Extreme Markets I: Perfect Competition Chapter 5 1 (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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The Ethanol Upheaval (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 3 In 2005 federal law began requiring that refiners add “renewable” ethanol into the nation’s gasoline supply. This requirement raises the demand for corn, and subsequently its price.

What’s Ahead (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 4 This chapter is about perfectly competitive markets, in which individual producers are so small relative to the market that each of them is a price-taker that cannot affect price by changing its output.

(c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 5

Substitutes and Competition – Preferences and Prices (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 6 Substitutes help determine competition. A set of producers is competitive if each supplies a good substitute for what the others produce.

Substitutes and Competition – Who Competes with Coke? (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 7 Does Coke compete with other carbonated beverage producers like Pepsi and Dr. Pepper, or with the producers of other beverages ranging from juice to bottled water?

Price-Takers and Monopolies (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 8 Whatever a firm produces, their strategies are constrained by customers’ abilities to substitute and the abilities of rivals to expand or enter the industry. A firm’s tactics to obtain an advantage next month may center on one subset of these factors, while a very different group of factors will help determine their strategy for the next decade.

(c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 9

What We Assume, and Why (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 10 There are many sellers, all of whom are price-takers. No seller is large enough to affect market price by its own actions. Each seller produces a good or service that is perfectly interchangeable with the output of any other; in other words, the product is homogeneous. Firms are not restricted from entering or leaving the industry in response to profits or losses. There are no important transaction costs. In particular, information is available to all participants at no cost. Without cost, buyers can learn the asking prices of sellers and sellers can compare the bids of buyers.

The Short Run and the Long Run (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 11 In the short run, all firms in the market have some fixed inputs that must be paid for, regardless of whether they are producing. In the long run all inputs are variable, and fixed costs need no longer be incurred.

(c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 12

Identical Firms – A Shift in Demand (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 13 Initial long-run equilibrium is at 10,000 units produced in the market selling at a price of $7.00. Individual firms will each produce 10 units. When there is a permanent increase in demand to D 2, price will rise to $16.00 and existing firms will expand production to 11 units. Profit will attract entry which will only stop when the market supply curve has shifted to SRS 1500 and the market price has once again fallen to $7.00.

Identical Firms – An Increase in Variable Costs (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 14 Here we begin in long-run equilibrium where the SRS 1500 intersects the LRS at 15,000 units selling for $7.00. Each firm produces 10 units. An increase in variable costs shifts the individual firm’s cost curves to MC’ and AC’. The market supply curve shifts to SRS’ Price begins to rise above $7.00 but firms are losing money and begin to exit the industry. Exit continues until market supply is SRS’ 1100 and price rises to $16.00.

Dissimilar Firms – A Shift in Demand (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 15 Here there are two types of firms facing different costs. If the market demand curve is D 1 only type A firms will exist in the market. Demand would have to rise to D 3 to attract type B firms into the market.

(c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 16

Ethanol Again – Long-Run Adjustment (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 17 Say there are a small number of low-cost Type A producers and a limitless potential number of high-cost Type Bs. We start in 2005 along demand curve D1 at long-run equilibrium of 7,000 (million) bushels at a price of $7. The ethanol requirement increases demand to D 3. With just type A firms the supply curve shifts to SRS1000, causing price to rise to $22. This begins to attract type B firms to the industry and the entry of type B firms will continue until price falls to $16.

Ethanol Again – Corn Prices (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 18

Ethanol Again – The Tortilla Effect (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 19 The graph on the left represents the market for corn in the US and the one on the right the market in Mexico. Initially, suppose both markets are in equilibrium at a price of $10. The ethanol regulation increase the demand for corn in the US to D 2 US. The price for corn in the US rises to $16. Mexican producers have an incentive to export corn. Eventually, the price of corn will settle at $13. The US will produce 40 bushels for themselves and import 30 bushels from Mexico. Mexicans are unhappy when the price of corn tortillas also increase!

Oil and Gasoline (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 20 Pictured is a simplified market for gasoline in the US. The domestic demand is D. US refiners can produce up to 1000 barrels at a marginal cost of $7. Assume US demand is small relative to global demand so the US has little impact on overall world demand. Market price of $11 per barrel prevails with 1500 barrels per day, 1000 produced domestically and 500 barrels imported.

Oil and Gasoline – Effect of Government Policies (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 21 In this example, domestic producers produce at a marginal cost of $7 and receive a price of $11 per barrel, for a profit of $4 per barrel. Suppose a domestic windfall profits tax of $4 is imposed, who benefits? The price of gasoline will not change. Instead of producers, the government will receive the $4 per barrel.

Oil and Gasoline – Political Platforms (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 22 Suppose that US policy increased domestic exploration. The US supply curve would shift to the right, reducing imports but having no effect on the world price.