Chapter 2 Competitive Product Markets 10 • Change in the profitability of producing other goods • Change in the scarcity (and prices) of various productive resources Many other factors, such as weather, can also affect production costs. A change in any of these determinants of supply can either increase or decrease supply. • An increase in supply is an increase in the quantity producers are willing and able to offer at each and every price. It is represented graphically by a rightward, or outward, shift in the supply curve. • A decrease in supply is a decrease in the quantity producers are willing and able to offer at each and every price. It is represented graphically by a leftward, or inward, shift in the supply curve. TABLE 2.2 Market Supply of Tomatoes Price-Quantity Combinations Price per Bushel Number of Bushels A $0 0 B 1 10 C 2 20 D 3 30 E 4 40 F 5 50 G 6 60 H 7 70 I 8 80 J 9 90 K 10 100 L 11 110 FIGURE 2.3 Supply of Tomatoes Supply, the assumed relationship between price and quantity produced, can be represented by a curve that slopes up toward the right. Here, as the price rises from zero to $11, the number of bushels of tomatoes offered for sale during the course of a week rises from zero to 110,000. Chapter 2 Competitive Product Markets 11 In Figure 2.4, an increase in supply is represented by the shift from S 1 to S 2 . Producers are willing to produce a larger quantity at each price -- Q 3 instead of Q2 at price P 2 , for example. They will also accept a lower price for each quantity -- P 1 instead of P2 for quantity Q 2 . Conversely, the decrease in supply represented by the shift from S 1 to S 3 means that producers will offer less at each price -- Q 1 instead of Q 2 at price P 2 . They must also have a higher price for each quantity -- P 3 instead of P 2 for quantity Q 2 . A few examples will illustrate the impact of changes in the determinants of supply. If firms learn how to produce more goods with the same or fewer resources, the cost of producing any given quantity will fall. Because of the technological improvement, firms will be able to offer a larger quantity at any given price or the same quantity at a lower price. The supply will increase, shifting the supply curve outward to the right. Similarly, if the profitability of producing oranges increases relative to grapefruit, grapefruit producers will shift their resources to oranges. The supply of oranges will increase, shifting the supply curve to the right. Finally, if lumber (or labor or equipment) becomes scarcer, its price will rise, increasing the cost of new housing and reducing the supply. The supply curve will shift inward to the left. FIGURE 2.4 Shifts in the Supply Curve A rightward, or outward, shift in the supply curve, from S 1 to S 2 , represents an increase in supply. A leftward, or inward, shift in the supply curve, from S 1 to S 3 , represents a decrease in supply. Market Equilibrium Supply and demand represent the two sides of the market—sellers and buyers. By plotting the supply and demand curves together, as in Figure 2.5 we can predict how buyers and sellers will be inconsistent, and a market surplus or shortage of tomatoes will result. Market Surpluses Suppose that the price of a bushel of tomatoes is $9, or P 2 in Figure 2.5. At this price the quantity demanded by consumers is 20,000 bushels, much less than the quantity offered by Chapter 2 Competitive Product Markets 12 producers, 90,000. There is a market surplus, or excess supply, of 70,000 bushels. A market surplus is the amount by which the quantity supplied exceeds the quantity demanded at any given price. Graphically, an excess quantity supplied occurs at any price above the intersection of the supply and demand curves. FIGURE 2.5 Market Surplus If a price is higher than the intersection of the supply and demand curves, a market surplus—a greater quantity supplied, Q 3 , than demanded, Q 1 —results. Competitive pressure will push the price down to the equilibrium price P 1 , the price at which the quantity supplied equals the quantity demanded (Q 2 ). What will happen in this situation? Producers who cannot sell their tomatoes will have to compete by offering to sell at a lower price, forcing other producers to follow suit. As the competitive process forces the price down, the quantity consumers are willing to buy will expand, while the quantity producers are willing to sell will decrease. The result will be a contraction of the surplus, until it is finally eliminated at a price of $5.50 or P 1 (at the intersection of the two curves). At that price, producers will be selling all they want to; they will see no reason to lower prices further. Similarly, consumers will see no reason to pay more; they will be buying all they want. This point, where the wants of buyers and sellers intersect, is called the equilibrium price. • The equilibrium price is the price toward which a competitive market will move, and at which it will remain once there, everything else held constant. It is the price at which the market “clears”—that is, at which the quantity demanded by consumers is matched exactly by the quantity offered by producers. At the equilibrium price, the quantities desired by buyers and sellers are also equal. This is the equilibrium quantity. • The equilibrium quantity is the output (or sales) level toward which the market will move, and at which it will remain once there, everything else held constant. Chapter 2 Competitive Product Markets 13 In sum, a surplus emerges when the price asked is above the equilibrium price. It will be eliminated, through competition among sellers, when the price drops to the equilibrium price. Market Shortages Suppose the price asked is below the equilibrium price, as in Figure 2.6. At the relatively low price of $1, or P 1 , buyers want to purchase 100,000 bushels—substantially more than the 10,000 bushels producers are willing to offer. The result is a market shortage. A market shortage is the amount by which the quantity demanded exceeds the quantity supplied at any given price. Graphically, it is the shortfall that occurs any price below the intersection of the supply and demand curves. As with a market surplus, competition will correct the discrepancy between buyers’ and sellers’ plans. Buyers who want tomatoes but are unable to get them at a price of $1 will bid higher prices, as at an auction. As the price rises, a larger quantity will be supplied because suppliers will be better able to cover their increasing production costs. At the same time the quantity demanded will contract as buyers seek substitutes that are now relatively less expensive compared with tomatoes. At the equilibrium price of $5.50, or P 2 , the market shortage will be eliminated. Buyers will have no reason to bid prices up further, for they will be getting all the tomatoes the want at that price. Sellers will have no reason to expand production further; they will be selling all they want to at that price. The equilibrium price will remain the same until some force shifts the position of either the supply or the demand curve. If such a shift occurs, the price will moves toward a new equilibrium at the new intersection of the supply and demand curves. FIGURE 2.6 Market Shortages A price that is below the intersection of the supply and demand curves will create a shortage—a greater quantity demanded, Q 3 than supplied Q 1 . Competitive pressure will push the price up to the equilibrium price P 2 , the price at which the quantity supplied equals the quantity demanded. The Effect of Changes in Demand and Supply Chapter 2 Competitive Product Markets 14 Figure 2.7 shows the effects of shifts in demand and supply on the equilibrium price and quantity. In panel (a), an increase in demand from D 1 to D 2 raises the equilibrium price from P 1 to P 2 and quantity from Q 2 to Q 1 . Panel (b) shows the reverse effects of a decrease in demand. An increase in supply from S 1 to S 2 -- panel (c) has a different effect. The equilibrium quantity rises from Q 1 to Q 2 , but the equilibrium price falls from P 2 to P 1 . A decrease in supply from S 1 to S 2 -- panel (d) -- causes the opposite effect: the equilibrium quantity falls from Q 2 to Q 1 , and the equilibrium price rises from P 1 to P 2 . FIGURE 2.7 The Effects of Changes in Supply and Demand An increase in demand—panel (a) -- raises both the equilibrium price and the equilibrium quantity. A decrease in demand -- panel (b) -- has the opposite effect: a decrease in the equilibrium price and quantity. An increase in supply -- panel (c)—causes the equilibrium quantity to rise but the equilibrium price to fall. A decrease in supply -- panel (d) -- has the opposite effect: a rise in the equilibrium price and a fall in the equilibrium quantity. Chapter 2 Competitive Product Markets 15 Price Ceilings and Price Floors Political leaders have occasionally objected to the prices charged in open, competitive markets and have mandated the prices at which goods must be sold. That is, the government has enforced price ceilings and price floors. A price ceiling is a government-determined price above which a specified good cannot be sold. A price floor is a government-determined price below which a specified good cannot be sold. Supply and demand graphs can illustrate the consequences of price ceilings and floors. For example, some cities impose ceilings on the rents (or prices) for apartments. Such a ceiling must be below the equilibrium price—somewhere below P 1 in Figure 2.8(a). (If the ceiling were above equilibrium, it would be above the market price and would serve no purpose.) As the graph shows, such a price control creates a market shortage. The number of people wanting apartments, Q 2 , is greater than the number of apartments available, Q 1 . Because of the shortage, landlords will be less concerned about maintaining their units, for they will be able to rent them in any case. If the government imposes a price floor -- on a commodity like milk, for example—the price must be above the equilibrium price, P 1 in Figure 2.8b. (A price floor below P 1 would be irrelevant, because the market would clear at a higher level on its own.) The result of such a price edict is a market surplus. Producers want to sell more milk, Q 2 , than consumers are willing to buy, Q 1 . Some producers -- those caught holding the surplus (Q 2 -- Q 1 ) -- will be unable to sell all they want to sell. Eventually someone must bear the cost of destroying or storing the surplus -- and in fact the government holds vast quantities of its past efforts to support an equilibrium price for those products. FIGURE 2.8 Price Ceilings and Floors A price ceiling P c —panel (a)—will create a market shortage equal to Q 2 - Q 1 . A price floor P f -- panel (b) -- will create a market surplus equal to Q 2- Q 1 . The Efficiency of the Competitive Market Model Chapter 2 Competitive Product Markets 16 Early in this chapter we asked how Fred Lieberman knows what prices to charge for the goods he sells. The answer is now apparent: he adjusts his prices until his customers buy the quantities that he wants to sell. If he cannot sell all the fruits and vegetables he has, he lowers his price to attract customers and cuts back on his orders for those goods. If he runs short, he knows he can raise his prices and increase his orders. His customers then adjust their purchases accordingly. Similar actions by other producers and customers all over the city move the market for produce toward equilibrium. The information provided by the orders, reorders, and cancellations from stores like Lieberman’s eventually reaches the suppliers of goods and then the suppliers of resources. Similarly wholesale prices give Fred Lieberman information on suppliers’ costs of production and the relative scarcity and productivity of resources. The use of the competitive market system to determine what and how much to produce has two advantages. First, it is tolerably accurate. Much of the time the amount produced in a competitive market system tends to equal the amount consumers want—no more, no less. Second, the market system maximizes output. In Figure 2.9(a), note that all price-quantity combinations acceptable to consumers lie either on or below the market demand curve, in the shaded area. (If consumers are willing to pay P 2 for Q 1 then they should also be willing to pay less for that quantity—for example, P 1 .) Furthermore, all price-quantity combinations acceptable to producers lie either on or above the supply curve, in the shaded area shown in Figure 2.9(b). (If producers are willing to accept P 1 for quantity Q 1 , then they should also be willing to accept a higher price—for example, P 2 ). When supply and demand curves are combined in Figure 2.9(c), we see that all price-quantity combinations acceptable to both consumers and producers lie in the darkest shaded triangular area. From all those acceptable output levels, the competitive market produces Q 1 , the maximum output level that can be produced given what producers and consumers are willing and able to do. In this respect, the competitive market can be said to be efficient, or to allocate resources efficiently. Efficiency is the maximization of output through careful allocation of resources, given the constraints of supply (producers’ costs) and demand (consumers’ preferences). The achievement of efficiency means that consumers’ or producers’ welfare will be reduced by an expansion or contraction of output. The market system exploits all possible trades between buyers and sellers. Up to the equilibrium quantity, buyers will pay more than suppliers require (those points on the demand curve lie above the supply curve). Beyond Q 1 , buyers will not pay as much as suppliers need to produce more (those points on the supply curve lie above the demand curve). Again, in this regard the market can be called efficient. Chapter 2 Competitive Product Markets 17 FIGURE 2.9 The Efficiency of the Competitive Market Only those price-quantity combinations on or below the demand curve—panel (a)—are acceptable to buyers. Only those price-quantity combinations on or above the supply curve -- panel (b) -- are acceptable to producers. Those price-quantity combinations that are acceptable to both buyers and producers are shown in the darkest shaded area of panel (c). The competitive market is efficient in the sense that it results in output Q 1 , the maximum output level acceptable to both buyers and producers. Nonprice Competition Markets in which suppliers compete solely in terms of price are relatively rare. Table salt is a relatively uniform commodity sold in a market in which price is an important competitive tool. Even producers of salt, however, compete in terms of real or imagined quality differences and the reputation and recognition of brand names. In most industries, competition is through a wide range of product features, such as quality or appearance, design, and durability. In general, competitors can be expected to choose the mix of features that gives them the greatest profit. In fact, price competition is not always the best method of competition, not only because price reductions mean lower average revenues, but also because the reductions can be costly to communicate to consumers. Advertising is expensive, and consumers may not notice price reductions as readily as they do improvements in quality. Quality changes, furthermore, are not as readily duplicated as price changes. Consumers’ preferences for quality over price should be reflected in the profitability of making such improvements. If consumers prefer a top- of-the-line calculator to a cheaper basic model, then producing the more sophisticated model could, depending on the cost of the extra features, be more profitable than producing the basic model and communicating its lower price to consumers. If all consumers had exactly the same preferences—size, color, and so on—producers would presumably make uniform products and compete through price alone. For most products, however, people’s preferences differ. To keep the analysis manageable, we will explore nonprice competition in terms of just one feature—product size. Suppose that in the market for television sets, consumer preferences are distributed along the continuum shown in Figure 2.10. The curve is bell shaped, indicating that most consumers are clustered in the middle of the distribution and want a middle-sized television. Fewer consumers want a giant screen or a mini-television. Everything else being equal, the first producer to enter the market, Terrific TV, will probably offer a product that falls somewhere in the middle of the distribution—for example, at the in Figure 2.10. In this way, Terrific TV offers a product that reflects the preferences of the largest number of people. Furthermore, as long as there are no competitors, the firm can expect to pick up customers to the left and right of center. (Terrific TV’s product may not come very Chapter 2 Competitive Product Markets 18 close to satisfying the wants of consumers who prefer a very large or very small television, but it is the only one available.) The more Terrific TV can meet the preferences of the greatest number of consumers, everything else being equal, the higher the price it can charge and the greater the profit it can make. (Because consumers value the product more highly, they will pay a higher price for it.) The first few competitors that enter the market may also locate close to the center—in fact, several may virtually duplicate Terrific TV’s product. These firms may conclude that they will enjoy a larger market by sharing the center with several competitors than by moving out into the wings of the distribution. They are probably right. Although they may be able to charge more for a giant screen or a mini-television that closely reflects some consumers’ preferences, there are fewer potential customers for those products. FIGURE 2.10 Consumer Preference in Television Size Consumers differ in their wants, but most desire a medium-sized television. Only a few want very small or large televisions. To illustrate, assume that competitor Fabulous Focus locates at F, close to T. It can then appeal to consumers on the left side of the curve because its product will reflect those consumers’ preferences more closely than does Terrific TV’s. Terrific TV can still appeal to consumers on the right half of the curve. If Fabulous Focus had located at C, however, it would have direct appeal only to consumers to the left of C, as well as to a few between C and T. Terrific TV would have appealed to more of the consumers on the left, between C and T, than in the first case. In short, Fabulous Focus has a larger potential market at F than at C. However, as more competitors move into the market, the center will become so crowded that new competitors will find it advantageous to move away from the center, to C or D. At those points the market will not be as large as it is in the center, but competition will be Chapter 2 Competitive Product Markets 19 less intense. If producers do not have to compete directly with as many competitors, they can charge higher prices. How far out into the wings they move will depend on the tradeoffs they must make between the number of customers they can appeal to and the price they can charge. Like price reductions, the movement of competitors into the wings of the distribution benefits consumers whose tastes differ from those of the people in the middle. These atypical consumers now have a product that comes closer to or even directly reflects their preferences. Our discussion has assumed free entry into the market. If entry is restricted by monopoly of a strategic resource or by government regulation, the variety of products offered will not be as great as in an open, competitive market. If there are only two or three competitors in a market, everything else being equal, we would expect them to cluster in the middle of a bell-shaped distribution. That tendency has been seen in the past in the broadcasting industry, when the number of television stations permitted in a given geographical area was strictly regulated by the Federal Communications Commission. Not surprisingly, stations carried programs that appealed predominantly to a mass audience—that is, to the middle of the distribution of television watchers. The Public Broadcasting System, PBS, was organized by the government partly to provide programs with less than mass appeal to satisfy viewers on the outer sections of the curve. When cable television emerged and programs became more varied, the prior justification for PBS subsidies became more debatable. Even with free market entry, product variety depends on the cost of production and the prices people will pay for variations. Magazine and newsstand operators would behave very much like past television managers if they could carry only two or three magazines. They would choose Newsweek or some other magazine that appeals to the largest number of people. Most motel operators, for instance, have room for only a very small newsstand, and so they tend to carry the mass-circulation weeklies and monthlies. For their own reasons, consumers may also prefer such a compromise. Although they may desire a product that perfectly reflects their tastes, they may buy a product that is not perfectly suitable if they can get it at a lower price. Producers can offer such a product at a lower price because of the economies of scale gained from selling to a large market. For example, most students take pre-designed classes in large lecture halls instead of private tutorials. They do so largely because the mass lecture, although perhaps less effective, is substantially cheaper than tutorials. In a market that is open to entry, producers will take advantage of such opportunities. If producers in one part of a distribution attempt to charge a higher price than necessary, other producers can move into that segment of the market and push the price down; or consumers can switch to other products. In this way, an optimal variety of products will eventually emerge in a free, reasonably competitive market. Thus the argument for a free market is an argument for the optimal product mix. Without freedom of entry, we cannot tell whether it is possible to improve on the existing combination of products. A free, competitive market gives rival firms a chance to better that combination. The case for the free market becomes even stronger when we recognize that market conditions—and therefore the optimal product mix—are constantly changing. . 3 instead of Q2 at price P 2 , for example. They will also accept a lower price for each quantity -- P 1 instead of P2 for quantity Q 2 . Conversely, the. area. (If consumers are willing to pay P 2 for Q 1 then they should also be willing to pay less for that quantity for example, P 1 .) Furthermore, all price-quantity