Competitive Markets Chapter 8. In this Chapter… 8.1. How the Industry in a Perfectly Competitive...

Competitive Markets

Chapter 8

In this Chapter…

8.1. How the Industry in a Perfectly Competitive Market Works?

The difference between firms and industries

8.2. The Long Run Outcomes of a Competitive Market

Zero Economic Profit and Its Implications

8.3. Why we want to have as Perfectly Competitive Markets as Possible?

Efficiency and Marginal Cost Pricing

The Market Supply Curve

The market supply curve together with the market demand curve determines the equilibrium price faced by an individual producer (the firm).

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.


A firm’s supply curve is its marginal cost curve above its minimum AVC.

Thus the Industry’s (market) supply curve is the sum of the marginal cost curves of all the firms.

Competitive Market Supply

0 20 40 60

1

2

3

4

$5

Pric

e

Farmer A

Quantity

a

MCA

0 20 40 60

Farmer B

Quantity

b

MCB

0 20 40 60

Farmer C

Quantity

c

MCC

0 100 200

Market supply

Quantity

d

+ =+


Whatever determines marginal cost curve of a competitive firm also determines the market supply curve (The Industry in a Competitive Market). These include:

The price of factor inputs. Technology. Expectations. Taxes. The number of firms in the industry.

Entry and Exit

When do new firms enter into a competitive the market?

ENTRY refers to INVESTMENT DECISION.

Investment decision - The decision to build, buy, or lease plant and equipment; to enter an industry.

Entry and Exit

What drives firms to enter into the competitive market?

The profit motive drives investment decisions.

Motivated by profit of the existing firm, when new firms enter into a competitive market, it has has immediate impact on the Market Supply, Market Price of the product and thus the Profit of the Incumbent firm

Entry and Exit

– If there are economic profits, more firms will enter the industry increasing market supply.

– entry of new firms into a competitive market (Investment decisions) shifts the market supply curve to the right, and lowers market price.

– Each existing firm will respond to the resulting lower price and profits by reducing output.

Quantity

Pri

ce

Quantity

Market Entry

Market demand

S2

S1

E1

E2

p1

p2

Market entry pushes price down and . . .

New firms enter

ATCMCf1

f1

p1

p2

q1 q2

Reduces profits of competitive firm

Tendency Toward Zero Profits

Gradually an increase in market supply causes the economic profits to disappear.

Note that Economic profits is the difference between total revenues and total economic costs.

When economic profits disappear, entry ceases and the market price stabilizes.

Tendency Toward Zero Profits

Implication: As long as it is easy for existing producers

to expand production or for new firms to enter an industry, in a competitive market, economic profits will not last long.

A competitive market is a market in which no buyer or seller has market power, mainly because of the number of firms and lack of Barriers to entry .

Revisiting 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.


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.


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.

Competition at Work-Real World Examples Microcomputers

Few, if any, product markets are perfectly competitive.

However, many industries function much like a competitive market.

The microcomputer market illustrates how the process of competition works.

Market Evolution

As in other industries, the computer industry has evolved over time.

It was never a monopoly, nor was it ever perfect competition.

Initial Conditions:The Apple I

Steve Jobs and Steven Wozniak created the Apple Computer Corporation in 1977.

Other companies noted the profits and, due to the low barriers to entry, followed Apple’s lead.

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).

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

Initial Equilibrium in the Computer Market

1200

1000

800

600

400

200

0 200 400 600 800 1000

Market price

Profits

mD Average

total cost

P = MR

Quantity

C

PR

ICE

OR

CO

ST

The typical firm

$1200

1000

800

600

400

200

0 20 40 60 80

Market demand

Market equilibrium

Market supply

Quantity (thousands)

Pri

ce (

per

com

pute

r)

The computer industry

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.

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

Given the following information, complete the table and determine the profit Maximizing output level

Computer Revenues, Costs and Profits

Given information in the pervious table and assuming that it a perfectly competitive market, complete the table and determine the profit Maximizing output level

Output per

Month

Marginal Revenue

Marginal Cost

Average Total Cost

Profit per Unit

0

100

200

300

400

500

600

700

800

900

Computer Revenues, Costs and Profits

Output per

Month

Price = Marginal Revenue

Marginal Cost

Average Total Cost

Profit per Unit

0

100 $1,000 $ 300 $ 900 $ 100

200 1,000 400 650 350

300 1,000 500 600 400

400 1,000 600 600 400

500 1,000 800 640 360

600 1,000 1,000 700 300

700 1,000 1,260 780 220

800 1,000 1,740 900 100

900 1,000 1,998 1,022 –22

The Lure of Profits

In competitive markets, economic profits attract new entrants.

Low entry barriers permit new firms to enter competitive markets.

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.

A Shift of Market Supply

Short-run equilibrium:

p = MC


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


Once established, long-run equilibrium will continue until market demand shifts or technological improvement reduces the cost of computer production.

500 6000

800

$1000

Price

or C

ost (

per c

ompu

ter)

Quantity (computers per month)

0 20,000

$1000

800


Price

(per

com

pute

r)The Competitive Price and Profit Squeeze

Profits

S1S2

Market demand

An expanded market supply . . .

MCOld price

G

Hm

ATC

Lowers price and profits for the typical firm

Newprice

500 6000

800

$1000

Price

or C

ost (

per c

ompu

ter)


0 20,000

$1000

800


Price

(per

com

pute

r)The Competitive Squeeze Approaching Its Limit

Profits

S2

Market demand

The computer industry

MC

Old priceJ

Km

ATC

The typical firm

Newprice

S3

700620

Short- vs. Long-Run Equilibrium

MCATC

pS

qS

Pric

e or

Cos

t

Quantity

Short-run equilibrium (p = MC)

pS

Pric

e or

Cos

t

pL

qL

Quantity

MCATC

Long-run equilibrium (p = MC = ATC)

Long-Run Rules for Entry and Exit

Price Level Result for typical firm Market Response

P > ATC Profits New firms enterindustry, Existing firmsexpand

P < ATC Loss Firms exit industry,Existing firms contract

P = ATC Break even No exit or entry,Existing firms maintaincurrent capacity

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.

Home Computers vs. Personal Computers

Manufactures of computers did both —separating the market into home computers and personal computers

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.

Price Competition in Home Computers

Costs were pushed down by reducing the number of components and using more powerful computer chips.

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.

Further Supply Shifts

Technological improvements are illustrated by a downward shift of the ATC and MC curves.

Pric

e (p

er c

ompu

ter)


Lower Costs Shifts the Supply Curve Downward

OldMC

NewMC

OldATC

NewATC

J N

R

430 600

$700

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.

Exits

Most firms withdrew from the home computer market due to low profits.

The exit rate in 1983-85 matched the entry rate of 1979-82.

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.

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.

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).


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.


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.


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.


The amount consumers are willing to pay for a good (its price) equals its opportunity cost (marginal cost).

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.

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.

Zero Economic Profit

In the long-run, all economic profit is eliminated.

Quantity (units per time period)

Pric

e (d

olla

rs p

er u

nit)

Summary of Competitive Process

Industry ATCIndustry MC

Market demand

Short-runequilibrium

Long-run equilibrium

a

bc

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.

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.


Throughout the process, producers experience great pressure to keep ahead of the profit squeeze by reducing costs.


The potential threat of other firms expanding production or of new firms entering the industry keeps existing firms on their toes.

Competitive Markets Chapter 8. In this Chapter… 8.1. How the Industry in a Perfectly Competitive...

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