Competitive Markets Chapter 23

Introduction This chapter focuses on three key questions: How are prices determined in competitive markets? How does competition affect the profits of a firm or industry? What does society gain from market competition?

The Market Supply Curve The market supply curve determines the equilibrium price faced by an individual producer. 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.

The Market Supply Curve The market supply curve is the sum of the marginal cost curves of all the firms. Marginal cost (MC) – The increase in total cost associated with a one-unit increase in production.

The Market Supply Curve Whatever determines marginal cost also determines the competitive firm’s supply response.

The Market Supply Curve The market supply of a competitive industry is determined by: The price of factor inputs. Technology. Expectations. Taxes. The number of firms in the industry.

Competitive Market Supply 20 40 60 1 2 3 4 $5 Price Farmer A Quantity a MCA 20 40 60 Farmer B Quantity b MCB 20 40 60 Farmer C Quantity c MCC 100 200 Market supply Quantity d + + =

Entry and Exit Investment decisions shift the market supply curve to the right. Investment decision - The decision to build, buy, or lease plant and equipment; to enter or exit an industry.

Entry and Exit The profit motive drives these investment decisions. If there are economic profits, more firms will enter the industry increasing market supply. Each firm will respond to the resulting lower price and profits by reducing output.

Market Entry Market entry pushes price down and . . . Reduces profits of competitive firm Price Quantity Quantity S1 MC S2 ATC E1 f1 p1 p1 f1 p2 p2 E2 Market demand New firms enter q1 q2

Tendency Toward Zero Profits An increase in market supply causes the economic profits to disappear. Economic profits – The difference between total revenues and total economic costs.

Tendency Toward Zero Profits When economic profits disappear, entry ceases and the market price stabilizes. 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.

Tendency Toward Zero Profits This is how competitive markets work. A competitive market is a market in which no buyer or seller has market power.

Low Barriers to Entry Barriers to entry are obstacles that make it difficult or impossible for would-be producers to enter a particular market.

Low Barriers to Entry Barriers to entry may include: Patents. Control of essential factors of production. Control of distribution outlets. Well-established brand loyalty. Government regulation.

Market 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.

Market 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.

Market 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.

Competition at Work: Microcomputers Few, if any, product markets are perfectly competitive. Many industries function much like a competitive market.

Competition at Work: Microcomputers The microcomputer market illustrates how the process of competition works.

Initial 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.

The Production Decision Each 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).

The Production Decision To maximize profit, each competitive firm seeks the rate of output at which marginal cost equals price.

Initial Equilibrium in the Computer Market $1200 1000 800 600 400 200 20 40 60 80 Market demand Market equilibrium Market supply Quantity (thousands) Price (per computer) The computer industry 1200 1000 800 600 400 200 Market price Profits m D Average total cost P = MR Quantity C PRICE OR COST The typical firm

Profit Calculations A profit-maximizing producer seeks to maximize total profit.

Total profit = profit per unit X quantity sold Profit Calculations This is not necessarily or even very frequently the same thing as maximizing profit per unit. Profit per unit - 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

Computer Revenues, Costs and Profits

Computer Revenues, Costs and Profits

The Lure of Profits In competitive markets, economic profits attract new entrants.

Low Entry Barriers Low entry barriers permit new firms to enter competitive markets.

A Shift of Market Supply The entry of new firms shifts the market supply curve to the right.

A Shift of Market Supply New entrants will continue to be attracted as long as there are economic profits in short-run competitive equilibrium. Short-run competitive equilibrium: p = MC

A Shift of Market Supply Any short-run equilibrium will not last. As supply increases, price drops toward the minimum of ATC. Once at minimum of ATC, there are no longer economic profits to attract firms to enter.

A Shift of Market Supply In long-run equilibrium, entry and exit cease, and zero economic profit (that is, normal profit) prevails. Long-run equilibrium: p =MC =minimum ATC

A Shift of Market Supply Once established, long-run equilibrium will continue until market demand shifts or technological improvement reduces the cost of computer production.

The Competitive Price and Profit Squeeze An expanded market supply . . . Lowers price and profits for the typical firm 20,000 $1000 800 Quantity (computers per month) Price (per computer) 500 600 800 $1000 Price or Cost (per computer) Quantity (computers per month) MC S1 ATC S2 Old price Profits G New price H m Market demand

The Competitive Squeeze Approaching Its Limit The computer industry The typical firm 20,000 $1000 800 Quantity (computers per month) Price (per computer) 500 600 800 $1000 Price or Cost (per computer) Quantity (computers per month) MC ATC S2 S3 Old price 700 J 620 New price Profits m K Market demand

Short- vs. Long-Run Equilibrium MC ATC pS qS Price or Cost Quantity Short-run equilibrium (p = MC) pS Price or Cost pL qL Quantity MC ATC Long-run equilibrium (p = MC = ATC)

Long-Run Rules for Entry and Exit

Home 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), or To reduce costs of production.

Home Computers vs. Personal Computers Manufactures of computers did both —separating the market into home computers and personal computers

Price 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.

Price Competition in Home Computers Costs were pushed down by reducing the number of components and using more powerful computer chips.

Further Supply Shifts With strong competition, often the only way for a firm to improve profitability is to reduce costs. Cost reductions were accomplished through technological improvements.

Further Supply Shifts Technological improvements are illustrated by a downward shift of the ATC and MC curves.

Lower Costs Shifts the Supply Curve Downward Price (per computer) Quantity (computers per month) Old MC New MC Old ATC New ATC J N $700 R 430 600

Shutdowns Once 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.

Exits Most firms withdrew from the home computer market due to low profits. The exit rate in 1983-85 matched the entry rate of 1979-82.

The 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.

Competitive Process Competitive market pressures were a driving force in the spectacular growth of the computer industry. Consumers reaped substantial benefit from competition in computer markets.

Allocative 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).

Allocative 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.

Allocative 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.

Allocative 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.

Allocative Efficiency: The Right Output Mix The amount consumers are willing to pay for a good (its price) equals its opportunity cost (marginal cost).

Production 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.

Production Efficiency When competitive pressure on prices is carried to the limit, the products in questions are produced at the least possible cost.

Production Efficiency Society is getting the most it can from its available (scarce) resources.

Zero Economic Profit In the long-run, all economic profit is eliminated.

Summary of Competitive Process Quantity (units per time period) Price (dollars per unit) Market demand Industry ATC Industry MC Short-run equilibrium a c b Long-run equilibrium

Relentless Profit Squeeze The sequence of events common to a competitive market situation includes the following.

Relentless Profit Squeeze High prices and profits signal consumers’ demand for more output.

Relentless Profit Squeeze Economic profit attracts new suppliers.

Relentless Profit Squeeze The market supply shifts to the right.

Relentless Profit Squeeze Prices slide down the market demand curve.

Relentless Profit Squeeze A new equilibrium is reached with increased quantities being produced and sold and the economic profit approaching zero.

Relentless Profit Squeeze Throughout the process, producers experience great pressure to keep ahead of the profit squeeze by reducing costs.

Relentless Profit Squeeze The potential threat of other firms expanding production or of new firms entering the industry keeps existing firms on their toes.

The Economy Tomorrow: HDTV for $500? The first HDTV sets appeared on the American market in 1993. They were not supplied in commercial quantities until 1998. The 56-inch Panasonic HDTV went on sale for a base price of $5,500 in August 1998.

Price and Competition In the first year of availability, consumers purchased only 10,000 HDTVs at the price of $5,500. They purchased 23 million analog TVs at a price closer to $300.

Price and Competition New entrants to the HDTV market are expected to dramatically lower prices and increase unit sales.

Price and Competition Sony, Sharp, Hitachi, Zenith, RCA, Samsung, Sanyo and others promised better and cheaper HDTVs.

Competitive Markets End of Chapter 23