Transcript perfect competition

Chapter 5
Competition and
Market Power
McGraw-Hill/Irwin
Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
Learning Objectives
• Define perfect competition, and identify its key
characteristics.
• Describe how businesses maximize profits in
perfectly competitive markets.
• Discuss the long-term outcome of perfect
competition.
• Compare and contrast the four types of market
structure.
• Explain how market power affects price and
quantity supplied.
5-2
The Role of Competition
• Competition plays a key role in a
market economy.
• Companies are forced to deliver to the
product that consumers want at the
lowest cost.
• Competition in the market leads to
more production, more innovation,
lower costs, and higher living
standards.
5-3
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.
5-4
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.
5-5
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.
5-6
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.
5-7
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 4,000 computers. At this output
level, P=MC.
Output
(Number of
Computers)
1,000
2,000
3,000
4,000
5,000
Marginal Cost
(Dollars)
Marginal Revenue
(Dollars)
$200
$300
$500
$500
$400
$500
$600
$500
$500
$500
5-9
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-maximizing
output
200
100
0
0
1,000
2,000
3,000
4,000
Output (number of computers)
5,000
6,000
5-10
Market Supply with Ten
Identical Businesses
700
600
Price (dollars)
Market price
500
Market supply curve
(with ten identical
businesses)
A
400
300
Profit-maximizing
output
200
100
0
0
10,000
40,000
20,000
30,000
Output (number of computers)
50,00
0
60,000
5-11
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 by
All Buyers
(Number of
Computers)
Quantity Supplied by
All Sellers
(Number of
Computers)
200
70,000
10,000
300
400
500
60,000
50,000
40,000
20,000
30,000
40,000
600
30,000
50,000
5-12
Graphing Market Equilibrium
700
600
Price (dollars)
Market price
A
500
Market supply curve
(with ten identical
businesses)
400
300
200
100
0
0
20,000
40,000
60,000
Output (number of computers)
80,000
5-13
Perfect Competition in the
Long Run
• In perfect competition, the existence
of profits attracts 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.
5-14
Perfect Competition in the
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.
5-15
New Entrants Drive Down the
Market Price
5-16
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.
5-17
Escaping Perfect Competition
• Businesses try to avoid the 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.
5-18
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.
5-19
Market Structure
• There are four market structures in the
economy:
– Perfect competition
– Monopolistic competition
– Oligopoly
– Monopoly
5-20
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 downwardsloping demand curve.
5-21
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 the
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.
5-23
MR, MC, and Profit
Maximization for Car Dealer
Cars Sold Price per
per Day
Car
(Dollars)
1
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
5-24
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 amongst 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.
5-25
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.
5-26
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.
5-27
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 in response to higher prices.
• A natural monopoly is an industry in which it
makes economic sense to have only one
supplier.
• Monopolies in recent years have been
undermined by globalization and technology.
5-28
Benefits of Perfect Competition
• Perfect competition is viewed to be the
most beneficial market structure
because:
– Businesses produce products consumers
want to purchase.
– Businesses produce products at their
lowest cost.
– Since businesses are price takers, they
will automatically increase their output
when price exceeds marginal cost.
5-29
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 that perfect competition
would produce.
• 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.
5-30
Market Power and Perfect
Competition
5-31