Market Structure

Aims & Objectives After studying this lesson, you will be able to understand: Introduction to market models Pure competition Short run Long run

Market Structure Continuum Four Market Models Pure competition Pure monopoly Monopolistic competition Oligopoly Oligopoly Pure Monopoly Pure Competition Monopolistic Competition We will be discussing all four of these market models, but first we will start with pure competition. From the continuum, you can see that we are starting at one extreme of the possible market models. The other market models will be discussed in future chapters. Market Structure Continuum 8-3 LO1

Monopolistic Competition Four Market Models Characteristics of the Four Basic Market Models Characteristic Pure Competition Monopolistic Competition Oligopoly Monopoly Number of firms A very large number Many Few One Type of product Standardized Differentiated Standardized or differentiated Unique; no close subs. Control over price None Some, but within rather narrow limits Limited by mutual inter-dependence; considerable with collusion Considerable Conditions of entry Very easy, no obstacles Relatively easy Significant obstacles Blocked Nonprice Competition Considerable emphasis on advertising, brand names, trademarks Typically a great deal, particularly with product differentiation Mostly public relation advertising Examples Agriculture Retail trade, dresses, shoes Steel, auto, farm implements Local utilities Pure competition is rare in the real world, but the model is important. The model helps analyze industries with characteristics similar to pure competition. The model provides a context in which to apply revenue and cost concepts developed in previous chapters. Pure competition provides a norm or standard against which to compare and evaluate the efficiency of the real world. 8-4 LO1

Pure Competition Short run

Pure Competition: Characteristics Very large numbers of sellers Standardized product “Price takers” Easy entry and exit Perfectly elastic demand Firm produces as much or little as they want at the price Demand graphs as horizontal line Examples of Competitive Markets Agricultural commodities. Prominent markets for intermediate goods and services. Very large numbers of independent sellers each acting alone cannot influence the market price by increasing or decreasing their output because each has such a miniscule part of the entire market. A standardized product is a product for which all other products in the market are identical and thus are perfect substitutes. The consequence of this is that buyers are indifferent as to whom they buy from. Price takers have no pricing power; in other words, no ability to price their product. Easy entry and exit means that there are no obstacles to entry or to exit the industry. Perfectly elastic demand means that firm has no power to influence price so the firm merely chooses to produce a certain level of output at the price that is given. The demand curve is not perfectly elastic for the industry; it only appears that way to the individual firm, since they must take the market price no matter what quantity they produce. The firm faces a perfectly elastic demand because each individual firm makes up such a small part of the total market and the goods are perfect substitutes. Note that this perfectly elastic demand curve is a horizontal line at the price. 8-6 LO2

Average, Total, and Marginal Revenue Total Revenue TR = P X Q Average Revenue Revenue per unit AR = TR/Q Marginal Revenue Extra revenue from 1 more unit of output sold MR = dTR/dQ When a firm charges the same price for each unit of output, the average revenue is just the price of the good. Total revenue refers to the total amount of money that the firm collects for the sale of all of the units of their good. Marginal revenue reflects the additional revenue that the firm will receive by producing one more unit of output. When the firm is deciding how much to produce, the firm considers the marginal revenue in their decision. 8-7 LO3

Profit Maximization: TR-TC Approach Three questions: Should the firm produce? If so, what amount? What economic profit (loss) will be realized? When looking at profit maximization there are essentially 3 questions that the firm must answer. The first question is whether or not the firm should produce at all in the short run. In the short run, the firm should shut-down under certain circumstances. If it has been determined that the firm should produce in the short run, then the firm must determine how much to produce. Lastly, based on the answers to the first two questions, it is necessary to calculate the profit or loss for the firm. Part of the profit-maximization rule is producing an output that minimizes losses in the short run when that is the best option. 8-8 LO3

Profit function λ = TR - TC It is given as Profit = Total revenue- Total cost Symbolically λ = TR - TC

Concept of Normal profit, Super normal profit & Loss Normal profit ⇒ λ = 0 ⇒TR = TC Super normal profit ⇒ λ > 0 ⇒TR > TC Loss ⇒ λ < 0 ⇒TR < TC

Profit Maximization in Competitive Markets Profit Maximization is Imperative Normal profit is necessary to attract and maintain capital investment. Efficient firms can earn normal profit. Inefficient firms suffer losses. Role of Marginal Analysis Set Mπ = MR – MC = 0 to maximize profits. Conditions for profit maximization is MR=MC d/dQ (MR) < d/dQ (MC)

Average, Total, and Marginal Revenue in pure competition Total Revenue TR = P X Q where P = P Average Revenue Revenue per unit AR = TR/Q = P Marginal Revenue Extra revenue from 1 more unit of output sold MR = dTR/dQ = d (PQ)/dQ = P Therefore, AR = MR = P When a firm charges the same price for each unit of output, the average revenue is just the price of the good. Total revenue refers to the total amount of money that the firm collects for the sale of all of the units of their good. Marginal revenue reflects the additional revenue that the firm will receive by producing one more unit of output. When the firm is deciding how much to produce, the firm considers the marginal revenue in their decision. 8-12 LO3

Average, Total, and Marginal Revenue in pure competition Firm’s Demand Schedule (Average Revenue) Revenue Data TR QD P TR MR 1 2 3 4 5 6 7 8 9 10 $131 131 $0 131 262 393 524 655 786 917 1048 1179 1310 ] $131 131 This graph shows a purely competitive firm’s demand and revenue curves. The demand curve (D) of a purely competitive firm is a horizontal line (perfectly elastic) because the firm can sell as much output as it wants at the market price (here, $131). Because each additional unit sold increases total revenue by the amount of the price, the firm’s total-revenue (TR) curve is a straight upsloping line and its marginal-revenue (MR) curve coincides with the firm’s demand curve. The average-revenue (AR) curve also coincides with the demand curve. D = MR = AR 8-13 LO3

Shape of MR, AR and Demand curve in perfect competition The AR curve of a seller is the demand curve of the consumer Price, cost P AR= MR Output

Equilibrium of a firm in perfect competition Equilibrium of a firm takes place when the individual firm maximizes profit Firms are in equilibrium when profit is maximized ⇒ MR= MC =P =AR P=MR =AR

Break-even & Shut down point Break-even point Shut down point Break even for a firm occurs at that level of output at which P = min ATC Shut down for a firm occurs at that level of output at which’ P = min AVC Q’ Firms shut down operations when prices come down to the level at which the Price =min AVC. Hence no output is produced for prices below OP in figure. There is production only if price> OP. Note: The derivation of shutdown and breakeven points is done in class

Marginal Cost and Firm Supply Short-run Firm Supply Firm’s marginal-cost curve shows the amount of output the firm would be willing to supply at any market price. Marginal cost curve is the short-run supply curve so long as P > min AVC .

3 Production Questions Output Determination in Pure Competition in the Short Run Question Answer Should this firm produce? Yes, if price is equal to, or greater than, minimum average variable cost. This means that the firm is profitable or that its losses are less than its fixed cost. What quantity should this firm produce? Produce where MR (=P) = MC; there, profit is maximized (TR exceeds TC by a maximum amount) or loss is minimized. Will production result in economic profit? Yes, if price exceeds average cost (TR will exceed TC). No, if average total cost exceeds price (TC will exceed TR). We must work through these 3 questions sequentially every time we are confronted with a new market price. This is a great table that summarizes the steps that you need to go through to determine profit maximizing output. 8-18 LO3

Pure Competition Long run

The Long Run in Pure Competition In the long run: Firms can expand or contract capacity Firms enter and exit the industry Recall that in the short run the industry is fixed in both the number of sellers and the plant size of existing sellers. In the long run all of these restrictions are relaxed. 9-20 LO1

Profit Maximization in the Long Run Easy entry and exit The only long run adjustment we consider Identical costs All firms in the industry have identical costs Constant-cost industry Entry and exit do not affect resource prices In our model all firms have identical costs. Therefore they will all make the same production decisions since they also all face the same market price. The goal of the firm is to make profits and avoid losses. This is easy to do in pure competition due to the easy entry into the industry and easy exit out of the industry. 9-21 LO2

Long-Run Equilibrium Entry eliminates profits Firms enter Supply increases Price falls Exit eliminates losses Firms exit Supply decreases Price rises Profits attract firms from less profitable industries and losses cause them to leave the unprofitable industry to find another more profitable one. This reflects the supply determinant, a change in the number of sellers. 9-22 LO3

Equilibrium of a perfectly competitive industry/long run equilibrium Let at the going price ‘P’ the representative firm in the industry earn supernormal profit as shown by the blue shaded area → new firms are attracted to the industry → pushing the supply curve to the right. Price starts coming down and the share of profit of each firm starts falling. This adjustment goes on till the time the entire supernormal profit is removed and each firm earns only normal profit (TC= TR) at price P’. The reverse mechanism works if existing firms in industry earns losses. Adjustment Happens through exit of firms till normal profit point is arrived at. Thus, industry is in equilibrium at normal profit at the minimum point of AC where AR=MR=MC=AC=P

Long Run Supply Constant cost industry - Long‑run supply will be perfectly elastic; the curve will be horizontal. In other words, the level of output will not affect the price in the long run. Entry/exit does not affect LR AC - Constant resource price - expansion or contraction does not affect resource prices or production costs. Special case Increasing cost industry - Long‑run supply will be upward sloping as industry expands output. Most industries LR AC increases with expansion - Average‑cost curves shift upward as the industry expands and downward as industry contracts, because resource prices are affected. Specialized resources Decreasing cost industry - Long‑run supply will be downward sloping as the industry expands output. Average‑cost curves fall as the industry expands and firms will enter until price is driven down to maintain only normal profits. In this first scenario, the constant-cost industry, the number of firms entering or leaving the industry do not affect costs. In this second scenario, entry or exit of firms does affect costs. When firms enter the industry, input costs will increase as firms enter the industry and input costs will fall as firms exit the industry. The long-run supply curve is upsloping. In the decreasing cost industry, as the number of firms increase or decrease due to entry or exit, the industry costs change inversely. If demand for their product falls, firms will leave the industry causing input costs to rise. If demand for their product increases, firms will enter the industry causing input costs to fall. The long-run supply curve is downsloping. 9-24 LO4

LR Supply: Constant-Cost Industry Q P1 P2 P3 $50 S Z3 Z1 Z2 In a constant-cost industry, entry and exit of firms does not affect resource prices and therefore does not affect per-unit costs. So an increase in demand raises output but not price. Similarly, a decrease in demand reduces output but not price. Therefore, the long-run supply curve is horizontal. D3 D1 D2 Q3 Q1 Q2 90,000 100,000 110,000 9-25 LO4

LR Supply: Increasing-Cost Industry Q S P2 $55 Y2 P1 $50 Y1 P3 $40 Y3 The long-run supply curve for an increasing-cost industry is upsloping. In an increasing-cost industry, the entry of new firms in response to an increase in demand (D3 to D1 to D2) will bid up resource prices and thereby increase unit costs. As a result, an increased industry output (Q3 to Q1 to Q2) will be forthcoming only at higher prices ($55>$50 > $45). The long-run industry supply curve (S) therefore slopes upward through points Y3, Y1, and Y2. D2 D1 D3 Q3 Q1 Q2 90,000 100,000 110,000 9-26 LO4

LR Supply: Decreasing-Cost Industry Q X3 P3 $55 X1 P1 $50 X2 P2 $40 S The long-run supply curve for a decreasing-cost industry is downsloping. In a decreasing-cost industry, the entry of new firms in response to an increase in demand (D3 to D1 to D2) will lead to decreased input prices and, consequently, decreased unit costs. As a result, an increase in industry output (Q3 to Q1 to Q2) will be accompanied by lower prices ($55 > $50 > $45). The long-run industry supply curve (S) therefore slopes downward through points X3, X1, and X2. D3 D2 D1 Q3 Q1 Q2 90,000 100,000 110,000 9-27 LO4

Pure Competition and Efficiency In the long run, efficiency is achieved Productive efficiency Producing where P = min. AC Allocative efficiency Producing where P = MC Productive efficiency is producing goods in the least costly way. Allocative efficiency is producing the mix of goods most desired by society. Another bonus is consumer surplus and producer surplus are maximized in the long run in pure competition. Note: P=min ATC=MC does not occur in decreasing cost industries. 9-28 LO5

Pure Competition and Efficiency Single Firm Market Price Quantity P=MC=Minimum ATC (Normal Profit) MC Consumer Surplus S ATC P MR P Producer Surplus Productive Efficiency: Price=minimum ATC Allocative Efficiency: Price=MC Pure competition achieves both efficiencies in its long-run equilibrium. This is important because it indicates the firm is using the most efficient technology, charging the lowest price, and producing the greatest output consistent with its costs. The firm is using society’s scarce resources in accordance with consumer preferences. The sum of consumer surplus (green area) and producer surplus (blue area) is maximized. D Qf Qe 9-29 LO5

Dynamic Adjustments Purely competitive markets will automatically adjust to: Changes in consumer tastes Resource supplies Technology Recall the “Invisible Hand” Dynamic adjustments will occur automatically in pure competition when changes in demand, resource supplies, or technology occur. Disequilibrium will cause expansion or contraction of the industry until the new equilibrium at P = MC occurs. “The invisible hand” works in a competitive market system since no explicit orders are given to the industry to achieve the P = MC result. The profit motivation brings about highly desirable economic outcomes. 9-30 LO6

Technological Advance: Competition Entrepreneurs would like to increase profits beyond just a normal profit Decrease costs by innovating New product development Innovation means using better technology or improved business organization. New product development means the firm may be first to the market with a new product but others will soon follow and may destroy the innovating firm’s position. 9-31 LO6

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