Chapter 11 idelaized competition

As long as marginal revenue MR, which equals market price, exceeds marginal cost MC, the perfect competitor will expand production [part b].. The firm maximizes profit by equating marg

Firm Production under Idealized

Competitive Conditions

Economists understand by the term market, not any particular market place in which things are bought and sold, but the whole of any region in which buyers and sellers are in such free intercourse with one another that the prices of the same goods tend to equality, easily and quickly

Augustin Cournot

receding chapters dealt separately with the two sides of markets, consumers and

producers We devised graphic means of representing consumer preferences (the

demand curve) and producer costs (average and marginal cost curves) This chapter brings demand and cost analysis together in order to examine the way in which individual

firms react to consumer demand in competitive markets Our focus will be on a highly

competitive market structure called perfect competition We will investigate an intriguing

question: at the limit, how much can competitive markets contribute to consumer welfare?

We will not attempt to give a full description of a real-world competitive market

setting Because markets are so diverse, such a description would probably not be very

useful Our aim is rather to devise a theoretical framework that will enable us to think about

how markets work in general, as a constructive behavioral force Although our model cannot tell much that is specific about real-world markets, it will provide a basis for predicting the

general direction of changes in market prices and output Through its analysis, we should

gain a deeper understanding of the meaning of market efficiency

Perfect competition is only one of four basic market structures The other three, and the detrimental effects of their restrictions on competition, are the subjects of following

chapters

The Four Market Structures

Markets can be divided into four basic categories, based on the degree of competition that

prevails within them that is, on how strenuously participants attempt to outdo, and avoid

being outdone by, their rivals The most competitive of the four market structures is perfect competition

Perfect Competition

As we stressed much earlier in the book, perfect competition represents an ideal degree of

competition Perfect competition can be recognized by the following characteristics:

P

1 There are many producers in the market, no one of which is large enough to

affect the going market price for the product All producers are price takers,

as opposed to price searchers or price makers (see the Perspective on the subject below)

2 All producers sell a homogeneous product, meaning that the goods of one

producer are indistinguishable from those of all others Consumers are fully knowledgeable about the prices charged by different producers and are totally indifferent as to which producer they buy from

3 Producers enjoy complete freedom of entry into and exit from the market—

that is, entry and exit costs are minimal, although not completely absent

4 There are many consumers in the market, no one of whom is powerful enough

to affect the market price of the product Like producers, consumers are price takers

As we have seen before, the demand curve facing the individual perfect competitor is not the same as the demand curve faced by all producers The market demand curve slopes downward, as shown in Figure 11.1(a) The demand curve facing an individual producer price taker is horizontal, as in Figure 11.1(b) This horizontal demand curve is perfectly

elastic That is, the individual firm cannot raise its price even slightly above the going

market price without losing all its customers to the numerous other producers in the market

or to other producers waiting for an opportunity to enter the market On the other hand, the individual firm can sell all it wishes at the going market price Hence it has no reason to

offer its output at a lower price The markets for wheat and for integrated computer circuits,

or computer chips, are both good examples of real-world markets that come close to perfect competition

Pure Monopoly

Pure monopoly: A single seller of a product for which there are no close substitutes

Protected from competition by barriers to entry into the market The barriers to entry into the monopolist’s market will be described in the next chapter For now, we will simply note that because the monopolistic firm does not have to worry about competitors undercutting its

price, it can raise its price without fear that customers will move to other producers of the

same product or similar products All the pure monopolist has to worry about is losing

customers to producers of distantly related products

Since the monopolist is the only producer of a particular good, the downward-sloping market demand curve [Figure 11.1(a)] is its individual demand curve Unlike the perfect

competitor, the monopolistic firm can raise its price and sell less, or lower its price and sell

more The critical task of the pure monopolist is to determine the one price-quantity

combination of all price-quantity combinations on its demand curve that maximizes its

profits In this sense the pure monopolist is a price searcher The best (but not perfect) world examples of a pure monopoly are regulated electric-power companies, which dominate

real-in given geographical areas, and the government’s first-class postal system

FIGURE 11.1 Demand Curve Faced by Perfect Competitors

The market demand for a product part (a) is always downward sloping The perfect competitor is on a

horizontal, or perfectly elastic, demand curve [part (b)] It cannot raise its price above the market price even slightly without losing its customers to other producers

Monopolistic Competition

Monopolistic competition is a market composed of a number of producers whose products

are differentiated and who face highly elastic, but not perfectly elastic, demand curves

A monopolistically competitive market can be recognized by the following

characteristics:

1 There are a number of competitors, producing slightly different products

2 Advertising and other forms of nonprice competition are prevalent

3 Entry into the market is not barred but is restricted by modest entry costs, mainly overhead

4 Because of the existence of close substitutes, customers can turn to other

producers if a monopolistically competitive firm raises its price Because of brand

loyalty, the monopolistic competitor’s demand curve still slopes downward; but it is

fairly elastic [see Figure 11.2)

The market for textbooks is a good example of monopolistic competition Most subjects are covered by two or three dozen textbooks, differing from one another in content, style of

presentation, and design

PERSPECTIVE: Price Takers and Price Searchers

Perfect competition is an extreme degree of competition, so much so that many students are understandably concerned about its relevance They often ask, “If there are few market structures that even closely approximate perfect competition, why bother to study it?” The question is a good one and not altogether easy to answer There are few markets that come close to having numerous producers of an identical product with complete freedom of entry and exit Markets for agricultural commodities and for stocks and bonds are probably the

closet markets we have to perfect competition, but still the products are not always completely identical, and

entry and exit costs abound in most markets Even wheat sold by a Kansas wheat farmer us not always viewed the same as wheat sold by a Texas wheat farmer

How can sense be made of perfect competition? The answer is remarkably simple We know that under the conditions of competition specified, certain results follow We can logically (with the use of graphs and

mathematics) derive them, and the results are developed in this and the following chapter One conclusion drawn is that in perfect competition each firm will extend production until the marginal cost of producing the

last unit equals the price paid by the consumer That conclusion necessarily follows As we will see, it is

mathematically valid The strict (extreme) assumptions about the nature of perfect competition assure that The demanding conditions for perfect competition are rarely met We nevertheless cannot conclude that

under less demanding competitive conditions, competitive results would not be observed [see the Perspectives

on contestable markets on page 240.) For example, it may be that the number of producers is not “numerous” that the products sold by all producers are not completely “identical,” and that there are costs to moving in and

out of markets Nonetheless, individual producers may act as if the conditions of perfect competition are met

Individual producers may still act as if they have no control over market price or that there are so many other actual or potential producers that it is best to think in terms of the other producers being numerous”—in which case many of the predicted results of perfect competition may be still observed in the less-than-perfect markets

For these reasons, many economists often talk not about perfect competitors but about price takers (who may

or may not fit exactly the description of perfect competitors) Price takers are sellers who do not believe they

can control the market price by varying their own production levels They simply observe the market price and either accept it (and produce accord ingly, to the point where marginal cost and marginal revenue and price are

equal) or reject it (and go into some other business) The price taker is someone who acts as if his or her demand

curve is horizontal (perfectly elastic, more or less) He or she is therefore someone who assumes the marginal revenue on each unit sold is constant (and equal to the price)—and that the marginal revenue curve is horizontal and the same as the firm’s demand curve

The price searcher stands in contrast to the price taker Price searchers are sellers who have some control

over the market price Price searchers have monopoly power due to the fact that they can alter production and thereby market supply sufficiently to change the price The individual price searcher’s task is not simply to accept or reject the current market price, but (like the monopolist) to “search” through the various price-quantity combinations on his or her downward sloping demand curve with the intent upon maximizing profits As we will see in the following chapter, the marginal revenue and demand curves of the price searcher are no longer the same (Exactly where the monopolist’s marginal revenue curve lies in relation to the demand curve will be discussed in detail in the next chapter)

FIGURE 11.2 Demand Curve Faced by a

Monopolistic Competitor

Because the product sold by the monopolistically

competitive firm is slightly different from the

products sold by competing producers, the firm

faces a highly elastic, but not perfectly elastic,

demand curve

Oligopoly

An oligopoly is a market composed of only a handful of dominant producers—as few as

two—whose pricing decisions are interdependent Oligopolists may produce either an

identical product (like steel) or highly differentiated products (like automobiles) Generally

the barriers to entry into the market are considerable, but the critical characteristic of

oligopolistic firms is that their pricing decisions are interdependent That is, the pricing

decisions of any one firm can substantially affect the sales of the others Therefore, each

firm must monitor and respond to the pricing and production decisions of the other firms in

the industry The importance of this characteristic will become clear in a following chapter

Table 11.1 summaries the characteristics of the four market structures

The Perfect Competitor’s Production Decision

As we learned earlier, the market price in a perfectly competitive market is determined by the intersection of the supply and demand curves If the price is above the equilibrium price

level, a surplus will develop forcing competitors to lower their prices If the price is below

equilibrium, a shortage will emerge, pushing the price upward [see Figure 11.3(a)] Given a market price over which it has no control, how much will the individual perfect competitor

produce?

The Production Rule: MC = MR

Suppose the price in the perfectly competitive market for computer chips $5 (P1 in Figure

11.3) For each individual competitor, the market price is given, that is, cannot be changed

It must be either accepted or rejected If the firm rejects the price, however, it must shut

down If it raises its price even slightly above the market level, its customers will move to

other competitors.) Demand, then, is horizontal at $5

Table 11.1 Characteristics of the Four Market Structures

Number of Firms

Freedom of Entry

Type of Product

Example

Computers, and Gold

and Postal service

Monopolistic com-

petition

Many Relatively easy Differentiated Pens,

Books, Paper, and Clothing

or differentiated

Steel, Light bulbs, Cereal, and Autos

_

The firm’s perfectly elastic horizontal demand curve is illustrated on the right side of

Figure 11.3 This horizontal demand curve is also the firm’s marginal revenue curve,

because marginal revenue is defined as the additional revenue acquired from selling one

additional unit Because each computer chip can be sold at a constant price of $5, the

additional, or marginal, revenue acquired from selling an additional unit must be constant at

$5

Because profit equals total revenue minus total cost (profit = TR = TC), the

profit-maximizing firm will produce any unit for which marginal revenue exceeds marginal cost

Thus the profit-maximizing firm in Figure 11.3(b) will produce and sell q 1 units, the quantity

at which marginal revenue equals marginal cost (MR = MC) Up to q1, marginal revenue is

greater than marginal cost Beyond q 1, all additional computer chips are unprofitable: the

additional cost of producing them is greater than the additional revenue acquired [with the

small “q” being used to remind you that the output individual producer in Figure 11.3(b) is a small fraction of the output for the market, designated by a capital “Q” in Figure 11.3 (a)]

Changes in Market Price

The perfectly competitive firm produces where MC = MR, both of which are equal to price Thus the amount the firm produces depends on market price As long as market demand

remains constant, the individual firm’s demand, and its price, will also remain constant If

market demand and price increase, however, the individual firm’s demand and price will also increase

FIGURE 11.3 The Perfect Competitor’s Production Decision

The perfect competitor’s price is determined by market supply and demand [part (a)] As long as

marginal revenue (MR), which equals market price, exceeds marginal cost (MC), the perfect

competitor will expand production [part (b)] The profit-maximizing production level is the point

at which marginal cost equals marginal revenue (price)

FIGURE 11.4 Change in the Perfect Competitor’s Market Price

If the market demand rises from D 1 to D 3 [part (a)], the price will rise with it, from P 1 to P 3 As a

result, the perfectly competitive firm’s demand curve will rise, from d1 to d3 [part (b)]

Figure 11.4 (above) shows how the shift occurs The original market demand of D1

leads to a market price of P1 [part (a)], which is translated into the individual firm’s demand,

d1 [part (b)] The firm maximizes profit by equating marginal cost with marginal revenue,

which is equal to d 1 , at an output level of q1.1

An increase in market demand to D2 leads to the higher price P2 and a higher

individual demand curve, d2 At this higher price, which equals marginal revenue, the perfect

competitor can support a higher marginal cost The firm will expand production from q 1 to

q 2 In the same way, an even greater market demand, D3, will lead to even higher output, q3,

by the individual competitor

Why does the market supply curve slope upward and to the right? The answer lies in the upward-sloping marginal cost curves confronted by individual firms (The market supply curve is obtained by horizontally adding the supply curves of individual firms.) The

individual firm’s marginal cost curves slope upward because of diminishing (marginal)

returns, a technological fact of the production process

Maximizing Short-Run Profits

Can perfect competitors make an economic profit? The answer is yes, at least in the short

run To see this point, we must incorporate the average and marginal cost curves developed

in the last chapter into our graph of the perfect competitor’s demand curve, as in Figure

11.5(b) [Figure 11.5(a) shows the market supply and demand curves.) As before, the

producer maximizes profits by equating marginal cost with price, rather than by looking at

average cost That is exactly what the perfect competitor does The firm produces q 2

computer chips because that is the point at which marginal revenue curve (which equals the

firm’s demand curve crosses the marginal cost curve At that intersection, marginal revenue

of the last unit sold equals its marginal cost If less were produced that q 1, the marginal cost would be less than the marginal revenue, and profits would be lost Similarly, by producing

anything more than q2, the firm incurs more additional costs (as indicated by the marginal

1

To prove this statement, first we note that

Q P

TR = Then we define short-run total cost to be a function of output:

SRTC = C (Q)

Next, we define profits π to be

) Q ( C Q P SRTC

= π Differentiating with respect to Q and equating with 0, we then obtain

dQ

) Q ( dC P

0 dQ

) Q ( dC P dQ d

=

=

−

= π

cost curve) than it receives in additional revenue (as indicated by the demand curve, which

beyond q2 is below the MC curve)

At q2 (and anywhere else), the firm’s profit equals total revenue minus total cost (TR

– TC) To find total revenue, we multiply the price, P1 (which also equals average revenue)

by the quantity produced, q2 (TR = P 1q2) Graphically, total revenue is equal to the area of

the rectangle bounded by the price and quantity, or 0P1aq2

Similarly, total cost can be found by multiplying the average total cost of production

(ATC) by the quantity produced The ATC curve shows us that the average total cost of

producing q2 computer chips is ATC1 Therefore total cost is ATC1q2, or the rectangular area

bounded by 0ATC1bq2 The profits of the company are therefore P1q2 – ATC1q2, which is the

same, mathematically, as q2(P1 – ATC1) This quantity corresponds to the area representing

total revenue, OP1aq2, minus the area representing total cost, 0ATC1bq2 Profit is the shaded

rectangle bounded by ATC1P1ab

FIGURE 11.5 The Profit-Maximizing Perfect Competitor

The perfect competitor’s demand curve is established by the market-clearing price [part (a)] The

profit-maximizing perfect competitor will extend production up to the point where marginal cost

equals marginal revenue (price), or point a in part (b) At that output level—q2—the firm will earn a

short -run economic profit equal to the shaded area ATC1P1ab If the perfect competitor were to

minimize average total cost, it would produce only q1 , losing profits equal to the darker shaded area

dca in the process

The perfect competitor does not seek to produce the quantity that results in the lowest

average total cost That quantity, q1, is defined by the intersection of the marginal cost curve

and the average total cost curve If it produced only q1, the firm would lose out on some of

its profits, shown by the darker shaded area dca (Suppose the firm is producing at q1 If it

expands production to q 2 , it will generate P1 times q2 – q1 in extra revenue (price times the

additional units sold), an amount represented graphically by the area q1daq2.)

Naturally, profit-maximizing firms will attempt to minimize their costs of production

That does not mean they will produce at the point of minimum average total cost Instead,

the will try to employ the most efficient technology available and to minimize their payments

for resources That is they will attempt to keep their cost curves as low as possible But

given those curves, the firm will produce where MC = MR, not where ATC is at its lowest

level Managers who cannot distinguish between those two objectives will probably operate their businesses on a less profitable basis than they might—and will risk being run out of

business

Minimizing Short-Run Losses

In the foregoing analysis the market-determined price was higher than the firm’s average

total cost, allowing it to make a profit Perfect competitors are not guaranteed profits,

however The market price may not be high enough for the firm to make a profit Suppose,

for example, that the market price is P1, below the firm’s average total cost curve [see Figure 11.6) Should the firm still produce where marginal cost equals marginal revenue (price)?

The answer, for the short run, is yes As long as the firm can cover its variable cost, it should

produce q1 computer chips

FIGURE 11.6 The Loss-Minimizing Perfect Competitor

The market-clearing price [part (a)] establishes the perfect competitor’s demand curve [part (b)] Because the price is below the average total cost curve, this firm is losing money As long as the price is above the low point of the average variable cost curve, however, the firm should minimize its short-run losses by continuing to

produce where marginal cost equals marginal revenue [price or point b in part (b)] This perfect competitor should produce q1 units, incurring losses equal to the shaded area P1ATC1ab (The alternative would be to shut

down, in which case the firm would lose all its fixed costs.)

It is true that the firm will lose money Its total revenues are only P1q1, or the area

bounded y 0P1bq1, whereas its total costs are ATC1q1, or the area 0ATC1aq1, whereas its total

costs are ATC1q1, or the area 0ATC1aq1 On the graph its total losses equal the difference between those two rectangular areas, the shaded area bounded by P1ATC1ab Whether the firm incurs losses is not the relevant question, however The real issue is whether the firm

loses more money by shutting down or by operating and producing q1 chips

In the short run, the firm will continue to incur fixed costs even if it shuts down If it

is not earning any revenues, its losses will equal its total fixed costs In the last chapter we

saw that the average fixed cost of production is the vertical distance between the average

variable cost and average total cost

In short, as long as the price is higher than average variable cost—if the price more

than covers the cost associated directly with production—the firm minimizes its short-run

losses by producing where marginal cost equals marginal revenue Only if the price dips

below the low point of the average variable cost curve—where the marginal and average

variable cost curves intersect—will the firm add to its losses by operating The firm will shut

down when price is at or below that point, Ps in Figure 11.6 At prices above that point, the firm simply follows its marginal cost curve to determine its production level Above the

average variable cost curve, then, the marginal cost curve is in effect the firm’s supply curve Therefore, if a perfect competitor produces at all, it produces in a range of increasing

marginal cost—and diminishing marginal returns

Our analysis has shown why, in the short run, fixed costs should be ignored The

relevant question is whether a given productive activity will add more to the firm’s revenues

than to its costs Understanding this principle, businesses may undertake activities that

superficially appear to be quite unprofitable Some grocery stores stay open all night, even

though the owners known they will attract few customers If all costs, including fixed costs,

are considered, the decision to operate in the early morning hours may seem misguided The only relevant question facing the store manager is whether the additional sales generated are greater than the additional cost of light, goods sold, and labor Similarly, many businesses

that are obviously failing continue to operate, for by staying open they can at least cover a

portion of their fixed costs—such as rent—that would still be due if they shut down They

stay open until their leases expire or until they can sell out

Producing Over the Long Run

In the long run businesses have an opportunity to change their total fixed costs If the market price remains too low to permit profitable operation, a firm can eliminate its fixed costs, sell

its plant and equipment, or terminate its contracts for insurance and office space If the

market price is above average total cost, new firms can enter the market, and existing firms

can expand their scale of operation Such long-run adjustments in turn affect market supply, which affects price and short-run production decisions

The Long-Run Effect of Short-Run Profits and Losses

When profits encourage new firms to enter an industry and existing firms to expand, the

result is an increase in market supply, a decrease in market price, and a decrease in the

profitability of individual firms For example, in Figure 11.7(a), the existence of economic

profits in the computer chip market means that investors can earn more in that industry than

in some others Some investors will move their resources to the computer chip industry

Because the number of producers increases, the supply curve shifts outward, expanding total

production from Q1 to Q2 and depressing the market price from P2 to P1

The expansion of industry supply and the resulting reduction in market price make

the computer chip business less profitable for individual firms The lower market price is

reflected in a downward shift of the firm’s horizontal demand curve, from d1 to d2 [see

Figure 11.7(b)] The individual firm reduces it output from q2 to q1, the intersection of the

new marginal revenue (price/demand) curve with the marginal cost curve Note that q1 is

also the low point of the average total cost curve Here price equals average total cost,

meaning that economic profit is zero The firm is making just enough to cover its

opportunity and risk costs, but no more

Losses have the opposite effect on long-run industry supply In the long run, firms

that are losing money will move out of the industry, because their resources can be employed more profitably elsewhere When firms drop out of the industry, supply contracts and total

FIGURE 11.7 The Long-Run Effects of Short-Run Profits

If perfect competitors are making short-run profits, other producers will enter the market, increasing the market

supply from S1 to S2 and lowering the market price, from P2 to P1 part (a) The individual firm’s demand curve,

which is determined by market price will shift down, from d1 to d2 [part (b)] The firm will reduce its output

from q2 to q1 , the new intersection of marginal revenue (price) and marginal cost Long-run equilibrium will be achieved when the price falls to the low point of the firm’s average total cost curve, eliminating economic profit

[price P1 in (b)]

production falls, from Q2 to Q1 in Figure 11.8(a) As a result, the price of the product rises, permitting some firms to break even and stay in the business Long-run equilibrium occurs

when the price reaches P2, where the individual firm’s demand curve is tangent to the low

point of the average total cost curve [Figure 11.8(b)] The output of each remaining

individual firm expands (from q1 to q2) to take up the slack left by the firms that have

withdrawn Again price and average total cost are equal, and economic profit is zero

FIGURE 11.8 The Long-Run Effects of Short-Run Losses

If perfect competitors are suffering short-run losses, some firms will leave the industry causing the market

supply to shift back from S1 to S2 and the price to rise, from P1 to P2 part (a) The individual firm’s demand

curve will shift up with price, from d1 to d2 [part (b)] The firm will expand from q1 to q2 , and equilibrium will

be reached when price equals the low point of average total cost P2, eliminating the firm’s short-run losses

The Effect of Economies of Scale

In the long run, competition forces firms to take advantage of economies of scale, if they

exist If expanding the use of resources reduces costs, the perfect competitor must expand Otherwise, other firms will expand their scale of operation, increasing market supply and

forcing the market price down Any firm that does not expand its scale will be caught with a cost structure that is higher than the market price In addition to mere self-preservation, the

firm also has a profit incentive for expansion If it expands before other firms, its lower

average total cost will allow it to make greater profits for a short period of time

Consider Figure 11.9, for instance Initially the market is in short-run equilibrium at

a price of P2 [part (a)] The individual firm is on cost scale ATC1, producing q1 chips and

breaking even [part (b)] If the firm expands its scale of operation and produces where its

demand curve d 1 intersects the long-run marginal cost curve, it will make a profit equal

graphically to the shaded area ATC1P2ab That is the firm’s incentive for expansion