Chapter 6: Competition Chapter 6 – Competition This chapter examines perfect competition, one of the market structures that exists in the U.S. It is characterized by a large number of small firms, each of which produces a small amount of the total good in the market. McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.

Market Structure The number and relative size of firms in an industry. Most real-world firms fall along a spectrum that stretches from the powerless (Perfect competition) to the powerful (Monopoly). Market structure refers to the number and relative size of firms in an industry. Most real-world firms fall along a spectrum that stretches from the powerless (Perfect competition) to the powerful (Monopoly). Perfect competition and Monopoly represent the two extreme market structures and the least common in the U.S. LO-1

Competitive Firm A perfectly competitive firm is one without market power: It is not able to alter the market price of the good it produces. It is a price taker. A perfectly competitive firm is one without market power. Because the firm is so small relative to the market, it is not able to alter the market price of the good it produces. The firm is at the mercy of the market and must accept or ‘take” the market price. A perfectly competitive firm is known as a price taker. LO-1

Competitive Market A competitive market is one in which no buyer or seller has market power. No single producer or consumer has any control over the price or quantity of the product. A competitive market is one in which no buyer or seller has market power. No single producer or consumer has any control over the price or quantity of the product. Again, a perfectly competitive firm is so small relative to the market that it has no control over the price. LO-1

Monopoly A monopoly firm is one that produces the entire market supply of a particular good or service: It is a price setter, not a price taker. A monopoly firm is one that produces the entire market supply of a particular good or service. A monopoly is the sole producer, so it has a great deal of control over the price. It is known as a price setter, not a price taker. LO-1

Market Power Market power is the ability to alter the market price of a good or service: Your campus book store has market power. Market power is the ability to alter the market price of a good or service. For example, your campus book store has market power. LO-1

Imperfect Competition Imperfect competition is between the extremes of monopoly and perfect competition: Duopoly: only two firms supply a product. Oligopoly: a few large firms supply all or most of a particular product. Monopolistic competition: many firms supply essentially the same product but each has brand loyalty. Imperfect competition is between the extremes of monopoly and perfect competition. Most industries fall somewhere in the middle of the two extremes. A duopoly occurs when only two firms supply a product. An oligopoly consists of a few large firms that supply all or most of a particular product. In monopolistic competition, many firms supply essentially the same product but each has brand loyalty. LO-1

Perfect Competition Perfectly competitive firms are pretty much faceless. They have no brand image, no real market recognition. A perfectly competitive firm is one whose output is so small in relation to market volume that its output decisions have no perceptible impact on price. Perfectly competitive firms are pretty much faceless. They have no brand image and no real market recognition. A perfectly competitive firm is one whose output is so small in relation to market volume that it output decisions have no perceptible impact on price. A good example of perfect competition is farming or agriculture. LO-1

No Market Power The output of a lone perfectly competitive firm is so small relative to market supply that it has no significant effect on the total quantity or price in the market. The output of a lone perfectly competitive firm is so small relative to market supply that it has no significant effect on the total quantity or price in the market. Again, the individual firm is insignificant and tiny compared to the market as a whole. LO-1

Price Takers A perfectly competitive firm is a price taker. An individual firms’ output decisions do not affect the market price. An individual firm must take the market price and do the best it can within these constraints. A perfectly competitive firm is a price taker. An individual firms’ output decisions do not affect the market price. An individual firm must take the market price and do the best it can within these constraints. LO-1

Market Demand vs. Firm Demand You must distinguish between the market demand curve and the demand curve confronting a particular firm: The market demand curve for a product is always downward sloping. The demand curve facing a perfectly competitive firm is horizontal. You must distinguish between the market demand curve and the demand curve confronting a particular firm. The market demand curve for a product is always downward sloping. The demand curve facing a perfectly competitive firm is horizontal. Any industry has a downward sloping demand curve. In perfect competition, however, the individual firm has a horizontal demand curve. LO-1

Market Demand vs. Firm Demand The first graph, Graph A, shows the market demand curve is always downward sloping. The second graph, Graph B, shows the demand curve facing a perfectly competitive firm and is horizontal. LO-1

The Firm’s Production Decision Choosing a rate of output is a firm’s production decision: It is the selection of the short-term rate of output (with existing plant and equipment). Choosing a rate of output is a firm’s production decision. It is the selection of the short-term rate of output (with existing plant and equipment). The production decision means determining how much to produce. LO-1

Total revenue = price x quantity Output and Revenues Total revenue is the price of a product multiplied by the quantity sold in a given time period: Total revenue = price x quantity Total revenue is the price of a product multiplied by the quantity sold in a given time period. Total revenue equals the market price times the amount sold. LO-2

Revenues versus Profits Profit is the difference between total revenue and total cost. Maximizing output or revenue is not the way to maximize profits. Total profits depend on how both revenues and costs increase as output expands. A business is profitable only within a certain range of output. Profit is the difference between total revenue and total cost. Maximizing output or revenue is not the way to maximize profits. Total profits depend on how both revenues and costs increase as output expands. The goal of a firm is to maximize total profits, not total revenue. A business will be profitable only within a certain range of output. LO-2

Profit Maximization and Price To maximize profit, the firm should produce an additional unit of output only if it brings in more revenue than it costs. Since competitive firms are price takers, they must take whatever price the market has put on their products. To maximize profit, the firm should produce an additional unit of output only if it brings in more revenue than it costs. As long as the additional revenue received exceeds the additional cost to make the good, a firm should continue to produce the good. Since competitive firms are price takers, they must take whatever price the market has put on their products. LO-3

Marginal Cost (MC) Marginal cost (MC) is the increase in total costs associated with a one-unit increase in production. Marginal cost generally increases as the rate of production increases due to diminishing returns. Marginal cost (MC) is the increase in total costs associated with a one-unit increase in production. MC is the extra or additional cost to produce one more good. Marginal cost generally increases as the rate of production increases due to diminishing returns. LO-3

Profit-Maximizing Rate of Output Never produce anything that costs more than it brings in – it boils down to comparing price and marginal cost. A competitive firm wants to expand the rate of production whenever price exceeds marginal cost. Short-run profits are maximized at the rate of output where price equals marginal cost. Never produce anything that costs more than it brings in. It boils down to comparing price and marginal cost. A competitive firm wants to expand the rate of production whenever price exceeds marginal cost. Short-run profits are maximized at the rate of output where price equals marginal cost. In other words, a firm should keep producing until price equals marginal cost and then stop. LO-3

Short-Run Decision Rules for a Competitive Firm Price = MC Maintain output rate (Profits maximized) Price < MC Decrease output rate Price > MC Increase output rate If price is greater than marginal cost, the firm should increase the output rate. If price equals marginal cost, the firm should maintain the output rate. This is where profits are maximized. If price is less than marginal cost, the firm should decrease the output rate. Again, the best place to produce is where price equals marginal cost. LO-3

Maximization of Profits for a Competitive Firm Point E shows where p = MC. Point E on the data table shows were Price equals Marginal Cost. This is the point where this firm is most profitable. LO-3

Point of Profit Maximization The graph shows the data from the previous table where Point E is equal to Marginal Cost. Note where profits increase and decrease in relation to that point. LO-3

Total Profit Total profit can be computed in one of two ways: Total profit = total revenue – total cost OR Total profit = average profit (profit per unit) x quantity sold Total profit can be computed in one of two ways. Total profit equals total revenue minus total cost OR total profit equals average profit (profit per unit) times the quantity sold. Both ways of calculating profit will give the same answer. LO-3

Total profit = (p – ATC) x q Profit per unit equals price minus average total cost: Total profit equals profit per unit times quantity: Profit per unit = p – ATC Profit per unit equals price minus average total cost. So profit per unit equals price minus average total cost. Total profit = (p – ATC) x q LO-3

Total Profit The profit-maximizing producer never seeks to maximize per-unit profits. The profit-maximizing producer has no particular desire to produce at that rate of output where ATC is at a minimum. Total profits are maximized only where p = MC. The profit-maximizing producer never seeks to maximize per-unit profits. The profit-maximizing producer has no particular desire to produce at that rate of output where ATC is at a minimum. Total profits are maximized only where price equals marginal cost. The goal of a producer is to maximize total profit, not per-unit profit. LO-3

Illustrating Total Profit This graph shows how total profits are maximized only where p = MC. In this case, the point is plotted at $13 and at a rate of 4 baskets of fish per hour. LO-3

Supply Behavior How firms make production decisions helps explain how the market establishes prices and quantities. Supply is the ability and willingness to sell specific quantities of a good at alternative prices in a given time period. How firms make production decisions helps explain how the market establishes price and quantities. As stated earlier, supply is the ability and willingness to sell specific quantities of a good at alternative prices in a given time period. LO-4

A Firm’s Supply Competitive firms adjust the quantity supplied until MC = price. The marginal cost curve is the short-run supply curve for a competitive firm. Competitive firms adjust the quantity supplied until marginal cost equals price. The marginal cost curve is the short-run supply curve for a competitive firm. LO-4

Supply Shifts Marginal costs determine the supply decisions of a firm. Anything that alters marginal cost will change supply behavior. Marginal costs determine the supply decisions of a firm. Anything that alters marginal cost will change supply behavior. When marginal costs change, that will change supply. LO-4

Supply Shifts Important influences on marginal cost (and supply behavior) are: The price of factor inputs Technology Expectations Important influences on marginal cost (and supply behavior) are: the price of factor inputs, technology, and expectations. These three things will affect marginal cost. LO-4

Market Supply Market supply is the total quantities of a good that sellers are willing and able to sell at alternative prices in a given time period, ceteris paribus. As defined earlier, market supply is the total quantities of a good that sellers are wiling and able to sell at alternative prices in a given time period, ceteris paribus. Market supply is the total supply of all producers of a good. LO-4

The market supply curve is the sum of the marginal cost curves of all the firms. The market supply curve is the sum of the marginal cost curves of all the firms. This series of graphs shows how Graph A, B, and C equal Graph D. That is, how the market supply of Farmer A, B, and C’s add up to be the total market supply depicted in Graph D. LO-4

Competitive Market Supply Determinants of the market supply of a competitive industry: The price of factor inputs Technology Expectations The number of firms in the industry The determinants of the market supply of a competitive industry include: the price of factor inputs, technology, expectations, and the number of firms in the industry. These four things determine market supply. LO-4

Industry Entry and Exit To understand how competitive markets work, we focus on changes in equilibrium rather than on a static equilibrium. The number of firms in a competitive industry is not fixed. Industry entry and exit is a driving force affecting market equilibrium. To understand how competitive markets work, we focus on changes in equilibrium rather than on a static equilibrium. The number of firms in a competitive industry is not fixed. Industry entry and exit is a driving force affecting market equilibrium. Firms can freely enter and exit the industry in perfect competition. LO-5

Entry Additional firms will enter the industry when profits are plentiful. Economic profits attract firms: More firms enter the industry. The market supply curve shifts to the right. The price decreases. Industry output increases and price falls when firms enter an industry. Additional firms will enter the industry when profits are plentiful. Economic profits attract firms. This causes more firms to enter the industry, the market supply curve shifts to the right, and the price decreases. Industry output increases and the price falls when firms enter an industry. So the existence of profits attracts new firms to an industry. The result is an increase in supply and a decrease in price. LO-5

Tendency Toward Zero Economic Profits New firms continue to enter a competitive industry so long as profits exist. Once price falls to the level of minimum average cost, all economic profits disappear. New firms continue to enter a competitive industry so long as profits exist. Once price falls to the level of minimum average cost, all economic profits disappear. In the long run there will be no economic profit. LO-5

Tendency Toward Zero Economic Profits Entry is the force driving down market prices. Price falls until there are no economic profits. At that point, average total cost is at a minimum. Entry is the force driving down market prices. Price falls until there are no economic profits. At that point, average total cost is at a minimum. Again, new firms entering the industry will decrease the price and eliminate the profits. When this happens, average total cost will be at its lowest. LO-5

Exit Firms exit the industry when profit opportunities look better elsewhere. Firms leave the industry if price falls below average cost. As firms exit the industry, the market supply curve shifts to the left. Firms exit the industry when profit opportunities look better elsewhere. Firms leave the industry if price falls below average cost. As firms exit the industry, the market supply curve shifts to the left. Losses will lead to firms leaving an industry. LO-5

Exit Price rises until there are no economic losses. At that point, average total cost is at a minimum. This decrease in supply means the price rises until there are no economic losses. At that point, average total cost is at a minimum. The economic losses will then be eliminated. LO-5

Equilibrium The existence of profits in a competitive industry induces entry. The existence of losses in a competitive industry induces exits. The existence of profits in a competitive industry induces entry. The existence of losses in a competitive industry induces exits. In perfect competition, profits will encourage firms to entry the industry while losses will encourage firms to leave the industry. LO-5

Long-Run Equilibrium In long-run competitive market equilibrium: Price equals minimum average total cost. Economic profit is eliminated. As long as it is easy for existing producers to expand production or for new firms to enter an industry, economic profits will not last long. In long-run competitive market equilibrium, price equals minimum average total cost and economic profit is eliminated. As long as it is easy for existing producers to expand production or for new firms to enter an industry, economic profits will not last long. Again, in perfect competition there will be no economic profit in the long run and price will equal average total cost. LO-5

Low Barriers to Entry There are no significant barriers to entry in competitive markets. Barriers to entry are obstacles that make it difficult or impossible for would-be producers to enter a market, e.g., patents. There are no significant barriers to entry in competitive markets. Barriers to entry are obstacles that make it difficult or impossible for would-be producers to enter a market; for example, patents. It is very easy for new firms to enter in perfectly competitive markets. LO-1

Characteristics of a Competitive Market Many firms Identical products Low entry barriers MC = p Zero economic profit Perfect information These are the characteristics of a competitive market: there are many small firms in the market, the products are identical or homogeneous, the firm will produce the output where marginal cost equals price, there will be zero economic profit in the long run, and all buyers and sellers have perfect information. LO-1

The Virtues of Competition The market helps signal what should and should not be produced. The market sends signals which reallocate resources to other products. The market helps signal what should and should not be produced. It also sends signals which reallocate resources to other products. LO-1

The Relentless Profit Squeeze The unrelenting squeeze on prices and profits is a fundamental characteristic of the competitive process. The market mechanism works best in competitive markets: Market mechanism – the use of market prices and sales to signal desired outputs. The unrelenting squeeze on prices and profits is a fundamental characteristic of the competitive process. The market mechanism works best in competitive markets. The market mechanism is the use of market prices and sales to signal desired outputs. In perfect competition the free market indicates which industries are profitable. LO-1

The Relentless Profit Squeeze High profits in a particular industry indicate that consumers want a different mix of output. As more firms enter the industry, consumers get their desired mix of output. They get more of the goods they desire at a lower price. High profits in a particular industry indicate that consumers want a different mix of output. As more firms enter the industry, consumers get their desired mix of output. They get more of the goods they desire at a lower price. LO-1

Maximum Efficiency Competitive pressure on prices forces suppliers to produce at the least possible cost. Society gets the most it can from its available (scarce) resources. Competitive pressure on prices forces suppliers to produce at the least possible cost. Society gets the most it can from its available (scarce) resources. Perfect competition is the most efficient market structure. LO-1

Zero Economic Profits All economic profits are eliminated at the limit of the competitive process. Again, all economic profits are eliminated at the limit of the competitive process. LO-5

The Social Value of Losses Economic losses are a signal to producers that they are not using society’s scarce resources in the best way. Economic losses are a signal to producers that they are not using society’s scarce resources in the best way. Losses tell producers to get out of a particular industry. LO-5

Policy Perspective Competitive markets present a strong argument for laissez faire. Government should promote competition because markets do a good job of allocating resources. This means keeping markets open and accessible to new entrants by dismantling entry barriers. Competitive markets present a strong argument for laissez faire. As stated earlier, laissez faire means “let it be” or “leave it alone”. Government should promote competition because markets do a good job of allocating resources. This means keeping markets open and accessible to new entrants by dismantling entry barriers. LO-1

Competition End of Chapter 6 In conclusion, we have examined the market structure of perfect competition. This is a structure with a large number of small firms. To maximize profit, each firm produces the output where marginal cost equals price. In the long run there will be no economic profit. 6-50