Download LECTURE 12: COMPETITIVE MARKETS A MARKET consists of all

LECTURE 12: COMPETITIVE MARKETS
A MARKET consists of all firms and individuals willing and able to buy or sell a particular
product.
MARKET STRUCTURE describes the competitive environment in the market for any good
or service. Market structure refers to the competitive environment in which the buyers and
sellers of the product operate. Market structure is typically characterized on the basis of four
important industry characteristics:
1. The number and size distribution of active buyers and sellers and potential entrants,
2. The degree of product differentiation,
3. The amount and cost of information about product price and quality,
4. Conditions of entry and exit.
Effects of market structure are measured in terms of the prices paid by consumers,
availability and quality of output. In general, the greater the number of market participants,
the more vigorous is price and product quality competition. The more even the balance of
power between sellers and buyers. As a result, the more likely it is that the competitive
process will yield maximum benefits.
POTENTIAL ENTRANT
A potential entrant is an individual or firm posing a sufficiently credible threat of market
entry to affect the price/output decisions of incumbent firms. Potential entrants play
extremely important roles in many industries. Some industries with only a few active
participants might at first appear to hold the potential for substantial economic profits.
However, a number of potential entrants can have a substantial effect on the price/output
decisions of incumbent firms. For example, Dell, Gateway, Hewlett-Packard, IBM, and other
leading computer manufacturers are viable potential entrants into the computer component
manufacturing industry. These companies use their threat of potential entry to obtain
favourable prices from suppliers of microprocessors, monitors, and peripheral equipment.
FACTORS THAT SHAPE THE COMPETITIVE ENVIRONMENT
Effect of Product Characteristics on Market Structure
Transportation service is available from several sources; railroads compete with bus lines,
truck companies, airlines, and private autos. The substitutability of these other modes of
transportation for rail service increases the degree of competition in the transportation service
market. Good substitutes always increase competition.
EFFECT OF ENTRY AND EXIT CONDITIONS ON COMPETITION
In order to maintain above-normal profits over the long run requires barriers to entry,
mobility, or exit. A barrier to entry is any factor that creates an advantage for existing firms
over new arrivals. Legal rights such as patents and provincial or federal licenses can present
substantial barriers to entry in beverages, pharmaceuticals, cable television, television and
radio broadcasting, and other industries.
A barrier to mobility in any factor that creates an advantage for large leading firms over
smaller non leading rivals. Factors that sometimes create barriers to entry and/or mobility
include substantial economies of scale, scope economies, large capital or skilled-labour
requirements, and ties of customer loyalty.
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Competitive forces can also be diminished through barriers to exit just as barriers to entry
could. A barrier to exit is any restriction on the ability of incumbents to redeploy assets from
one industry or line of business to another.
EFFECT OF PRODUCT DIFFERENTIATION ON COMPETITION
Product differentiation includes any real or perceived differences in the quality of goods and
services offered to consumers. Sources of product differentiation include all of the various
forms of advertising promotion, plus new products and processes made possible by effective
programs of research and development that is innovation.
In short, market structure is broadly determined by entry and exit conditions. Low regulatory
barriers, modest capital requirements, and nominal standards for skilled labor and other
inputs all increase the likelihood that competition will be vigorous. Because all of these
elements of market structure have important consequences for the price/output decisions
made by firms, the study of market structure is an important ingredient of managerial
economics.
MARKET STRUCTURE AND DEGREE OF COMPETITION
Market structure refers to the competitive environment in which the buyers and sellers of the
product operate. Four types of market structure are usually identified. These are perfect
competition at one extreme, pure monopoly at the opposite extreme, and monopolistic competition and oligopoly in between.
PERFECT COMPETITION (NO MARKET POWER)
 Many buyers and sellers
 Buyers and sellers are price takers
 Product is homogeneous
 Very easy market entry and exit
 Non price competition not possible
 Perfect mobility of resources
 Economic agents have perfect knowledge
Examples: Stock Market, agricultural products, financial instruments, precious metals,
petroleum products, prominent markets for intermediate goods and services, e.g., discount
retailing, unskilled labor market.
MONOPOLY (absolute market power s.t. Govt regulation)
 One firm, firm is the industry
 No close substitutes for product
 Significant barriers to resource mobility
 Market entry and exit difficult or legally impossible
 Non price competition not necessary
Examples: pharmaceuticals, Microsoft, Government franchise: Post office, Water Supply,
Energy, National Airlines
Monopolistic Competition (market power based on Differentiated products)
 Many sellers and buyers ( large no of relatively small firms acting
independently)
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 Differentiated product
 Market entry and exit relatively easy
 Non price competition is very important
 Perfect mobility of resources
Examples: Fast-food outlets, boutiques, restaurants
OLIGOPOLY (market power based on product differentiation and/or the firm’s dominance
in the market)
o Few sellers and many buyers (small no of relatively large firms )
o Product may be homogeneous or differentiated
o Market entry and exit difficult
o Non price competition is very important among firms selling Differentiated
products
o Barriers to resource mobility
Examples: Automobile manufacturers, oil refining, processed foods, airlines
CHARACTERISTICS OF PERFECTLY COMPETITIVE MARKETS
Perfect competition exists when individual producers have no influence on market prices;
they are price takers as opposed to price makers. This lack of influence on price typically
requires.
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Large numbers of buyers and sellers. Each firm produces a small portion of industry
output, and each customer buys only a small part of the total.
Product homogeneity. The output of each firm is essentially the same as the output of
any other firm in the industry.
Free entry and exit. Firms are not restricted from entering or leaving the industry.
Perfect dissemination of information. Cost, price, and product quality information is
known by all buyers and all sellers.
Opportunity for normal profit in long run equilibrium. Fierce price competition
keeps P = MC and P =AR = AC.
Non price competition not possible.
There is a great number of buyers and sellers of the product, and each seller and buyer is too
small in relation to the market to be able to affect the price of the product. This means that a
change in the output of a single firm will not affect the market price of the product. Similarly,
each buyer of the product is too small to be able to extract from the seller such things as
quantity discounts and special credit terms.
The product of each competitive firm is homogeneous, identical, or perfectly standardized.
An example of this might be grading of wheat and cotton crops. As a result buyers cannot
distinguish between the output of one firm and the output of another, so they are indifferent
from which firm they buy the product.
Under perfect competition, there is perfect mobility of resources. That is, workers and other
inputs can easily move geographically from one job to another and can respond quickly to
monetary incentives. That is, there are no patents or copyrights, "vast amounts" of capital are
not necessary to enter the market, and already established firms do not have any lasting cost
advantage over new entrants because of experience or size.
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Finally, under perfect competition, consumers, resource owner, and firms in the market have
perfect knowledge as to present and future prices, costs, and economic opportunities in
general. Thus, consumers will not pay a higher price than necessary for the product. Price
differences are quickly eliminated, and a single price will prevail throughout the market for
the product.
Perfect competition, as defined above, has never really existed. Perhaps the closest we might
come today to a perfectly competitive market is the stock market. Another example is the
market for such agricultural commodities as wheat, cotton and corn. The natural gas industry
and the trucking industries also approach perfect competition. In the milk market, each dairy
farmer produces the milk that is essentially identical to that offered by other dairy farmers.
Similarly each milk buyer purchases a small portion of aggregate production, so that he does
not receive a cut-rate or volume discount. Because both buyers and sellers can trade as much
milk as they want at the going price, both are price-takers and the milk market is said to be
perfectly competitive.
The fact that perfect competition in its pure form has never really existed in the real world,
does not reduce the usefulness of the perfectly competitive model. A theory must be
accepted, or rejected on the basis of its ability to explain and to predict correctly and not on
the realism of its assumptions. And the perfectly competitive model does give us some useful
explanations and predictions of many real world economic phenomena when the assumptions
of the perfectly competitive model are only approximately satisfied.
PRICE DETERMINATION UNDER PERFECT COMPETITION
In Figure 1, the Total cost and total revenue curves of a perfectly competitive firm are shown.
The TR curve is a straight line through the origin showing that price is constant at all levels
of output. The firm is a price taker and can sell any amount of output at the given market
price, with its TR increasing proportionately with its sales. The slope of the TR curve is the
MR. It is constant and equal to the prevailing market price, since all units are sold at the same
price. Thus P = MR = AR. The shape of the TC curve reflects the U shape of the AC and MC
curves. The firm maximizes its profit at Q = $50,000 units, where the distance between the
TR and TC is the greatest.
The TR- TC approach is awkward to use when firms are combined together in study of the
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industry. The alternative approach which is based on marginal cost- marginal revenue, uses
price as an explicit variable, and shows clearly the behavioural rule leads to profit
maximization.
Under perfect competition, the price of a product is determined at the intersection of the
market demand curve and the market supply curve of the product. The market demand curve
for product is simply the horizontal summation of the demand curves of all the consumers in
the market. The market supply curve of a product is similarly obtained from the horizontal
summation of the supply curve of the individual producers of the product.
Given that the market price of a product is determined at the intersection, of the market
demand and supply curves of the product, the perfectly competitive firm is a price taker. That
is, the perfectly competitive firm takes the price of the product as given and has no
perceptible effect on that price by varying its own level of output and sales of the product.
Since the products of all firms are homogeneous, a firm cannot sell at a price higher than the
market price of the product; otherwise the firm would lose all its customers. On the other
hand, there is no reason for the firm to sell at a price below the market price, since it can sell
any quantity of the product at the given market price. As a result, the firm faces a horizontal
or infinitely elastic demand curve for the product at the market price determined at the
intersection of the market demand and supply curves of the product. For example, a small
wheat farmer can sell any amount of wheat at the given market price of wheat. This is shown
in Figure 2.
Role of Marginal Analysis
y Set Mπ= MR – MC = 0 to maximize profits.
y MR= MC when profits are maximized.
Normal Profit Equilibrium
y There are no economic profits in competitive equilibrium; firms earn a normal
rate of return.
y With a horizontal market demand curve, MR = P, so P = MR = MC = ATC.
Given the equilibrium price of P = $45, a perfectly competitive firm producing, the product
faces the horizontal or infinitely elastic demand curve shown by d at P = $45 in Figure 2. The
perfectly competitive firm only determines what quantity of the product to produce at P = $
45 in order to maximize its total profits. When the product price is constant, the change in the
total revenue per unit change in output or marginal revenue (MR) is also constant and is equal
to the product price. That is, for a perfectly competitive firm, P = MR
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The equilibrium price and quantity can be determined algebraically by setting the market
demand and supply functions equal to each other and solving for the equilibrium price.
Substituting the equilibrium price into the demand or supply functions and solving for Q, we
the get the equilibrium quantity. For example, the equations for the market demand and
supply curves for the product in Figure 2 are:
QD = 625 – 5P
QS = 175
+ 5P QD =
QS
625 – 5P = 175 + 5P
Solving for P, we
have 450 = 10P
P = $45
Substituting P = $45 into the demand function and solving for Q, we have
QD = 625 – 5P = 625 – 5(45) = 400 units
PROFIT MAXIMIZATION WITH CALCULUS
π= TR – TC
dπ/dQ = dTR/dQ - dTC/dQ
= 0 so that dTR/dQ =
dTC/dQ
Since dTR/dQ = MR and dTC/dQ = MC
The above condition becomes MR = MC. But under perfect competition, the price is given to
the firm and is constant.
Therefore,
dTR/dQ = d(PQ)/dQ = P = MR
so that the FOC for maximization under perfect competition becomes P = MR = MC.
(The product Rule of differentiation will not apply as under perfect competition P (price) is
constant so d(PQ)/dQ = P)
The second order condition for profit maximization requires that the second derivative of Π
with respect to Q be negative. That is,
SOC
- d2 TC /dq2 <
2
2
2
2
d π /Dq = d TR /dq 0
d2 TR /dq2 < d2 TC /dq2
So verbally, Slope of MR curve < Slope of MC curve, thus MC must have a steeper slope
than the MR curve or the MC curve must cut the MR curve from below.
Under perfect competition, t he slope of MR curve is zero, hence the SOC is simplified as
follows :
0 < d2 TC /dq2
MC must have a +tive slope, or the MC must be rising.
SHORT-RUN ANALYSIS OF A PERFECTLY COMPETITIVE FIRM
In the short run, some inputs are fixed, and these give rise to fixed costs, which go on
whether the firm produces or not. Thus, it pays for the firm to stay in business in the short run
even if it incurs losses, as long as these losses are smaller than its fixed costs. Thus, the best
level of output of the firm in the short run is the one at which the firm maximizes profits or
minimizes losses.
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The best level of output of the firm in the short run is the one at which the marginal revenue
(MR) of the firm equals its short run marginal cost (MC). As long as MR exceeds MC, it pays
for the firm to expand output because by doing so the firm would add more to its total
revenue than to its total costs (so that its total profits increase or its total losses decrease). On
the other hand, as long as MC exceeds MR, it pays for the firm to reduce output because by
doing so the firm will reduce its total costs more than its total revenue (so that, once again, its
total profits increase or its total losses decrease) . Thus, the best level of output of any firm
(not just a perfectly competitive firm) is the one at which MR = MC. Since a perfectly
competitive firm faces a horizontal or infinitely elastic demand curve, P = MR, so that the
condition for the best level of output can be restated as the one at which P = MR = MC. This
can be seen in Figure 3.
In the top panel of Figure 3, d is the demand curve for the output of the perfectly competitive
firm and the marginal and average total cost (i.e., MC and ATC) curves are also drawn. The
best level of output of the firm is given at point E, where the MC curve intersects the firm's d
or MR curve. At point E, the firm produces 4 units of output at P = MR = MC = $45. Since at
point E, P = $45 and ATC = $ 35, the firm earns a profit of EA = $10 per unit and EABC =
$40 in total (the shaded area). This is the largest total profit that the firm can earn. Thus, the
best level of output for the firm is QX = 4, at which MR = P = MC and the total profits of the
firm are maximized.
The bottom panel of Figure 3 shows that if the market price of the product is $25 instead of
$45, so that the demand curve faced by the perfectly competitive firm is d', the best level of
output of the firm is 3 units, as indicated by point E', where P’= MR’ = MC At QX = 3, P =
$25 and ATC = $35, so that the firm incurs the loss of FE' = $10 per unit and FE'C'B = $30
in total. If the firm stopped producing the product and left the market, however, it would
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incur the greater loss of FA' =' $20 per unit and FA'B'B = $60 (its total fixed costs) . Another
way of looking at this is to say that at the best level of output of Q = 3, the excess of P = $25
over the firm's average variable cost (AVC) of $15 can be applied to cover part of the firm's
fixed costs (FA' per unit and FA'B'B in total). Thus, the firm minimizes its losses by
continuing to produce its best level of output. If the market price of the product declined to
slightly below $15, so that the demand curve facing the firm crossed the MC curve at point H
(see the bottom panel of Figure 3), the firm would be indifferent whether to produce or not.
The reason is that at point H, P = AVC and the total losses of the firm would be equal to its
total fixed costs whether it produce or not. Thus, point H is the shut down point of the firm.
Below point H, the firm would not even cover its variable costs, and so by going out of
business, the firm would limit its losses to be equal to its total fixed costs.
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