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Chapter 6

Competition

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Chapter 6

• The goal of this chapter is to examine how supply decisions are made in competitive markets. Specifically:

– What are the unique characteristics of competitive markets?

– How do competitive firms make supply decisions?

– How are production levels, prices, and profits determined?

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Learning Objectives

After completing this chapter, you should know:

1. The unique characteristics of perfectly competitive firms and markets.

2. How total profits change as output expands.

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Learning Objectives

3. How the profit-maximizing rate of output is found.

4. The determinants of competitive market supply.

5. Why profits get eliminated in competitive markets.

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Market Structure

• The number and relative size of firms vary across industries.

• Most real-world firms fall somewhere along a spectrum that stretches from one extreme (powerless) to another (powerful).

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Five common types of market structure:

• Perfect competition

• Monopolistic competition

• Oligopoly

• Duopoly

• Monopoly

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Market Structure

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Figure 6.1

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Market Power

• This is the ability of a firm to alter the market price of a good or service.

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Competitive Firm

• A perfectly competitive firm has no market power: It is not able to alter the market price of the good it produces.

– It is a price taker.

– It competes with many other firms selling homogenous products.

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Monopoly

• A monopoly firm is one that produces the entire market supply of a particular good or service. It has complete market power; it can alter the market price of a good or service.

– It is a price setter, not a price taker.

– It has no direct competitors.

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Imperfect Competition

• Other forms of imperfect competition lie between monopoly and perfect competition, with decreasing market power.– Duopoly: only two firms supply a product.

– Oligopoly: a few large firms supply all or most of a particular product.

– Monopolistic competition: many firms supply essentially the same product but each enjoys significant brand loyalty.

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Competitive Market

• A competitive market is one in which no buyer or seller has market power.

• No single producer or consumer has any control over the price or quantity of the product.

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Perfect Competition

• Perfectly competitive firms have no brand image, no real market recognition.

• A perfectly competitive firm is one whose output is so small in relation to market volume that its output decisions have no perceptible impact on price.

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No Market Power

• The output of a perfectly competitive firm is so small relative to market supply that it has no significant effect on the total quantity or price in the market.

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Price Takers

• A perfectly competitive firm is a price taker.

• An individual firm’s output decisions do not affect the market price.

• An individual firm must take the market price and do the best it can within these constraints.

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Market Demand versus Firm Demand

• There is a big difference between the market demand curve and the demand curve confronting a particular firm.

– The market demand curve for a product is always downward-sloping.

– The demand curve facing a perfectly competitive firm is horizontal.

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Figure 6.2

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The Firm’s Production Decision

• Choosing a rate of output is a firm’s production decision:

– It is the selection of the short-term rate of output (with existing plant and equipment).

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Output and Revenues

• Total revenue is the price of a product multiplied by the quantity sold in a given time period:

Total revenue = Price x Quantity

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Revenues versus Profits

• Profit is the difference between total revenue and total cost.

– Maximizing output or revenue is not the way to maximize profits.

– Total profits depend on how both revenue and cost increase as output expands.

• A business is profitable only within a certain range of output.

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Profit Maximization and Price

• To maximize profit, the firm should produce an additional unit of output only if it brings in revenue that is greater than the cost of producing it.

– The firm compares the market price to the marginal cost of producing the next unit of output.

– If price is greater than marginal cost, increase production.

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Figure 6.5

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Profit-Maximizing Rate of Output

• Never produce anything that costs more than it brings in – it boils down to comparing price and marginal cost.

• A competitive firm wants to expand the rate of production whenever price exceeds marginal cost.

• Short-run profits are maximized at the rate of output where price equals marginal cost.

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Short-Run Decision Rules for a Competitive Firm

• Price = MC Maintain output rate

(Profits maximized)

• Price < MC Decrease output rate

• Price > MC Increase output rate

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Total Profit

• Total profit can be computed in one of two ways:

Total profit = Total revenue – Total cost

OR

Total profit = Average profit (Profit per unit)

x Quantity sold

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Total Profit

• Profit per unit equals price minus average total cost:

– Profit/unit = p – ATC

• Total profit equals profit per unit times quantity:

– Profit = (p – ATC) x q

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• What counts is total profits, not profit per unit.

• Total profits are maximized only where

p = MC.

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Total Profit

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Figure 6.6

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A Firm’s Supply

• Competitive firms simply take the market price.

• Competitive firms adjust the quantity supplied until MC = price.

• The marginal cost curve is the short-run supply curve for a competitive firm.

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Supply Shifts

• Anything that alters marginal costs affects the supply decisions of a firm.

• Important influences on marginal cost (and supply behavior) are:

– The price of factor inputs.

– Technology.

– Expectations.

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Market Supply

• Market supply is the total quantity of a good that sellers are willing and able to sell at alternative prices in a given time period, ceteris paribus.

• The market supply curve is the sum of the marginal cost curves of all the firms.

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Competitive Market Supply

• Determinants of the market supply of a competitive industry:

– The price of factor inputs.

– Technology.

– Expectations.

– The number of firms in the industry.

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Industry Entry and Exit

• To understand how competitive markets work, we focus on changes in equilibrium rather than on a static equilibrium.

• The number of firms in a competitive industry is not fixed.

• Industry entry and exit are driving forces affecting market equilibrium.

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Entry

• Additional firms will enter the industry when profits are plentiful.

• Economic profits attract firms.

– More firms enter the industry.

– The market supply curve shifts to the right.

– The price decreases.

• Industry output increases and price falls when firms enter an industry.

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Figure 6.8

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Tendency toward Zero Economic Profits

• New firms continue to enter a competitive industry so long as profits exist.

• Once price falls to the level of minimum average cost, all economic profits disappear.

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• Entry is the force driving down market prices.

• Price falls until there are no economic profits.

• At that point, average total cost is at a minimum.

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Tendency toward Zero Economic Profits

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Exit

• Firms exit the industry when:

– Profit opportunities look better elsewhere.

– If price falls below average cost (profits turn into losses).

• As firms exit the industry, the market supply curve shifts to the left.

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• As supply shifts left, price begins to rise, reducing losses.

• Price rises until there are no economic losses.

• At that point, average total cost is at a minimum.

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Exit

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Equilibrium

• The existence of profits in a competitive industry induces entry, shifting supply to the right, lowering price, and reducing profits.

• The existence of losses in a competitive industry induces exits, shifting supply to the left, increasing price, and reducing losses.

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Long-Run Equilibrium

• In long-run competitive market equilibrium:

– Price equals minimum average total cost.

– Economic profit (or loss) is eliminated.

• As long as it is easy for existing producers to expand production or for new firms to enter an industry, economic profits will not last long.

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Figure 6.9

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Low Barriers to Entry

• There are no significant barriers to entry in competitive markets.

• Barriers to entry are obstacles that make it difficult or impossible for would-be producers to enter a market, such as patents.

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Characteristics of a Competitive Market

• Many small firms.

• Perceived horizontal demand.

• Identical products.

• Low entry barriers.

• Set output where MC= p.

• Zero economic profit in the long run.

• Perfect information.

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The Relentless Profit Squeeze

• The unrelenting squeeze on prices and profits is a fundamental characteristic of the competitive process.

• The market mechanism works best in competitive markets.

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The Relentless Profit Squeeze

• Economic profits indicate consumers want more of that industry’s goods.

• Firms expand and more firms enter, increasing output and driving down price.

• This continues until p = min ATC and economic profit = 0.

• Then expansion stops.

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The Relentless Profit Squeeze

• Economic losses indicate consumers no longer want as much of that industry’s goods.

• Firms depart the industry, decreasing output and causing price to rise.

• This continues until p = min ATC and economic losses = 0.

• Then industry shrinkage stops.

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Maximum Efficiency

• Competitive pressure on prices forces suppliers to produce at the least possible cost.

• Society gets the most it can from its available scarce resources.

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Zero Economic Profits

• All economic profits are eliminated at the limit of the competitive process.

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What We learned

1. A perfectly competitive firm has no market power; it is a price taker. It is one of many small firms producing a homogeneous product.

2. As output increases, profits grow initially because p > MC, then maximize when p = MC, but decrease when p < MC.

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What We Learned

3. The competitive firm maximizes profits by producing the quantity at p = MC.

4. The determinants of supply include the price of inputs, technology, and expectation, all of which can shift a firm’s MC curve. Market supply is also affected by the number of firms.

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What We Learned

5. If economic profits exist, new firms enter, market supply shifts right, price falls until it equals min ATC, profits will be squeezed to zero, and expansion will stop.

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