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
W
a does
oes soc
society
e y ga
gain from
o market
a e co
competition?
pe o ?
COMPETITIVE MARKETS
Chapter 8
2
THE MARKET SUPPLY CURVE
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.
The market supply curve is the sum of the
marginal cost curves of all the firms.
G

Marginal
g
cost ((MC)) – The increase in total cost
associated with a one-unit increase in
production.
Whatever determines marginal cost also
determines the competitive firm’s supply response.
3
THE MARKET SUPPLY CURVE
COMPETITIVE MARKET SUPPLY
The market supply of a competitive industry is
determined by:
Farmer A
Farmer B
Farmer C
Market supply
$5
G
G
G
G
G
3
MCB
MCA
4
The p
price of factor inputs.
p
Technology.
Expectations.
Taxes.
The number of firms in the industry.
Pric
ce

4
a
2
MCC
c
b
+
+
d
=
1
0
5
20 40 60
Quantity
0
20 40 60
Quantity
0
20 40 60
Quantity
0
100 200
Quantity
6
ENTRY AND EXIT

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.
G
G
If there are economic p
profits,, more firms will
enter the industry increasing market supply.
Each firm will respond to the resulting lower
price and profits by reducing output.
7
MARKET ENTRY
8
TENDENCY TOWARD ZERO PROFITS
Market entry pushes
price down and . . .

Reduces profits of
competitive firm
An increase in market supply causes the
economic profits to disappear.

S1
Price
E1
p1
p2
S2
p1
p2
E2
New firms
enter
Quantity
MC
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.
ATC

f1
f1
Market
demand
q1 q2
Quantity
9
TENDENCY TOWARD ZERO PROFITS


Economic profits – The difference between total
revenues and total economic costs.
10
LOW BARRIERS TO ENTRY
This is how competitive markets work.
A competitive market is a market in which no
buyer or seller has market power.
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:






11
Patents.
Patents
Control of essential factors of production.
Control of distribution outlets.
Well-established brand loyalty.
Government regulation.
12
MARKET CHARACTERISTICS OF PERFECT
COMPETITION

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
y
and sellers have
complete information on supply, demand, and prices.
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
p
firms seek to expand
p
output
p
until marginal cost equals the product’s market price.
13
MARKET CHARACTERISTICS OF PERFECT
COMPETITION

COMPETITION AT WORK:
MICROCOMPUTERS
Some of the structures, behaviors and outcomes
of a competitive market are:


14
Few, if any, product markets are perfectly
competitive.
 Many industries function much like a competitive
market.
 The microcomputer market illustrates how the
process of competition works.

Low barriers to entry - entry barriers are low,
economic profits will attract more firms.
Zero economic p
profit - market supply
as
pp y expands
p
long as there are economic profits, pushing prices and
economic profits down.
15
INITIAL CONDITIONS:
THE APPLE I
16
THE PRODUCTION DECISION
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.


Each firm seeks to make the best short-run
production decision.


17
Production decision - The selection of the shortrun 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.
18
INITIAL EQUILIBRIUM IN THE COMPUTER
MARKET
Market
equilibrium
$1200
1200
1000
800 Market
supply
600
400
Market
demand
200
0
1000
800
600
Market price C
P = MR
Profits
m
400
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.

The typical firm
PRICE OR C
COST
Price (per com
mputer)
The computer industry
PROFIT CALCULATIONS
 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
Average
D total
cost
200
20 40 60 80
Quantity (thousands)
0
200 400 600 800 1000
Quantity
19
20
COMPUTER REVENUES, COSTS AND PROFITS
Output
per Month
0
100
200
300
400
500
600
700
800
900
Price
$1000
1000
1000
1000
1000
1000
1000
1000
1000
Total
Revenue
$100,000
200 000
200,000
300,000
400,000
500,000
600,000
700,000
800,000
900,000
Total Cost
$ 60,000
90,000
130 000
130,000
180,000
240,000
320,000
420,000
546,000
720,000
919,800
COMPUTER REVENUES, COSTS AND PROFITS
Total Profit
–$60,000
10,000
70 000
70,000
120,000
160,000
180,000
180,000
154,000
80,000
–19,800
Output
per Month
0
100
200
300
400
500
600
700
800
900
21
THE LURE OF PROFITS
Price =
Marginal
Revenue
$1,000
$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
1,000
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
22
A SHIFT OF MARKET SUPPLY
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 be attracted as
long as there are economic profits in short-run
competitive equilibrium.
 Short-run competitive equilibrium: p = MC


I
I
23
Any short-run equilibrium will not last.
As supply increases, price drops toward
the minimum of ATC.
ATC
Once at minimum of ATC, there are no
longer economic profits to attract firms to
enter.
24
A SHIFT OF MARKET SUPPLY

I
A SHIFT OF MARKET SUPPLY
In long-run equilibrium, entry and exit cease,
and zero economic profit (that is, normal profit)
prevails.

Once established, long-run equilibrium will
continue until market demand shifts or
technological improvement reduces the cost of
computer production.
Long-run equilibrium:
p =MC =minimum ATC
25
THE COMPETITIVE PRICE AND PROFIT
SQUEEZE
S2
800
Market demand
$1000
800
ATC
Old price
Profits
m
0 20,000
Quantity (computers per month)
G
New
price
H
0
500 600
Quantity (computers per month)
27
SHORT- VS. LONG-RUN EQUILIBRIUM
Short-run equilibrium
(p = MC)
pS
qS
Quantity
S3
800
Market demand
MC
ATC
$1000
800
700
620
0 20,000
Quantity (computers per month)
Old price
J
Profits
m K
New
price
0
500 600
Quantity (computers per month)
28
LONG-RUN RULES FOR ENTRY AND EXIT
Long-run equilibrium
(p = MC = ATC)
MC
ATC
Price or Cos
st
Price or Cos
st
MC
S2
$1000
The typical firm
Price or Cost (per coomputer)
$1000
The computer industry
MC
Price (per compuuter)
Price (per compuuter)
S1
THE COMPETITIVE SQUEEZE
APPROACHING ITS LIMIT
Lowers price and profits
for the typical firm
Price or Cost (per coomputer)
An expanded market
supply . . .
26
Price Level Result for typical firm
ATC
P > ATC
Profits
P < ATC
Loss
Firms exit industry,
Existing firms contract
P = ATC
Break even
No exit or entry,
Existing firms maintain
current capacity
pS
pL
qL
Quantity
29
Market Response
New firms enter
y Existing
g firms
industry,
expand
30
LOWER COSTS SHIFTS THE SUPPLY CURVE
DOWNWARD
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.
 Technological improvements are illustrated by a
downward shift of the ATC and MC curves.

Price (per com
mputer)
Old
MC
Old New
ATC ATC
$700
J
N
R
430
600
Quantity (computers per month)
31
SHUTDOWNS
New
MC
32
EXITS
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.
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.


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.

33
34
ALLOCATIVE EFFICIENCY: THE RIGHT
OUTPUT MIX
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.
markets


The market mechanism works best in
competitive markets.

Market mechanism – the use of market prices and
sales to signal desired output (or resource
allocations).
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.

35
36
ALLOCATIVE EFFICIENCY: THE RIGHT
OUTPUT MIX
PRODUCTION EFFICIENCY
The price signal the consumer gets in a
competitive market is an accurate reflection of
opportunity cost.
 The marginal cost pricing characteristic of
competitive markets answers the WHAT
WHAT-toto
produce question efficiently.
 Marginal cost pricing – The offer (supply) of
goods at prices equal to their marginal cost.

amount consumers are willing to pay
for a good (its price) equals its opportunity
cost (marginal cost).

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.
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.
 In the long-run, all economic profit is eliminated.

 The
37
SUMMARY OF COMPETITIVE PROCESS
38
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.
suppliers
 Economic profit attracts new suppliers.
 The market supply shifts to the right.
 Prices slide down the market demand curve.

Market demand
Price (dollars pe
er unit)
Industry ATC
Industry MC
Short-run
equilibrium
a
c
b
Long-run equilibrium
Quantity (units per time period)
39
40
THE ECONOMY TOMORROW: HDTV FOR
$500?
RELENTLESS PROFIT SQUEEZE
A new equilibrium is reached with increased
quantities being produced and sold and the
economic profit approaching zero.
 Throughout the process, producers experience
great pressure to keep ahead of the profit squeeze
by reducing costs.
 The potential threat of other firms expanding
production or of new firms entering the industry
keeps existing firms on their toes.
The first HDTV sets appeared on the American
market in 1993.
 They were not supplied in commercial quantities
until 1998.
 The 56-inch
56 inch Panasonic HDTV went on sale for a
base price of $5,500 in August 1998.


41
42
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.
$300
 New entrants to the HDTV market are expected
to dramatically lower prices and increase unit
sales.
 Sony, Sharp, Hitachi, Zenith, RCA, Samsung,
Sanyo and others promised better and cheaper
HDTVs.

COMPETITIVE MARKETS
End of Chapter 8
43