Unit 2: Microeconomics:
Understanding the
Canadian Market Economy
Chapter 4: Demand and Supply
Chapter 5: Applications of Demand and Supply
Chapter 6: Business Organization and Finance
Chapter 7: Production, Firms, and the Market
Chapter 8: Resource Economics: The Case of Labour Economics
Chapter 7: Production, Firms,
and the Market
• Overview
• Determining how much to produce of a product and
the best way to do it
• The role that profit plays in a market
• The nature and importance of productivity and
efficiency
• The nature and importance of competition in different
markets
• The forms and importance of market regulation
• Analyzing proposals to change the way in which goods
and services are provided
How to Produce
• The function of any economic system is to provide
goods and services to satisfy wants and needs
• In Chapter 2, we learned that all economic systems
must answer three basic production questions in
order to achieve this goal
• What to produce?
• How to produce
• For whom to produce?
How to Produce
• Our comic kingdom illustrates how these questions are
answered in a command economy
• An economy directed by a central governing body
• The central authority is the King, who owns and controls
all productive resources
• He speaks of “my fields” and “my shops” and he can
command his workers to do everything from “[die] in my
battles” to “take tomorrow off ”
• Although markets exist where goods may be purchased for a
price, consumers in the Kingdom of Id have little market
power because their choices are limited, and His Majesty sets
the prices
How to Produce
• All real systems have elements of this comic kingdom’s
economy
• For example, Canada’s governments own:
• Productive economic resources (such as crown land)
• Rights to natural resources
• Public infrastructure (including most roads and public
buildings)
• The three levels of government provide a wide variety of
public goods and services, such as education
How to Produce
• However, more differences than
similarities exist between
Canada’s and Id’s economic
systems
• Primarily, the Canadian economy
is a market economy – one largely
determined by free competition
among businesses
• Private companies play a very
large role in the production and
sale of goods and services in
Canada
How to Produce
• The Canadian government does take part by
providing services funded by taxes
• If Canadians decide that the prices (i.e. the taxes
they pay) are too high, they can always elect a new
government that promises lower taxes
How to Produce
• No Canadian prime minister
has the King of Id’s power to
determine what people will
do, what goods and services
are produced, and what
price will be paid for them
• The prime minister also
doesn’t have the power to
make a profit
• Canada does have a monarch
(The Queen of England) but
the power she wields is
purely symbolic
Table 7.1: Canada’s Gross Domestic Product (in millions of dollars)
1997
1998
1999
2000
2001
Real GDP
885,022
919,770
966,362
1,009,182
1,024,196
Government
Expenditure
171,183
174,947
179,555
183,562
187,634
How to Produce
• Figure 7.1 shows the real and relative value of the goods and
services provided by the Canadian government
• Real Gross Domestic Product (GDP) is a measure of the total
value of goods and services produced by the Canadian economy
in a year, taking into account the influence of price changes
• This figure includes the goods and services produced by private
industry for both national consumption and export
• GDP also includes everything that the government produces
• This can be measured by looking at how much the government
spends in a given year, called government expenditure
How to Produce
• The data in this figure indicates that government produces
nearly 20% of the total value of goods and services produced
by the economy
• Who provides the rest?
• The answer is a wide variety of firms that vary in size, from
large to small, and vary in legal form, from small sole
proprietorships to large corporations and co-operatives
• These commercial enterprises make up the private sector
• Some firms provide goods and services to other companies,
while many others provide goods and services to consumers
• Some produce primarily for export while others sell mostly to
Canadians
How to Produce
• Sometimes businesses behave unethically and seek to
benefit their board managers and top executives
• However, most firms seek to make a profit to benefit
the shareholders who own them and to stay in business
• In a market economy, it is a multitude of private
firms (not a king’s court) that answers the basic
economic question “How will we produce?”
How to Produce
• Canadians, through their governments, create laws to
define, limit, and protect the process of producing
• Our society has taken action to give individuals within firms
the power to make most of the production decisions
• In Canada, private firms largely determine how our
scarce economic resources will be developed and used to
meet Canadian’s needs
Origins of the Firm
•
Where did the structure known as
the firm come from?
•
At one time all people hunted,
fished, or gathered their food and
were self-sufficient
•
Eventually humans learned to
grow their own food, which led to
trading
•
Trading led to the invention of
money, a necessary ingredient of
the firm, and people could hire
others for a wage or invest in other
people’s enterprises
Origins of the Firm
• Eventually firms got bigger and bigger when:
• People figured out the benefits of the division of labour
• Individual workers specialized in the various tasks required
to produce a good
• They learned to build machinery that made large-scale
production possible
• What is the goal of the firm?
• Its primary goal is to create profit
• Its role is to create the goods and services that society
needs
How Firms Think: Calculating
Profit
• Firms can’t think or have goals
• It’s the people within firms that make economic decisions about
what and how much to produce as well as about how to do it,
all with the principal goal of helping the firm make a profit
• In a small firm, one person may make all the decisions
• In a large firm, decision making is delegated to a small group
of executive managers with specialized training and experience
• One manager may handle suppliers while another oversees the
delivery of finished goods
• This illustrates Adam Smith’s division of labour in the realm of
decision making, leading to better decisions and greater
productivity
How Firms Think: Calculating
Profit
•
Firms may make decisions for a wide
variety of reasons, but all decisions
should take into account the “bottom
line”
• This expression originally referred to the
last line of an accounting sheet
• Shows whether a firm is taking a loss or
earning an accounting profit
•
Accounting profit is what we usually
think of and refer to simply as profit,
that is, the excess of revenues over costs
•
Most firms attempt to maximize profit
• All must ultimately break even
How Firms Think: Calculating
Profit
• Profits are beneficial to a business’s success for many
reasons
• For producers, profits act as an incentive and a reward
for the work they do and the risks they take
• Profits are the producer’s least expensive source of
money for expanding or improving production
• Producers also use profits to evaluate how well their
firm is doing by comparing theirs with those of their
competitors
How Firms Think: Calculating
Profit
• Producers pay close attention to which of their
product lines are selling the most and making the
most profit
• They may shift resources to increase the production of
goods and services that clearly meet the most urgent
demands
• As a result, consumer choice improves along with the
company’s profitability
How Firms Think: Calculating
Profit
• High profits also allow privately owned companies to pay
dividends to their shareholders
• Many shares in companies are owned by:
• Pension funds
• Insurance companies (which invest premiums for eventual
payment on claims)
• Individuals purchasing stocks or mutual funds through their
retirement savings plans
• When companies make profits, many people within the
community benefit because their savings grow
Theory of the Firm
• To understand how firms make decisions, we must
analyze the relationship between profits, revenues,
and costs
• This is referred to as the Theory of the Firm
• This theory assumes that producers are all profit
maximizers
• Adam Smith’s “invisible hand” of self-interest leads
them to increase their revenues and decrease their costs
in order to increase their profits
Theory of the Firm
• This theory seems quite simple, and it is!
• If we return to the Kingdom of Id, which of the 5
products at the beach would you choose to sell?
• Obviously you would choose the one that you thought
would be the most profitable
• The Theory of the Firm (i.e. the relationship
between profits, revenues, and costs) can be
expressed in the simple equation of accounting
profit:
Total profit = total revenues – total costs
Total Revenue
• Total revenue refers to the money a firm receives from its
sales
• Only two factors influence how much total revenue will
be:
• The price firms decide to charge
• The quantity firms can sell at that price
• This can be placed in our equation showing the
relationship between profits, revenues, and costs:
Total profit = (price X quantity sold) – total costs
Total Revenue
• To be profitable, a firm must maximize its revenues
• Before launching a new product, a firm’s economic
decision makers gather information from markets about
how many people would probably purchase the
potential product and at what price
• i.e. they must determine the demand for the product
• At the beach in the Kingdom of Id, which of the 5
products do you think would be in highest demand?
• It is highly likely that sunburn ointment would be in
highest demand
Total Costs
• Higher priced products don’t necessarily mean
greater profit
• A higher price may simply reflect a higher cost of
production
• A high price may also discourage sales
• To determine profitability, firms must gather
information about the necessary costs
Total Costs
• A firm’s total cost of production refers to the money
the firm spends to purchase the productive resources
it needs to produce its good or service
• This money includes all payments a firm must make to
its suppliers, employees, landlords, bankers, and so on
• When economists analyze the production decisions
of firms, they divide cost into two categories
Total Costs
Fixed Costs
Variable Costs
Must be paid and remain the same
whether or not production occurs
Vary with the level of production.
They tend to rise with an increase
in production and fall with a
decrease in production
Include such items as:
• Lease payments or rent for
premises
• Loan payments to a bank or
lending institution
• Property taxes
• Payment of insurance premiums
• Cost of security
Includes such items as:
• Wages or salaries paid to labour
• Costs of raw materials or
inventory
• Cost of electricity used for
productive purposes
• Costs of fuel, power, and
transportation
Total Costs
• This can be placed in our equation showing the
relationship between profits, revenues, and costs:
Total profit = (price X quantity sold) – (fixed +
variable costs)
• After determining revenue and costs, we can
calculate potential profits
• This calculation can sometimes hold surprises (see
Table 7.3) and can definitely influence a firm’s business
decisions
Table 7.3: Information about the five businesses of the King of Id
Business
Selling Price
Total Sold
Total Costs of
Goods Sold
Leg casts
$50.00
10
$300
Rubbing
liniment
$12.00
5
$5
First aid kits
$28.95
25
$400
Resuscitator
$70.00
2
$130
Sunburn
ointment
$25.00
50
$1000
Calculate the profit made by each of the king’s businesses.
Why was the sunburn ointment not the most profitable?
The Short Run and the Long
Run
• When assessing the overall
costs of a business,
economists consider both
the short run and the long
run
• The costs of some
resources, such as labour,
fuel, and raw materials, are
relatively flexible and can be
adjusted very quickly
The Short Run
• Period over which the firm’s maximum capacity becomes
fixed because of a shortage of at least one resource
• Ex: A printing company has purchased enough paper to
keep its printing presses running at 80% capacity
• Suddenly it gets a new contract that requires it to expand
production immediately
• If it is able to acquire the additional paper it needs, the paper
is a short-run, or variable cost and doesn’t limit the firm’s
ability to expand production
The Short Run
• Some resources can’t be quickly increased
• Ex: If the new contract was for a huge job, the printing
company might have to build and addition to its factory
to handle it
• This change couldn’t be accomplished quickly, so the
company would be unable to accept the order
• Its ability to produce is limited, or fixed, by the size of
its plant
• The length of the company’s short run would be
defined by the length of time it would need to build an
extension to its plant so that production could increase
The Long Run
• Period when all costs become variable
• Over the long run, a firm will be able to adjust not only its
labour, fuel, and raw material, but also its plant or factory
facilities
• In a firm’s long run, there are no fixed costs of production
• All costs become variable, from staffing to location
• The long run is considered the planning period when the firm
has enough time to:
• Enlarge its productive capacity
• Shift production to generate other goods or services
• If necessary, shut down completely
The Long Run
• The long run is considered the planning period when
the firm has enough time to:
• Enlarge its productive capacity
• Shift production to generate other goods or services
• If necessary, shut down completely
The Short Run and the Long
Run
• The long-run and short-run periods are not measured in a fixed
number of days, months, or years
• The periods are different for various firms
• Ex: When executives at the Honda car plant in Alliston,
Ontario, realized the plant was operating at capacity, they
decided to expand. The years it took to build the new facility
and add new production and assembly lines constituted
Honda’s long run
• Ex: When a small textile firm operating in downtown
Vancouver found that it was near plant capacity, it found more
space nearby and stocked it with more sewing machines in a
matter of weeks. These weeks constituted the long run for that
firm
Marginal Revenue and
Marginal Cost
• When determining how to maximize profits,
economists must try to determine the exact
production level that will result in the most profit
• These detailed calculations nearly always involve a
consideration of the costs and benefits of making small
changes in production
Marginal Revenue and
Marginal Cost
• If a firm wishes to maximize its profit, it should always
produce up to the point at which there is no added benefit
(profit) from producing any more
• It should keep producing to the point at which the
marginal cost (additional cost) of producing one more
unit equals the marginal revenue (additional revenue)
received from the unit’s sale
• At the point when the marginal cost exceeds the marginal
revenue that results from producing one more unit, the
firm would waste resources and reduce its profit
Marginal Revenue and
Marginal Cost
• Let’s consider an example of a dairy that specializes
in goat cheese
• The dairy is located near a dozen goat famers, which
regularly supply it with the goats’ milk it requires to
make cheese
• If the dairy decides to increase production, it would
have to transport the additional milk from another area,
requiring a sharp increase in transportation costs
• If the additional revenue to be had from producing
more goat cheese doesn’t exceed the additional costs,
the dairy will have no incentive to produce more
Marginal Revenue and
Marginal Cost
• A firm will maximize its profit by producing up to
the point at which its marginal revenue equals its
marginal cost
• The following equation sums up this concept:
Marginal revenue = marginal cost
Marginal Revenue and
Marginal Cost
• The King of Id’s rubbing liniment offers an example
of the value of marginal analysis
• Table 7.3 indicated that, at a price of $12, the firm sold
5 units that cost a total of $5 to produce
• That’s an impressive $11 profit per unit sold (for a total
of $55 profit), but so few units were sold at that price
that only the resuscitators produced less total profit
($10), which is what really counts
• Perhaps the King of Id forgot the law of demand and
set his prices too high
Marginal Revenue and
Marginal Cost
• Let’s say the King decides to reassess what he’s charging for
rubbing liniment
• We’ll assume cost of production stays at $1 per bottle and that
the King could sell one more bottle for each dollar reduction in
price
• What price should he charge, and how many units should he
produce to maximize his profit?
• The King uses marginal analysis
• He knows his marginal cost will always be $1, so he needs only
to calculate the marginal revenue he would earn from each
additional sale
• He can then see at which point his marginal cost would equal
his marginal revenue
Table 7.4: The King of Id’s marginal analysis
Price
Units of Rubbing
Liniment Sold
Total Revenue
Marginal Revenue
(revenue for additional
unit)
$12
5
$12 X 5 = $60
-
$11
6
$11 X 6 = $66
$66 - $60 = $6
$10
7
$10 X 7 = $70
$70 - $66 = $4
$9
8
$9 X 8 = $72
$72 - $70 = $2
$8
9
$8 X 9 = $72
$72 - $72 = $0
At which price level does the marginal revenue no longer exceed
the marginal cost of $1?
Marginal Revenue and
Marginal Cost
• From his marginal analysis, the King can tell he will
maximize his profit by reducing his price to $9 and
selling 8 units
• This will allow him to maximize his total profit at $64
rather than the $55 he received when he charged $12
• The lower price will also please consumers, who
now purchase more
Marginal Revenue and
Marginal Cost
• An even lower price would please more consumers,
but the King would never sell at this price because
his analysis indicates there is no incentive for him to
do so
• If he charged $8, his total revenues would not increase
and he would have to pay an additional dollar in costs
to produce the extra unit
• His total profits would fall from $64 to $63
Table 7.5: Confirming the King of Id’s marginal analysis conclusions
Price
Total Cost
Total Profit (revenue –
costs)
$12
$1 X 5 = $5
$60 - $5 = $55
$11
$1 X 6 = $6
$66 - $6 = $60
$10
$1 X 7 = $7
$70 - $7 = $63
$9
$1 X 8 = $8
$72 - $8 = $64
$8
$1 X 9 = $9
$72 - $9 = $63
Do the data in this table confirm the price level you decided
would maximize profits?
Making Production Choices:
Costs of Production
• Many firms have little
control over the total
revenue they receive in a
market
• Consumer demand plays a
major role in determining
market price and total sales
(the two factors that
determine total revenue)
• Competition also
contributes to control of
revenue
Controlling the Costs of
Production
• Instead of attempting to control revenue, firms tend
to focus their efforts on controlling the costs of
production
• The firm that is able to produce the desired product at
the lowest possible cost has the best chance of
maximizing profits
• This is why productivity (maximizing the output from
the resources used) and efficiency (producing at the
lowest possible cost) are of such importance to a firm
Controlling the Costs of
Production
• Output per worker is the most
common measure of productivity
• A great many factors influence
productivity
• The skills, education, and experience
of the workforce
• The quantity and quality of the
resources with which labour works
• A factory with constantly breaking
down machinery will produce less
than a factory with state-of-the-art
machinery
• How the work is organized
Controlling the Costs of
Production
• When a firm improves its productivity (and not its costs)
it can produce more goods and services for the same cost
• Consequently, it can offer its goods or services at a lower
price, making the firm more competitive
• The same equation applies to an economy
• When an economy becomes more productive, it can produce
more for the same cost and can, therefore, offer its goods and
services to other countries for a lower price
• Increased productivity results in increased competitiveness
Controlling the Costs of
Production
• Cost per unit produced and unit labour cost are the most
common measures of efficiency when applied to either a
firm or an economy
• Cost per unit takes into account all costs entailed in creating
a product
• Unit labour cost measures only the cost of labour involved
in producing one unit
• These measures of efficiency help us gauge
competitiveness in the local, national, and global markets
• A firm or economy becomes more efficient when its
productivity is increasing faster than its costs of production
Table 7.6: Measures of efficiency in Canada’s business sector (shown as
percentage change from the previous year)
Year
Labour
Productivity (%)
Hourly
Compensation (%)
Unit Labor Cost
(%)
1997
+2.5
+4.7
+2.0
1998
+2.1
+3.9
+1.7
1999
+2.5
+2.0
-0.4
2000
+1.5
+4.2
+2.6
When did increases in labour productivity actually outpace
increases in labour costs?
Controlling the Costs of
Production
• Table 7.6 shows how labour productivity and hourly
compensation affect the unit labour cost, as demonstrated
in Canada’s business sector
• The data indicate that, while average productivity was
increasing each year, average hourly compensation paid to
labour increased more rapidly, with the exception of 1999
• As a result, unit labour cost (the cost of producing the
average unit of output) went up
• In other words, efficiency declined
• If the efficiency of the firm decreases, or if the efficiency of
its competitors improves, the firm will be at a competitive
disadvantage
Controlling the Costs of
Production
• Many Canadian businesses compete in a global
marketplace
• If unit labour costs in other countries are decreasing
faster than they are in Canada (or at least increasing at
a slower rate), then Canada will be less competitive
internationally and will lose both sales and profits
Controlling the Costs of
Production
• Competitiveness is ultimately determined market by
market and company by company
• Ex: Bombardier, a Canadian aerospace company, is one
of the largest producers of transportation vehicles in
the world. It would be in trouble if its competitors
production efficiency improved more rapidly than its
own. Its international sales and profits would slump if
its competitors’’ unit labour costs decreased more, or
increased less, than its own
Choosing Production Methods
• With the goal of keeping production costs to a
minimum, firms will try to produce goods or
services in a way that makes the most productive use
of available resources
• This combination will vary among countries, regions,
industries, and individual firms, depending on the
available resources
• Firms will choose resources and mix them in a way
that will result in the most efficient method of
production
• Ex: Producers may use parts supplied by another
company instead of producing all parts themselves
Choosing Production Methods
• Many factors influence the
choices made in production
• In the medieval times of
Europe most production was
carried out in a labourintensive fashion
• Most work was conducted by
hand
• People worked in small shops
or in their homes so this
approach is called the cottage
system of production
Choosing Production Methods
• This system made economic sense because it was the
most efficient way to produce
• Labour was plentiful and cheap
• The market was usually a small local one
• Neither technology nor large sums of capital existed to
do it any other way
• Most of the costs of production were variable costs
that could be adjusted easily to meet demand
• Fixed costs were extremely low
Choosing Production Methods
• The Industrial Revolution began
in the 18th century with the
development of new
technologies
• Entrepreneurs created large
pools of investment capital,
which they invested in a new
form of business called joint
stock company
• These firms were owned jointly
by a large number of
individuals according to the
number of shares of stock they
have purchased
Choosing Production Methods
• Transportation improved, trade became more certain,
and populations and markets grew
• Workers flowed from their rural cottages to the rapidly
developing urban centres, where work became centralized
in large factories with machinery
Choosing Production Methods
• Labour-intensive production gave way to the capitalintensive production of the factory system
• This development made economic sense because the capital
investment in buildings and machinery made the labour force
more productive and the production process more efficient
• The drawback to switching to capital-intensive
production was a sharp increase in fixed costs relative to
variable costs
• It became difficult to increase production in a boom or
decrease costs in bad times
• Financial risks grew, but so did the potential for profit,
thanks to economies of scale
Choosing Production Methods
• Economies of scale refers to
the greater efficiency that
some firms can achieve when
they produce a very large
amount of output
• While some firms may
become less efficient owing to
the law of diminishing
returns, others may see their
cost per unit drop sharply as
output increases
Choosing Production Methods
• This is particularly true for firms that produce in a
capital-intensive way
• This method of production has high fixed costs and
lower variable costs
• Increasing output allows a firm to spread its fixed costs
over the increasing number of units produced
• Ex: A firm produces 200 units per month. If it pays
$2000 per month to rent its premises, the rental cost per
unit is $10. If the company could increase production
to 400 units per month, the rental cost per unit would
drop to $5
Choosing Production Methods
• Other benefits are derived from the greater
specialization of labour that is possible in a large
staff
• Large firms also have more market power to
negotiate better prices from their suppliers
Choosing Production Methods
• Firms in the private sector largely determine the
economic question of “How do we produce?” in a
market economy
• The decision-making process involves the artful
acquisition and balancing of economic resources
whose prices have been determined by resource
markets
• Resources must be blended and organized to avoid
diminishing returns and maximize productivity at
the lowest possible cost
Firms, Competition, and the
Market
• Firms in the private sector consider many factors in
determining the business strategies that will best
serve their self-interest
• Financial considerations related to profitability
motivate all firms
• However, the ultimate purpose of all economic
activity is not the profit of individual firm but the
satisfaction of consumer needs
• In this larger picture, both firms and profits are means
to an end, not ends in themselves
Firms, Competition, and the
Market
• In Canada, we rely mainly on private firms operating in
markets to produce the goods and services we need
• A market is a group of buyers and sellers of particular goods
or services
• We rely mainly on competition among producers to
create choices for consumers and to keep prices down
within markets
• Competition is the primary mechanism that ensures firms
remain accountable to consumers as well as their managers
and shareholders
Firms, Competition, and the
Market
•
Firms compete against one another
in many ways
•
Price competition
• A lower price will increase the sale of
most products
•
Non-price competition
• Involves changing anything but price
• Ex: Firms compete on the basis of
quality
• Which firm offers the best-built good
or delivers the most complete and
timely service? Which one offers the
best warranty, the latest style, the best
location, or most convenient care?
Firms, Competition, and the
Market
• The competition for customers
among firms in the market
encourages the supply of good
products at low prices
• It also encourages firms to use
their resources to produce new
and better products and do so
more efficiently
• However, not all markets are
the same and there are some
that have little competition or
choice for consumers
Market Structure
• What factors influence the production decisions of
large corporations?
• Do the same factors affect the decisions of a small
restaurant in a rural area?
• Clearly a large corporation and a rural restaurant
operate in different market structures
• The structure of the industry or market in which a firm
operates influences its decisions regarding price and
output
Market Structure
• The five factors that help determine market structure
are:
The number and size of firms in the market
The degree to which competitors’ products are similar
A firm’s control over price
The ease with which firms can enter or leave the
market
• The amount of non-price competition
•
•
•
•
Market Structure
• Most markets and industries can be classified into
one of four basic market structures
•
•
•
•
Perfect competition
Monopolistic competition
Oligopoly
Monopoly
Market Structure
• Perfect competition and monopoly represent
opposite poles of the market spectrum
• Monopolistic competition and oligopoly represent
benchmarks along this spectrum and characterize
conditions faced by most firms in the Canadian
economy
Market Structure
Perfect Competition
• Perfect competition is
characterized by many
producers and a uniform
product
• Ex: Suppliers of
agricultural goods operate
in such a market
• A perfectly competitive
market is distinguished by
five main characteristics
Perfect Competition
• There are many buyers and sellers in the market
• There are so many sellers that individual firms have no
control over total market supply
• All the firms sell a standardized product
• Imagine a very long country road along which every
second farmer has a stand selling the same produce:
corn peaches, and apples
Perfect Competition
• Producers must accept the market equilibrium price for
their product
• They can sell as much or as little as they choose at that price
without changing it
• They are price takers (they must take the market price)
because individually they have no impact on total supply
• It is relatively easy to enter and exit the market
• The start-up costs or the costs of leaving are not so great as
to prevent firms from doing either one
• Because all firms sell the same product and each firm can
sell as much or as little as it wants as the market price,
there is little non-price competition among them
Perfect Competition
• The success of a firm in a perfectly competitive
market depends entirely on how well it manages its
costs
• Decision making focuses entirely on reducing the costs
per unit produced
• Because the firm has not influence on price or total
quantity sold, profitability depends entirely on making
efficient use of the economy’s scarce resources
• Those firms that are most efficient (that is, can
maintain low costs) will be rewarded with profit
Perfect Competition
• Achieving low costs can work against a firm, however,
because the large profits will attract more producers, who,
collectively, will increase supply and drive market prices
and profits down
• Such competitive pressure guarantees the lowest price to
consumers with just enough profit for producers to keep
them producing
• In reality, the perfectly competitive market doesn’t exist
• Primarily because there are always some start-up costs and
some use of non-price competition
Perfect Competition
• The classic example of a group of producers that
comes closest to being perfect competitors are wheat
farmers
• They produce an identical product, have no influence
over the market price, and don’t participate in non-price
competition
• Nonetheless, wheat farmers need huge amounts of
capital to start up a new business, so there is a barrier to
entering the market
Monopolistic Competition
• When the product can be
differentiated and there
are a substantial number
of firms operating in the
market, the market
structure is called
monopolistic competition
Monopolistic Competition
• The major characteristics of monopolistic
competition are:
• A substantial number of firms compete in the market
• Firms sell a similar but not identical product
• Individual firms are large enough to influence total
supply, and so they have some influence over price
• It is relatively easy for a new firm to start up
• Non-price competition is significant
Monopolistic Competition
• Monopolistically competitive markets are most
prevalent in the service and retail sectors of the
Canadian economy
• As consumers we shop at them frequently
• Ex: Think of your favorite pizza store. It competes
with several other pizza stores. The competition might
come in the form of a price war if each store attempts
to increase its market share by offering lower prices and
special deals
Monopolistic Competition
• Competition might also include non-price factors
• Ex: Each pizza store might try to differentiate itself
from the rest by offering different services, such as
guaranteed 15-minute delivery, gourmet toppings, thincrust or deep-dish pizza, and 24-hour service
• It might expand its product line or advertise its goods in
various media
• The problem with any of these initiatives is that they all
have to be factored into the firm’s cost of production
Monopolistic Competition
• Relatively easy to enter and exit the market
• Generally, the firms are fairly small
• The economies of scale and capital requirements are limited
• Firms must distinguish their products from those of
competitors, so this can create a financial barrier to entry
• Firms seek to distinguish their product or service from
those of their competitors in some desirable way
• They use a number of techniques to accomplish this product
differentiation
Product Differentiation
1. Product Quality: Firms attempt to create a physical or qualitative differences
Examples
- Tender vs. tough meat (at restaurants)
- High-end computer hardware (in the home computer business)
2. Services: Firms offer special follow-up services surrounding the sale of a product
Examples
- “Delivery in 15 minutes or your pizza’s free!”
- Providing an extended warranty for a new home computer
3. Location and accessibility: Firms choose location convenient to their customers
or stay open long hours
Examples
- 24-hour stores
- Locating a gas station on a highway rather than along a rural route
4. Promotion and packaging: Firms attempt to differentiate their products by
packaging them in different ways or by advertising them
Examples
- Glitzy packaging
- Advertising with a celebrity endorsement of one product that is virtually identical
to another
Monopolistic Competition
• When product differentiation is successful, it leads to
something marketers call brand loyalty, a situation in
which consumers become attached to a product and
will pay more to satisfy that preference
• Because of brand loyalty, successful firms in a
monopolistically competitive market do have some
control over price
Oligopoly
• The main characteristics of the market structure known as an
oligopoly are:
• It is dominated by a few, very large firms
• Competing firms may produce products as similar as steel or as
different as automobiles
• The firm’s freedom to set price varies from slight to substantial
• Significant financial and other barriers to entry exist
• Non-price competition can be intense
Oligopoly
• Examples of firms in this market include airline
providers, banks, gas stations, and grocery stores
• Many consumers become frustrated as they watch
competition play out between firms in an oligopoly
• Their frustration comes from a sense of helplessness
because oligopolies seem to raise and lower prices at
will
Oligopoly
• Prices do move up or down, but competitiors’ prices
all seem to move in exactly the same way at exactly
the same time
• Gasoline prices are an excellent example of this: they
all go up about the same time and then go down about
the same time
• At times, observers suspect a price conspiracy exists,
and they demand that the firms be investigated for
illegal activity
Oligopoly
• Further suspicion arises because prices for products
in an oligopoly tend to stay within a particular range
• Ex: The service charges on your bank account will be
pretty similar no matter which bank you decide to trust
with your savings. Similarly all banks charge about the
same rate of interest on funds borrowed on a credit
card
• Again, is there a conspiracy going on? No necessarily.
Oligopoly
• By shopping around for the lowest price, consumers push
firms to compete on the basis of price
• In a free-market economy, firms have the right to set prices at
any level they see fit
• A firm that sticks with a slightly higher price will lose a lot of
business
• Nonetheless, a common pricing strategy among
oligopolists may occur
• Collusion is a secret agreement among firms to set prices,
limit output, or reduce or eliminate competition
• It is illegal in Canada and the US for firms to collude
Monopoly
• The word monopoly comes from the Greek words
monos polein, which mean “alone to sell”
• In a monopoly, one firm or organization enjoys
complete control of the market
Monopoly
• The major characteristic of a monopolistic market are:
• It is a market completely dominated by a single firm
• This firm has complete control over total supply
• The firm produces a unique product for which there are no
close substitutes
• The firm is a price maker
• By changing supply, it can set whatever price will maximize
its profits
• Major barriers to entry prevent other firms from entering the
market
• Because it has no direct competitors, a monopoly need not
engage in non-price competition
Monopoly
• A firm can establish a monopoly by gaining legal
control of its product and the exclusive right to
benefit from its sale
• Copyright law gives writers control of the work they
produce
• Patent law protects the inventors and developers of a
new product or technology by giving them the sole
right to benefit from its sale for a period of time
• Many a private firm owes its birth, growth, and
profitability to patent protection
Monopoly
• Government may also create at least a local
monopoly by awarding the sole right to provide a
product or service to a particular firm
• In a few cases, producers themselves may create a
monopoly by selling franchises
• Ex: Professional sport leagues (Hamilton would
probably love to have an NHL team in their city, but
NHL team owners in Toronto and Buffalo would
oppose it)
Monopoly
• Are monopolies better at producing goods at lower
prices than perfect competitors?
• Monopolies are able to produce large quantities of
output
• They have the financial resources to assume the costs
and risks of capital-intensive production and can
achieve efficiencies that come from economies of scale
Monopoly
• Some products, particularly those with high fixed costs,
are more efficiently produced by a monopoly than by a
few or many smaller producers
• This type of monopoly is referred to as a natural monopoly
• It is found most often in the field of public utilities, where
having more than on supplier would be impractical and
wasteful. Examples include:
• The generation, supply, and delivery of natural gas or
electricity
• Local telephone service
• Water and sewer supply
Monopoly
• Many markets that were once considered more
efficient as natural monopolies as now being opened
up for market competition through a process of
deregulation or privatization
• Deregulation involves opening a market to more
competition, which can be accomplished in a variety of
ways
• Privatization refers to one method of deregulation that
involves, among other things, the sale of public assets
to private firms