Competition

Chapter 6Copyright © 2011 by The McGraw-Hill Companies, Inc. All Rights Reserved.McGraw-Hill/Irwin

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Market Structure

• The number and relative size of firms in an industry.

• Most real-world firms fall somewhere along a spectrum that stretches from one extreme (powerless) to another (powerful).

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Five common types of market structure:

• Perfect Competition

• Monopolistic Competition

• Oligopoly

• Duopoly

• Monopoly

Market Structure

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Figure 6.1

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Competitive Firm

• A perfectly competitive firm is one without market power.– It is not able to alter the market price of

the good it produces.– It is a price taker.– It competes with many other firms selling

homogenous products.

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Competitive Market

• A competitive market is one in which no buyer or seller has market power.

• No single producer or consumer has any control over the price or quantity of the product.

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Monopoly

• A monopoly firm is one that produces the entire market supply of a particular good or service.– It is a price setter, not a price taker. – It has no direct competitors.– It has complete market power; it can alter

the market price of a good or service.

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Imperfect Competition

• Other forms of imperfect competition lie between the extremes of monopoly and perfect competition.– Duopoly: only two firms supply a product.– Oligopoly: a few large firms supply all or most of

a particular product.– Monopolistic competition: many firms supply

essentially the same product but each enjoys significant brand loyalty.

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Perfect Competition

• Perfectly competitive firms are pretty much faceless.

• They have no brand image, no real market recognition.

• A perfectly competitive firm is one whose output is so small in relation to market volume that its output decisions have no perceptible impact on price.

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No Market Power

• The output of a lone perfectly competitive firm is so small relative to market supply that it has no significant effect on the total quantity or price in the market.

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Price Takers

• A perfectly competitive firm is a price taker.

• An individual firm’s output decisions do not affect the market price.

• An individual firm must take the market price and do the best it can within these constraints.

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Market Demand versus Firm Demand

• We must distinguish between the market demand curve and the demand curve confronting a particular firm.– The market demand curve for a product is

always downward-sloping.– The demand curve facing a perfectly

competitive firm is horizontal.

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Figure 6.2

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The Firm’s Production Decision

• Choosing a rate of output is a firm’s production decision:– It is the selection of the short-term rate of

output (with existing plant and equipment).

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Output and Revenues

• Total revenue is the price of a product multiplied by the quantity sold in a given time period:

Total revenue = price x quantity

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Revenues versus Profits

• Profit is the difference between total revenue and total cost.

• Maximizing output or revenue is not the way to maximize profits.

• Total profits depend on how both revenue and cost increase as output expands.

• A business is profitable only within a certain range of output. LO-2

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Profit Maximization and Price

• To maximize profit, the firm should produce an additional unit of output only if it brings in revenue that is greater than the cost of producing it.

• Since competitive firms are price takers, they must take whatever price the market has determined for their products.

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Figure 6.5

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Profit-Maximizing Rate of Output

• Never produce anything that costs more than it brings in – it boils down to comparing price and marginal cost.

• A competitive firm wants to expand the rate of production whenever price exceeds marginal cost.

• Short-run profits are maximized at the rate of output where price equals marginal cost.

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Short-Run Decision Rules for a Competitive Firm

o Price = MCMaintain output rate (Profits maximized)

o Price < MCDecrease output rate

o Price > MCIncrease output rate

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Total Profit

• Total profit can be computed in one of two ways:

Total profit = total revenue – total cost

OR

Total profit = average profit (profit per

unit) x quantity soldLO-3

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• Profit per unit equals price minus average total cost:

Profit per unit = p – ATC

Total Profit

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• Total profit equals profit per unit times quantity:

Total profit = (p – ATC) x q

Total Profit

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• The profit-maximizing producer doesn’t seek to maximize per-unit profits.

• The profit-maximizing producer has no particular desire to produce at that rate of output where ATC is at a minimum.

• Total profits are maximized only where

p = MC.

Total Profit

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Figure 6.6

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Supply Behavior

• How firms make production decisions helps explain how the market establishes prices and quantities.

• Supply is the ability and willingness to sell specific quantities of a good at alternative prices in a given time period.

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A Firm’s Supply

• Competitive firms adjust the quantity supplied until MC = price.

• The marginal cost curve is the short-run supply curve for a competitive firm.

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Figure 6.7 (a) & (b)

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Figure 6.7 (c) & (d)

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Supply Shifts

• Marginal costs determine the supply decisions of a firm.

• Anything that alters marginal cost will change supply behavior.

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• Important influences on marginal cost (and supply behavior) are:– The price of factor inputs – Technology – Expectations

Supply Shifts

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Market Supply

• Market supply is the total quantity 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 is the sum of the marginal cost curves of all the firms.

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Competitive Market Supply

• Determinants of the market supply of a competitive industry:– The price of factor inputs – Technology – Expectations – The number of firms in the industry

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Industry Entry and Exit

• To understand how competitive markets work, we focus on changes in equilibrium rather than on a static equilibrium.

• The number of firms in a competitive industry is not fixed.

• Industry entry and exit is a driving force affecting market equilibrium.

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Entry

• Additional firms will enter the industry when profits are plentiful.

• Economic profits attract firms.– More firms enter the industry.– The market supply curve shifts to the

right.– The price decreases.

• Industry output increases and price falls when firms enter an industry.

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Figure 6.8

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Tendency Toward Zero Economic Profits

• New firms continue to enter a competitive industry so long as profits exist.

• Once price falls to the level of minimum average cost, all economic profits disappear.

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• Entry is the force driving down market prices.

• Price falls until there are no economic profits.

• At that point, average total cost is at a minimum.

Tendency Toward Zero Economic Profits

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Exit

• Firms exit the industry when profit opportunities look better elsewhere.

• Firms leave the industry if price falls below average cost.

• As firms exit the industry, the market supply curve shifts to the left.

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• Price rises until there are no economic losses.

• At that point, average total cost is at a minimum.

Exit

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Equilibrium

• The existence of profits in a competitive industry induces entry.

• The existence of losses in a competitive industry induces exits.

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Long-Run Equilibrium

• In long-run competitive market equilibrium:– Price equals minimum average total cost.– Economic profit is eliminated.

• 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.

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Figure 6.9

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Low Barriers to Entry

• There are no significant barriers to entry in competitive markets.

• Barriers to entry are obstacles that make it difficult or impossible for would-be producers to enter a market, like patents.

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Characteristics of a Competitive Market

• Many firms

• Identical products

• Low entry barriers

• MC = p

• Zero economic profit

• Perfect information

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The Relentless Profit Squeeze

• The unrelenting squeeze on prices and profits is a fundamental characteristic of the competitive process.

• The market mechanism works best in competitive markets.– Market mechanism – the use of market

prices and sales to signal desired outputs.

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Maximum Efficiency

• Competitive pressure on prices forces suppliers to produce at the least possible cost.

• Society gets the most it can from its available scarce resources.

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Zero Economic Profits

• All economic profits are eliminated at the limit of the competitive process.

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The Social Value of Losses

• Economic losses are a signal to producers that they are not using society’s scarce resources in the best way.

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Policy Perspective

• Competitive markets present a strong argument for laissez faire.

• Government should promote competition because markets do a good job of allocating resources.

• This means keeping markets open and accessible to new entrants by dismantling entry barriers.

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End of Chapter 6