2In this Chapter…8.1. How the Industry in a Perfectly Competitive Market Works?The difference between firms and industries8.2. The Long Run Outcomes of a Competitive MarketZero Economic Profit and Its Implications8.3. Why we want to have as Perfectly Competitive Markets as Possible?Efficiency and Marginal Cost Pricing
3The Market Supply Curve The market supply curve together with the market demand curve determines the equilibrium price faced by an individual producer (the firm).Equilibrium price – The price at which the quantity of a good demanded in a given time period equals the quantity supplied.Market supply – The total quantities of a good that sellers are willing and able to sell at alternative prices in a given time period, ceteris paribus.
4The Market Supply Curve A firm’s supply curve is its marginal cost curve above its minimum AVC.Thus the Industry’s (market) supply curve is the sum of the marginal cost curves of all the firms.
6The Market Supply Curve Whatever determines marginal cost curve of a competitive firm also determines the market supply curve (The Industry in a Competitive Market). These include:The price of factor inputs.Technology.Expectations.Taxes.The number of firms in the industry.
7Entry and Exit When do new firms enter into a competitive the market? ENTRY refers to INVESTMENT DECISION.Investment decision - The decision to build, buy, or lease plant and equipment; to enter an industry.
8Entry and Exit What drives firms to enter into the competitive market? The profit motive drives investment decisions.Motivated by profit of the existing firm, when new firms enter into a competitive market, it has has immediate impact on the Market Supply, Market Price of the product and thus the Profit of the Incumbent firm
9Entry and ExitIf there are economic profits, more firms will enter the industry increasing market supply.entry of new firms into a competitive market (Investment decisions) shifts the market supply curve to the right, and lowers market price.Each existing firm will respond to the resulting lower price and profits by reducing output.
10Market Entry Market entry pushes price down and . . . Reduces profits of competitive firmPriceQuantityQuantityS1MCS2ATCE1f1p1p1f1p2p2E2Market demandNew firms enterq1q2
11Tendency Toward Zero Profits Gradually an increase in market supply causes the economic profits to disappear.Note that Economic profits is the difference between total revenues and total economic costs.When economic profits disappear, entry ceases and the market price stabilizes.
12Tendency Toward Zero Profits Implication:As long as it is easy for existing producers to expand production or for new firms to enter an industry, in a competitive market, economic profits will not last long.A competitive market is a market in which no buyer or seller has market power, mainly because of the number of firms and lack of Barriers to entry .
13Low Barriers to Entry Barriers to entry Barriers to Entry include: are obstacles that make it difficult or impossible for would-be producers to enter a particular market.Barriers to Entry include:Patents.Control of essential factors of production.Control of distribution outlets.Well-established brand loyalty.Government regulation.
14Revisiting Characteristics of Perfect Competition Some of the structures, behaviors and outcomes of a competitive market are:Many firms - none of which has a significant share of total output.Perfect information - buyers and sellers have complete information on supply, demand, and prices.
15Revisiting Characteristics of Perfect Competition Some of the structures, behaviors and outcomes of a competitive market are:Identical products - products are homogeneous; one firm’s products is the same as any other’s.MC = p - all competitive firms seek to expand output until marginal cost equals the product’s market price.
16Revisiting Characteristics of Perfect Competition Some of the structures, behaviors and outcomes of a competitive market are:Low barriers to entry - entry barriers are low, economic profits will attract more firms.Zero economic profit - market supply expands as long as there are economic profits, pushing prices and economic profits down.
17Competition at Work-Real World Examples Microcomputers Few, if any, product markets are perfectly competitive.However, many industries function much like a competitive market.The microcomputer market illustrates how the process of competition works.
18Market EvolutionAs in other industries, the computer industry has evolved over time.It was never a monopoly, nor was it ever perfect competition.
19Initial Conditions: The Apple I Steve Jobs and Steven Wozniak created the Apple Computer Corporation in 1977.Other companies noted the profits and, due to the low barriers to entry, followed Apple’s lead.
20The Production Decision Each competitive firm seeks to make the best short-run production decision.Production decision - The selection of the short-run rate of output (with existing plant and equipment).To maximize profit, each competitive firm seeks the rate of output at which marginal cost equals price.
21Initial Equilibrium in the Computer Market $1200100080060040020020406080Market demandMarket equilibriumMarket supplyQuantity (thousands)Price (per computer)The computer industry12001000800600400200Market priceProfitsmDAverage total costP = MRQuantityCPRICE OR COSTThe typical firm
22Profit CalculationsA profit-maximizing producer seeks to maximize total profit.This is not necessarily or even very frequently the same thing as maximizing profit per unit.
23Total profit = profit per unit X quantity sold Profit CalculationsProfit per unit is total profit divided by the quantity produced in a given time period.; price minus average total cost.Total profit = profit per unit X quantity sold
24Given the following information, complete the table and determine the profit Maximizing output level
28The Lure of ProfitsIn competitive markets, economic profits attract new entrants.Low entry barriers permit new firms to enter competitive markets.The entry of new firms shifts the market supply curve to the right.New entrants will continue to enter as long as there are economic profits in short-run competitive equilibrium.
29A Shift of Market Supply Short-run equilibrium: p = MC
30A Shift of Market Supply As supply increases, price drops toward the minimum of ATC.In long-run equilibrium, entry and exit cease, and zero economic profit (that is, normal profit) prevails.Long-run equilibrium: p = MC = minimum ATC
31A Shift of Market Supply Once established, long-run equilibrium will continue until market demand shifts or technological improvement reduces the cost of computer production.
32The Competitive Price and Profit Squeeze An expanded market supply . . .Lowers price and profits for the typical firm20,000$1000800Quantity (computers per month)Price (per computer)500600800$1000Price or Cost (per computer)Quantity (computers per month)MCS1ATCS2Old priceProfitsGNewpriceHmMarket demand
33The Competitive Squeeze Approaching Its Limit The computer industryThe typical firm20,000$1000800Quantity (computers per month)Price (per computer)500600800$1000Price or Cost (per computer)Quantity (computers per month)MCATCS2S3Old price700J620NewpriceProfitsmKMarket demand
34Short- vs. Long-Run Equilibrium MCATCpSqSPrice or CostQuantityShort-run equilibrium (p = MC)pSPrice or CostpLqLQuantityMCATCLong-run equilibrium (p = MC = ATC)
36Home Computers vs. Personal Computers Once long-run equilibrium was reached in the microcomputer market, producers were forced either:To develop a better product (to increase demand), orTo reduce costs of production.
37Home Computers vs. Personal Computers Manufactures of computers did both —separating the market into home computers and personal computers
38Price Competition in Home Computers The home computer market confronted the fiercest form of price competition leaving the only option to make an extra buck to push the cost curve down.
39Price Competition in Home Computers Costs were pushed down by reducing the number of components and using more powerful computer chips.
40Further Supply ShiftsWith strong competition, often the only way for a firm to improve profitability is to reduce costs.Cost reductions were accomplished through technological improvements.
41Further Supply ShiftsTechnological improvements are illustrated by a downward shift of the ATC and MC curves.
42Lower Costs Shifts the Supply Curve Downward Price (per computer)Quantity (computers per month)OldMCNewMCOldATCNewATCJN$700R430600
43ShutdownsOnce a firm is no longer able to cover variable costs, it should shut down production.The shutdown point is the rate of output at which price equals minimum AVC.
44ExitsMost firms withdrew from the home computer market due to low profits.The exit rate in matched the entry rate of
45The Personal Computer Market Firms initially competed on the basis of product improvements.Eventually, firms could not sell all the PCs they produced at prevailing prices.They were forced to cut their prices.Many shut down.
46Competitive ProcessCompetitive market pressures were a driving force in the spectacular growth of the computer industry.Consumers reaped substantial benefit from competition in computer markets.
47Allocative Efficiency: The Right Output Mix The market mechanism works best in competitive markets.Market mechanism – the use of market prices and sales to signal desired output (or resource allocations).
48Allocative Efficiency: The Right Output Mix High profits in a particular industry indicate consumers want a different mix of output.A competitive market determines the opportunity cost of producing different goods.
49Allocative Efficiency: The Right Output Mix The price signal the consumer gets in a competitive market is an accurate reflection of opportunity cost.Opportunity cost – The most desired goods or services that are forgone in order to obtain something else.
50Allocative Efficiency: The Right Output Mix The marginal cost pricing characteristic of competitive markets answers the WHAT-to-produce question efficiently.Marginal cost pricing – The offer (supply) of goods at prices equal to their marginal cost.
51Allocative Efficiency: The Right Output Mix The amount consumers are willing to pay for a good (its price) equals its opportunity cost (marginal cost).
52Production Efficiency Production efficiency means that we are producing at minimum average total cost.Efficiency – Maximum output of a good from the resources used to produce it.
53Production Efficiency When competitive pressure on prices is carried to the limit, the products in questions are produced at the least possible cost.Society is getting the most it can from its available (scarce) resources.
54Zero Economic ProfitIn the long-run, all economic profit is eliminated.
55Summary of Competitive Process Quantity (units per time period)Price (dollars per unit)Market demandIndustry ATCIndustry MCShort-runequilibriumacbLong-run equilibrium
56Relentless Profit Squeeze The sequence of events common to a competitive market situation includes the following:High prices and profits signal consumers’ demand for more output.Economic profit attracts new suppliers.
57Relentless Profit Squeeze The market supply shifts to the right.Prices slide down the market demand curve.A new equilibrium is reached with increased quantities being produced and sold and the economic profit approaching zero.
58Relentless Profit Squeeze Throughout the process, producers experience great pressure to keep ahead of the profit squeeze by reducing costs.
59Relentless Profit Squeeze The potential threat of other firms expanding production or of new firms entering the industry keeps existing firms on their toes.