MANAGERIAL MANAGERIAL ECONOMICS 11ECONOMICS 11thth Edition Edition

ByByMark HirscheyMark Hirschey

Competitive MarketsCompetitive MarketsChapter 10Chapter 10

Chapter 10Chapter 10OVERVIEWOVERVIEW

Competitive Environment Factors That Shape the Competitive

Environment Competitive Market Characteristics Profit Maximization in Competitive

Markets Marginal Cost and Firm Supply Competitive Market Supply Curve Competitive Market Equilibrium

Competitive Environment What is Market Structure?

A market consists of all firms and individuals willing and able (potential entrants) to buy or sell a particular product at a given time and place.

Market structure describes the competitive environment in the market for any good or service. Four important industry characteristics:

1. Number of buyers, sellers and potential entrants.2. The degree to which products are similar or

dissimilar.3. The amount and cost of information about

product price and quality.4. Barriers to entry and exit, etc.

Vital Role of Potential Entrants Competition comes from actual and

potential competitors. Potential entrants often affect

price/output decisions.

Factors that Shape the Competitive Environment

The competitive environment is shaped by the number and relative size of buyers and sellers, and the extent to which the product is standardized. In turn, these factors are influenced by distinctive production methods, and entry and exit condition)

Product Differentiation Real or perceived differences in the

quality of goods and services. R&D, innovation, and advertising are

important in many markets Competitive markets characterized by

vigorous rivalry among competitors offering essentially the same product.

Production Methods Economies of scale can preclude small-firm

size. Entry and Exit Conditions

Barriers to entry and exit can shelter incumbents from potential entrants.

Barrier to mobility: any factor or industry characteristics that creates an advantage for large leading firms over smaller nonleading rivals

Buyer Power Powerful buyers can limit seller power.

Competitive Market Characteristics

Perfect Competition: a market structure that exists when

1. All firms produce homogenous product2. Each firm is so small it cannot affect price.3. Entry and exit are unrestricted4. Each firm has complete knowledge about

production and prices5. Individual buyers and sellers are price

takers

Examples of Competitive Markets Agricultural commodities. Prominent markets for intermediate

goods and services. Unskilled labor market.

Profit Maximization in Competitive Markets

Profit Maximization Imperative. In competitive markets, firms are price

takers. Their individual production decisions have no effect on market prices. Therefore, maximum profits result when the market price is set equal to marginal cost. In a competitive market a firm “might” be able to control costs.

Normal profit is return necessary to attract and maintain capital investment.

Efficient firms can earn normal profit. Inefficient firms suffer losses.

Role of Marginal Analysis Set Mπ = MR – MC = 0 to maximize

profits. MR=MC when profits are maximized.

Marginal Cost and Firm Supply Short-run Firm Supply

Marginal cost curve is the short-run supply curve so long as P > AVC .

The point of minimum ATC is found by setting MC=ATC and solving for Quantity.

The minimum point on the AVC is found by setting MC=AVC and solving for quantity.

Competitive market price (P) is shown as a horizontal line because P=MR.

Only in competitive markets P=AR=MR=MC at the profit maximizing activity level.

Short-run Firm Supply. Produce Pride, Inc., supplies sweet corn to canneries located throughout the Missouri River Valley. Like many grain and commodity markets, the market for sweet corn is perfectly competitive. With $500,000 in fixed costs, the company's total and marginal costs per ton (Q) are: TC = $500,000 + $400Q + $0.04Q2

MC = TC/Q = $400 + $0.08Q A. Calculate the industry price necessary to induce short-run firm supply of 5,000, 10,000, and 15,000 tons of sweet corn. Assume that MC > AVC at every point along the firm's marginal cost curve and that total costs include a normal profit. B. Calculate short-run firm supply at industry prices of $400, $1,000, and $2,000 per ton.

Long-run Firm Supply Marginal cost curve is the long-run

supply curve so long as P > ATC. In long run, firm must cover all

necessary costs of production and earn a normal profit.

Long-run Firm Supply. The Los Angeles retail market for unleaded gasoline is fiercely price competitive. Consider the situation faced by a typical gasoline retailer when the local market price for unleaded gasoline is $2.50 per gallon and total cost (TC) and marginal cost (MC) relations are: TC = $156,250 + $2.25Q + $0.0000001Q2

MC = TC/Q = $2.25 + $0.0000002Q and Q is gallons of gasoline. Total costs include a normal profit. A. Using the firm's marginal cost curve, calculate the profit-maximizing long-run supply from a typical retailer B. Calculate the average total cost curve for a typical gasoline retailer, and verify that average total costs are less than price at the optimal activity level.

Competitive Market Supply Curve Market Supply Short Run (Fixed

Number of Competitors) : Supply is the sum of competitor output.

Market Supply Long Run : Entry and Exit Cause Market Supply to be perfectly elastic at the market price

Market Supply With Entry and Exit Entry results in more firms, increased

output, a rightward shift in the supply curve, and drives down prices and profits.

Exit reduces the number of firms, decreases the quantity of output, shifts the supply curve leftward, and allows prices and profits to rise for remaining competitors.

Short-run Market Supply. Carolina Textiles, Inc., is a small manufacturer of cotton linen that it sells in a perfectly competitive market. Given $100,000 in fixed costs per day, the daily total cost function for this product is described by: TC = $100,000 + $2Q + $0.0625Q2

MC = TC/Q = $2 + $0.125Q where Q is units of cotton linen produced per day. Assume that MC > AVC at every point along the firm's marginal cost curve, and that total costs include a normal profit. A. Derive the firm's supply curve, expressing quantity as a function of price. B. Derive the market supply curve if North Carolina Textiles is one of 1,000 competitors. C. Calculate market supply per day at a market price of $47 per unit. .

Long-run Competitive Firm Supply. Calvin's Barbershop is a popularly-priced hair cutter on the south side of Chicago. Given the large number of competitors, the fact that barbers routinely tailor services to meet customer needs, and the lack of entry barriers, it is reasonable to assume that the market is perfectly competitive and that the average $10 price equals marginal revenue, P = MR = $10. Furthermore, assume that the barbershop's monthly operating expenses are typical of the 50 barbershops in the local market and can be expressed by the following total and marginal cost functions: TC = $9031.25 + $1.5Q + $0.002Q2

MC = $1.5. + $0.004Q where TC is total cost per month including capital costs, MC is marginal cost, and Q is the number of hair cuts provided. Total costs include a normal profit. A. Calculate Calvin's profit-maximizing output level. B. Calculate the Calvin's economic profits at this activity level. Is this activity level sustainable in the long run?

Competitive Market Equilibrium Balance of Supply and Demand

Equilibrium is a balance of supply and demand.

Normal Profit Equilibrium With a horizontal market demand curve,

MR=P. P=MR=MC=ATC. There are no economic profits. All firms earn a normal rate of return.

Perfectly Competitive Equilibrium. Fuel costs have risen sharply during recent years as consumption, refining and production costs have increased. Demand and supply conditions in the perfectly competitive domestic crude oil market are: P = $105 - 1.5QD (Demand) P = $37.50+ 0.75QS (Supply) where P is price per barrel and Q is quantity in millions of barrels per day. A. Graph industry demand and supply curves. B. Determine both graphically and algebraically the equilibrium industry

price/output combination.

Self Test Problem 1Self Test Problem 1

A. The marginal cost curve constitutes the short-run supply curve for firms in perfectly

competitive markets so long as price is greater than average variable cost. Market Supply is the Sum of Firm Supply Across all

Competitors Firm One

Supply Firm Two

Supply Firm Three

Supply Market Supply

Price

P = MC1= $5 + $0.0004Q1 and Q1 = -12,500 + 2,500P

P = MC2= $15 + $0.002Q2 and Q2 = -7,500 + 500P

P = MC3= $1 + $0.0002Q3 and Q3 = -5,000 + 5,000P

P = $3.125 + $0.000125P and QI = -25,000 + 8,000P (QI = Q1 + Q2 + Q3)

$0 -12,500 -7,500 -5,000 -25,000 5 0 -5,000 20,000 15,000

10 12,500 -2,500 45,000 55,000 15 25,000 0 70,000 95,000 20 37,500 2,500 95,000 135,000 25 50,000 5,000 120,000 175,000 30 62,500 7,500 145,000 215,000 35 75,000 10,000 170,000 255,000 40 87,500 12,500 195,000 295,000 45 100,000 15,000 220,000 335,000 50 112,500 17,500 245,000 375,000 55 125,000 20,000 270,000 415,000 60 137,500 22,500 295,000 455,000 65 150,000 25,000 320,000 495,000 70 162,500 27,500 345,000 535,000 75 175,000 30,000 370,000 575,000 80 187,500 32,500 395,000 615,000

BB

Self Test Problem 2Self Test Problem 2A.

Quantity Supplied

by Firm (000)

Price 1 + 2 + 3 + 4 + 5 = Partial Market Supply

1,000 = Total Market Supply (000)

$1 20 18 52 32 18 140 140,000 2 22 24 64 44 26 180 180,000 3 24 30 76 56 34 220 220,000 4 26 36 88 68 42 260 260,000 5 28 42 100 80 50 300 300,000 6 30 48 112 92 58 340 340,000 7 32 54 124 104 66 380 380,000 8 34 60 136 116 74 420 420,000

The data in the Table illustrate the process by which an industry supply curve is constructed. First, suppose that each of five firms in an industry is willing to supply varying quantities at different prices. Summing the individual supply quantities of these five firms at each price determines their combined supply schedule, shown in the Partial Market Supply column. For example, at a price of $2, the output supplied by the five firms are 22, 24, 64, 44, and 26 (thousand) units, respectively, resulting in a combined supply of 180(000) units at that price. With a competitive market price of $8, supply quantities would become 34, 60, 136, 116, and 74, for a total supply by the five firms of 420(000) units, and so on. Now assume that there are 1,000 firms just like each one illustrated in the table. There are actually 5,000 firms in the industry, each with an individual supply schedule identical to one of the five firms illustrated in the table. In that event, the total quantity supplied at each price is 1,000 times that shown under the Partial Market Supply schedule. Because the numbers shown for each firm are in thousands of units, the total market supply column is in thousands of units. Therefore, the number 140,000 at a price of $1 indicates 140 million units, the number 180,000 at a price of $2 indicates 180 million units, and so on.

B. To find the market supply curve, simply sum each individual firm’s supply curve, where quantity is expressed as a function of the market price: QI = Q1 + Q2 + Q3 + Q4 + Q5 = 18 + 2P +12 +6P +40 + 12P +20 +12P +10 +8P = 100 + 40P (Market Supply)

Plotting the market demand curve and the market supply curve allows one to determine the equilibrium market price of $6 and the equilibrium market quantity of 340,000(000), or 340 million units. To find the market equilibrium levels for price and quantity algebraically, simply set the market demand and market supply curves equal to one another so that QD = QS. To find the market equilibrium price, equate the market demand and market supply curves where quantity is expressed as a function of price:

Demand = Supply 400,000 - 10,000P = 100,000 + 40,000P 50,000P = 300,000 P = $6

To find the market equilibrium quantity, set equal the market demand and market supply curves where price is expressed as a function of quantity, and QD = QS:

Demand = Supply $40 - $0.0001Q = -$2.5 + $0.000025Q 0.000125Q = 42.5 Q = 340,000(000)

Therefore, the equilibrium price-output combination is a market price of $6 with an equilibrium output of 340,000(000), or 340 million units.