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Competitive Markets Chapter 8 McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. The Market Supply Curve • The market supply curve determines the equilibrium price faced by an individual producer. – Equilibrium price – The price at which the quantity of a good demanded in a given time period equals the quantity supplied. – Market supply – The total quantities of a good that sellers are willing and able to sell at alternative prices in a given time period, ceteris paribus. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. The Market Supply Curve • The market supply curve is the sum of the marginal cost curves of all the firms. – Marginal cost (MC) – The increase in total cost associated with a one-unit increase in production. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. The Market Supply Curve • Whatever determines marginal cost also determines the competitive firm’s supply response. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. The Market Supply Curve • The market supply of a competitive industry is determined by: – The price of factor inputs. – Technology. – Expectations. – Taxes. – The number of firms in the industry. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Competitive Market Supply Farmer A Farmer B Farmer C Market supply $5 MCA Price 4 3 a 2 MCB MCC c b + + d = 1 0 20 40 60 Quantity McGraw-Hill/Irwin 0 20 40 60 Quantity 0 20 40 60 Quantity 0 100 200 Quantity © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Entry and Exit • Investment decisions shift the market supply curve to the right. – Investment decision - The decision to build, buy, or lease plant and equipment; to enter or exit an industry. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Entry and Exit • The profit motive drives these investment decisions. – If there are economic profits, more firms will enter the industry increasing market supply. – Each firm will respond to the resulting lower price and profits by reducing output. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Market Entry Market entry pushes price down and . . . S1 Price E1 p1 p2 Reduces profits of competitive firm p1 p2 E2 New firms enter Quantity McGraw-Hill/Irwin MC S2 ATC f1 f1 Market demand q1 q2 Quantity © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Tendency Toward Zero Profits • An increase in market supply causes the economic profits to disappear. – Economic profits – The difference between total revenues and total economic costs. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Tendency Toward Zero Profits • When economic profits disappear, entry ceases and the market price stabilizes. • A competitive market is a market in which no buyer or seller has market power. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Tendency Toward Zero Profits • 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. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Low Barriers to Entry • Barriers to entry are obstacles that make it difficult or impossible for would-be producers to enter a particular market. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Low Barriers to Entry • Barriers to entry may include: – Patents. – Control of essential factors of production. – Control of distribution outlets. – Well-established brand loyalty. – Government regulation. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Market Characteristics of Perfect Competition • Some of the structures, behaviors and outcomes of a competitive market are: – Many firms - none of which has a significant share of total output. – Perfect information - buyers and sellers have complete information on supply, demand, and prices. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Market Characteristics of Perfect Competition • Some of the structures, behaviors and outcomes of a competitive market are: – Identical products - products are homogeneous; one firm’s products is the same as any other’s. – MC = p - all competitive firms seek to expand output until marginal cost equals the product’s market price. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Market Characteristics of Perfect Competition • Some of the structures, behaviors and outcomes of a competitive market are: – Low barriers to entry - entry barriers are low, economic profits will attract more firms. – Zero economic profit - market supply expands as long as there are economic profits, pushing prices and economic profits down. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Competition at Work: Microcomputers • Few, if any, product markets are perfectly competitive. • Many industries function much like a competitive market. • The microcomputer market illustrates how the process of competition works. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Market Evolution • As in other industries, the computer industry has evolved over time. • It was never a monopoly, nor was it ever perfect competition. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Initial Conditions: The Apple I • Steve Jobs and Steven Wozniak created the Apple Computer Corporation in 1977. • Other companies noted the profits and, due to the low barriers to entry, followed Apple’s lead. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. The Production Decision • Each competitive firm seeks to make the best short-run production decision. – Production decision - The selection of the short-run rate of output (with existing plant and equipment). McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. The Production Decision • To maximize profit, each competitive firm seeks the rate of output at which marginal cost equals price. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Initial Equilibrium in the Computer Market Market equilibrium $1200 1000 1200 800 Market supply 600 400 Market demand 200 0 20 40 60 80 Quantity (thousands) McGraw-Hill/Irwin The typical firm PRICE OR COST Price (per computer) The computer industry 1000 800 600 400 Market price C P = MR Profits m D Average total cost 200 0 200 400 600 800 1000 Quantity © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Profit Calculations • A profit-maximizing producer seeks to maximize total profit. • This is not necessarily or even very frequently the same thing as maximizing profit per unit. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Profit Calculations • Profit per unit is total profit divided by the quantity produced in a given time period.; price minus average total cost. Total profit = profit per unit X quantity sold McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Computer Revenues, Costs and Profits Output per Month 0 100 200 300 400 500 600 700 800 900 McGraw-Hill/Irwin Price ($) 1000 1000 1000 1000 1000 1000 1000 1000 1000 Total Revenue ($) 100,000 200,000 300,000 400,000 500,000 600,000 700,000 800,000 900,000 Total Cost $ 60,000 90,000 130,000 180,000 240,000 320,000 420,000 546,000 720,000 919,800 Total Profit –$60,000 10,000 70,000 120,000 160,000 180,000 180,000 154,000 80,000 –19,800 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Computer Revenues, Costs and Profits Output per Month 0 100 200 300 400 500 600 700 800 900 McGraw-Hill/Irwin Price = Marginal Revenue $1,000 1,000 1,000 1,000 1,000 1,000 1,000 1,000 1,000 Marginal Cost Average Total Cost Profit per Unit $ 300 400 500 600 800 1,00 1,260 1,740 1,998 $ 900 650 600 600 640 700 780 900 1,022 $ 100 350 400 400 360 300 220 100 –22 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. The Lure of Profits • In competitive markets, economic profits attract new entrants. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Low Entry Barriers • Low entry barriers permit new firms to enter competitive markets. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. A Shift of Market Supply • The entry of new firms shifts the market supply curve to the right. • New entrants will continue to enter as long as there are economic profits in short-run competitive equilibrium. • Short-run equilibrium: p = MC McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. A Shift of Market Supply • As supply increases, price drops toward the minimum of ATC. • In long-run equilibrium, entry and exit cease, and zero economic profit (that is, normal profit) prevails. • Long-run equilibrium: p = MC = minimum ATC McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. A Shift of Market Supply • Once established, long-run equilibrium will continue until market demand shifts or technological improvement reduces the cost of computer production. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. The Competitive Price and Profit Squeeze Price (per computer) S1 $1000 S2 800 Market demand 0 20,000 Quantity (computers per month) McGraw-Hill/Irwin Lowers price and profits for the typical firm Price or Cost (per computer) An expanded market supply . . . MC $1000 800 ATC Old price Profits m G H New price 0 500 600 Quantity (computers per month) © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. The Competitive Squeeze Approaching Its Limit S2 $1000 S3 800 Market demand 0 20,000 Quantity (computers per month) McGraw-Hill/Irwin The typical firm Price or Cost (per computer) Price (per computer) The computer industry MC ATC $1000 800 700 620 Old price J Profits m K New price 0 500 600 Quantity (computers per month) © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Short- vs. Long-Run Equilibrium Short-run equilibrium (p = MC) pS qS Quantity McGraw-Hill/Irwin MC ATC Price or Cost Price or Cost MC Long-run equilibrium (p = MC = ATC) ATC pS pL qL Quantity © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Long-Run Rules for Entry and Exit Price Level Result for typical firm Market Response P > ATC Profits New firms enter industry, Existing firms expand P < ATC Loss Firms exit industry, Existing firms contract P = ATC Break even No exit or entry, Existing firms maintain current capacity McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Home Computers vs. Personal Computers • Once long-run equilibrium was reached in the microcomputer market, producers were forced either: – To develop a better product (to increase demand), or – To reduce costs of production. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Home Computers vs. Personal Computers • Manufactures of computers did both — separating the market into home computers and personal computers McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Price Competition in Home Computers • The home computer market confronted the fiercest form of price competition leaving the only option to make an extra buck to push the cost curve down. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Price Competition in Home Computers • Costs were pushed down by reducing the number of components and using more powerful computer chips. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Further Supply Shifts • With strong competition, often the only way for a firm to improve profitability is to reduce costs. • Cost reductions were accomplished through technological improvements. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Further Supply Shifts • Technological improvements are illustrated by a downward shift of the ATC and MC curves. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Lower Costs Shifts the Supply Curve Downward Price (per computer) Old MC New MC Old New ATC ATC $700 J N R 430 600 Quantity (computers per month) McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Shutdowns • Once a firm is no longer able to cover variable costs, it should shut down production. • The shutdown point is the rate of output at which price equals minimum AVC. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Exits • Most firms withdrew from the home computer market due to low profits. • The exit rate in 1983-85 matched the entry rate of 1979-82. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. The Personal Computer Market • Firms initially competed on the basis of product improvements. • Eventually, firms could not sell all the PCs they produced at prevailing prices. • They were forced to cut their prices. • Many shut down. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Competitive Process • Competitive market pressures were a driving force in the spectacular growth of the computer industry. • Consumers reaped substantial benefit from competition in computer markets. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Allocative Efficiency: The Right Output Mix • The market mechanism works best in competitive markets. – Market mechanism – the use of market prices and sales to signal desired output (or resource allocations). McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Allocative Efficiency: The Right Output Mix • High profits in a particular industry indicate consumers want a different mix of output. • A competitive market determines the opportunity cost of producing different goods. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Allocative Efficiency: The Right Output Mix • The price signal the consumer gets in a competitive market is an accurate reflection of opportunity cost. – Opportunity cost – The most desired goods or services that are forgone in order to obtain something else. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Allocative Efficiency: The Right Output Mix • The marginal cost pricing characteristic of competitive markets answers the WHAT-toproduce question efficiently. – Marginal cost pricing – The offer (supply) of goods at prices equal to their marginal cost. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Allocative Efficiency: The Right Output Mix • The amount consumers are willing to pay for a good (its price) equals its opportunity cost (marginal cost). McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Production Efficiency • Production efficiency means that we are producing at minimum average total cost. – Efficiency – Maximum output of a good from the resources used to produce it. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Production Efficiency • When competitive pressure on prices is carried to the limit, the products in questions are produced at the least possible cost. • Society is getting the most it can from its available (scarce) resources. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Zero Economic Profit • In the long-run, all economic profit is eliminated. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Summary of Competitive Process Market demand Price (dollars per unit) Industry ATC Industry MC Short-run equilibrium a c b Long-run equilibrium Quantity (units per time period) McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Relentless Profit Squeeze • The sequence of events common to a competitive market situation includes the following: • High prices and profits signal consumers’ demand for more output. • Economic profit attracts new suppliers. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Relentless Profit Squeeze • The market supply shifts to the right. • Prices slide down the market demand curve. • A new equilibrium is reached with increased quantities being produced and sold and the economic profit approaching zero. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Relentless Profit Squeeze • Throughout the process, producers experience great pressure to keep ahead of the profit squeeze by reducing costs. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Relentless Profit Squeeze • The potential threat of other firms expanding production or of new firms entering the industry keeps existing firms on their toes. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Competitive Markets End of Chapter 8 McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.