McGraw-Hill/Irwin ©2009 The McGraw-Hill Companies, All Rights Reserved Competitive Markets Chapter 23

2 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.

3 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.

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

5 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 $5 Price Farmer A Quantity a MC A Farmer B Quantity b MC B Farmer C Quantity c MC C Market supply Quantity d +=+

7 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. LO1

8 Entry and Exit The profit motive drives these investment decisions. If there are economic profits, more firms will enter the industry increasing market supply. The typical firm will respond to the resulting lower price and profits by reducing output. LO1

9 Quantity Price Quantity Market Entry Market demand S2S2 S1S1 E1E1 E2E2 p1p1 p2p2 Market entry pushes price down and... New firms enter ATC MC f1f1 f1f1 p1p1 p2p2 q1q1 q2q2 Reduces profits of competitive firm LO1

10 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. LO2

11 Tendency Toward Zero Profits When economic profits disappear, entry ceases and the market price stabilizes. A competitive market is a market in which no buyer or seller has market power. LO2

12 Tendency Toward Zero Profits 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. LO2

13 Low Barriers to Entry Barriers to entry are obstacles that make it difficult or impossible for would-be producers to enter a particular market. LO2

14 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. LO2

15 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. LO1

16 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. LO1

17 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. LO1

18 Competition at Work: Microcomputers Few, if any, product markets are perfectly competitive. Many industries function much like a competitive market. The microcomputer market illustrates how the process of competition works.

19 Market Evolution As in other industries, the computer industry has evolved over time. It was never a monopoly, nor was it ever perfect competition.

20 Initial Conditions:The Apple I Steve Jobs and Steven Wozniak created the Apple Computer Corporation in Other companies noted the profits and, due to the low barriers to entry, followed Apple’s lead.

21 The 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).

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

23 Initial Equilibrium in the Computer Market Market price Profits m D Average total cost P = MR Quantity C PRICE OR COST The typical firm $ Market demand Market equilibrium Market supply Quantity (thousands) Price (per computer) The computer industry LO2

24 Profit Calculations A profit-maximizing producer seeks to maximize total profit. Profit 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 LO2

25 Computer Revenues, Costs and Profits LO2

26 Computer Revenues, Costs and Profits LO2

27 The Lure of Profits In competitive markets, economic profits attract new entrants. LO2

28 Low Entry Barriers Low entry barriers permit new firms to enter competitive markets. LO2

29 A Shift of Market Supply The entry of new firms shifts the market supply curve to the right. Firms will continue to enter as long as there are economic profits. LO2

30 A 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 LO2

31 A Shift of Market Supply Once reached, long-run market equilibrium will continue until something changes. Long-run equilibrium will change if market demand shifts or if technological improvements reduce production costs. LO2

$1000 Price or Cost (per computer) Quantity (computers per month) 020,000 $ Quantity (computers per month) Price (per computer) The Competitive Price and Profit Squeeze Profits S1S1 S2S2 Market demand An expanded market supply... MC Old price G H m ATC Lowers price and profits for the typical firm New price LO2

$1000 Price or Cost (per computer) Quantity (computers per month) 020,000 $ Quantity (computers per month) Price (per computer) The Competitive Squeeze Approaching Its Limit Profits S2S2 Market demand The computer industry MC Old price J K m ATC The typical firm New price S3S LO2

34 Short- vs. Long-Run Equilibrium MC ATC pSpS qSqS Price or Cost Quantity Short-run equilibrium (p = MC) pSpS Price or Cost pLpL qLqL Quantity MC ATC Long-run equilibrium (p = MC = ATC) LO2

35 Long-Run Rules for Entry and Exit LO2

36 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.

37 Home Computers vs. Personal Computers Manufacturers of computers did both -separating the market into home computers and personal computers.

38 Price Competition in Home Computers The home computer market confronted the fiercest form of price competition. For most firms, the only option to make an extra buck was to push the cost curve down.

39 Price Competition in Home Computers Costs were pushed down by reducing the number of components and using more powerful computer chips. LO3

40 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. LO3

41 Further Supply Shifts Technological improvements are illustrated by a downward shift of the ATC and MC curves. LO3

42 Price (per computer) Quantity (computers per month) Lower Costs Shifts the Supply Curve Downward Old MC New MC Old ATC New ATC J N R $700 LO3

43 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.

44 Exits Most firms withdrew from the home computer market due to low profits. The exit rate in matched the entry rate of

45 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.

46 The 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. LO3

47 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). LO3

48 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. LO3

49 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. LO3

50 Allocative Efficiency: The Right Output Mix Marginal cost pricing efficiently answers the WHAT-to-produce question. Marginal cost pricing – The offer (supply) of goods at prices equal to their marginal cost. LO3

51 Allocative Efficiency: The Right Output Mix The amount consumers are willing to pay for a good (its price) equals its opportunity cost (marginal cost). LO3

52 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. LO3

53 Production Efficiency Competitive pressure on prices force producers to produce at the lowest possible cost. Society is getting the most it can from its available (scarce) resources. LO3

54 Zero Economic Profit In the long-run, all economic profit is eliminated. LO3

55 Quantity (units per time period) Price (dollars per unit) Summary of Competitive Process Industry ATC Industry MC Market demand Short-run equilibrium Long-run equilibrium a b c LO3

56 Relentless 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. The market supply shifts to the right. LO3

57 Relentless Profit Squeeze The sequence of events common to a competitive market situation includes the following: Prices slide down the market demand curve. A new equilibrium is reached with increased quantities being produced and sold and economic profit approaching zero. LO3

58 Relentless Profit Squeeze The sequence of events common to a competitive market situation includes the following: Throughout the process, producers experienced great pressure to keep ahead of the profit squeeze by reducing costs. LO3

59 Relentless Profit Squeeze The potential threat of other firms expanding production or of new firms entering the industry keeps existing firms on their toes. LO3

McGraw-Hill/Irwin ©2009 The McGraw-Hill Companies, All Rights Reserved Competitive Markets End of Chapter 23