McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Competitive Markets Chapter 8

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 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.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 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.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. The Market Supply Curve Whatever determines marginal cost also determines the competitive firm’s supply response.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 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.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 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 +=+

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 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.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 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.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 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

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 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.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 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.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 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.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Low Barriers to Entry Barriers to entry are obstacles that make it difficult or impossible for would-be producers to enter a particular market.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 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.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 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.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 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.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 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.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 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.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Market Evolution As in other industries, the computer industry has evolved over time. It was never a monopoly, nor was it ever perfect competition.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 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.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 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).

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. The Production Decision To maximize profit, each competitive firm seeks the rate of output at which marginal cost equals price.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 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

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Profit Calculations A profit-maximizing producer seeks to maximize total profit. This is not necessarily or even very frequently the same thing as maximizing profit per unit.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Profit Calculations 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

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Computer Revenues, Costs and Profits

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Computer Revenues, Costs and Profits

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. The Lure of Profits In competitive markets, economic profits attract new entrants.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Low Entry Barriers Low entry barriers permit new firms to enter competitive markets.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. A Shift of Market Supply 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. Short-run equilibrium: p = MC

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 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

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 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.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved $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

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved $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

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 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)

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Long-Run Rules for Entry and Exit

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 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.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Home Computers vs. Personal Computers Manufactures of computers did both — separating the market into home computers and personal computers

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 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.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Price Competition in Home Computers Costs were pushed down by reducing the number of components and using more powerful computer chips.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 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.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Further Supply Shifts Technological improvements are illustrated by a downward shift of the ATC and MC curves.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 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

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 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.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Exits Most firms withdrew from the home computer market due to low profits. The exit rate in matched the entry rate of

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 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.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 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.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 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).

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 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.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 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.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 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.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Allocative Efficiency: The Right Output Mix The amount consumers are willing to pay for a good (its price) equals its opportunity cost (marginal cost).

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 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.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Production 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.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Zero Economic Profit In the long-run, all economic profit is eliminated.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 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

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 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.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Relentless 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.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Relentless Profit Squeeze Throughout the process, producers experience great pressure to keep ahead of the profit squeeze by reducing costs.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Relentless Profit Squeeze The potential threat of other firms expanding production or of new firms entering the industry keeps existing firms on their toes.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Competitive Markets End of Chapter 8