Chapter 9 Competitive Markets PDF

1 of 31 Chapter 9 Competitive Markets Copyright © 2008 Pearson Education Canada  2 of 31 In this chapter you will learn 1. the key assumptions of the theory of perfect competition. 2. how to derive a competitive f...

1 of 31 Chapter 9 Competitive Markets Copyright © 2008 Pearson Education Canada  2 of 31 In this chapter you will learn 1. the key assumptions of the theory of perfect competition. 2. how to derive a competitive firm’s supply curve. 3. to determine whether competitive firms are making profits or losses in the short run. 4. the role played by profits, entry, and exit in a competitive industry’s long-run equilibrium. Copyright © 2008 Pearson Education Canada  3 of 31 9.1 MARKET STRUCTURE AND FIRM BEHAVIOUR 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 market’s structure. Copyright © 2008 Pearson Education Canada  4 of 31 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. Copyright © 2008 Pearson Education Canada  5 of 31 The Significance of Market Structure The demand curve faced by an individual firm may be different from the demand curve for the industry as a whole. Market structure plays a central role in determining the efficiency of the market. In this chapter we focus on competitive market structures. Copyright © 2008 Pearson Education Canada  6 of 31 9.2 THE THEORY OF PERFECT COMPETITIO The Assumptions of Perfect Competition 1. All firms sell a homogeneous product. 2. Customers know the product and each firm’s price. 3. Each firm reaches its minimum LRAC at a level of output that is small relative to the industry’s total output. 4. Firms are free to exit and enter the industry. Copyright © 2008 Pearson Education Canada  7 of 31 The Demand Curve for a Perfectly Competitive Firm S Price Price D (Firm) D 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. Copyright © 2008 Pearson Education Canada  8 of 31 This does not mean the firm could actually sell an infinite amount at the market price.  “Normal” variations in the firm’s level of output have a negligible effect on total industry output. APPLYING ECONOMIC CONCEPTS 9-1 Demand Under Perfect Competition: Firm and Industry Copyright © 2008 Pearson Education Canada  9 of 31 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. Copyright © 2008 Pearson Education Canada  10 of 31 Price Quantity TR = p x q AR = TR/q MR = TR/q 3 10 30 3 3 3 11 33 3 3 3 12 36 3 3 3 13 39 3 TR 39 Dollar Dollars per AR = MR = p 30 s 3 Unit 10 10 13 Output Output Copyright © 2008 Pearson Education Canada  11 of 31 9.3 SHORT-RUN DECISIONS Rules for All Profit-Maximizing Firms Should the Firm Produce at All? A firm should produce only if at some level of output, price exceeds AVC. MC AVC Dollars per unit p = MR = AR q* Output Copyright © 2008 Pearson Education Canada  12 of 31 At the shut-down price the firm can just cover its average variable cost, and so is indifferent between producing and not producing. 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. Copyright © 2008 Pearson Education Canada  13 of 31 TC Profits if output is TR equal to q* The market determines the equilibrium price. Dollars The firm then picks the quantity of the output that maximizes its own profits. 0 q* Output When the firm has reached q*, it has no incentive to change its output. Copyright © 2008 Pearson Education Canada  14 of 31 Short-Run Supply Curves MC S = MC p3 p3 Dollars per Unit AVC p2 p2 Price p1 p1 p0 p0 q0 q1 q2 q3 q0 q1 q2 q3 Output Output A competitive firm’s supply curve is given by its marginal cost curve (at prices above AVC). Copyright © 2008 Pearson Education Canada  15 of 31 Price Price Price SA = MCA SB = MCB SA+B 3 3 3 2 2 2 1 1 2 4 3 2 7 Quantity Quantity Quantity A competitive industry’s supply curve is the horizontal summation of the individual MC curves (above minimum of AVC curves). Copyright © 2008 Pearson Education Canada  16 of 31 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 firm’s profits in this SR equilibrium? There are three possibilities: Copyright © 2008 Pearson Education Canada  17 of 31 Case 1: Zero (Economic) Profits MC The typical firm is ATC just covering its costs, p = ATC. Dollars per p Unit There is zero q* Output economic profit. Copyright © 2008 Pearson Education Canada  18 of 31 Case 2: Positive (Economic) Profits MC Typical firm maximizes profit at q*. ATC Dollars per p Since p > ATC, the firm makes positive Unit economic profits equal q* Output to the blue area. Positive profits means that this firm is earning more than it could in its next best alternative venture. Copyright © 2008 Pearson Education Canada  19 of 31 Case 3: Negative Profits (Losses) The typical firm MC maximizes its profits by ATC AVC producing at q*. Dollars per p But if p < ATC, the firm Unit suffers losses equal to q* Output the blue shaded area. Copyright © 2008 Pearson Education Canada  20 of 31 A firm that is maximizing its profit but still making losses is actually minimizing its losses. To see a detailed numerical example of a firm in such a situation, look for “An Example of Loss Minimization as Profit Maximization” in the Additional Topics section of this book’s MyEconLab. www.myeconlab.com APPLYING ECONOMIC CONCEPTS 9-2 The Parable of the Seaside Inn Copyright © 2008 Pearson Education Canada  21 of 31 9.4 LONG-RUN DECISIONS 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. Copyright © 2008 Pearson Education Canada  22 of 31 Example — suppose there are positive profits at initial SR equilibrium: S0 1. Positive profits Price S1 attract new firms. E0 p0 2. Entry leads to an p1 increase in supply E1 and a decline in price. D 3. Positive profits are eroded. Q0 Q1 Quantity Copyright © 2008 Pearson Education Canada  23 of 31 Long-Run Equilibrium The LR industry equilibrium occurs when there is no longer 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 not able to increase their profits by changing the size of their production facilities. Copyright © 2008 Pearson Education Canada  24 of 31 In LR equilibrium, competitive firms Dollars per Unit MC produce at the SRATC minimum point on their LRAC curves. Price p0 LRAC At q0, the firm is maximizing short- q0 qM run profits but not Output long-run profits. Copyright © 2008 Pearson Education Canada  25 of 31 Minimum Efficient Scale (MES) Dollar Per Unit MC SRATC LRAC p q0 Output In LR competitive equilibrium, each firm’s average cost of production is the lowest attainable, given the limits of known technology and factor prices. Copyright © 2008 Pearson Education Canada  26 of 31 Consider a competitive industry that is in long-run equilibrium. Now suppose that the market demand for the industry’s product increases. The price will rise, and profits will rise. Entry will then occur, and price will eventually fall. But what will the new long-run equilibrium look like? Copyright © 2008 Pearson Education Canada  27 of 31 Demand shocks in competitive industries naturally lead to price changes. As prices change, firms’ profits rise or fall, and these adjustments cause entry to or exit from the industry. After a new long-run equilibrium is reached, will the market price be at its initial level? The answer depends on the nature of costs within the industry. For more details, look for “The Long-Run Industry Supply Curve”, in the Additional Topics section of this book’s MyEconLab. www.myeconlab.com Copyright © 2008 Pearson Education Canada  28 of 31 Changes in Technology Suppose technological development reduces the costs for newly built plants. New plants will earn economic profits, expand industry output and drive down price. The price will fall until it is equal to the SRATC of the new plants. Old plants may continue, but will earn losses. They will eventually exit. Copyright © 2008 Pearson Education Canada  29 of 31 Plant 1: High Cost SRATC MC AVC1 Dollars per p Plant 3: Low Cost Unit MC SRATC q1 Output AVC3 Dollars per Plant 2: Medium Cost p Unit SRATC MC q3 Output AVC2 Dollars per p Unit q2 Output Copyright © 2008 Pearson Education Canada  30 of 31 Declining Industries What happens when a competitive industry in LR equilibrium experiences a continual decrease in demand? The efficient response is to continue operating with existing equipment as long as its variable costs of production can be covered. As demand shrinks, so will capacity. Antiquated equipment in a declining industry is often the effect rather than the cause of the industry’s decline. Copyright © 2008 Pearson Education Canada  31 of 31 Copyright © 2008 Pearson Education Canada