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Chapter 9 Competitive Markets

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9.1 Market Structure and Firm Behaviour

The Significance of Market Structure
1. Understand behaviour of an individual firm 2. Evaluate overall efficiency of market outcomes In this chapter we focus on competitive market structures.

Firms:

max Profits = TR TC

Individual firm demand curve ! industry demand curve From the industry demand curve we can infer firms demand curve
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Different market structures

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Competitive Market Structure

The competitiveness of the market the influence that individual firms have on market prices. The less power an individual firm has to influence the market price, the more competitive is that markets structure. Zero market power: ! Extreme form of competitive market: perfectly competitive market ! Firms able to sell as much as they want at the prevailing price.
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Competitive Behaviour
The term competitive behaviour refers to the degree to which individual firms actively vie with one another for business. Examples: 1. GM and Toyota engage in competitive behaviour but their market is not competitive. 2. Two wheat farmers do not engage in competitive behaviour but they both exist in a very competitive market.

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9.2 The Theory of Perfect Competition

The Assumptions of Perfect Competition
1. All firms sell a homogeneous product. 2. Customers know the product and each firms price. 3. Each firm reaches its minimum LRAC at a level of output that is small relative to the industrys total output. 1, 2 and 3 imply that the firm is price taker. 4. Firms are free to exit and enter the industry.
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The Demand Curve for a Perfectly Competitive Firm

S
Price Price

D (Firm)

Quantity (Millions of Tonnes)

Quantity (Thousands of Tonnes)

Each firm in a perfectly competitive market faces a horizontal demand curve even though the industry demand curve is downward sloping.

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This does not mean the firm could actually sell an infinite amount at the market price. " Normal variations in the firms level of output have a negligible effect on total industry output.

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Why Small Firms Are Price Takers

Consider an individual wheat farmer and the world market for wheat: 1. Market elasticity of demand for wheat = 0.25. If price decreases 10%, quantity demanded increases 2.5% 2. 2009: total world production wheat = 650 millions tonnes 3. Canada: 20 000 wheat farms. Each 1200 tonnes. Each farm produces 0.0002% world wheat crop. 4. If a farmer increases production by 200%. The percentage increase in world output (2400/650 million) X 100 = 0.0004% ! worlds price decreases by 0.0016% 5. Farms own demand curve has an elasticity of 200/0.0016= 125 000, enormous!

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Review the following figure and answer the following questions: S

Price Price

D (Firm)

Quantity (Millions of Tonnes)

Quantity (Thousands of Tonnes)

1. Explain what would happen if the individual firm tried to charge a higher price for its product. 2. Explain why the individual firm has no incentive to charge a lower price for its product. 3. Explain why the demand curve for an individual firm is horizontal at the current market price.
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Total, Average, and Marginal Revenue

Total revenue (TR): TR = p x q Average revenue (AR): AR = (p x q)/q = p Marginal revenue (MR): MR = !TR/!q = p Note: For a perfectly competitive firm, AR = MR = p.
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Price 3 3 3 3

Quantity 10 11 12 13

TR = p x q 30 33 36 39

AR = TR/q 3 3 3 3

MR = !TR/!q 3 3 3

Dollars per Unit

Dollars

AR = MR = p

39 30

TR

Output

10

10 13 Output

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9.3 Short-Run Decisions

Should the Firm Produce at All?
If produces something ! fixed costs + variable costs If produces nothing ! fixed costs

The firm will not produce if: TVC of producing that output > TR of selling the outcome

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Should the Firm Produce at All? Table 9.1

Low price $2 Q 0 10 20 30 40 50 60 70 80 90 100 TVC 0 50 80 100 110 130 160 200 260 320 380 TFC 200 200 200 200 200 200 200 200 200 200 200 TC 200 250 280 300 310 330 360 400 460 520 580 TR 0 20 40 60 80 100 120 140 160 180 200 Profit -200 -230 -240 -240 -230 -230 -240 -260 -300 -340 -380 High price $5 TR 0 50 100 150 200 250 300 350 400 450 500 Profit -200 -200 -180 -150 -110 -80 -60 -50 -60 -70 -80

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Should the Firm Produce at All?

TVC of producing that output > TR of selling the outcome ! then the firm does not produce AVC > Market price !firm does not produce At the shut-down price the firm can just cover its average variable cost, and so is indifferent between producing and not producing.

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How Much Should the Firm Produce?

Suppose p > AVC " firm does not shut down When firm decides to increase production in 1 unit, then for each extra unit the firms has to contemplate: If MR>MC ! produce more q If MR=MC ! no incentive to change q If MR<MC ! produce less q

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How Much Should the Firm Produce?

Suppose p > AVC " firm does not shut down To maximize profits, the firm chooses the output where MR = MC. But for a competitive firm, MR = p: " The rule: choose output where p = MC.

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Profits if output is equal to q* Dollars

TC TR

The market determines the equilibrium price. The firm then picks the quantity of the output that maximizes its own profits.

q*

Output

When the firm has reached q*, it has no incentive to change its output.

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TR TC TR

If market price increases, then the firm picks a different quantity of the output that maximizes its own profits.

Dollars 0

q* q* Output

When the firm has reached q*, it has no incentive to change its output.

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MC

q*

Output

The market determines the equilibrium price. The firm then picks the quantity of the output that maximizes its own profits.

When the firm has reached q*, it has no incentive to change its output.

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Should the Firm Produce at All? " The rule: firm does not shut down if p>AVC How Much Should the Firm Produce? " The rule: choose output where p = MC.

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Short-Run Supply Curves

MC Dollars per Unit S=MC Price AVC p3 p2 p1 p0 p3 p2 p1 p0

q0 q1 q2q3

q0 q1 q2q3

Output

Output

A competitive firms supply curve is given by its marginal cost curve (at prices above AVC).

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A competitive industrys supply curve is the horizontal summation of the individual MC curves (above minimum of AVC curves).

Price

Price

SA = MCA

SB = MCB

Price

SA+B

3 2 1 2

3 2

3 2 1

4 Quantity

3 Quantity

7 Quantity

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Short-Run Equilibrium in a Competitive Market

When an industry is in short-run equilibrium, two things are true: - market price is such that the market clears - each firm is maximizing its profits at this price
MC S
Price Price

ATC

D (Firm)

Quantity (Millions of Tonnes)

Quantity (Thousands of Tonnes)

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Short-Run Equilibrium in a Competitive Market

When an industry is in short-run equilibrium, two things are true: - market price is such that the market clears - each firm is maximizing its profits at this price

But how large are each firms profits in this SR equilibrium? There are three possibilities:

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Short-Run Equilibrium in a Competitive Market

Profits= TR TC = (p x Q) (ATC x Q) = (p - ATC) x Q ! Profit per unit = p ATC But how large are each firms profits in this SR equilibrium? ! There are three possibilities: positive, negative or zero

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Case 1: Zero Economic Profits

MC Dollars per Unit ATC p

The typical firm is just covering its costs, p = ATC. There is zero economic profit.

q*

Output

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Case 2: Positive Economic Profits

MC ATC p

Typical firm maximizes profit at q*. Since p > ATC, the firm makes positive economic profits equal to the blue area.

q*

Output

Positive profits means that this firm is earning more than it could in its next best alternative venture.
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Case 3: Negative Profits (Losses)

ATC Dollars per Unit

MC AVC

The typical firm maximizes its profits by producing at q*. But if p < ATC, the firm suffers losses equal to the blue shaded area.

q*

Output

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9.4 Long-Run Decisions

Short-Run versus Long-Run Profit Maximization for a Competitive Firm
MC SRATC

In LR equilibrium, competitive firms produce at the minimum point on their LRAC curves. At q0, the firm is maximizing shortrun profits but not its long-run profits.
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Dollars per Unit

p0

Price LRAC

q0

qM

Output

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Minimum efficient scale (MES)

Dollars Per Unit MC SRATC LRAC

q0

Output

In LR competitive equilibrium, each firms average cost of production is the lowest attainable, given the limits of known technology and factor prices.
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Entry and Exit

If existing firms have positive economic profits, new firms have an incentive to enter the industry.

If existing firms have zero profits, there are no incentives for new firms to enter, and no incentives for existing firms to exit.

If existing firms have economic losses, there is an incentive for existing firms to exit the industry.

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Example suppose there are positive profits at initial SR equilibrium: S0 Price S1 E0 E1 D 3. Positive profits are eroded.
Q0 Q1

1. Positive profits attract new firms. 2. Entry leads to an increase in supply and a decline in price.

p0 p1

Quantity
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How about positive profits, and entry?

MC p0 p1 ATC

q1q0

Output

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How about negative profits, and exit?

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Long-Run Equilibrium
The LR industry equilibrium occurs when there is no longer any incentive for entry or exit (or expansion). In long-run equilibrium, all existing firms: must be maximizing their profits. are earning zero economic profits. are at the minimum point of its LRAC: are not able to increase their profits by changing the size of their production facilities.

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Changes in Technology
1. Market with firms where p = ATC, profits = 0. 2. New firms enter the market. Technological developments reduce the costs for newly build plants. 3. Expand industry output and drive down price: p = ATC new firms. 4. At this price old plants will not cover long-run costs. 5. If p > AVC, they will still produce, otherwise they will exit. 6. Eventually, new long-run equilibrium: market price will be lower and output higher than under the old technology

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Continuous technological change

1. Plants of different ages and with different costs exist side by side. 2. Price governed by the minimum ATC of the lowest-cost plants. 3. Old plants are discarded when the p < AVCs.

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Plant 1: High Cost MC SRATC Dollars per Unit AVC1 Plant 3: Low Cost Dollars per Unit SRATC p MC AVC3

q1

Output

Plant 2: Medium Cost SRATC Dollars per Unit MC AVC2

q3

Output

q2

Output
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Klepper and Simons (2005), IJIO

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Declining Industries
What happens when a competitive industry in LR equilibrium experiences a continual decrease in demand? The response of firms The efficient response is to continue operating with existing equipment as long as variable costs of production can be covered. Antiquated equipment in a declining industry is often the effect rather than the cause of the industrys decline.

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Declining Industries
What happens when a competitive industry in LR equilibrium experiences a continual decrease in demand? The response of governments Governments are often tempted to support declining industries because they are worried about the resulting job losses. Intervention that is intended to increase mobility while reducing the social and personal costs of mobility is a viable long-run policy; trying to freeze the existing industrial structure by shoring up an inevitably declining industry is not.
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The Long-Run Industry Supply Curve

Consider a competitive industry that is in long-run equilibrium. Now suppose that the market demand for the industrys product increases The price will rise, and profits will rise. Entry will then occur, and price will eventually fall. But what will happen to the LRAC? What will the new long-run equilibrium look like?

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The Long-Run Industry Supply Curve

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