Chapter 6
COMPETITIVE MARKETS
1. Competitive Markets
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The invisible hand of Adam Smith
describes how an economy works when
there is competition among sellers and
competition among buyers.
The greatest degree of competition
exists when no single buyer or seller
has any control over price.
1.1 Perfect Competition
In perfect competition, the seller has absolutely no
control over price; each individual seller faces so
much competition from other sellers that the market
price is taken as given. (Perfect competition is a
market with many sellers, perfect information, a
homogeneous product, and freedom of entry.)
 When the price is given to the individual seller by the
market, the seller is said to be a price taker. (The
price taker has no control over the price.)
Price Taking and High Liquid Markets: Exxonmobil Ex.
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1.1 Perfect Competition cont
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Characteristics of perfect competition
resulting in price taking:
1.
2.
3.
4.
5.
The product’s price is the same for each buyer
and seller.
The product is homogeneous—one seller’s
product cannot be distinguished from another’s.
Buyers and sellers have perfect information
about prices and product qualities.
There are a large number of buyers and sellers.
There is complete freedom of entry into and exit
from the industry.
1.2 Monopolistic
Competition
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Monopolistic competition is a highly competitive
market that has all the characteristics of perfect
competition except for price uniformity (Characteristic
1) and product homogeneity (Characteristic 2).
Monopolistic competition allows each firm to have a
slightly differentiated product because of such factors
as location and costs of information.
Differentiation can be on the basis of location, price,
speed of service, or variety of styles or colors.
2. The Firm and the Market:
Perfect Competition
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In perfect competition, all firms in the
industry sell a homogeneous, or identical,
product.
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No firm has an advantage over other forms in terms of
quality, location or other product features.
No rational buyer will buy from Firm A if it charges a
higher price than Firm B.
In a perfect competitive market, buyers would know if
Firm B’s price was lower than Firm A’s price.
2. The Firm and the Market:
Perfect Competition - cont
The Demand Curve Facing the Perfectly
Competitive Firm Example
 The demand curve facing the perfectly
competitive firm is horizontal, or perfectly
elastic, at the market price.
 If the price-taking firm can sell all it wants at
the going market price, what prevents a
single firm from supplying the entire market?
Costs.
3. The Competitive Firm in
the Short Run
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In a perfectly competitive market, marginal
cost plays a major role in determining the
supply curve, which shows how much the
firm is willing to supply at different prices.
The firm’s supply behavior is the outcome of
three factors:
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Its marginal curve;
The horizontal demand curve facing the firm;
The desire to maximize profits or minimize losses.
3.1 Marginal Revenue
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Marginal revenue (MR) is the increase
in revenue brought about by increasing
output or sales by one unit.
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If MR exceeds MC, and extra unit of output
adds more to revenues than to cost.
Thus, MR > MC implies that the profits of
the firm can be increased, or its losses
reduced, by producing one more unit of
output.
3.1 Marginal Revenue cont
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Firms will look at the relationship
between MR and MC in making
decisions about how much output to
produce.
In the case of a perfect competitive
firm, marginal revenues is simply the
market price. MR = Price (P)
4. The Short-Run Supply
Curve
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In the short run, the firm’s objective is to
maximize profits or, if necessary, to minimize
losses.
Once the market price is set: the following
outcomes:
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The firm makes economic profits.
The economic profit is zero.
The firm stays in business but produces at a loss.
The firm shuts down temporarily and hopes for the price
to rise.
4. The Short-Run Supply
Curve – cont.
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Prices effect output decisions:
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At very low prices, the firm may have to shut
down.
At higher prices, it produces a positive amount
of output.
The quantity supplied at each price is
simply the firm’s profit-maximizing
output or its loss-minimizing output.
4. The Short-Run Supply
Curve – cont.
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Output will be pushed up to P = MC
Perfectly competitive firm, profitmaximizing level P = MC
Any output short of P = MC; too little is
produced.
Any output P < MC; too much is produced.
Competitive firms adjust output to P = MC
4. The Short-Run Supply
Curve – cont.
The Profit-Maximizing Firm Example
 If the price exceeds minimum ATC, the
firm can make an economic profit.
4. The Short-Run Supply
Curve – cont.
The Profitable Firm: Perfectly profitable firms
choose that level of output where P = MC, provided
price is greater than the minimum level of AVC.
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The Loss-Minimizing Firm: The market price is
not high enough for the firm to make an economic
profit.
The Loss-Minimizing Firm Example
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The Shutdown case: The shutdown rule: If
the firm’s price at all levels of output is less than
AVC, it minimizes its losses by shutting down.
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4.1 The Industry Supply
Curve
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The supply curve shows the output that
competitive firms are prepared to supply at
each price.
The profit-maximizing level of output
increases as the price increases.
In the short run, the market supply is the
horizontal summation of the supply curves of
each firm, which in turn are their MC curves
above minimum AVC.
4.2 Short-Run Equilibrium
The market equilibrium is achieved
when the market price equates the
market supply with the market demand.
Short-Run Equilibrium Example
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5. Long Run Adjustments
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The effect of economic profits on perfectly
competitive industries is felt primarily in the
long run, when new firms can enter the
industry and established firms can exit.
As competitive firms respond to economic
profits and losses, the industry short run
supply schedule shifts and prices change.
5.1 Economic Profit
Attracts Resources
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Economic profits equal revenues minus
opportunity costs.
Opportunity costs are the best alternatives
sacrificed by the business firm when it
engages in production.
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E.g. The best return that could be earned by the owner if
the owner’s money capital, labor, and managerial time
had been used elsewhere.
Economic losses are incurred when the return to the
resources used in the business firm is less than the
normal return they could earn in the next-best
alternative.
5.1 Economic Profit
Attracts Resources – cont.
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When economic profits are zero, the business
firm is earning a normal profit.
A normal profit requires a normal competitive
return on the resources used in the firm.
If economic profits continue, new firms enter
the industry. If there are economic losses,
some will exit from the industry.
Long-run equilibrium occurs when firms no
longer wish to enter or leave the industry.
5.2 Entry and Exit
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When economic profits are being made
in one industry, the resources used in
that industry are being used more
profitable than in other industries.
Why?
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The returns in other industries are part of the
opportunity costs of doing business in the first
industry.
New firms will be attracted to the more
successful industry and away from others.
5.2 Entry and Exit – cont.
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When economic losses are being made,
the resources used in that industry are
being used less profitable than in other
industries.
At any given time, there are sunset
industries experiencing economic losses
and sunrise industries earning economic
profits.
5.3 Characteristics of
Long-Run Equilibrium
Long-Run Equilibrium: Adjustments That Eliminate
Economic Profits Example
 The industry is brought to a long-run equilibrium by
entry in response to economic profits and exit due to
losses.
 Characteristics of long-run equilibrium:
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The firm operates at an efficient scale of operation. When P
= MC and P = ATC at the long-run equilibrium output, and
when MC intersects ATC at its minimum point, the perfectly
competitive firm is producing at the lowest average cost in
the long run.
6. Efficiency and Monopolistic Competition
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There is basis for distinguishing between the goods
and services of different sellers, even though there
may be a large number of sellers and freedom of
entry.
Product distinctions may be based on:
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The physical attributes of the product (one pair of shoes is
slightly different from other shoes);
Location (one dry cleaner is located more conveniently than
another);
Type of service (one film developer takes one hour, the other
one day);
Imagined differences (one brand of aspirin may be perceived
as being more effective than another).
6. Efficiency and Monopolistic Competition – cont.
Monopolistic Competition versus Perfect
Competition Example
 The perfectly competitive firm faces a
horizontal demand curve.
 The entry and exit of other firms ensures that
economic profits (and losses) will eventually
disappear, and that the perfectly competitive
firm will operate at minimum efficient scale
(minimum ATC) with a zero economic profit.
6. Efficiency and Monopolistic Competition – cont.
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Although monopolistic competitive industries also
tend toward a normal, or zero, economic profit in the
long run:
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They do not operate like their perfectly competitive
counterparts at minimum efficient scale of operation.
They tend to underutilize capacity by operating below
minimum efficient scale.
Freedom of entry causes monopolistic competitive
industries to more closely resemble perfect
competition in the very long run.
7. Policies to Promote
Competition
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Competitive industries produce output at
minimum efficient scale.
The entry and exit of firms push prices down
to yield only normal profits of firms.
(Economists have praised the virtues of
competition).
There are a number of policies that can be
pursued to increase the level of competition.
7.1 Removal of Trade
Barriers
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Countries can protest domestic firms by
imposing tariffs and other restrictions on
foreign competitors.
As these restrictions are removed:
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there are more suppliers to the domestic market,
competing more effectively with domestic firms;
it reduces prices to consumers and lowers costs of
production.
Are Mexican Trucks Unsafe? Example
7.2 Deregulation
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Deregulation is the elimination of government
controls over a firm’s prices, quantity and quality of
service.
The argument for deregulation is that , where the
potential for competition exists, it is better to have
professional managers make decisions about prices,
fares, and services rather than government
bureaucrats.
Deregulation has increased competition (Banks,
airlines and TV viewers example)
Deregulation has also revealed the consequences of
competition. Competition creates winners and losers.
7.3 Antitrust Laws
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Antitrust laws can set the legal rules of
the game for businesses.
They can:
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forbid certain types of anticompetitive
behavior (price fixing);
prohibit specific forms of markets (market
with only one supplier);
prevent mergers and other acts that
restrict competition.
7.4 Reducing Licensing
Restrictions and Work Rules
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Licensing agencies can lessen competition by
restricting entry into a business.
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Unions determine which individuals can perform
what tasks (plumbers cannot turn a screw or
hammer a nail).
Licensing agencies determine who can be a truck
driver, manicurist, or taxi driver.
Eliminating unneeded licensing restrictions
and work rules can help bolster competition.