1 1ReadingsReadings Baye 6 th edition or 7 th edition, Chapter 8 BA 445 Lesson A.8 Competitive Markets

2 2OverviewOverview

3 3Overview Competitive Price and Quantity starts with price set to the competition, then quantity set where marginal cost equals price — provided that production is better than shutting down. Efficient Quantity is implied when price and willingness to pay equals marginal cost. — So, after your market purchases, there is no deal between you and an electronics supplier that can benefit you both. Competitive Entry and Exit are determined by profits. Positive profit causes entry, slightly-negative profit causes exit in the long run, and significantly-negative profit causes exit in the short run. BA 445 Lesson A.8 Competitive Markets

4 4 Competitive Price and Quantity BA 445 Lesson A.8 Competitive Markets

5 5 Overview Competitive Price and Quantity starts with price set to the competition, then quantity set where marginal cost equals price — provided that production is better than shutting down. BA 445 Lesson A.8 Competitive Markets Competitive Price and Quantity

6 6 Perfect Competition Environment Many buyers and sellers. Homogeneous (perfectly substitutable) products across sellers. n Example: USB Thumb Drives from SanDisk or Kingston. Perfect product information for both buyers and sellers. Free exit from the industry (from selling) at any time. Free entry into the industry (begin selling) in the long run. n You can change capital in the long run. n So free entry means you can enter if you have the capital. BA 445 Lesson A.8 Competitive Markets Competitive Price and Quantity

7 7 Preview of Perfect Competition Implications What effect did cancer have on the cigarette industry? Demand down, so price, quantity, and profit down (according to demand-supply analysis).Demand down, so price, quantity, and profit down (according to demand-supply analysis). But, profit down makes some producers exit.But, profit down makes some producers exit. As some producers exit, industry supply down.As some producers exit, industry supply down. As industry supply down, price and profit start back up.As industry supply down, price and profit start back up. Adjustment continues until producers stop exiting, which means profits back to where they started.Adjustment continues until producers stop exiting, which means profits back to where they started. n Remaining producers thus regain profits in the long run. BA 445 Lesson A.8 Competitive Markets Competitive Price and Quantity

8 8 Preview of Perfect Competition Implications General implications: Firms are price takers. n They each set price P = competitor’s price n Marginal revenue MR = P (since R = P x Q, with P constant) In the short-run, firms may earn profits or losses (negative profits). Entry (if short-run profits are positive) and exit (if negative) forces long-run profits to zero. BA 445 Lesson A.8 Competitive Markets Competitive Price and Quantity

9 9 Since few producers are perfectly competitive, why analyze perfect competition? Many small businesses are almost perfectly competitive. n We could analyze them as monopolistic competitors, but the predictions would be almost like perfect competitors. Gives an extreme contrast to monopoly. Illuminates the danger of competition to managers, and the importance of product differentiation to reduce competition. n Chevron with Techron (an additive for cleanliness) n Standard Oil “Put a tiger in your tank” BA 445 Lesson A.8 Competitive Markets Competitive Price and Quantity

10 Setting Price to Match the Competition Demand for SanDisk Thumb Drives (perfectly elastic) QfQf $ DfDf Demand and Supply for USB Thumb Drives QMQM $ D S PePe BA 445 Lesson A.8 Competitive Markets Competitive Price and Quantity

11 Setting Quantity General rule, set Q where MC(Q) = MR(Q). Since, MR(Q) = constant competitive-equilibrium price P e, equate MC(Q) = P e to set Q. Calculating Profit  = P e x Q – C(Q) = (P e – C(Q)/Q) x Q = (P e – ATC) x Q BA 445 Lesson A.8 Competitive Markets Competitive Price and Quantity

12 $ QfQf ATC AVC MC P e = MC(Q) Q ATC PePe BA 445 Lesson A.8 Competitive Markets Setting Quantity and Calculating Profit Profit = (P e - ATC)  Q > 0 Competitive Price and Quantity

13 $ Q ATC AVC MC P e = MC(Q) Q ATC PePe BA 445 Lesson A.8 Competitive Markets Setting Quantity and Calculating Profit Profit = (P e - ATC)  Q < 0 Competitive Price and Quantity

14 A Numerical Example Given n Competitor’s Price =$10 n C(Q) = 5 + Q 2 Optimal Price? n P = $10 Optimal Output? n MR = P = $10 and MC = 2Q n Set 2Q = 10 n Q = 5 units Optimal Profit? n PQ - C(Q) = $(10)(5) - $( ) = $20 > 0 BA 445 Lesson A.8 Competitive Markets Competitive Price and Quantity

15 Efficient Quantity BA 445 Lesson A.8 Competitive Markets

16 Overview Efficient Quantity is implied when price and willingness to pay equals marginal cost. — So, after your market purchases, there is no deal between you and an electronics supplier that can benefit you both. BA 445 Lesson A.8 Competitive Markets Efficient Quantity

17 Features of Competitive Equilibrium P = MC n That implies output is socially efficient. n Any other output can be changed to make all concerned better off. For example, suppose P = $2 and MC = $1 for candy. P = $2 means there is some consumer willing to buy another candy for nearly $2. MC = $1 means there is a firm that can produce and distribute another candy for $1. All concerned would be better off if the firm produced and sold another candy for $1.50. –The consumer gains nearly $.50 surplus; the producer, $.50 surplus. –No one else is affected. BA 445 Lesson A.8 Competitive Markets Efficient Quantity

18 Competitive Entry and Exit BA 445 Lesson A.8 Competitive Markets

19 Overview Competitive Entry and Exit are determined by profits. Positive profit causes entry, slightly-negative profit causes exit in the long run, and significantly-negative profit causes exit in the short run. BA 445 Lesson A.8 Competitive Markets Competitive Entry and Exit

20 Shutdown Decision Rule A profit-maximizing firm should continue to produce in the short run even if profit is negative as long as its operating loss is less than its sunk cost, since sunk cost is the loss if shut down. Recall the simplifying assumption that FC = sunk costRecall the simplifying assumption that FC = sunk cost Operating loss  = PQ – TC > -FC, or PQ > TC – FC = VC.Operating loss  = PQ – TC > -FC, or PQ > TC – FC = VC. P > VC/Q = AVC implies continue to produce in the Short Run.P > VC/Q = AVC implies continue to produce in the Short Run. P = VC/Q = AVC implies its does not matter if produce in the Short Run.P = VC/Q = AVC implies its does not matter if produce in the Short Run. P < VC/Q = AVC implies immediate shut down in the Short Run.P < VC/Q = AVC implies immediate shut down in the Short Run. BA 445 Lesson A.8 Competitive Markets Competitive Entry and Exit

21 Slightly-negative profit In the Short-Run, should this firm shut down? P > AVC, so continue producing in the short run. Slightly-negative profit BA 445 Lesson A.8 Competitive Markets $ Q ATC AVC MC P e = MC(Q) Q ATC PePe Competitive Entry and Exit

22 Significantly-negative profit In the Short-Run, should this firm shut down? P < AVC, so immediately shut down in the short run. Significantly-negative profit BA 445 Lesson A.8 Competitive Markets $ Q ATC AVC MC P e = MC(Q) Q ATC PePe Competitive Entry and Exit

23 $ QfQf ATC AVC MC Q f* P = min AVC Firm’s Short-Run Supply Curve Profit maximization MC = P and the shutdown rule imply the firms short-run (FC > 0) supply is MC above Min AVC. BA 445 Lesson A.8 Competitive Markets Competitive Entry and Exit

24 Short-Run Market Supply Curve The number of firms is fixed in the short run (because capital is fixed). The market supply curve is the horizontal summation of each individual firm’s supply at each price. Firm 1Firm Market Q QQ P PP S1S1 S2S2 SMSM BA 445 Lesson A.8 Competitive Markets Competitive Entry and Exit

25 Long Run Adjustments if profits are positive If the industry is perfectly competitive, not only are firms price takers but there is free entry into the industry. n Firms producing perfect substitutes enter the industry if profits in the industry are positive. BA 445 Lesson A.8 Competitive Markets Competitive Entry and Exit

26 Effect of Entry on Price As firms enter, market supply increases and prices decrease. Firm QfQf $ DfDf Market QMQM $ D S PePe S* P e* D f* Entry BA 445 Lesson A.8 Competitive Markets Competitive Entry and Exit

27 Effect of Entry on Firm’s Price, Output, and Profit. Entry continues until  = PQ – C = 0, meaning P = C/Q = AC, or P = min AC. $ Q AC MC PePe DfDf P e* D f* Qf*Qf* QLQL BA 445 Lesson A.8 Competitive Markets Competitive Entry and Exit

28 Summary of competitive markets Short run profits lead to entry. Entry increases market supply, drives down market price, increases market quantity. Lower price means lower quantity supplied by each firm. Profit and price adjustment continues until the long run, where profits are zero. BA 445 Lesson A.8 Competitive Markets Competitive Entry and Exit

29 $ QfQf ATC AVC MC Q f* P = min AC Features of Long Run Competitive Equilibrium P = minimum AC BA 445 Lesson A.8 Competitive Markets Competitive Entry and Exit

30 Features of Long Run Competitive Equilibrium P = minimum AC n Price depends solely on cost. n Why does a Mercedes cost more to consumers than a Honda? Any long-run difference in price is from a difference in production cost. BA 445 Lesson A.8 Competitive Markets Competitive Entry and Exit

31 Review Questions BA 445 Lesson A.8 Competitive Markets Review Questions  You should try to answer some of the review questions (see the online syllabus) before the next class.  You will not turn in your answers, but students may request to discuss their answers to begin the next class.  Your upcoming Exam 1 and cumulative Final Exam will contain some similar questions, so you should eventually consider every review question before taking your exams.

32 End of Lesson A.8 BA 445 Managerial Economics BA 445 Lesson A.8 Competitive Markets