But Firm B is better off producing in the short-run, even at a loss. It loses more by shutting down than what it loses by operating.
What is going on here? It goes back to something we talked about in the beginning of the class. In making the decision about whether to operate, the fixed cost is a sunk cost. In the short-run, the firm has to pay the fixed cost regardless of whether it operates or shuts down. So, in fact, the fixed cost is a sunk cost that is not relevant to its decision. The only relevant information is whether the revenue that the firm earns is enough to cover its variable costs.
For Firm A, its revenues do not even cover its variable costs, so it is better for Firm A just to shut down and not operate at all. It can’t even cover the costs to open its doors. But for Firm B, the $500 revenues cover the $200 variable costs, plus they can offset some of the loss from the fixed costs. If Firm B shut down, it would lose all of the $600 fixed cost. So Firm B should operate.
So our rule for the short-run is that the firm should stay in operation as long as its total revenues exceed its total variable costs. The firm should shut down in the short run when its total revenues are lower than its total variable cost.
We have stated these rules in terms of total revenues and total costs. But they are often stated in terms of prices and average costs. These formulations are equivalent, just stated in per-unit terms.
The definition of total revenue is 𝑇𝑇𝑇𝑇 = 𝑃𝑃×𝑞𝑞, so we can write 𝑇𝑇𝑇𝑇
𝑞𝑞 = 𝑃𝑃. Also remember that the
definitions of average variable cost and average total cost are 𝐴𝐴𝐴𝐴𝐴𝐴 =𝑇𝑇𝑇𝑇𝑇𝑇
𝑞𝑞 and 𝐴𝐴𝑇𝑇𝐴𝐴 = 𝑇𝑇𝑇𝑇
𝑞𝑞.
So we can restate the rules, dividing through the inequalities by 𝑞𝑞:
• In the short-run, a firm should shut down when 𝑇𝑇𝑇𝑇 <𝑇𝑇𝐴𝐴𝐴𝐴 ⇒ 𝑃𝑃 <𝐴𝐴𝐴𝐴𝐴𝐴
• In the long-run, a firm should shut down when 𝑇𝑇𝑇𝑇 <𝑇𝑇𝐴𝐴 ⇒ 𝑃𝑃 <𝐴𝐴𝑇𝑇𝐴𝐴
In words, the firm should shut down in the short-run when the price it can charge is not enough to cover the variable costs of production. The fixed piece of the costs is irrelevant in the short-run because it is sunk. But it should shut down in the long-run any time the price is not sufficient to cover its total costs of production.
If we summarize the rule, there are 3 cases.
• If 𝑃𝑃> 𝐴𝐴𝑇𝑇𝐴𝐴, then the firm earns a profit. It should operate both in the short-run and in the long-run.
• If 𝐴𝐴𝐴𝐴𝐴𝐴 <𝑃𝑃 < 𝐴𝐴𝑇𝑇𝐴𝐴, then the firm should operate at a loss in the short-run. The price is enough to cover the variable costs, so the firm should operate in the short-run. But it is not enough to cover the total cost, so the firm should shut down in the long-run.
• If 𝑃𝑃< 𝐴𝐴𝐴𝐴𝐴𝐴, then the firm should shut down immediately in the short-run.
Short-Run Supply Curve
Remember that the firm’s marginal revenue curve is constant at the market price for perfect competition
• If the firm observes that the market price is 𝑃𝑃1, then it will produce where 𝑀𝑀𝑇𝑇1 = 𝑀𝑀𝐴𝐴, and its profit-maximizing level of output will be 𝑞𝑞1.
• If the firm observes that the market price is 𝑃𝑃2, then it will produce where 𝑀𝑀𝑇𝑇2 = 𝑀𝑀𝐴𝐴, and its profit-maximizing level of output will be 𝑞𝑞2.
So, if you want to trace out how the firm’s output depends on the price in the market, the quantity of output supplied is given on the marginal cost curve. The supply curve is the marginal cost curve.
However, there is one warning. The firm’s supply curve is the same as its marginal cost curve only if the price is above average variable cost. If the price is lower than average variable cost, then the shut-down rule applies, and so the firm would shut down and supply nothing.
To summarize, a firm’s supply curve is the same as its marginal cost curve as long as 𝑃𝑃 >𝐴𝐴𝐴𝐴𝐴𝐴. If price goes below the minimum level of AVC, then the firm shuts down and supplies no output. The diagram below shows the firm’s supply curve – the level of output that it produces as a function of the price in the market.
4.2: Perfect competition in the long-run
Profits and Entry
Let us begin by summarizing the range of possible prices in a perfectly competitive market. Remember that the firm has no control over the price and simply accepts the market price
When the price at which the firm can sell its output is higher than average total cost, then the firm earns a profit. When the price is lower than average total cost, the firm earns a loss but continues to operate in the short-run as long as the price is greater than average variable cost.
The price where the firm earns exactly zero profit is where price exactly equals ATC, which is at the minimum of the ATC curve. As we will see below, this zero-profit price is important in understanding the long-run equilibrium in perfectly competitive markets.
Suppose that the short-run price is greater than ATC, which allows each firm to earn a profit. New firms will want to enter, and one of the key conditions in perfect competition is easy entry.
→ P > ATC means that firms earn a profit
→ Entry of new firms who want to take advantage of the profit opportunity
This process of new entry and falling price continues to repeat all the way until the price drops down to the zero-profit level. Basically, any time the price is high enough to allow a profit in a competitive market, new firms will want to enter the market to have a chance at earning these profits. But this entry raises supply and lowers the market price, which continues until the price falls to the level where the profit is gone.
On the other hand, if the market price is below the zero-profit price, exactly the opposite happens.
→ P < ATC means that firms earn a loss
→ Exit of existing firms, who will leave the market to avoid losses → The market supply curve falls because of exit
→ The equilibrium price in the market rises
Basically, any time the price in the market is so low that firms are losing money, firms will exit the market, reducing the supply and raising the price. And firms will continue to exit until the price rises high enough that loss disappears.
In summary, the long-run equilibrium price in a market is the price where each firm earns exactly zero profit. At higher prices that allow firms to earn profits, new firms will enter in the long-run, causing the equilibrium price to fall. At lower prices that create losses, some existing firms exit in the long-run, causing the equilibrium price to rise.
Don’t get confused about the short-run and the long-run. In the short-run, the market price is where supply and demand are equal. Firms take this price P* and set their output where P* = MC. In the
short-run, this market price might be at a level that causes the firm to earn a profit or a loss.
But in the long-run, this market equilibrium price P* will always be at the zero-profit level, at the minimum of the ATC curve identified above. The firm always sets it output where P* = MC. It just so happens that, at the long run equilibrium, this market price P* will be at the zero profit level.
Zero Profit
Π𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 = total revenue−explicit costs
Π𝑒𝑒𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑒𝑒𝑎𝑎𝑎𝑎 = total revenue−explicit costs−implicit costs
Here is an example. Consider a firm that earns $65,000 of revenue annually. It has explicit costs of $40,000 and implicit costs of $25,000. The firm’s accounting profit is:
Π𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 = $65,000−$40,000 = $25,000
But the firm’s economic profit is:
Π𝑒𝑒𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑒𝑒𝑎𝑎𝑎𝑎 = $65,000−$40,000−$25,000 = $0
Although this firm earns an accounting profit of $25,000, it earns an economic profit of $0 because its implicit costs are exactly enough to cancel out its accounting profits.
Remember what implicit costs are. Implicit costs represent the next-best use of the firm’s resources if they were not tied up in the firm. What does it mean to say that a firm has implicit costs of $25,000? It means that the next-best use of the firm’s resources would have generated $25,000 of profit. In other words, if the firm takes its resources out of their current use and moves them to another industry, the next-best use would generate $25,000 in profit. But $25,000 is exactly the firm’s accounting profit with the resources in their current use!
Now we see what zero economic profit really means. It means that the firm earns exactly enough
accounting profit to cover the opportunity cost of its resources. In other words, the firm makes exactly enough profit to prevent to prevent the owners from wanting to switch to some other use of their resources. Enough profit so that there is no incentive to exit, but not a dollar more.
A normal profit is an accounting profit that exactly covers firms’ implicit costs (the next-best use
of their resources). In other words, a normal profit is an accounting profit such that firms earn zero economic profit. Any accounting profit in excess of normal profit is referred to as excess profit.
Now we know what it means to say that firms earn zero profit in the long-run in competitive markets. It doesn’t mean that there is literally no profit shown in the checkbook at the end of the year. It means that there are no excess profits – no profits above what would have been the next-best use of the firm’s resources. When we say zero profit, we mean zero excess profit.
profit for grapefruit farmers were higher than $90,000, then orange and lemon farmers would start growing grapefruit instead. This would raise the supply of grapefruit and cut into the excess profits.
Basically, profit levels tend to equalize in competitive markets. This is a really important piece of economic intuition. If profit rates weren’t approximately equal, people would move their resources to the more profitable industries. There can be no excess profits when there is perfect competition.
Adjustment to a Change in Demand
Suppose that a market is initially in long-run equilibrium, with equilibrium price at the zero-profit level. Suddenly, there is an increase in demand for the product, which pushes the price up above the zero-profit level. For the short-run, firms in the industry will earn some excess profits.
But what will happen over the long-run?
→ Entry of new firms who want to take advantage of excess profits
→ The market supply curve rises because of entry of new firms
→ The equilibrium price in the market falls back to the zero-profit level
In other words, the excess profits are short-lived. New firms enter to grab a piece of the profit, which ultimately increases supply and makes the excess profit disappear.
Embedded in this example is a nice characteristic of competitive markets. When consumer demand rises, the higher equilibrium price acts as a “market signal” for new firms to enter. Higher demand by consumers automatically attracts new resources and brings new firms to enter the market. No government planning is needed to satisfy consumer wants. If consumers want something, it pushes the price up, which attracts new firms to enter automatically.
This works in reverse too. If demand for a product drops, we don’t need the government to force firms out. The lower price will cause economic losses and will induce some firms to exit the market until the zero-profit equilibrium price is again restored. This is one reason economists don’t like bailouts. Exit is a good thing if the reason firms are exiting is that consumers don’t want to buy the product anymore.
Adjustment to a Change in Technology
still at the original zero-profit level, the new technology will enable firms to earn some excess profits in the short-run. But what happens in the long-run?
→ Entry of new firms who want to take advantage of excess profits enabled by the new
technology
→ The market supply curve rises because of entry of new firms
→ The equilibrium price in the market falls to the new zero profit-level
This example also illustrates a nice property of competitive markets. Suppose that cost of production is originally $20 per unit with the market price at $20. Suddenly, a new technology enables firms to reduce their production cost to $10. In the short-run, when the market price is still $20, firms that adopt the new technology can enjoy excess profits. Firms that don’t adopt the new technology are still OK in the short-run – they’ll just continue to earn zero profit instead of enjoying a positive economic profit.
But the firm with the old technology is not OK in the long-run. The market price will eventually drop to $10 because of entry of firms using the new technology. Any firms still using the old technology with its $20 cost will be losing money and will be driven out of business. In other words, the market actually forces firms to adopt the new, efficient technology.
Perfect competition is brutal for firms. Firms are forced to keep up with the most efficient production techniques or risk being driven out of business in the long-run. Again, the process is all automatic. No government regulation is needed to encourage firms to operate efficiently. Competition forces firms to adopt efficient production techniques.
Efficiency of Perfect Competition
When the price is at the zero-profit level 𝑃𝑃∗, the firm produces where MR=MC at output level 𝑞𝑞∗. But this level of output 𝑞𝑞∗ is actually the productively efficient level of output – the level of output with the lowest cost per unit (at the minimum of the ATC curve).
• In long-run equilibrium in a perfectly competitive market, firms produce at the productively efficient level of output.
Firms also produce at the efficient scale, at the lowest point of the long-run average total cost curve. If firms are currently operating at a scale where the zero-profit price is $20, but changing the scale of operation could lower the zero-profit price to $15, then eventually all firms are forced to adopt this new scale after new firms enter and the price drops to $15.
• In long-run equilibrium in a perfectly competitive market, firms produce at the productively efficient scale of output.
Finally, the perfectly competitive pricing rule P = MC is exactly the recipe for allocative efficiency.
To see why pricing at marginal cost is efficient, suppose that the firm’s marginal cost of producing another bushel of wheat is $40. If the firm sets the price at $50, then a person who is willing to pay $45 would not buy the wheat. But this is inefficient since there would have been $5 of surplus from the trade. Any price other than $40 is not allocatively efficient.
Setting price at marginal cost gets the incentives exactly right for both sides of the market. Which buyers get wheat? The ones who value wheat the most. The price being equal to the marginal cost of $40 ensures that all buyers who value wheat more than its production cost will get it, and buyers who value wheat at less than its cost of production won’t get it. And this is exactly efficient. Perfect competition and the price system move goods and services to people who value them the most. Non-market allocation runs the risk of allocating scarce resources inefficiently.
From the perspective of sellers, if a seller can sell wheat for $40, the sellers who get into the business are the ones with the most efficient production techniques. Anyone whose costs will be more than $40 has no incentive to enter. In summary, price equal to marginal cost gets the incentives exactly right for buyers and sellers, and thus maximizes gains from trade.
Economic Rent
Prior to Adam Smith, people thought that the government should regulate the market as a way of preventing sellers from exploiting buyers by charging high prices. But Adam Smith had a different view. He pointed out that the best regulator of prices is robust competition. If a seller is making an excess profit by selling something, and there is no barrier to entry by competitors, then there is an opportunity for someone else to enter the market and compete with the existing seller, undercutting him and taking his customers.
Economic rent is any payment that is higher than what is required to keep some factor of
production in its current use. Applied to firms, excess profit is an economic rent – profit earned by firms above and beyond the profit that would have been earned if the firm switched its resources to its next-best alternative. If a sushi restaurant generates $100,000 in profit, but other restaurant owners make only $80,000, then $20,000 of this profit is an economic rent. Along similar lines, if I get paid $100,000 at my current job, but the next best use of my skills would only pay $80,000, then $20,000 of my salary is economic rent.
Any time there is free entry and markets are competitive, you can’t get economic rent, because then other people would come and do what you’re doing. The only way to get economic rent is if you have something scarce (in inelastic supply), which can’t be competed away. Unless you do something that other people can’t do, there is no way to permanently earn an economic rent.
Here’s a classic example. Coffee in subway stations in London sells for a price much higher than its cost of production – and much more than coffee at other places in London. Where’s the money going? Do you think the workers are getting paid more than other coffee shop workers? Probably not; the workers can be easily changed and don’t have any unique skills, so they don’t get paid more than any other coffee shop employees. Equipment costs? Interest on loans? All these things are easily substitutable. Is it exploitation by the greedy owner? But if the owner is making a huge profit, why doesn’t someone else compete with him?
What’s the one thing about the whole operation that’s unique? The location! If you examine the coffee shop’s books, they’re paying a huge rent to the owner of the space. The coffee shop owner isn’t anything special, but the owner of the space does control something unique. The money isn’t going to the business owner. The money is going to pay high rents to the landlord. But we should have been able to predict this. The only way to make an above-normal return is to control something unique that can’t be competed away.
that most people are not willing to invest what it takes to get a PhD. Thus, the wage we are paid is exactly what it takes to get enough people to do it.
Some people have suggested tipping dishwashers at restaurants. But if that catches on, then everyone will want to be a dishwasher instead of other low-paid jobs, and then owners will be able to pay lower wages to dishwashers. If a resource is not scarce, it cannot earn economic rents, period. On the other hand, if you tip one dishwasher who is extraordinarily nice, that’s a different story because this dishwasher has a unique skill (his shining personality).
As a final example of this concept, suppose there is one manager in the air conditioner installation business who has special managerial skills that can generate $60,000 more profit for the business than any other manager. The firm that hires him at first, at the going manager salary, will be getting an excess profit. But then another firm will look at this and realize that they should pay the manager a higher salary to attract him. Ultimately, as long as the manager can easily move between firms, then the manager’s salary will get bid up by almost the whole $60,000. In other words, the manager himself is getting the benefits from his expertise, not the firm that employs him. But we should have been able to predict this. It’s the manager who controls the scarce resource (his special skill) and it’s the manager who earns the economic rent. Not the firm.
Economists use the term rent-seeking behavior to describe actions that siphon rents out of the economy – basically increasing your share of wealth without actually creating any new wealth. Think about firms that spend money to lobby the government for regulations that limit competition. This is classic rent-seeking behavior – the firm is not trying to make its money by improving its product or by expanding its customer base. It’s just trying to suck rents out of the system by eliminating competition. Think about taxi drivers fighting against the expansion of the ride-sharing service Uber, or a firm that buys up patents just so they can sue people who infringe on the patent. These are classic examples of rent-seeking behavior.
