1 14- Competition 8

Overview 8- 2 After studying this chapter, you should be able to: Name the primary market structures and describe their characteristics. Define a competitive market and the assumptions that underlie it. Distinguish the differences between competitive markets in the short run and the long run. Analyze the conditions for profit maximization, loss minimization, and plant shutdown for a firm. Derive the firm’s short-run supply curve. Use the short-run competitive model to determine long- run equilibrium. Describe why competition is in the public interest.

Some good blogs and other sites to get the juices flowing: Food for Thought…. 8- 3

4 Market Structure Analysis By observing a few industry characteristics, we can predict pricing and output behavior of the firm. These factors are important: Number of firms Nature of product Barriers to entry Extent of control over price

8- 5 Primary Market Structures 1.Competition 2.Monopolistic Competition 3.Oligopoly 4.Monopoly

8- 6Competition Wheat Industry

8- 7 Competitive Markets Characteristics of Competitive Markets: Many buyers and sellers Homogeneous (standardized) products No barriers to market entry or exit No long-run economic profits No control over price

8- 8 Monopolistic Competition Restaurant Industry

8- 9 Monopolistic Competition Characteristics of Monopolistic Competition: Many buyers and sellers Differentiated products No barriers to market entry or exit No long-run economic profits Some control over price

8- 10Oligopoly Auto Industry

8- 11Oligopoly Characteristics of Oligopoly: Fewer firms Mutually interdependent decisions Substantial barriers to entry Potential for long-run economic profits Shared market power and considerable control over price

8- 12Monopoly Diamond Industry

8- 13Monopoly Characteristics of Monopoly: One firm No close substitutes for product Nearly insuperable barriers to entry Potential for long-run economic profits Substantial market power and control over price

8- 14 Competitive Markets In a competitive market, each firm is a price taker. Price taker: Individual firms in competitive markets get their prices from the market since they are so small they cannot influence market price. Each firm’s total revenue will be equal to price x quantity sold = (PxQ)

8- 15 Marginal Revenue Marginal revenue = change in total revenue that results from the sale of one added unit of a product. Reminder: Total revenue = P x Q

8- 16 A Firm in a Competitive Market D S Industry Output Firm’s Output Price ($) Panel A (Industry) Panel B (Firm) 200 Qe d=MR=P=$200 q1q1 q2q2 The individual firm takes the market price as given.

8- 17 The Short Run and the Long Run Reminder: in the short run, plant size is fixed… We focus here on short-run profit maximization (at a given plant size)

8- 18 The Profit-Maximizing Rule A firm maximizes profit by producing at the point where marginal revenue equals marginal cost, MR = MC If a firm is earning zero economic profits at this point, it means that it is earning a normal rate of accounting profit.

8- 19 Economic Profits MC ATC AVC d=MR=P=$ Costs ($) Output 84 Profit Profit = (P – ATC) x Quantity

8- 20 The Short Run and the Long Run In the short run, one factor of production is fixed, usually the plant size. Firms cannot enter or leave the industry. In the long run, all factors are variable. Firms will enter the industry in response to profits. Firms will leave the industry in response to losses.

8- 21 Normal Profits MC ATC AVC PLPL Costs ($) Output d=MR=P=$ The firm earns zero economic profit. This is a normal rate of return. Normal profits: equal to zero economic profits, where P = ATC

8- 22 Loss Minimization If price falls below average total cost, the firm will incur a loss. The firm can minimize the loss by following this rule: Continue to produce (in the short run) as long as price covers average variable cost. Shut down in the short run if price falls below average variable cost.

8- 23 Loss Minimization MC ATC AVC d=MR=P=$170 $ $170 Costs ($) Output 65 Loss Loss = Negative Profit = (P – ATC) x Quantity= -$ If price falls to $170…

8- 24 Shutdown rule: when the price falls below minimum AVC, firm should shut down immediately. When to Shut Down? MC ATC AVC d=MR=P=$ $ Costs ($) Output 65 Loss Losses begin to exceed fixed costs. The firm will do better to close down and limit losses to fixed costs. If price falls below $ (minimum AVC)…

8- 25 Short-Run Supply Curve The firm’s short-run supply curve is its marginal cost curve above the minimum point on the average variable cost curve.

8- 26 Who’s Who Nobel Prize 1978: Herbert Simon ( ) Professor of Computer Science and Psychology Argued that firms are NOT always perfectly rational, because realistically: They do not possess perfect information They do not always strive to maximize profits Instead, firms recognize limitations and form an “acceptable solution to acute problems” Attacked the assumption of profit maximization as too simple…

8- 27 Long Run Adjustments If firms in the industry are earning short run economic profits, new firms can be expected to enter the industry in the long run, or existing firms may increase the scale of their operations. Losses will lead to the exit of some firms. Final equilibrium in the long run is the point at which industry price is just tangent to the minimum point on the ATC curve. P = MR = MC = LRATC min

8- 28 Profit Economic profits attract more supply… D S0S0 Industry Output Price ($) Panel A (Industry) P0P0 Q0Q0 S1S1 P1P1 QLQL MC ATC AVC P1P1 Costs ($) Firm’s Output P0P0 Panel B (Firm) As long as there are above-normal profits, industry supply increases and market price falls. Profits decline toward zero economic profits.

8- 29 Losses cause firms to exit Supply decreases, price rises and profits must rise (or losses must decrease).

8- 30 Competition and the Public Interest The long-run outcome in competitive markets will have: Productive Efficiency: Goods are supplied at the lowest possible opportunity cost. Allocative Efficiency: The mix of goods and services produced are just what society desires. The price that consumers pay is equal to marginal cost and is also equal to the least average total cost.

8- 31 Long Run Industry Supply Long run industry supply: How much does the expansion of an industry influences resource prices? When an industry expands, this new demand for raw materials and labor may push up the price of some inputs. Increasing cost industry: an industry that faces higher prices and costs as industry output expands.

8- 32 Decreasing Cost Industries Decreasing cost industry: An industry that experiences lower costs as it expands. Decreasing cost industry: An industry that experiences lower costs as it expands. Semiconductor industry: As the demand for semiconductors has risen over the past few decades, their price has fallen dramatically.

8- 33 Constant Cost Industries Constant cost industries. expand in the long run without significant changes in average cost. Some fast food restaurants re-create their operations from market to market without a noticeable rise in costs.

8- 34 Increasing, Constant and Decreasing Cost Industries

8- 35 Key Concepts Market Structure Analysis Competition Price taker Marginal revenue Profit maximizing rule Normal profits Shutdown point Short-run supply curve Productive efficiency Allocative efficiency Increasing cost industry Decreasing cost industry Constant cost industry

8- 36 If a Gnomes-R-Us (a competitive firm) produces at the where the marginal cost curve intersects with the average total cost curve at its minimum point, the firm will earn: a)Economic profits b)Normal profits c)A short-run loss

8- 37 Should a competitive firm keep producing even if it faces short run losses (and is producing at a point on its MC curve that is above the minimum AVC curve)? a)Yes, it is earning normal profits b)Yes, because it covers its variable costs and has some revenue left to pay for fixed costs c)No, it should never incur losses

8- 38 If the market price is 20, about how much will this firm produce? a)50 b)60 c)75 d)95

8- 39 If the market price is 5, about how much will this firm produce? a)0b) 30c) 60d) 95 e)As much as it can

8- 40 Which of the following markets is likely to be the most competitive? a)Cable television b)Automobiles and trucks c)Oil refining d)Farm commodities