Transcript Chap005

Chapter 5
Competition and
Market Power
McGraw-Hill/Irwin
Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Objectives
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Perfect competition
Market structure
Monopolistic competition
Oligopoly
Monopoly
Market power
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The Role of Competition
• Competition plays a key role in a market
economy.
• Companies are forced to deliver to
consumers the product they want at the
lowest cost.
• Competition in the market leads to more
production, more innovation, lower costs,
and higher living standards.
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Perfect Competition
• The highest degree of competition is found
in a perfectly competitive market.
• This is an extreme type of market structure
rarely found in the real world.
• In perfect competition, all buyers and
sellers are price takers.
– In this case, buyers and sellers do not set the
price of their product, but take the price as
given.
– Prices are determined by the market.
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Conditions Necessary for Perfect
Competition
• For a market to be perfectly competitive,
the following conditions must hold:
– First, products have to be standardized or
homogenous so there is little difference
between them.
– Second, sellers and buyers must be wellinformed about what all the other sellers are
charging.
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Conditions Necessary for Perfect
Competition
– Third, a market with perfect competition will
have many sellers and many buyers.
• No buyer or seller is large enough to have an
impact on the price.
• In national or global markets, buyers and sellers
are in different parts of the country or the world.
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Examples of Perfect Competition
• Most markets do not meet all three of the
conditions necessary for perfect
competition.
• But today’s economy is moving more
toward perfect competition as more
markets become global.
• Agricultural markets are the best examples
of perfect competition.
– There are many buyers and sellers, products
are standardized, and no buyer or seller can
set the price.
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Profit Maximization in Perfect
Competition
• Remember, profit maximization occurs at
the output level, where marginal revenue
(MR) equals marginal cost (MC).
• In perfect competition, the marginal
revenue received from selling one more
unit of output is simply equal to the price
(P).
• So in perfect competition the firm will
produce at the point where price equals
marginal cost.
– Profit maximization occurs at P=MC.
5-8
Profit Maximization for a Computer
Maker
• Assuming a firm can sell its computer for
$500, the firm will maximize profits by
producing 4000 computers. At this output
level, P=MC.
Output
(no. of computers)
Marginal cost
(dollars)
Marginal revenue
(dollars)
1000
200
500
2000
3000
300
400
500
500
4000
5000
500
600
500
500
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Profit Maximization by a Single
Business in a Competitive Market
700
600
Price (dollars)
Market price
500
Marginal cost curve
(also individual supply
curve)
A
400
300
Profit maximization
output
200
100
0
0
1000
2000
3000
4000
Output (number of computers)
5000
6000
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Market Supply with Ten Identical
Businesses
700
600
Price (dollars)
Market price
500
Market supply curve
(with ten identical
businesses)
A
400
300
Profit maximization
output
200
100
0
0
10000
40000
20000
30000
Output (number of computers)
50000
60000
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Market Equilibrium in Perfect
Competition
• In perfect competition, the price is set in the market.
• This table shows market demand and supply for
computers. At a price of $500, quantity demanded
equals quantity supplied.
Price (dollars)
Quantity demanded
Quantity supplied
200
70000
10000
300
400
60000
50000
20000
30000
500
600
40000
30000
40000
50000
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Graphing Market Equilibrium
700
600
Price (dollars)
Market price
A
500
Market supply curve
(with ten identical
businesses)
400
300
200
100
0
0
20000
40000
60000
Output (number of computers)
80000
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Perfect Competition in Long Run
• In perfect competition, the existence of
profits attract competition as new firms
enter the market.
• In some industries, barriers to entry
make it difficult for firms to enter a market.
– Barriers to entry include government
regulation, availability of land, capital
investment required, etc.
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Perfect Competition in Long Run
• Barriers to entry are insignificant in
perfectly competitive markets.
• Thus, in a market with perfect competition
and no barriers to entry, profits will trend
toward zero in the long run.
• This is because new firms enter the
industry, causing the supply curve to shift
to the right and the market price to fall.
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New Entrants Drive Down the
Market Price
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Consequence of No Barriers to Entry
• If there are no barriers to entry, only the
low cost producers survive in the long run.
• The low cost providers will drive down the
price to the point at which the high cost
producers will not be able to make a profit.
• These firms will then simply leave the
industry (the shutdown decision), since
costs exceed revenues.
– This trend to low cost producers is evident in
such industries as retail, apparel and
furniture.
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Escaping Perfect Competition
• Businesses try to avoid extreme
competition evident in perfectly
competitive markets.
• To do this, businesses try to differentiate
their product from rivals.
• This gives firms some power over price.
• Firms differentiate through product design
and advertising.
– Advertising enables a firm to establish a
brand name.
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Market Structure
• Economists classify markets into different
types, or market structures.
• Classification depends on:
– the intensity of competition in the markets.
– the number of buyers and sellers.
– whether the product is similar or differentiated.
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Market Structure
• There are four market structures in the
economy:
– Perfect competition
– Monopolistic competition
– Oligopoly
– Monopoly
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Monopolistic Competition
• Monopolistic competition is characterized by a
large number of sellers with similar but not
standardized products.
• Monopolistic competition is the most common
market structure in today’s economy.
– Restaurants and gasoline stations are good
examples.
• Monopolistic competitive firms are not pricetakers and the firms face a downward-sloping
demand curve.
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Profit Maximization with Monopolistic
Competition
• In the case of perfect competition, the
profit maximization rule is that price equals
marginal cost (MC).
– In this case, price is equal to marginal
revenue (MR) since the business can sell as
much as it likes at the market price.
• In monopolistic competition, MR is below
price.
– The reason MR is below price is that business
must cut the price to everyone to sell another
unit.
5-22
Profit Maximization with Monopolistic
Competition
• The business gains more revenue from
new sales, but loses on products it is
already selling.
• A monopolistic competitive firm maximizes
product at the output level where marginal
revenue equals marginal cost (MR=MC).
• In the long run, monopolistic competition
starts looking more and more like perfect
competition as more businesses enter the
market.
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MR and MC and Profit Maximization
for Car Dealer
Cars sold
per day
1
Price per
car
(dollars)
30,000
Total
revenue
(dollars)
30,000
Marginal
revenue
(dollars)
30,000
Marginal
cost
(dollars)
24,000
2
29,000
58,000
28,000
25,000
3
28,000
84,000
26,000
26,000
4
27,000
108,000
24,000
27,000
5
26,000
130,000
22,000
28,000
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Oligopoly
• An oligopoly occurs when there are a
small number of sellers (usually 4 or less)
in a market producing similar products.
• This is a common market structure in
manufacturing and the airlines.
• Oligopolists can compete very intensely.
• In this case, the market looks very much
like perfect competition, with prices under
downward pressure and profits very low.
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Oligopoly
• But oligopolistic firms may engage in
illegal collusion, working together to keep
the price of their product high.
• Oligopolistic firms often engage in implicit
collusion, where they do not
communicate directly about price.
– In this case, one company (the market leader)
sets the price.
– There is a tendency for parties in a collusive
arrangement to cheat on the deal.
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Monopoly
• A monopoly is a market where there is
only one seller, and buyers have no good
alternatives.
• Monopoly is the extreme opposite of
perfect competition.
• A monopolist can push up price due to its
control over a market.
• But to do so, it must restrict output.
– Why? Because of the law of demand:
• Higher prices result in lower quantity demanded.
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Monopoly
• The extent to which a monopolist can raise
price depends on the elasticity of demand.
– If demand is very inelastic, the monopolist has
the ability to substantially raise price above
the competitive level.
– But if demand is elastic, the pricing power of
the monopolist is limited as consumers will cut
purchases a lot in response to higher prices.
• Monopolies in recent years have been
undermined by globalization and
technology.
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Benefits of Perfect Competition
• Perfect competition is viewed to be the
most beneficial market structure because:
– Business produces products consumers want
to purchase.
– Business produces products at their lowest
cost.
– Since businesses are price takers, they will
automatically increase their output when price
exceeds marginal cost.
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Downside of Market Power
• Monopoly, monopolistic competition, and
oligopoly are all sellers with some degree of
market power.
• Market power is the ability to raise prices above
the level in perfect competition.
• Thus, firms with market power will produce less
and charge a higher price than a perfectly
competitive firm.
• This leads to higher profits for the firm with
market power.
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