Ch 8 – Competitive markets The Market Supply Curve • The market supply curve is the sum of the marginal cost curves of all the firms. • Whatever determines marginal cost also determines the competitive firm’s supply response.
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. • 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.
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 • An increase in market supply causes the economic profits to disappear. • Economic profits – The difference between total revenues and total economic costs. • When economic profits disappear, entry ceases and the market price stabilizes.
Low Barriers to Entry • Barriers to entry are obstacles that make it difficult or impossible for would-be producers to enter a particular market. • Barriers to entry may include: • Patents. • Control of essential factors of production. • Control of distribution outlets. • Well-established brand loyalty. • Government regulation.
A Shift of Market Supply • 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. Short-run equilibrium: p = MC
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 Supply • Once established, long-run equilibrium will continue until market demand shifts or technological improvement reduces the cost of production.
$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
$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-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
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, illustrated by a downward shift of the ATC and MC curves.
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 • 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.
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. • A new equilibrium is reached with increased quantities being produced and sold and the economic profit approaching zero. • In the long run, all economic profit is eliminated!