1. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. Chapter 9 Competitive Markets

2. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 9-2 In this chapter you will learn to 2. Derive a competitive firm’s supply curve. 3. Determine whether competitive firms are making profits or losses in the short run. 4. Explain the role played by profits, entry, and exit in a competitive industry’s long-run equilibrium. 1. State the key assumptions of the theory of perfect competition.

3. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 9-3 Competitive Market Structure Market power — the influence that individual firms have on market prices. The less power an individual firm has to influence the market price, the more competitive is that market’s structure. Market Structure and Firm Behavior

4. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 9-4 Competitive Behavior Competitive behavior is the degree to which individual firms actively vie with one another for business. Examples: 1. GM and Toyota engage in competitive behavior but their market is not competitive. 2. Two wheat farmers do not engage in competitive behavior but they both exist in a very competitive market.

5. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 9-5 The Significance of Market Structure The demand curve faced by an individual firm may be different from the demand curve for the industry as a whole. Market structure plays a central role in determining the efficiency of the market. In this chapter, we focus on competitive market structures.

6. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 9-6 The Theory of Perfect Competition The Assumptions of Perfect Competition 1. All firms sell a homogeneous product. 2. Customers know the product and each firm’s price. 3. Each firm reaches its minimum LRAC at a level of output that is small relative to the industry’s total output. 4. Firms are free to exit and enter the industry. 1-3  Firms are price takers.

7. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 9-7 Figure 9.1 The Demand Curve for a Competitive Industry and for One Firm in the Industry

8. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 9-8 This does not mean the firm could actually sell an infinite amount at the market price. “Normal” variations in the firm’s level of output have a negligible effect on total industry output. The Demand Curve for a Perfectly Competitive Firm

9. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 9-9 Total, average, and marginal revenue Total revenue (TR): TR = p x Q Average revenue (AR): AR = (p x Q)/Q Marginal revenue (MR): MR =  TR/  Q Note: For a perfectly competitive firm, AR = MR = p. Revenue

10. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 9-10 Figure 9.2 Revenues for a Price- Taking Firm

11. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 9-11 APPLYING ECONOMIC CONCEPTS 9.1 Demand Under Perfect Competition: Firm and Industry Demand Under Perfectly Competition

12. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 9-12 Short-Run Decisions Rules for All Profit-Maximizing Firms Should the Firm Produce at All? A firm should produce only if at some level of output, price exceeds AVC. MC AVC q*q* Output Dollars per unit p = MR = AR

13. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 9-13 At a low price of $2, there is no level of output at which the firm’s revenues cover its variable costs. Table 9.1 Negative Profits and the Firm’s Shut-Down Decision

14. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 9-14 At the shut-down price the firm can just cover its average variable cost, and so is indifferent between producing and not producing. How Much Should the Firm Produce? When p > AVC, the firm does not shut down. To maximize profits, the firm chooses the output where MR = MC. But for a competitive firm, MR = p: The rule: choose output where p = MC. Production Decision

15. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 9-15 Figure 9.3 Profit Maximization for a Competitive Firm

16. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 9-16 Figure 9.4 The Derivation of the Supply Curve for a Competitive Firm

17. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 9-17 Figure 9.5 The Derivation of a Competitive Industry’s Supply Curve

18. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 9-18 But how large are each firm’s profits in this SR equilibrium? There are three possibilities: Short-Run Equilibrium in a Competitive Market When an industry is in short-run equilibrium, two things are true: - market price is such that the market clears - each firm is maximizing its profits at this price

19. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 9-19 Figure 9.6 A Typical Firm When the Competitive Market Is in Short-Run Equilibrium

20. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 9-20 Figure 9.7 Alternative Short-Run Profits of a Competitive Firm

21. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 9-21 APPLYING ECONOMIC CONCEPTS 9.2 The Parable of the Seaside Inn Short-Run Equilibrium

22. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 9-22 Long-Run Decisions Entry and Exit If existing firms have positive economic profits, new firms have an incentive to enter the industry. If existing firms have zero profits, there are no incentives for new firms to enter, and no incentives for existing firms to exit. If existing firms have economic losses, there is an incentive for existing firms to exit the industry.

23. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 9-23 Figure 9.8 The Effect of New Entrants Attracted by Positive Profits

24. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 9-24 Figure 9.9 The Effect of Exit Caused by Losses

25. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 9-25 Sunk Costs and the Speed of Exit The process of exit is not always quick and is sometimes painfully slow for the loss-making firms in the industry. This depends on how quickly capital becomes obsolete or becomes too costly to operate. The longer it takes for firms’ capital to become obsolete or too costly to operate, the longer firms will remain in the industry while they are earning economic losses.

26. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 9-26 Long-Run Equilibrium The LR industry equilibrium occurs when there is no longer incentive for entry or exit (or expansion). In long-run equilibrium, all existing firms: must be maximizing their profits. are earning zero economic profits. are not able to increase their profits by changing the size of their production facilities.

27. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 9-27 Figure 9.10 Short-Run versus Long-Run Profit Maximization for a Competitive Firm

28. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 9-28 Figure 9.11 A Typical Competitive Firm When the Industry Is in Long-Run Equilibrium

29. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 9-29 Consider a competitive industry that is in long-run equilibrium. Now suppose that the market demand for the industry’s product increases. The price will rise, and profits will rise. Entry will then occur, and price will eventually fall. But what will the new long-run equilibrium look like? Entry in the Long Run

30. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 9-30 Changes in Technology Suppose technological development reduces the costs for newly built plants. New plants will earn economic profits, expand industry output and drive down price. The price will fall until it is equal to the SRATC of the new plants. Old plants may continue, but will earn losses. They will eventually exit.

31. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 9-31 Figure 9.12 Plants of Different Vintages in an Industry with Continuous Technological Progress

32. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 9-32 Declining Industries What happens when a competitive industry in LR equilibrium experiences a continual decrease in demand? The efficient response is to continue operating with existing equipment as long as its variable costs of production can be covered. As demand shrinks, so will capacity. Antiquated equipment in a declining industry is often the effect rather than the cause of the industry’s decline.