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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

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in this chapter
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
  • 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.
the market supply curve1
The Market Supply Curve
  • 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

Farmer A

Farmer B

Farmer C

Market supply

$5

MCA

MCB

MCC

4

b

c

d

a

3

Price

2

1

0

20

40

60

0

20

40

60

0

20

40

60

0

100

200

Quantity

Quantity

Quantity

Quantity

Competitive Market Supply

+

+

=

the market supply curve2
The Market Supply Curve
  • 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
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 exit1
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 exit2
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.
market entry

Price

Quantity

Quantity

Market Entry

Market entry pushes price down and . . .

Reduces profits of competitive firm

S1

MC

S2

ATC

E1

f1

p1

p1

f1

p2

p2

E2

Market demand

New firms enter

q1

q2

tendency toward zero profits
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 profits1
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.
  • Acompetitive 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
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.
revisiting characteristics of perfect competition1
Revisiting 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.
revisiting characteristics of perfect competition2
Revisiting 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.
competition at work real world examples microcomputers
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
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
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
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

The computer industry

The typical firm

Market equilibrium

$1200

1200

Market price

C

1000

1000

P = MR

Profits

800

800

Market supply

Price (per computer)

PRICE OR COST

Average total cost

D

600

600

m

400

400

Market demand

200

200

0

20

40

60

80

0

200

400

600

800

1000

Quantity (thousands)

Quantity

Initial Equilibrium in the Computer Market
profit calculations
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 calculations1
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
Given the following information, complete the table and determine the profit Maximizing output level
slide25

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

the lure of profits
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
A Shift of Market Supply

Short-run equilibrium: p = MC

a shift of market supply1
A Shift of Market Supply
  • 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
a shift of market supply2
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.
the competitive price and profit squeeze

$1000

$1000

800

800

Profits

Price or Cost (per computer)

Price (per computer)

0

20,000

0

500

600

Quantity (computers per month)

Quantity (computers per month)

The Competitive Price and Profit Squeeze

An expanded market supply . . .

Lowers price and profits for the typical firm

MC

S1

ATC

S2

Old price

G

New

price

H

m

Market demand

the competitive squeeze approaching its limit

$1000

$1000

800

800

Price or Cost (per computer)

Price (per computer)

0

20,000

0

500

600

Quantity (computers per month)

Quantity (computers per month)

The Competitive Squeeze Approaching Its Limit

The computer industry

The typical firm

MC

ATC

S2

S3

Old price

J

700

620

New

price

K

Profits

m

Market demand

short vs long run equilibrium

Short-run equilibrium (p = MC)

Long-run equilibrium (p = MC = ATC)

MC

MC

ATC

ATC

pS

pS

Price or Cost

Price or Cost

pL

qS

qL

Quantity

Quantity

Short- vs. Long-Run Equilibrium
home computers vs personal computers
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 computers1
Home Computers vs. Personal Computers
  • Manufactures of computers did both —separating the market into home computers and personal computers
price competition in home 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 computers1
Price Competition in Home Computers
  • Costs were pushed down by reducing the number of components and using more powerful computer chips.
further supply shifts
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 shifts1
Further Supply Shifts
  • Technological improvements are illustrated by a downward shift of the ATC and MC curves.
lower costs shifts the supply curve downward

Price (per computer)

Quantity (computers per month)

Lower Costs Shifts the Supply Curve Downward

Old

MC

New

MC

New

ATC

Old

ATC

N

J

$700

R

430

600

shutdowns
Shutdowns
  • Once a firm is no longer able to cover variable costs, it should shut down production.
  • Theshutdown point is the rate of output at which price equals minimum AVC.
exits
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
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 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
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).
allocative efficiency the right output mix1
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.
allocative efficiency the right output mix2
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.
allocative efficiency the right output mix3
Allocative Efficiency: The Right Output Mix
  • 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.
allocative efficiency the right output mix4
Allocative Efficiency: The Right Output Mix
  • The amount consumers are willing to pay for a good (its price) equals its opportunity cost (marginal cost).
production efficiency
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 efficiency1
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
Zero Economic Profit
  • In the long-run, all economic profit is eliminated.
summary of competitive process

Short-run

equilibrium

Price (dollars per unit)

Quantity (units per time period)

Summary of Competitive Process

Market demand

Industry ATC

Industry MC

a

c

b

Long-run equilibrium

relentless profit squeeze
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.
relentless profit squeeze1
Relentless Profit Squeeze
  • 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.
relentless profit squeeze2
Relentless Profit Squeeze
  • Throughout the process, producers experience great pressure to keep ahead of the profit squeeze by reducing costs.
relentless profit squeeze3
Relentless Profit Squeeze
  • The potential threat of other firms expanding production or of new firms entering the industry keeps existing firms on their toes.