Transcript McGraw-Hill/Irwin Competitive Markets

Competitive Markets
Chapter 23
McGraw-Hill/Irwin
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Introduction

This chapter focuses on three key
questions:
 How
are prices determined in competitive
markets?
 How does competition affect the profits of a
firm or industry?
 What does society gain from market
competition?
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The Market Supply Curve

The market supply curve determines the
equilibrium price faced by an individual producer.
 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.
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The Market Supply Curve

The market supply curve is the sum of the
marginal cost curves of all the firms.
 Marginal
cost (MC) – The increase in total cost
associated with a one-unit increase in
production.
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The Market Supply Curve

Whatever determines marginal cost also
determines the competitive firm’s supply
response.
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The Market Supply Curve

The market supply of a competitive
industry is determined by:
 The
price of factor inputs.
 Technology.
 Expectations.
 Taxes.
 The number of firms in the industry.
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Competitive Market Supply
Farmer A
Farmer B
Farmer C
Market supply
$5
MCA
Price
4
3
a
2
MCB
MCC
c
b
+
+
d
=
1
0
20 40 60
Quantity
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0
20 40 60
Quantity
0
20 40 60
Quantity
0
100 200
Quantity
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Entry and Exit

Investment decisions shift the market
supply curve to the right.
 Investment
decision - The decision to build,
buy, or lease plant and equipment; to enter or
exit an industry.
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Entry and Exit

The profit motive drives these investment
decisions.
 If
there are economic profits, more firms will
enter the industry increasing market supply.
 Each firm will respond to the resulting lower
price and profits by reducing output.
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Market Entry
Market entry pushes
price down and . . .
S1
Price
E1
p1
p2
Quantity
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MC
S2
p1
p2
E2
New firms
enter
Reduces profits of
competitive firm
ATC
f1
f1
Market
demand
q1 q2
Quantity
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Tendency Toward Zero Profits

An increase in market supply causes the
economic profits to disappear.
 Economic
profits – The difference between
total revenues and total economic costs.
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Tendency Toward Zero Profits
When economic profits disappear, entry
ceases and the market price stabilizes.
 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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Tendency Toward Zero Profits
This is how competitive markets work.
 A competitive market is a market in which
no buyer or seller has market power.

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Low Barriers to Entry

Barriers to entry are obstacles that make
it difficult or impossible for would-be
producers to enter a particular market.
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Low Barriers to Entry

Barriers to entry may include:
 Patents.
 Control
of essential factors of production.
 Control of distribution outlets.
 Well-established brand loyalty.
 Government regulation.
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Market 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.
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Market Characteristics of
Perfect Competition

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.
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Market Characteristics of
Perfect Competition

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.
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Competition at Work:
Microcomputers
Few, if any, product markets are perfectly
competitive.
 Many industries function much like a
competitive market.

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Competition at Work:
Microcomputers

The microcomputer market illustrates how
the process of competition works.
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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.

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The Production Decision

Each 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).
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The Production Decision

To maximize profit, each competitive firm
seeks the rate of output at which marginal
cost equals price.
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Initial Equilibrium in the
Computer Market
Market
equilibrium
$1200
1000
800 Market
supply
600
400
Market
demand
200
0
20 40 60 80
Quantity (thousands)
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The typical firm
1200
PRICE OR COST
Price (per computer)
The computer industry
1000
800
600
400
Market price C
P = MR
Profits
m
D
Average
total
cost
200
0
200 400 600 800 1000
Quantity
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Profit Calculations

A profit-maximizing producer seeks to
maximize total profit.
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Profit Calculations

This is not necessarily or even very
frequently the same thing as maximizing
profit per unit.
 Profit
per unit - 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
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Computer Revenues, Costs and
Profits
Output
per
Month
0
100
$1000
200
300
400
500
600
700
800
900
1000
1000
1000
1000
1000
1000
1000
1000
Price
Total
Revenue
$100,00
0
200,000
300,000
400,000
500,000
600,000
700,000
800,000
900,000
Total Cost
Total Profit
$ 60,000
90,000
–$60,000
10,000
130,000
180,000
240,000
320,000
420,000
546,000
720,000
919,800
70,000
120,000
160,000
180,000
180,000
154,000
80,000
–19,800
Computer Revenues, Costs and
Profits
Output
per
Month
0
100
200
300
400
500
600
700
800
900
Price =
Marginal
Revenue
$1,000
1,000
1,000
1,000
1,000
1,000
1,000
1,000
1,000
Marginal
Cost
Average
Total
Cost
Profit per
Unit
$ 300
400
500
600
800
1,00
1,260
1,740
1,998
$ 900
650
600
600
640
700
780
900
1,022
$ 100
350
400
400
360
300
220
100
–22
The Lure of Profits

In competitive markets, economic profits
attract new entrants.
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Low Entry Barriers

Low entry barriers permit new firms to
enter competitive markets.
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A Shift of Market Supply

The entry of new firms shifts the market
supply curve to the right.
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A Shift of Market Supply
New entrants will continue to be attracted
as long as there are economic profits in
short-run competitive equilibrium.
 Short-run competitive equilibrium: p = MC

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A Shift of Market Supply
Any short-run equilibrium will not last.
 As supply increases, price drops toward
the minimum of ATC.
 Once at minimum of ATC, there are no
longer economic profits to attract firms to
enter.

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A Shift of Market Supply
In long-run equilibrium, entry and exit
cease, and zero economic profit (that is,
normal profit) prevails.
 Long-run equilibrium:
p =MC =minimum ATC

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A Shift of Market Supply

Once established, long-run equilibrium will
continue until market demand shifts or
technological improvement reduces the
cost of computer production.
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The Competitive Price and
Profit Squeeze
Price (per computer)
S1
$1000
S2
800
Market demand
0 20,000
Quantity (computers per month)
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Lowers price and profits
for the typical firm
Price or Cost (per computer)
An expanded market
supply . . .
MC
$1000
800
ATC
Old price
Profits
m
G
H
New
price
0
500 600
Quantity (computers per month)
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The Competitive Squeeze
Approaching Its Limit
S2
$1000
S3
800
Market demand
0 20,000
Quantity (computers per month)
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The typical firm
Price or Cost (per computer)
Price (per computer)
The computer industry
MC
ATC
$1000
800
700
620
Old price
J
Profits
m K
New
price
0
500 600
Quantity (computers per month)
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Short- vs. Long-Run
Equilibrium
Short-run equilibrium
(p = MC)
pS
qS
Quantity
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MC
ATC
Price or Cost
Price or Cost
MC
Long-run equilibrium
(p = MC = ATC)
ATC
pS
pL
qL
Quantity
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Long-Run Rules for Entry and
Exit
Price Level Result for typical firm
Market Response
P > ATC
Profits
New firms enter
industry, Existing firms
expand
P < ATC
Loss
Firms exit industry,
Existing firms contract
P = ATC
Break even
No exit or entry,
Existing firms maintain
current capacity
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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.
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Home Computers vs. Personal
Computers

Manufactures of computers did both —
separating the market into home
computers and personal computers
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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.
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Price Competition in Home
Computers

Costs were pushed down by reducing the
number of components and using more
powerful computer chips.
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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.

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Further Supply Shifts

Technological improvements are illustrated
by a downward shift of the ATC and MC
curves.
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Lower Costs Shifts the Supply
Curve Downward
Price (per computer)
Old
MC
New
MC
Old New
ATC ATC
$700
J
N
R
430
600
Quantity (computers per month)
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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.

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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.

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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.

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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.

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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).
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Allocative Efficiency: The
Right Output Mix
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.

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Allocative Efficiency: The
Right Output Mix

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.
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Allocative Efficiency: The
Right Output Mix

The marginal cost pricing characteristic of
competitive markets answers the WHAT-toproduce question efficiently.
 Marginal
cost pricing – The offer (supply) of
goods at prices equal to their marginal cost.
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Allocative Efficiency: The
Right Output Mix

The amount consumers are willing to pay
for a good (its price) equals its opportunity
cost (marginal cost).
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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.
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Production Efficiency

When competitive pressure on prices is
carried to the limit, the products in
questions are produced at the least
possible cost.
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Production Efficiency

Society is getting the most it can from its
available (scarce) resources.
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Zero Economic Profit

In the long-run, all economic profit is
eliminated.
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Summary of Competitive
Process
Market demand
Price (dollars per unit)
Industry ATC
Industry MC
Short-run
equilibrium
a
c
b
Long-run equilibrium
Quantity (units per time period)
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Relentless Profit Squeeze

The sequence of events common to a
competitive market situation includes the
following.
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Relentless Profit Squeeze

High prices and profits signal consumers’
demand for more output.
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Relentless Profit Squeeze

Economic profit attracts new suppliers.
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Relentless Profit Squeeze

The market supply shifts to the right.
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Relentless Profit Squeeze

Prices slide down the market demand
curve.
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Relentless Profit Squeeze

A new equilibrium is reached with
increased quantities being produced and
sold and the economic profit approaching
zero.
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Relentless Profit Squeeze

Throughout the process, producers
experience great pressure to keep ahead
of the profit squeeze by reducing costs.
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Relentless Profit Squeeze

The potential threat of other firms
expanding production or of new firms
entering the industry keeps existing firms
on their toes.
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The Economy Tomorrow:
HDTV for $500?
The first HDTV sets appeared on the
American market in 1993.
 They were not supplied in commercial
quantities until 1998.
 The 56-inch Panasonic HDTV went on sale
for a base price of $5,500 in August 1998.

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Price and Competition
In the first year of availability, consumers
purchased only 10,000 HDTVs at the price
of $5,500.
 They purchased 23 million analog TVs at a
price closer to $300.

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Price and Competition

New entrants to the HDTV market are
expected to dramatically lower prices and
increase unit sales.
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Price and Competition

Sony, Sharp, Hitachi, Zenith, RCA,
Samsung, Sanyo and others promised
better and cheaper HDTVs.
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Competitive Markets
End of Chapter 23
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