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CHAPTER 11 Firm Production under Idealized Competitive Conditions Economists understand by the term market, not any particular market place in which things are bought and sold, but the whole of any region in which buyers and sellers are in such free intercourse with one another that the prices of the same goods tend to equality, easily and quickly. Augustin Cournot receding chapters dealt separately with the two sides of markets, consumers and producers. We devised graphic means of representing consumer preferences (the demand curve) and producer costs (average and marginal cost curves). This chapter brings demand and cost analysis together in order to examine the way in which individual firms react to consumer demand in competitive markets. Our focus will be on a highly competitive market structure called perfect competition. We will investigate an intriguing question: at the limit, how much can competitive markets contribute to consumer welfare? We will not attempt to give a full description of a real-world competitive market setting. Because markets are so diverse, such a description would probably not be very useful. Our aim is rather to devise a theoretical framework that will enable us to think about how markets work in general, as a constructive behavioral force. Although our model cannot tell much that is specific about real-world markets, it will provide a basis for predicting the general direction of changes in market prices and output. Through its analysis, we should gain a deeper understanding of the meaning of market efficiency. Perfect competition is only one of four basic market structures. The other three, and the detrimental effects of their restrictions on competition, are the subjects of following chapters. The Four Market Structures Markets can be divided into four basic categories, based on the degree of competition that prevails within them that is, on how strenuously participants attempt to outdo, and avoid being outdone by, their rivals. The most competitive of the four market structures is perfect competition. Perfect Competition As we stressed much earlier in the book, perfect competition represents an ideal degree of competition. Perfect competition can be recognized by the following characteristics: P Chapter 11 Firm Production under Idealized Competitive Conditions 1. There are many producers in the market, no one of which is large enough to affect the going market price for the product. All producers are price takers, as opposed to price searchers or price makers (see the Perspective on the subject below). 2. All producers sell a homogeneous product, meaning that the goods of one producer are indistinguishable from those of all others. Consumers are fully knowledgeable about the prices charged by different producers and are totally indifferent as to which producer they buy from. 3. Producers enjoy complete freedom of entry into and exit from the market— that is, entry and exit costs are minimal, although not completely absent. 4. There are many consumers in the market, no one of whom is powerful enough to affect the market price of the product. Like producers, consumers are price takers. As we have seen before, the demand curve facing the individual perfect competitor is not the same as the demand curve faced by all producers. The market demand curve slopes downward, as shown in Figure 11.1(a). The demand curve facing an individual producer price taker is horizontal, as in Figure 11.1(b). This horizontal demand curve is perfectly elastic. That is, the individual firm cannot raise its price even slightly above the going market price without losing all its customers to the numerous other producers in the market or to other producers waiting for an opportunity to enter the market. On the other hand, the individual firm can sell all it wishes at the going market price. Hence it has no reason to offer its output at a lower price. The markets for wheat and for integrated computer circuits, or computer chips, are both good examples of real-world markets that come close to perfect competition. Pure Monopoly Pure monopoly: A single seller of a product for which there are no close substitutes. Protected from competition by barriers to entry into the market. The barriers to entry into the monopolist’s market will be described in the next chapter. For now, we will simply note that because the monopolistic firm does not have to worry about competitors undercutting its price, it can raise its price without fear that customers will move to other producers of the same product or similar products. All the pure monopolist has to worry about is losing customers to producers of distantly related products. Since the monopolist is the only producer of a particular good, the downward-sloping market demand curve [Figure 11.1(a)] is its individual demand curve. Unlike the perfect competitor, the monopolistic firm can raise its price and sell less, or lower its price and sell more. The critical task of the pure monopolist is to determine the one price-quantity combination of all price-quantity combinations on its demand curve that maximizes its profits. In this sense the pure monopolist is a price searcher. The best (but not perfect) real- world examples of a pure monopoly are regulated electric-power companies, which dominate in given geographical areas, and the government’s first-class postal system. Chapter 11 Firm Production under Idealized Competitive Conditions FIGURE 11.1 Demand Curve Faced by Perfect Competitors The market demand for a product part (a) is always downward sloping. The perfect competitor is on a horizontal, or perfectly elastic, demand curve [part (b)]. It cannot raise its price above the market price even slightly without losing its customers to other producers. Monopolistic Competition Monopolistic competition is a market composed of a number of producers whose products are differentiated and who face highly elastic, but not perfectly elastic, demand curves. A monopolistically competitive market can be recognized by the following characteristics: 1. There are a number of competitors, producing slightly different products. 2. Advertising and other forms of nonprice competition are prevalent. 3. Entry into the market is not barred but is restricted by modest entry costs, mainly overhead. 4. Because of the existence of close substitutes, customers can turn to other producers if a monopolistically competitive firm raises its price. Because of brand loyalty, the monopolistic competitor’s demand curve still slopes downward; but it is fairly elastic [see Figure 11.2). The market for textbooks is a good example of monopolistic competition. Most subjects are covered by two or three dozen textbooks, differing from one another in content, style of presentation, and design. Chapter 11 Firm Production under Idealized Competitive Conditions PERSPECTIVE: Price Takers and Price Searchers Perfect competition is an extreme degree of competition, so much so that many students are understandably concerned about its relevance. They often ask, “If there are few market structures that even closely approximate perfect competition, why bother to study it?” The question is a good one and not altogether easy to answer. There are few markets that come close to having numerous producers of an identical product with complete freedom of entry and exit. Markets for agricultural commodities and for stocks and bonds are probably the closet markets we have to perfect competition, but still the products are not always completely identical, and entry and exit costs abound in most markets. Even wheat sold by a Kansas wheat farmer us not always viewed the same as wheat sold by a Texas wheat farmer. How can sense be made of perfect competition? The answer is remarkably simple. We know that under the conditions of competition specified, certain results follow. We can logically (with the use of graphs and mathematics) derive them, and the results are developed in this and the following chapter. One conclusion drawn is that in perfect competition each firm will extend production until the marginal cost of producing the last unit equals the price paid by the consumer. That conclusion necessarily follows. As we will see, it is mathematically valid. The strict (extreme) assumptions about the nature of perfect competition assure that. The demanding conditions for perfect competition are rarely met. We nevertheless cannot conclude that under less demanding competitive conditions, competitive results would not be observed. [see the Perspectives on contestable markets on page 240.) For example, it may be that the number of producers is not “numerous” that the products sold by all producers are not completely “identical,” and that there are costs to moving in and out of markets. Nonetheless, individual producers may act as if the conditions of perfect competition are met. Individual producers may still act as if they have no control over market price or that there are so many other actual or potential producers that it is best to think in terms of the other producers being numerous”—in which case many of the predicted results of perfect competition may be still observed in the less-than-perfect markets. For these reasons, many economists often talk not about perfect competitors but about price takers (who may or may not fit exactly the description of perfect competitors). Price takers are sellers who do not believe they can control the market price by varying their own production levels. They simply observe the market price and either accept it (and produce accordingly, to the point where marginal cost and marginal revenue and price are equal) or reject it (and go into some other business). The price taker is someone who acts as if his or her demand curve is horizontal (perfectly elastic, more or less). He or she is therefore someone who assumes the marginal revenue on each unit sold is constant (and equal to the price)—and that the marginal revenue curve is horizontal and the same as the firm’s demand curve. The price searcher stands in contrast to the price taker. Price searchers are sellers who have some control over the market price. Price searchers have monopoly power due to the fact that they can alter production and thereby market supply sufficiently to change the price. The individual price searcher’s task is not simply to accept or reject the current market price, but (like the monopolist) to “search” through the various price-quantity combinations on his or her downward sloping demand curve with the intent upon maximizing profits. As we will see i n the following chapter, the marginal revenue and demand curves of the price searcher are no longer the same. (Exactly where the monopolist’s marginal revenue curve lies in relation to the demand curve will be discussed in detail in the next chapter). Chapter 11 Firm Production under Idealized Competitive Conditions ________________________________________ FIGURE 11.2 Demand Curve Faced by a Monopolistic Competitor Because the product sold by the monopolistically competitive firm is slightly different from the products sold by competing producers, the firm faces a highly elastic, but not perfectly elastic, demand curve. Oligopoly An oligopoly is a market composed of only a handful of dominant producers—as few as two—whose pricing decisions are interdependent. Oligopolists may produce either an identical product (like steel) or highly differentiated products (like automobiles). Generally the barriers to entry into the market are considerable, but the critical characteristic of oligopolistic firms is that their pricing decisions are interdependent. That is, the pricing decisions of any one firm can substantially affect the sales of the others. Therefore, each firm must monitor and respond to the pricing and production decisions of the other firms in the industry. The importance of this characteristic will become clear in a following chapter. Table 11.1 summaries the characteristics of the four market structures. The Perfect Competitor’s Production Decision As we learned earlier, the market price in a perfectly competitive market is determined by the intersection of the supply and demand curves. If the price is above the equilibrium price level, a surplus will develop forcing competitors to lower their prices. If the price is below equilibrium, a shortage will emerge, pushing the price upward [see Figure 11.3(a)]. Given a market price over which it has no control, how much will the individual perfect competitor produce? The Production Rule: MC = MR Suppose the price in the perfectly competitive market for computer chips $5 (P 1 in Figure 11.3). For each individual competitor, the market price is given, that is, cannot be changed. It must be either accepted or rejected. If the firm rejects the price, however, it must shut down. If it raises its price even slightly above the market level, its customers will move to other competitors.) Demand, then, is horizontal at $5. Chapter 11 Firm Production under Idealized Competitive Conditions Table 11.1 Characteristics of the Four Market Structures. Number of Firms Freedom of Entry Type of Product Example Perfect competition Many Very easy Homogeneous Wheat, Computers, and Gold Pure monopoly One Barred Single product Public utilities and Postal service Monopolistic com- petition Many Relatively easy Differentiated Pens, Books, Paper, and Clothing Oligopoly Few Difficult Either standardized or differentiated Steel, Light bulbs, Cereal, and Autos _____________________________________________________________________ The firm’s perfectly elastic horizontal demand curve is illustrated on the right side of Figure 11.3. This horizontal demand curve is also the firm’s marginal revenue curve, because marginal revenue is defined as the additional revenue acquired from selling one additional unit. Because each computer chip can be sold at a constant price of $5, the additional, or marginal, revenue acquired from selling an additional unit must be constant at $5. Because profit equals total revenue minus total cost (profit = TR = TC), the profit- maximizing firm will produce any unit for which marginal revenue exceeds marginal cost. Thus the profit-maximizing firm in Figure 11.3(b) will produce and sell q 1 units, the quantity at which marginal revenue equals marginal cost (MR = MC). Up to q 1 , marginal revenue is greater than marginal cost. Beyond q 1 , all additional computer chips are unprofitable: the additional cost of producing them is greater than the additional revenue acquired [with the small “q” being used to remind you that the output individual producer in Figure 11.3(b) is a small fraction of the output for the market, designated by a capital “Q” in Figure 11.3 (a)]. Changes in Market Price The perfectly competitive firm produces where MC = MR, both of which are equal to price. Thus the amount the firm produces depends on market price. As long as market demand remains constant, the individual firm’s demand, and its price, will also remain constant. If market demand and price increase, however, the individual firm’s demand and price will also increase. Chapter 11 Firm Production under Idealized Competitive Conditions FIGURE 11.3 The Perfect Competitor’s Production Decision The perfect competitor’s price is determined by market supply and demand [part (a)]. As long as marginal revenue (MR), which equals market price, exceeds marginal cost (MC), the perfect competitor will expand production [part (b)]. The profit-maximizing production level is the point at which marginal cost equals marginal revenue (price). FIGURE 11.4 Change in the Perfect Competitor’s Market Price If the market demand rises from D 1 to D 3 [part (a)], the price will rise with it, from P 1 to P 3 . As a result, the perfectly competitive firm’s demand curve will rise, from d1 to d3 [part (b)]. Chapter 11 Firm Production under Idealized Competitive Conditions Figure 11.4 (above) shows how the shift occurs. The original market demand of D 1 leads to a market price of P 1 [part (a)], which is translated into the individual firm’s demand, d 1 [part (b)]. The firm maximizes profit by equating marginal cost with marginal revenue, which is equal to d 1 , at an output level of q 1 . 1 An increase in market demand to D 2 leads to the higher price P 2 and a higher individual demand curve, d 2 . At this higher price, which equals marginal revenue, the perfect competitor can support a higher marginal cost. The firm will expand production from q 1 to q 2 . In the same way, an even greater market demand, D 3 , will lead to even higher output, q 3 , by the individual competitor. Why does the market supply curve slope upward and to the right? The answer lies in the upward-sloping marginal cost curves confronted by individual firms. (The market supply curve is obtained by horizontally adding the supply curves of individual firms.) The individual firm’s marginal cost curves slope upward because of diminishing (marginal) returns, a technological fact of the production process. Maximizing Short-Run Profits Can perfect competitors make an economic profit? The answer is yes, at least in the short run. To see this point, we must incorporate the average and marginal cost curves developed in the last chapter into our graph of the perfect competitor’s demand curve, as in Figure 11.5(b). [Figure 11.5(a) shows the market supply and demand curves.) As before, the producer maximizes profits by equating marginal cost with price, rather than by looking at average cost. That is exactly what the perfect competitor does. The firm produces q 2 computer chips because that is the point at which marginal revenue curve (which equals the firm’s demand curve crosses the marginal cost curve. At that intersection, marginal revenue of the last unit sold equals its marginal cost. If less were produced that q 1 , the marginal cost would be less than the marginal revenue, and profits would be lost. Similarly, by producing anything more than q 2 , the firm incurs more additional costs (as indicated by the marginal 1 To prove this statement, first we note that QPTR= Then we define short-run total cost to be a function of output: SRTC = C (Q) Next, we define profits π to be )Q(CQPSRTCTR −=−=π Differentiating with respect to Q and equating with 0, we then obtain dQ )Q(dC P 0 dQ )Q(dC P dQ d = =−= π Since dQ )Q(dC = SRMC, profits are maximized when SRMC P= . Chapter 11 Firm Production under Idealized Competitive Conditions cost curve) than it receives in additional revenue (as indicated by the demand curve, which beyond q 2 is below the MC curve). At q 2 (and anywhere else), the firm’s profit equals total revenue minus total cost (TR – TC). To find total revenue, we multiply the price, P 1 (which also equals average revenue) by the quantity produced, q 2 (TR = P 1q2 ). Graphically, total revenue is equal to the area of the rectangle bounded by the price and quantity, or 0P 1aq2 . Similarly, total cost can be found by multiplying the average total cost of production (ATC) by the quantity produced. The ATC curve shows us that the average total cost of producing q2 computer chips is ATC 1 . Therefore total cost is ATC 1q2 , or the rectangular area bounded by 0ATC 1 bq 2 . The profits of the company are therefore P 1q2 – ATC 1 q 2 , which is the same, mathematically, as q 2 (P 1 – ATC 1 ). This quantity corresponds to the area representing total revenue, OP 1 aq 2 , minus the area representing total cost, 0ATC 1 bq 2 . Profit is the shaded rectangle bounded by ATC 1 P 1 ab. FIGURE 11.5 The Profit-Maximizing Perfect Competitor The perfect competitor’s demand curve is established by the market-clearing price [part (a)]. The profit-maximizing perfect competitor will extend production up to the point where marginal cost equals marginal revenue (price), or point a in part (b). At that output level—q2—the firm will earn a short-run economic profit equal to the shaded area ATC 1 P 1ab . If the perfect competitor were to minimize average total cost, it would produce only q 1 , losing profits equal to the darker shaded area dca in the process. The perfect competitor does not seek to produce the quantity that results in the lowest average total cost. That quantity, q 1 , is defined by the intersection of the marginal cost curve and the average total cost curve. If it produced only q 1 , the firm would lose out on some of its profits, shown by the darker shaded area dca. (Suppose the firm is producing at q 1 . If it expands production to q 2 , it will generate P 1 times q 2 – q 1 in extra revenue (price times the additional units sold), an amount represented graphically by the area q 1 daq 2 .) Chapter 11 Firm Production under Idealized Competitive Conditions Naturally, profit-maximizing firms will attempt to minimize their costs of production. That does not mean they will produce at the point of minimum average total cost. Instead, the will try to employ the most efficient technology available and to minimize their payments for resources. That is they will attempt to keep their cost curves as low as possible. But given those curves, the firm will produce where MC = MR, not where ATC is at its lowest level. Managers who cannot distinguish between those two objectives will probably operate their businesses on a less profitable basis than they might—and will risk being run out of business. Minimizing Short-Run Losses In the foregoing analysis the market-determined price was higher than the firm’s average total cost, allowing it to make a profit. Perfect competitors are not guaranteed profits, however. The market price may not be high enough for the firm to make a profit. Suppose, for example, that the market price is P 1 , below the firm’s average total cost curve [see Figure 11.6). Should the firm still produce where marginal cost equals marginal revenue (price)? The answer, for the short run, is yes. As long as the firm can cover its variable cost, it should produce q 1 computer chips. FIGURE 11.6 The Loss-Minimizing Perfect Competitor The market-clearing price [part (a)] establishes the perfect competitor’s demand curve [part (b)]. Because the price is below the average total cost curve, this firm is losing money. As long as the price is above the low point of the average variable cost curve, however, the firm should minimize its short-run losses by continuing to produce where marginal cost equals marginal revenue [price or point b in part (b)]. This perfect competitor should produce q 1 units, incurring losses equal to the shaded area P 1 ATC 1 ab. (The alternative would be to shut down, in which case the firm would lose all its fixed costs.) It is true that the firm will lose money. Its total revenues are only P 1q1 , or the area bounded y 0P 1 bq 1 , whereas its total costs are ATC 1 q 1 , or the area 0ATC 1 aq 1 , whereas its total [...]... that they would be willing to pay to keep from being provided For example, assume the government mandated that all employers provide a smoke-free work environment For some employers a smoke-free environment makes sense, and many firms had such a policy before they were required But consider an employer whose workers all smoke Providing a smoke-free work place would shift the demand curve down from... motivation to provide fringe benefits that cost less than they are worth to workers Both employers and employees win when such benefits are provided Yet many people believe that private businesses are not sufficiently motivated to provide fringe benefits to their workers and that the government should mandate Chapter 11 Firm Behavior under Idealized Competitive Conditions 25 certain employment-related benefits... William J Baumol, “Contestable Markets: An Uprising in the Theory of Industry Structure,” American Economic Review, 72 (March 1982), 1-1 5 For a critical analysis of the model, see William G Shepherd, “‘Contestability’ vs Competition,” American Economic Review 74 (September 1984), pp 57 2-5 87 Chapter 11 Firm Production under Idealized Competitive Conditions entrants do not appear to be at a cost disadvantage... draws heavily on an article by one of the authors: Dwight R Lee, “Why Workers Should Want Mandated Benefits to Lower Their Wages,” Economic Inquiry (April 1996), pp 40 1-4 07 Chapter 11 Firm Behavior under Idealized Competitive Conditions 24 These shifts reflect the fact that (assuming workers are worth the same as before and are just as willing to work as before) once the additional vacation is provided:... cost, new firms can enter the market, and existing firms can expand their scale of operation Such long-run adjustments in turn affect market supply, which affects price and short-run production decisions Chapter 11 Firm Production under Idealized Competitive Conditions The Long-Run Effect of Short-Run Profits and Losses When profits encourage new firms to enter an industry and existing firms to expand,... intersects the long-run marginal cost curve, it will make a profit equal graphically to the shaded area ATC1 P2 ab That is the firm’s incentive for expansion Chapter 11 Firm Production under Idealized Competitive Conditions FIGURE 11.9 The Long-Run Effects of Economies of Scale If the market is in equilibrium at price P1 in part (a) and the individual firm is producing q 1 units on short -run average total... “real,” or fully Chapter 11 Firm Behavior under Idealized Competitive Conditions 27 descriptive Rather, they must be judged by their usefulness in understanding behavior In the manager’s corner, we once again used the model of perfect competition to understand why cutting the pay of workers, under some conditions, can be in the interest of workers Review Questions 1 In a graph, draw in the short-run average... worth more than they cost But clearly employers do provide fringe benefits without being required for reasons that should be obvious by now It pays employers to provide fringe benefits that are worth more than they cost because workers are willing to pay for more than the costs of those benefits in lower wages If it were true that a fringe benefit, if provided, would not be paid for partly by workers, then... more Losses have the opposite effect on long-run industry supply In the long run, firms that are losing money will move out of the industry, because their resources can be employed more profitably elsewhere When firms drop out of the industry, supply contracts and total FIGURE 11.7 The Long-Run Effects of Short-Run Profits If perfect competitors are making short-run profits, other producers will enter... Long-run equilibrium occurs when the price reaches P2 , where the individual firm’s demand curve is tangent to the low point of the average total cost curve [Figure 11.8(b)] The output of each remaining individual firm expands (from q1 to q2 ) to take up the slack left by the firms that have withdrawn Again price and average total cost are equal, and economic profit is zero FIGURE 11.8 The Long-Run . perfect) real- world examples of a pure monopoly are regulated electric-power companies, which dominate in given geographical areas, and the government’s first-class postal system. Chapter 11. Economic Review, 72 (March 1982), 1-1 5. For a critical analysis of the model, see William G. Shepherd, “‘Contestability’ vs. Competition,” American Economic Review 74 (September 1984), pp. 57 2-5 87 “identical,” and that there are costs to moving in and out of markets. Nonetheless, individual producers may act as if the conditions of perfect competition are met. Individual producers may still act