I understand that a competitive market is necessary for a market to equilibriate to a pareto optimal state, and that things like economies of scale, network effects, government restrictions, and government imposed costs can prevent reaching pareto optimality. But do other barriers like startup capital also prevent reaching pareto optimality? I would think the answer is no, since something like sunk costs can be amortized over all products sold by a market actor. Is this correct, or am I missing something?
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$\begingroup$ I think my confusion stems from the many conflicting definitions of "barriers to entry" out there, as is exhaustively articulated by this paper: authors.library.caltech.edu/11284/1/MCAaer04.pdf $\endgroup$– B TMar 27, 2016 at 8:32
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$\begingroup$ I suggested an edit to the name because this is really asking about whether a lack of barriers to entry is a necessary condition for pareto optimality (rather than the first welfare theorem). $\endgroup$– DornerAMar 30, 2016 at 17:23
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$\begingroup$ @DornerA Thanks, I modified your edit a bit $\endgroup$– B TMar 30, 2016 at 21:13
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Let us quickly define a competitive market. A competitive market satisfies the following:
1) All firms sell an identical product
2) All firms and buyers are price takers (have no control over price)
3) Buyers and firms have complete information about the market
4) The market is characterized by free entry (no barriers to entry)
If this is the market structure, we can have the existence of pareto optimality, so I am assuming this is the competitive market to which you are referring in your question. What happens when we try to relax assumption 4?
We can show this using your example of startup capital:
Suppose we have a competitive market and the amount of startup capital needed to enter this market is $A$. When deciding to enter this market the firm would subtract $A$ from the long term profit possibility $\Pi$ (because it would be another cost). By definition $A\geq 0$. Because the situation where $A=0$ is trivial (because that means there is no startup capital needed), we know that $A>0$. Suppose at a point in time there is opportunity for profit in this market. As long as $\Pi\geq 0$ firms will decide to enter the market, but if $\Pi <0$, a firm would decide not to enter the market. However, note that firms who are already in the market are earning positive profit. This is a contradiction because if positive profits persist, we do not have a competitive market.
As you noted in your question, a competitive market is a necessary condition for the existence of pareto optimality. If the nonexistence of barriers to entry is a necessary condition for a competitive market, nonexistence of barriers to entry is also a necessary condition for pareto optimality.
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$\begingroup$ Could you please give your definition of 'competitive market'. Does it have anything to do with so called price-taking behavior? $\endgroup$– GiskardMar 30, 2016 at 18:35
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$\begingroup$ @denesp yes, we are using the standard definition of a perfectly competitive market. I have revised my answer to reflect that. $\endgroup$– DornerAMar 30, 2016 at 20:51
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$\begingroup$ But this seems like circular reasoning to me. The startup capital and profit possibility are not independent variables. If your lifetime expected return for entering a venture is less than the startup capital needed, then your profit possibility would be less than 0, even before considering opportunity costs. In which case, tendency toward pareto optimality is preserved. $\endgroup$– B TMar 30, 2016 at 21:18
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$\begingroup$ @BT this seems to be a problem of my word selection. Would revenue opportunity be more appropriate? $\endgroup$– DornerAMar 30, 2016 at 21:24
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$\begingroup$ @BT or should I specify that $\Pi$ is the profit possibility if $A=0$? $\endgroup$– DornerAMar 30, 2016 at 21:33