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CHAPTER 6 Competition LEARNING OBJECTIVES After reading this chapter, you should be able to: 1 2 3 4 5 Identify the unique characteristics of perfectly competitive firms and markets. Illustrate how total profits change as output expands. Describe how the profit-maximizing rate of output is found. Recite the determinants of competitive market supply. Explain why profits get eliminated in competitive markets. Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 6-1 MARKET STRUCTURE The goal of this chapter is to examine how supply decisions are made in competitive markets. Market structure is the number and relative size of firms in an industry. • Market structure varies. Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 6-2 MARKET STRUCTURE Firms fall along a spectrum of competition. Imperfect competition Perfect competition Monopolistic competition Oligopoly Duopoly Monopoly • Number of firms, relative size of firms, type of product, and market power are important determinants in this spectrum. • Spectrum shows the range of power a firm might have. Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 6-3 MARKET STRUCTURE A perfectly competitive firm competes with many other firms in a perfectly competitive market. No market power: • No one producer or consumer is able to alter the market price or quantity. • Everyone is a price taker. Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 6-4 MARKET STRUCTURE Imperfect competition are market structures that lie between monopoly and perfect competition. Duopoly • Two firms supply a particular product. Oligopoly • A few large firms supply all or most of a similar product. Monopolistic competition • Many firms supply essentially the same product but each enjoys significant brand loyalty. Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 6-5 PERFECT COMPETITION A competitive market is one in which producers have no market power. • All firms sell a homogenous product. • Output of a single firm is so small compared to market supply that it has no significant effect on total quantity or price in the market. Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 6-6 PERFECT COMPETITION Market Demand versus Firm Demand In perfect competition, the market demand curve and the firm demand curve are distinct. • The market demand curve is always downward-sloping. • The firm demand curve is always horizontal. Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 6-7 PERFECT COMPETITION Demand for an individual firm’s output Market Demand PRICE ($ per unit) Market Supply pe Demand facing a single firm pe Market Demand QUANTITY (per day) QUANTITY (per day) Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 6-8 THE FIRM’S PRODUCTION DECISION Since a perfectly competitive firm cannot influence price, the only decision it makes is its firm’s production decision. • Chooses a rate of output during a certain time period with its fixed capital. • Best rate of output is the one that maximizes profits. Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 6-9 THE FIRM’S PRODUCTION DECISION Output, Revenues, and Profit Total revenue is the value of a firm’s sales. TR = P x Q where TR = total revenue, P = price, Q = quantity. Total profit is the difference between total revenue and total cost Total profit = TR – TC where TC = total cost. Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 6-10 THE FIRM’S PRODUCTION DECISION Total profit varies with the rate of output PRICE ($ per unit) Total Cost Total Revenue = p x q profits Fixed Cost 0 q1 q2 QUANTITY (per day) Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 6-11 PROFIT MAXIMIZATION To maximize profits, a firm should produce an additional unit of output only if it brings in revenue that is greater than the cost of producing it. MARGINAL REVENUE MARGINAL COST = extra revenue from selling one more unit. = price (in perfectly competitive markets) = extra cost from selling one more unit. = (change in cost) (change in quantity) Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 6-12 PROFIT MAXIMIZATION Profit maximizing rate of output Price > MC Increase output rate Price = MC Maintain output rate (profits are maximized) Price < MC Decrease output rate Produce additional output if : MARGINAL REVENUE >_ MARGINAL COST Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 6-13 PROFIT MAXIMIZATION Quantity (per day) Price Total Total Revenue Cost (=Q*P) Total Profit (=TR-TC) Price Marginal Cost 0 --- 0 $10 -$10 --- --- 1 $13 $13 $15 -$2 $13 $5 2 $13 $26 $22 $4 $13 $7 3 $13 $39 $31 $8 $13 $9 4 $13 $52 $44 $8 $13 $13 5 $13 $65 $61 $4 $13 $17 Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 6-14 PROFIT MAXIMIZATION Profit can be computed in one of two ways. Total profit = TR – TC or Total profit = (p – ATC) x q where ATC is the average total cost. Notice that: • (p – ATC) is profit per unit. • Firms maximize total profits, not profit per unit. • Profit-maximizing may not minimize ATC. • Total profits are maximized where p = MC. Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 6-15 PROFIT MAXIMIZATION Total profit = $8 MC PRICE ($ per unit) 16 ATC P = $13 Profit per unit = $2 12 8 Cost per unit = $11 4 1 2 3 4 5 6 7 QUANTITY (per day) Quantity maximizing profit Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 6-16 SUPPLY BEHAVIOR As the market price changes in a competitive market: • Firms take the new price as given. • Firms adjust quantity until MC = price. • Profit-maximizing quantity moves along marginal cost curve. • Firm’s short-run supply curve is it’s marginal cost curve. Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 6-17 SUPPLY BEHAVIOR Anything that alters marginal cost will change the supply behavior of a firm. • The price of factor inputs. • Technology. • Expectations. For example, if wages increase, marginal cost rises as well. This shifts the MC curve inward. Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 6-18 ENTRY AND EXIT Positive economic profits influence firms entry/exit into the market. • New firms enter the industry. • Market supply curve shifts outward. • Market price decreases and output expands. Firms enter a competitive industry so long as positive economic profits exist. Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 6-19 ENTRY AND EXIT S1 S2 E1 P1 p2 p3 S3 E2 E3 Market demand (b) Reduces profits of competitive firms. PRICE (per pound) PRICE (per pound) (a) Market entry pushes price down and . . . MC ATC p1 p2 p3 QUANTITY (thousands of pounds per day) q3 q2 q1 QUANTITY (pounds per day) Long-run competitive market equilibrium occurs when: • P = min(ATC) • Economic profits are zero. Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 6-20 ENTRY AND EXIT 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. Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 6-21 COMPETITIVE MARKET CHARACTERISTICS Market Characteristics • Many firms. • Downward sloping demand. • Identical products. • Low entry barriers. • Perfect information. Firm Characteristics • Price taker. • Set output where MC = p. • Zero economic profit in long run. Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 6-22 SUMMARY • We identified the unique characteristics of perfectly competitive firms and markets. • We illustrated how total profits change as output expands • We described how the profit-maximizing rate of output is found. • We discussed the determinants of competitive market supply. • We explained why profits get eliminated in competitive markets. Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 6-28