Chapter 10 COMPETITIVE MARKETS QUESTIONS & ANSWERS

Transcription

1 Chapter 10 COMPETITIVE MARKETS QUESTIONS & ANSWERS Q10.1 Historically, the Regional Bell Operating Companies (RBOCs) had a monopoly on the provision of local voice phone service. Regulation has now been eased to permit competition from Competitive Local Exchange Carriers (CLECs), cable companies, satellite operators and wireless competitors. Is the local phone service market likely to become a vigorously competitive market? Q10.1 ANSWER The local voice phone service market is not one likely to support dozens of competitors in each local market, but competition among the few can become vigorous in this market. Market structure is described in terms of the complete array of industry characteristics that directly affect the price/output decisions made by firms. Primary elements of market structure include: the number and size distribution of actual sellers and buyers as well as potential entrants, the degree of product differentiation, the availability and cost of information regarding prices and output quality, and conditions of entry and exit. All of these elements of market structure can have important consequences for the vigor of competition in the local voice phone service market, and for the price/output decisions made by firms. The technology for voice phone service that is clear and reliable can be offered by many firms. Thus, product quality is becoming homogenous. Brutal price competition is sure to erupt in this market as voice over the Internet (VoIP) service becomes widely available. Q10.2 One way of inferring competitive conditions in a market is to consider the lifestyle enjoyed by employees and owners. In vigorously competitive markets, employee compensation tends to be meager and profits are apt to be slim. Describe the perfectly competitive market structure and provide some examples. Q10.2 ANSWER Perfect competition is a market structure characterized by a large number of buyers and sellers of an essentially identical product, where each market participant's

2 transactions are so small that they have no influence on the market price of the product. Individual buyers and sellers are price takers. This means that they take market prices as given, and devise their production strategy accordingly. Free and complete demand and supply information is available in a perfectly competitive market, and no meaningful barriers to entry and exit are present. As a result, vigorous price competition is prevalent, and only a normal rate of return on investment is possible in the long-run. Excess profits are possible only in periods of short-run disequilibrium before rivals are able to mount an effective competitive response. Examples of perfectly competitive markets include: agricultural markets for corn, wheat, soybeans and other grains; commodity, stock and bond markets; and unspecialized input markets (e.g., unskilled labor), among others. Many retail markets, like gas stations, are also vigorously competitive. Q10.3 Competitive firms are sometimes criticized for costly but superfluous product differentiation. Is there an easy means for determining if such efforts are in fact wasteful? Q10.3 ANSWER Yes. A simple market test is the most effective means available for determining if customers value real or perceptual differences in the quality of goods and services. Sources of valuable product differentiation include physical differences, such as those due to superior research and development, plus any useful perceived differences due to effective advertising and promotion. Price competition tends to be most vigorous for homogenous products with few actual or perceived differences. If firms spend money on superfluous product differentiation, these added costs will not translate into added benefits for consumers, and consumers will not pay higher prices to cover such costs. Q10.4 The Worker Adjustment and Retraining Notification Act (WARN) requires employers with 100 or more employees to provide notification 60 calendar days in advance of plant closings and mass layoffs. Advance notice gives workers and their families transition time to adjust to the prospective loss of employment, seek other jobs, or get necessary training. Some employers complain that WARN reduces necessary flexibility and makes them reluctant to open new production facilities. How are barriers to entry and exit similar? How are they different? Q10.4 ANSWER

3 A barrier to entry is defined as any factor or industry characteristic that creates an advantage for incumbents over new arrivals. Legal rights such as patents and local, state, or federal licenses can present formidable barriers to new entry in pharmaceutical, cable television, television and radio broadcasting, and other industries. Additional factors that sometimes create barriers to entry include substantial economies of scale, scope economies, large capital or skilled labor requirements, and ties of customer loyalty created through advertising and other means. Factors giving rise to a barrier to entry can sometimes result in compensating advantages for consumers. Although patents can lead to monopoly profits for inventing firms, they also spur valuable new product and process development. And, although extremely efficient or innovative leading firms make entry and nonleading firm growth difficult, they can have the favorable effect of lowering industry prices and increasing product quality. Therefore, a complete evaluation of the economic effects of entry barriers involves a consideration of both costs and benefits, if any. Whereas barriers to entry have the potential to impede competition by making entry or growth difficult, competitive forces can also be diminished through barriers to exit. A barrier to exit is any restriction on the ability of incumbents to redeploy assets from use in one industry or line of business to another. During the late 1980s, for example, several state governments initiated legal proceedings in order to impede plant closures by large employers in the steel, glass, automobile and other industries. By imposing large fines, severance taxes, or requirements calling for substantial expenditures for worker retraining, significant barriers to exit were created. Like barriers to entry, barriers to exit can dramatically increase the costs of entry or expansion in any given industry or locale. Barriers to exit impede the asset redeployment that is typical of any vigorous competitive environment. By impeding this process, barriers to exit can dramatically increase both the costs and risk of doing business. Some differences in the competitive effects of barriers to entry and exit may be noted in that barriers to entry have an immediate effect on potential entrants, whereas barriers to exit have an immediate influence on industry incumbents. In the short-run, particularly during a period of economic expansion, however, barriers to exit can have minimal impact. In the long-run, barriers to exit become an important consideration for industry incumbents and potential entrants, and like barriers to entry can have an important effect limiting actual and potential competition. Q10.5 A higher minimum wage means some low wage workers will get fired because there will be less money available for labor costs. An international minimum wage, scaled according to the working conditions and cost of living in a particular country, would allow local workers to benefit without significant trade disruption. Discuss this statement and explain why the demand curve is apt to be horizontal in the unskilled labor market

4 Q10.5 ANSWER In competitive markets, the demand curve tends to be horizontal because homogeneous products are offered by several competitors. In product markets, firms are price takers in perfectly competitive markets. This means that the activity level of each firm is so small relative to that of the overall industry total that no influence on industry prices is noted following a change in the firm's production decisions. All of the firm's output can be sold at the industry's prevailing price. Price discounts are unnecessary to sell even dramatically higher firm output. Moreover, the presence of perfect substitutes means that buyers would immediately switch to alternate suppliers following a price increase. Thus, prices above the industry norm are not feasible. This gives rise to a horizontal firm demand curve. A similar situation exists in the unskilled labor market. Not only are there lots of part-time unskilled workers looking for jobs at any point in time, self-service labor supplied by the customer is typically a perfect substitute for unskilled labor. This makes consumers very reluctant to pay high wages for unskilled labor. This is the basic problem faced by low-income workers, not competition from unskilled workers in other countries, like India. The best way to improve incomes among the working poor around the globe is to improve worker skills and productivity through better education and training. Make low-income workers worth more, and they will get paid more. Q10.6 For smaller firms managed by their owners in competitive markets, profit considerations are apt to dominate almost all decisions. However, managers of giant corporations have little contact with stockholders, and often deviate from profit-maximizing behavior. Get real. Look at Tyco, for Pete s sake. Discuss this statement. Q10.6 ANSWER This is, of course, a controversial subject. Most analysts concede that profit maximization is a prime concern of owner-managers that run small businesses in hotly competitive markets. In vigorously competitive markets, productive efficiency is mandatory if the firm is to earn even a modest normal profit. Without close attention to detail, smaller firms in competitive markets quickly find themselves victimized by more efficient rivals. Faster, cheaper and better is not only the battle cry of the successful competitive firm, it is the mantra of the long-term survivor. However, some disagree with the contention that profit maximization is the primary motivation of all competitive firms, large and small. Managers of giant corporations are sometimes criticized for being motivated by empire building (revenue maximization) or other forms of self-indulgent behavior. Surely, top

5 managers at Tyco International, Enron, and WorldCom have been seen to deviate markedly from the norms of profit-maximizing behavior. Still, it is worth pointing out that these egregious examples of self-indulgent behavior were quickly rooted out, the executives got fired, and in some cases, served time in prison for their malfeasance. Vigorous competitors, unfriendly bidders, and the courts are all enemies of inefficient managers. As a result, successful firms that have been in business for long periods of time typically act in a manner consistent with profit maximization. Q10.7 If excess profits are rampant in the oil business, why aren t the stockholders of industry giants like Exxon Mobil, Chevron Texaco, and Royal Dutch Petroleum making huge stock-market profits? Discuss this statement. Q10.7 ANSWER The stock market is a forward-looking device. If anticipated profits rise, stock prices go up. If anticipated profits fall, stock prices go down. At any point in time, there can be only a weak relationship between the amount of excess profits generated in a business and stock-market returns because only unanticipated changes in excess profits will affect stock prices. For example, if Exxon Mobil were making excess profits, the stock price could perform in line with the overall market so long as no earnings surprises came along. In the stock market, it is important to recognize that while monopolies make excess profits, these advantages tend to get reflected in the stock price at the time monopoly power is created. Investors in monopoly make only a risk-adjusted fair return so long as there are no unanticipated changes in excess profits. All that being said, it is noteworthy that long-term investor rates of return to investors in the energy sector have not been above average. If investor returns are average to below-average in the energy business, and they are, it is difficult to argue that excess profits are widespread in the sector. Critics of the oil industry allege that the industry receives large and unwarranted government subsidies and that rival technologies, such as those for ethanol, renewable energy, and energy efficiency, deserve compensating government preferences. However, industry studies indicate that, on balance, the oil industry is not a net beneficiary of government subsidies. In fact, the oil industry may be more harmed than helped by government intervention in energy markets. Special tax deductions, direct expenditures, net excise taxes, and research and development expenditures are constantly targeted by oil critics. However, those subsidies are a small share of oil revenues and far less generous than the preferences and subsidies provided for rival businesses and technologies such as mass transit and alternative fuels. Moreover, most energy subsidies are wealth transfers that do not significantly distort energy prices or affect energy markets

6 Q10.8 Airline passenger service is a terrible high-fixed cost business featuring fierce price competition. With uniform safety, customers pick the lowest airfare with the most convenient departures. Except for pilots, nobody in the airline business makes any money. Use the competitive firm short-run supply curve concept to explain entry and exit in the airline passenger business. Why are pilots well paid? Q10.8 ANSWER An individual airline will supply output so long as it is profitable to do so. Profits are maximized by setting MR = MC. Because P = MR in a competitive industry, perfectly competitive firms maximize profits by setting P = MR = MC. This means that the individual firm supply curve in a competitive industry is given by the marginal cost curve, so long as marginal cost exceeds average variable cost, P = MC > AVC. Given the U-shaped average cost curve that is typical of firms in perfectly competitive industries, the MC and firm supply curve will tend to be upward sloping over the range where MC > AVC. This means that individual airlines will increase output as prices rise, and decrease output as prices fall. In the airline business, any excess capacity is met by price cutting. Fare wars are a permanent feature of the competitive landscape. The reason why pilots make money in such a tough business is obvious: You can t fly a plane without them. With enormous investment in highly technical aircraft, the airlines need highly trained pilots, and pay them accordingly. Q10.9 Suppose that a competitive firm long-run supply curve is given by the expression Q F = P. Does this mean that the firm will supply -500 units of output at a zero price? If so, what does output of -500 units mean? Q10.9 ANSWER Taken literally, a competitive firm long-run supply curve given by the expression Q F = P means that the firm will supply -500 units of output at a zero price. However, this is a nonsensical interpretation. There is no such thing as negative production. Instead, there is a simple and economically appropriate interpretation of the expression Q F = P. This expression simply means that firm supply will equals zero unless the market price exceeds $50. When P > $50, the firm will begin to supply a positive amount of production. For market prices less than or equal to $50, firm supply will equal zero. Q10.10 The long-run supply curve for a given competitive firm can be written as Q F = P or P = $ $0.125Q F. Explain why the amount supplied by 50 such

7 Q10.10 ANSWER competitors is determined by multiplying the first expression by 50 rather than by multiplying the second expression by a similar amount. The amount supplied in a competitive market is simply the sum of output produced by all established competitors. In a market comprised of 50 firms with identical costs, the long-run market supply 50 times the quantity indicated by the individual firm s long-run supply curve. In this case, 50 identical competitors would supply Q M = ( P) Η 50 = 12, P, so long as the market price exceeds average variable cost, each firm s marginal cost curve is its supply curve. In general, the market supply curve is derived by simply adding up the quantities supplied by all competitors. If the competitive market is comprised of 50 firms with identical marginal costs, market supply at every market price will total 50 times the quantity supplied by a single firm. Students must be careful not to multiply the expression P = $ $0.125Q F by 50 in an effort to derive the competitive market long-run supply curve. Such an approach would suggest a marginal cost 50 times greater than the market cost curve facing a single firm. Remember, to find aggregate supply, one must add up individual firm supply. This is a horizontal summation of supply across all competitors. SELF-TEST PROBLEMS & SOLUTIONS ST10.1 Market Supply. In some markets, cutthroat competition can exist even when the market is dominated by a small handful of competitors. This usually happens when fixed costs are high, products are standardized, price information is readily available, and excess capacity is present. Airline passenger service in large city-pair markets, and electronic components manufacturing are good examples of industries where price competition among the few can be vigorous. Consider three competitors producing a standardized product (Q) with the following marginal cost characteristics: MC 1 = $5 + $0.0004Q 1 (Firm 1) MC 2 = $15 + $0.002Q 2 (Firm 2) MC 3 = $1 + $0.0002Q 3 (Firm 3) A. Using each firm s marginal cost curve, calculate the profit-maximizing short-run supply from each firm at the competitive market prices indicated in the following

8 table. For simplicity, assume price is greater than average variable cost in every instance. Market Supply is the Sum of Firm Supply Across all Competitors Firm One Supply P = MC 1 = $5 + $0.0004Q 1 Price and Q 1 = -12, ,500P $ Firm Two Supply P = MC 2 = $15 + $0.002Q 2 and Q 2 = -7, P Firm Three Supply P = MC 3 = $1 + $0.0002Q 3 and Q 3 = -5, ,000P Market Supply P = $ $ P and Q I = -25, ,000P (Q I = Q 1 + Q 2 + Q 3 ) B. Use these data to plot short-run supply curves for each firm. Also plot the market supply curve. STP10.1 SOLUTION A. The marginal cost curve constitutes the short-run supply curve for firms in perfectly competitive markets so long as price is greater than average variable cost. Market Supply is the Sum of Firm Supply Across all Competitors

9 Firm One Supply Firm Two Supply Firm Three Supply Market Supply P = MC 1 = P = $ P = MC $5 + $0.0004Q 2 = $15 + P = MC 3 = $1 + 1 $ P and $0.002Q Price and 2 and $0.0002Q 3 and Q Q Q 1 = -12, = -7,500 + Q 3 = -5,000 + I = -25, ,000P (Q 500P 5,000P I = Q 1 2,500P + Q 2 + Q 3 ) $0-12,500-7,500-5,000-25, ,000 20,000 15, ,500-2,500 45,000 55, , ,000 95, ,500 2,500 95, , ,000 5, , , ,500 7, , , ,000 10, , , ,500 12, , , ,000 15, , , ,500 17, , , ,000 20, , , ,500 22, , , ,000 25, , , ,500 27, , , ,000 30, , , ,500 32, , ,000 B

10 ST10.2 Competitive Market Equilibrium. Competitive market prices are determined by the interplay of aggregate supply and demand; individual firms have no control over price. Market demand reflects an aggregation of the quantities that customers will buy at each price. Market supply reflects a summation of the quantities that individual firms are willing to supply at different prices. The intersection of industry demand and supply curves determines the equilibrium market price. To illustrate this process, consider the following market demand curve where price is expressed as a function of output: P = $40 - $0.0001Q D (Market Demand) or equivalently, when output is expressed as a function of price Q D = 400,000-10,000P Assume market supply is provided by five competitors producing a standardized product (Q). Firm supply schedules are as follows:

11 Q 1 = 18 +2P (Firm 1) Q 2 = P (Firm 2) Q 3 = P (Firm 3) Q 4 = P (Firm 4) Q 5 = P (Firm 5) A. Calculate optimal supply by each firm at the competitive market prices indicated in the following table. Then, assume there are actually 1,000 firms just like each one illustrated in the table. Use this information to complete the Partial Market Supply and Total Market Supply columns. + Price 1 2 $ Quantity Supplied by Firm (000) = Partial Market Supply Η 1,000 = Total Market Supply (000) B. Sum the individual firm supply curves to derive the market supply curve. Plot the market demand and market supply curve with price as a function of output to illustrate the equilibrium price and level of output. Verify that this is indeed the market equilibrium price-output combination algebraically. STP10.2 SOLUTION A. Quantity Supplied by Firm (000) Price = Partial Market Supply Η 1,000 = Total Market Supply (000)

12 $ , , , , , , , ,000 The data in the Table illustrate the process by which an industry supply curve is constructed. First, suppose that each of five firms in an industry is willing to supply varying quantities at different prices. Summing the individual supply quantities of these five firms at each price determines their combined supply schedule, shown in the Partial Market Supply column. For example, at a price of $2, the output supplied by the five firms are 22, 24, 64, 44, and 26 (thousand) units, respectively, resulting in a combined supply of 180(000) units at that price. With a competitive market price of $8, supply quantities would become 34, 60, 136, 116, and 74, for a total supply by the five firms of 420(000) units, and so on. Now assume that there are 1,000 firms just like each one illustrated in the table. There are actually 5,000 firms in the industry, each with an individual supply schedule identical to one of the five firms illustrated in the table. In that event, the total quantity supplied at each price is 1,000 times that shown under the Partial Market Supply schedule. Because the numbers shown for each firm are in thousands of units, the total market supply column is in thousands of units. Therefore, the number 140,000 at a price of $1 indicates 140 million units, the number 180,000 at a price of $2 indicates 180 million units, and so on

13 B. To find the market supply curve, simply sum each individual firm s supply curve, where quantity is expressed as a function of the market price: Q I = Q 1 + Q 2 + Q 3 + Q 4 + Q 5 = P P P P P = P (Market Supply) Plotting the market demand curve and the market supply curve allows one to determine the equilibrium market price of $6 and the equilibrium market quantity of 340,000(000), or 340 million units. To find the market equilibrium levels for price and quantity algebraically, simply set the market demand and market supply curves equal to one another so that Q D = Q S. To find the market equilibrium price, equate the market demand and market supply curves where quantity is expressed as a function of price: Demand = Supply 400,000-10,000P = 100, ,000P 50,000P = 300,000 P = $

14 To find the market equilibrium quantity, set equal the market demand and market supply curves where price is expressed as a function of quantity, and Q D = Q S : Demand = Supply $40 - $0.0001Q = -$2.5 + $ Q Q = 42.5 Q = 340,000(000) Therefore, the equilibrium price-output combination is a market price of $6 with an equilibrium output of 340,000(000), or 340 million units. PROBLEMS & SOLUTIONS P10.1 Competitive Markets Concepts. Indicate whether each of the following statements is true or false, and explain why. A. In long-run equilibrium, every firm in a perfectly competitive industry earns zero profit. B. Perfect competition exists in a market when all firms are price takers as opposed to price makers. C. In competitive markets, P > MC at the profit-maximizing output level. D. Downward-sloping industry demand curves characterize perfectly competitive markets. E. A firm might show accounting profits in a competitive market but be suffering economic losses. P10.1 SOLUTION A. False. In long-run equilibrium, every firm in a perfectly competitive industry earns zero economic profit. For long-term viability, firms in competitive markets must earn a normal rate of return on investment. B. True. Perfect competition exists in a market when individual customers and individual firms have no influence over price. In such markets, both customers and firms take prices as given. C. False. Profit maximization requires that a firm operate at the output level at which marginal revenue and marginal cost are equal. With price constant, average revenue

15 equals marginal revenue. Therefore, maximum profits result when market price is set equal to marginal cost for firms in a perfectly competitive industry D. True. Downward sloping demand curves follow from the law of diminishing marginal utility and characterize both competitive markets. E. True. Normal profit is defined as the rate of return necessary to retain and attract needed capital investment. Economic profit represents an above-normal rate of return. The firm incurs economic losses whenever it fails to earn a normal profit. A firm might show a small accounting profit but be suffering economic losses because these profits are insufficient to provide an adequate return to the firm's stockholders. In such instances, firms are unable to replace plant and equipment and will exit the industry in the long run. P10.2 Short-run Firm Supply. Mankato Paper, Inc., produces uncoated paper used in a wide variety of industrial applications. Newsprint, a major product, is sold in a perfectly competitive market. The following relation exists between the firm's newsprint output and total production costs: Total Output (tons) Total Cost 0 $ A. Construct a table showing Mankato's marginal cost of newsprint production. B. What is the minimum price necessary for Mankato to supply one ton of newsprint? C. How much newsprint would Mankato supply at industry prices of $75 and $100 per ton? P10.2 SOLUTION A

16 Total Output Total Cost 0 $ $ Marginal Cost B. The minimum marginal cost of newsprint is $50, so this also represents the minimum price necessary to justify supplying a single unit of output. C. In a perfectly competitive market, P = MR. Therefore, Mankato will supply output so long as price at least covers the marginal cost of production. At a price of $75, Q = 3 units of output can be justified because P = $75 > MC Q=3 = $70. However, production of a fourth unit is not warranted because P = $75 < MC Q=4 = $80. Similarly, Q = 6 could be justified at a price of $100 because P = $100 = MC Q=6. P10.3 Short-run Firm Supply. Florida is the biggest sugar-producing state, but Michigan and Minnesota are home to thousands of sugar beet growers. Sugar prices in the United States average about 20 per pound, or more than double the world-wide average of less than 10 per pound given import quotas that restrict imports to about 15% of the U.S. market. Still, the industry is perfectly competitive for U.S. growers who take the market price of 20 as fixed. Thus, P = MR = 20 in the U.S. sugar market. Assume that a typical sugar grower has fixed costs of $30,000 per year. Total variable cost (TVC), total cost (TC), and marginal cost (MC) relations are: TVC = $15,000 + $0.02Q + $ Q 2 TC = $45,000 + $0.02Q + $ Q 2 MC = ΜTC/ΜQ = $ $ Q where Q is pounds of sugar, total costs include a normal profit. A. Using the firm s marginal cost curve, calculate the profit-maximizing short-run supply from a typical grower

17 B. Calculate the average variable cost curve for a typical grower, and verify that average variable costs are less than price at this optimal activity level. P10.3 SOLUTION A. The marginal cost curve constitutes the short-run supply curve for firms in perfectly competitive markets if price exceeds average variable cost. Because P = MR, the price necessary to induce firm supply in the short run of a given amount is found by setting P = MC, provided that P > AVC: P = $ $ Q 0.20 = Q 0.18 = Q Q = 500,000 B. The average variable cost curve is determined by dividing total variable cost by output: AVC = ($15,000 + $0.02Q + $ Q 2 )/Q = $15,000/Q + $ $ Q At the Q = 500,000 activity level, average variable cost is 14 and less than the market price: AVC = $15,000/Q + $ $ Q = $15,000/500,000 + $ $ (500,000) = $0.14 Because P = MR = MC and P > AVC at the 500,000 pounds per year activity level, this is an optimal amount of short-run supply from the typical sugar grower. P10.4 Long-run Firm Supply. The retail market for unleaded gasoline is fiercely price competitive. Consider the situation faced by a typical gasoline retailer when the local market price for unleaded gasoline is $1.80 per gallon and total cost (TC) and marginal cost (MC) relations are:

18 TC = $40,000 + $1.64Q + $ Q 2 MC = ΜTC/ΜQ = $ $ Q and Q is gallons of gasoline. Total costs include a normal profit. A. Using the firm s marginal cost curve, calculate the profit-maximizing long-run supply from a typical retailer B. Calculate the average total cost curve for a typical gasoline retailer, and verify that average total costs are less than price at the optimal activity level. P10.4 SOLUTION A. The marginal cost curve constitutes the long-run supply curve for firms in perfectly competitive markets if price is greater than average total cost. Because P = MR, the price necessary to induce firm supply in the long run of a given amount is found by setting P = MC, provided that P > ATC: P = $ $ Q 1.80 = $ $ Q 0.16 = Q Q = 800,000 B. The average total cost curve is determined by dividing total cost by output: ATC = ($40,000 + $1.64Q + $ Q 2 )/Q = $40,000/Q + $ $ Q At the Q = 800,000 activity level, average total cost is $1.77 and less than the market price: ATC = $40,000/800,000 + $ $ (800,000) = $

19 Because P = MR = MC and P > ATC at the 800,000 gallons per year activity level, this is a sustainable amount of long-run supply from the typical gasoline retailer. However, the economic profits being earned in the industry will attract entry until prices fall or costs rise sufficiently to ensure that only a normal profit is earned by each competitor in long-run equilibrium. P10.5 Short-run Firm Supply. Farm Fresh, Inc., supplies sweet peas to canneries located throughout the Mississippi River Valley. Like many grain and commodity markets, the market for sweet peas is perfectly competitive. With $250,000 in fixed costs, the company's total and marginal costs per ton (Q) are: TC = $250,000 + $200Q + $0.02Q 2 MC = ΜTC/ΜQ = $200 + $0.04Q A. Calculate the industry price necessary to induce short-run firm supply of 5,000, 10,000, and 15,000 tons of sweet peas. Assume that MC > AVC at every point along the firm s marginal cost curve and that total costs include a normal profit. B. Calculate short-run firm supply at industry prices of $200, $500, and $1,000 per ton. P10.5 SOLUTION A. The marginal cost curve constitutes the short-run supply curve for firms in perfectly competitive industries provided price exceeds average variable cost. Because P = MR, the price necessary to induce short-run firm supply of a given amount is found by setting P = MC, assuming P > AVC. Here: Therefore, at: MC = ΜTC/ΜQ = $200 + $0.04Q Q = 5,000: P = MC = $200 + $0.04(5,000) = $400 Q = 10,000: P = MC = $200 + $0.04(10,000) = $600 Q = 15,000: P = MC = $200 + $0.04(15,000) = $800 (Note: Variable Cost = $200Q + $0.02Q 2, and AVC = $200 + $0.02Q, so MC > AVC at each point along the firm s short-run supply curve.)

20 B. When quantity is expressed as a function of price, the firm s supply curve can be written: Therefore, at: P = MC = $200 + $0.04Q 0.04Q = P Q = -5, P P = $200: Q = -5, ($200) = 0 P = $500: Q = -5, ($500) = 7,500 P = $1,000: Q = -5, ($1,000) = 20,000 P10.6 Short-run Market Supply. New England Textiles, Inc., is a medium-sized manufacturer of blue denim that sells in a perfectly competitive market. Given $25,000 in fixed costs, the total cost function for this product is described by: TC = $25,000 + $1Q + $ Q 2 MC = ΜTC/ΜQ = $1 + $ Q where Q is square yards of blue denim produced per month. Assume that MC > AVC at every point along the firm s marginal cost curve, and that total costs include a normal profit. A. Derive the firm's supply curve, expressing quantity as a function of price. B. Derive the market supply curve if New England Textiles is one of 500 competitors. C. Calculate market supply per month at a market price of $2 per square yard. P10.6 SOLUTION

21 A. The perfectly competitive firm will supply output so long as it is profitable to do so. Because P = MR in perfectly competitive markets, the firm supply curve is given by the relation: P = MC = ΜTC/ΜQ = $1 + $ Q when quantity is expressed as a function of price, the firm supply curve is: P = $1 + $ Q Q = -1 + P Q S = -62, ,500P (Note: Variable Cost = $1Q + $ Q 2, and AVC = $1 + $ Q, so MC > AVC at each point along the firm s short-run supply curve.) B. If the company is one of 500 such competitors, the industry supply curve is found by simply multiplying the firm supply curve derived in part A by 500. This is equivalent to a horizontal summation of all 500 individual firm supply curves. When quantity is expressed as a function of price: Q S = 500 Η (-62, ,500P) = -31,250, ,250,000P When price is expressed as a function of quantity: Q S 31,250,000P P = -31,250, ,250,000P = 31,250,000 + Q S = $1 + $ Q S C. Q S = -31,250, ,250,000P = -31,250, ,250,000($2) = 31,250,000 P10.7 Long-run Competitive Firm Supply. The Hair Stylist, Ltd., is a popular-priced hairstyling salon in College Park, Maryland. Given the large number of competitors,

22 the fact that stylists routinely tailor services to meet customer needs, and the lack of entry barriers, it is reasonable to assume that the market is perfectly competitive and that the average $20 price equals marginal revenue, P = MR = $20. Furthermore, assume that the firm's operating expenses are typical of the 100 firms in the local market and can be expressed by the following total and marginal cost functions: TC = $5,625 + $5Q + $0.01Q 2 MC = $5 + $0.02Q where TC is total cost per month including capital costs, MC is marginal cost, and Q is the number of hairstylings provided. Total costs include a normal profit. A. Calculate the firm s profit-maximizing output level. B. Calculate the firm s economic profits at this activity level. Is this activity level sustainable in the long run? P10.7 SOLUTION A. The optimal output level can be determined by setting marginal revenue equal to marginal cost and solving for Q: MR = MC $20 = $5 + $0.02Q $0.02Q = $15 Q = 750 hairstylings per month. B. Because the cost of capital is already included in the total cost function, any excess of revenues over total cost represents economic profits. At this output level, maximum economic profits are Β = TR - TC = $20Q - $5,625 - $5Q - $0.01Q 2 = $20(750) - $5,625 - $5(750) - $0.01(750 2 )

23 = $0. The Q = 750 activity level results in zero economic profits. This means that the Hair Stylist is just able to obtain a normal or risk-adjusted rate of return on investment because capital costs are already included in the cost function. The Q = 750 output level is also the point of minimum average production costs (ATC = MC = $20), and thereby constitutes the firm s long-run sustainable supply. Finally, with 100 identical firms in the industry, industry output totals 75,000 hairstylings per month. P10.8 Competitive Market Equilibrium. Dozens of Internet web sites offer quality auto parts for the replacement market. Their appeal is obvious. Price-conscious shoppers can often obtain up to 80% discounts from the prices charged by original equipment manufacturers (OEMs) for such standard items as wiper blades, air filters, oil filters, and so on. With a large selection offered by dozens of online merchants, the market for standard replacement parts is vigorously competitive. Assume that market demand and supply conditions for windshield wiper blades can be described by the following relations: Q D = P (Market Demand) Q S = 15P (Market Supply)

24 where Q is millions of replacement wiper blades and P is price per unit. A. Graph the market demand and supply curves. B. Determine the market equilibrium price-output combination both graphically and algebraically. P10.8 SOLUTION A

25 B. From the graph, it is clear that Q D = Q S = 60 at a price of $4 per unit. Thus, P = $4 and Q = 60 is the equilibrium price-output combination. Algebraically, Q D = Q S P = 15P 25P = 100 P = $4 Both demand and supply equal 60 because: Demand: Q D = (4) = 60 Supply: Q S = 15(4) = 60 P10.9 Dynamic Competitive Equilibrium. Big Apple Music, Inc., enjoys an exclusive copyright on music written and produced by the Fab Four, a legendary British rock group. Total and marginal revenues for the group's CDs are given by the following relations: TR = $20Q - $ Q 2 MR = ΜTR/ΜQ = $20 - $ Q Total costs (TC) and marginal costs (MC) for production and distribution are: TC = $6,187,500 + $2.5Q + $ Q 2 MC = ΜTC/ΜQ = $2.5 + $ Q and Q is units (CDs). Total costs include a normal profit. A. Use the marginal revenue and marginal cost relations given above to calculate Big Apple's CD output, CD price, and economic profits at the profitmaximizing activity level for the period during which the company enjoys an exclusive copyright on the group s material

26 B. Calculate optimal output and profit levels in the period following expiration of copyright protection based on the assumption that a competitive market where P = MR = $10.75 would result. Is this a stable equilibrium? P10.9 SOLUTION A. Set MR = MC to find the profit-maximizing activity level: MR = MC $20 - $ Q = $2.5 + $ Q Q = 17.5 Q = 1,000,000 P = TR/Q = ($20Q - $ Q 2 )/Q = $20 - $ Q = $20 - $ (1,000,000) = $14 Β = TR - TC = $14(1,000,000) - $6,187,500 - $2.5(1,000,000) - $ (1,000,000 2 ) = $2,562,500 B. In a perfectly competitive industry, P = MR = MC in equilibrium. Thus, after expiration of copyright protection, P = MC = $10.75 would result. Set P= MR = MC to find the profit-maximizing activity level: MR = MC $10.75 = $2.5 + $ Q

27 Q = 8.25 Q = 1,500,000 Β = TR - TC $2.5(1,500,000) = $10.75(1,500,000) - $6,187,500 - = $0 - $ (1,500,000 2 ) Because only normal profits are being made, this is a stable equilibrium in the market and there will be no incentive for entry nor exit. P10.10 Stable Competitive Equilibrium. Bada Bing, Ltd., supplies standard 256 MB-RAM chips to the U.S. computer and electronics industry. Like the output of its competitors, Bada Bing's chips must meet strict size, shape, and speed specifications. As a result, the chip-supply industry can be regarded as perfectly competitive. The total cost and marginal cost functions for Bada Bing are: TC = $1,000,000 + $20Q + $0.0001Q 2 MC = ΜTC/ΜQ = $20 + $0.0002Q where Q is the number of chips produced. Total costs include a normal profit. A. Calculate Bada Bing's optimal output and profits if chip prices are stable at $60 each. B. Calculate Bada Bing's optimal output and profits if chip prices fall to $30 each. C. If Bada Bing is typical of firms in the industry, calculate the firm's long-run equilibrium output, price, and economic profit levels. P10.10 SOLUTION A. Because the industry is perfectly competitive, P = MR = $60. Set MR = MC to find the profit-maximizing activity level. From the total cost function note:

28 TC = $1,000,000 + $20Q + $0.0001Q 2 MC = ΜTC/ΜQ = $20 + $0.0002Q Therefore, MR = MC $60 = $20 + $0.0002Q Q = 40 Q = 200,000 Β = TR - TC = $60(200,000) - $1,000,000 - $20(200,000) - $0.0001(200,000 2 ) = $3,000,000 B. After a fall in chip prices to $30, the optimal activity level falls to Q = 50,000 because: MR = MC $30 = $20 + $0.0002Q Q = 10 Q = 50,000 Β = TR - TC = $30(50,000) - $1,000,000 - $20(50,000) - $0.0001(50,000 2 ) = -$750,000 (A loss)

29 C. In equilibrium, P = AC and MR = MC at the point where average cost is minimized. To find the point of minimum average costs set MC = AC, and solve for Q: MC = AC = TC/Q $20 + $0.0002Q = ($1,000,000 + $20Q + $0.0001Q 2 )/Q Q = func {{1,000,000} over {Q} ~+~ 20 ~+~ Q} Q = Q 2 = Q = func {{1,000,00 0} func {{1,000,00 0} func {sqrt { = 100,000 P = AC = func {{$1,000,000} over {100,000} ~+~ $20 ~+~ $0.0001(100,000)} Β = $40 = TR - TC = $40(100,000) - $1,000,000 - $20(100,000) - $0.0001(100,000 2 ) = $0 CASE STUDY FOR CHAPTER 10 Profitability Effects of Firm Size for DJIA Companies

30 Does large firm size, pure and simple, give rise to economic profits? This question has long been a source of great interest in both business and government, and the basis for lively debate over the years. Economic theory states that large relative firm size within a given economic market gives rise to the potential for above-normal profits. However, economic theory makes no prediction at all about a link between large firm size, pure and simple, and the potential for above-normal profits. By itself, it is not clear what economic advantages are gained from large firm size. Pecuniary or money-related economies of large size in the purchase of labor, raw materials, or other inputs are sometimes suggested. For example, some argue that large firms enjoy a comparative advantage in the acquisition of investment funds given their ready access to organized capital markets, like the New York Stock Exchange. Others contend that capital markets are themselves very efficient in the allocation of scarce capital resources and that all firms, both large and small, must offer investors a competitive rate of return in order to grow and prosper. Still, without a doubt, the profitability effects of large firm size is a matter of significant business and public policy interest. Ranking among the largest corporations in the United States is a matter of significant corporate pride for employees, top executives, and stockholders. Sales and profit levels achieved by such firms are widely reported and commented upon in the business and popular press. At times, congressional leaders have called for legislation that would bar mergers among giant companies on the premise that such combinations create monolithic giants that impair competitive forces. Movements up and down lists of the largest corporations are chronicled, studied, and commented upon. It is perhaps a little known fact that, given the dynamic nature of change in the overall economy, few companies are able to maintain, let alone enhance, their relative position among the largest corporations over a 5- to 10-year period. With an annual attrition rate of 6% to 10% among the 500 largest corporations, it indeed appears to be slippery at the top. To evaluate the link, if any, between profitability and firm size, it is interesting to consider the data contained in Table 1.1 on the corporate giants found within the Dow Jones Industrial Average (DJIA). These are profit and size data on 30 of the largest and most successful corporations in the world. Companies included in the DJIA are selected by and reviewed by editors of The Wall Street Journal. For the sake of continuity, changes in the composition of the DJIA are rare. Changes occur twice a decade, and only after corporate acquisitions or other dramatic shifts in a component corporation s core business. When events necessitate a change in the DJIA, the entire index is reviewed and multiple component changes are often implemented simultaneously. There are no hard and fast rules for component selection. A major corporation is typically added to the DJIA only if it has an excellent reputation, demonstrates sustained growth, is of interest to a large number of individual and institutional investors. Most importantly, the overall makeup of the DJIA is structured so as to be representative of the overall stock market. Despite its name, the DJIA is not limited to industrial stocks, at least as stocks are traditionally defined. The DJIA serves as a measure of the entire U.S. market, covering such diverse industries as financial services, technology, retail, entertainment and consumer goods

31 Table 1.1 shows profitability as measured by net income, and two standard measures of firm size. Sales revenue is perhaps the most common measure of firm size. From an economic perspective, sales is an attractive measure of firm size because it is not susceptible to accounting manipulation or bias, nor is it influenced by the relative capital or labor intensity of the enterprise. When size is measured by sales revenue, measurement problems tied to inflation, replacement cost errors, and so on, are minimized. Another popular measure of firm size is net worth, or the book value of stockholders' equity, defined in accounting terms as total assets minus total liabilities. Stockholders equity is a useful measure of the total funds committed to the enterprise by stockholders through paid in capital plus retained earnings. The simplest means for studying the link between profitability and firm size is to compare profits and firm size, when size is measured using sales and stockholders' equity. However, it is important to remember that a link between profits and firm size may mean nothing at all in terms of the effects of firm size on the rate of profitability. Big firms make big profits. Just because big firms make lots of money there is no reason to fear large-firm exploitation in the economy. To consider if firm size might be a contributor to the pace of profitability, it is necessary to compare the profit margin on sales to sales (MGN), and the rate of return on stockholders equity (ROE) on the size of stockholders equity. A significant link between the rate of profitability and firm size is suggested to the extent that MGN and ROE tend to be highest among the very largest companies. The effects of firm size on profits and firm size on profit rates among the corporate giants found among the DJIA are shown in Table Table 10.2 here A. Based upon the findings reported in Table 10.2, discuss the relation between firm size and profitability, and the link, if any, between firm size and profit rates. In general, does large firm size increase profitability? B. Using a spreadsheet, sort the DJIA according to profit rates and firm size. Use firmspecific information found on company web sites or investment portals, like Yahoo! Finance or msn Money, to explain the superior profitability of these corporate giants. C. What other important factors might be included in a more detailed study of the determinants of corporate profitability? CASE STUDY SOLUTION A. Using a simple ordinary least squares regression approach to investigating the firm size-profit rate relation, there is no apparent profit advantage to large firm size. These results are perhaps surprising because it is commonly perceived that larger firms enjoy revenue and cost advantages when compared with smaller companies

32 Perhaps long-held notions of large firm advantages are no longer relevant in the globally competitive twenty-first century. A high degree of correlation between profitability and firm size is clearly evident for corporate giants found within the DJIA. The statistically-significant size coefficient in the profit = f (sales) relation suggest that unsurprising fact that profits rise with sales revenue. Similarly, a statistically-significant size coefficient in the profit = f (net worth) relation confirms that profits rise with the amount of capital invested in the firm, measured by the book value of stockholders equity. It is important to recognize that such relations do not mean that large firms have a competitive advantage stemming from their large firm size. These linkages mean only that big firms make big profits. There is no high degree of correlation between profit rates and firm size for corporate giants found within the DJIA. The lack of a statistically-significant size coefficient in the profit margin (MGN) = f (sales) relation suggests that profit margins do not rise with sales revenue. Similarly, the lack of a statisticallysignificant size coefficient in the return on equity (ROE) = f (stockholders equity) relation confirms that profit rates are not systematically related to the amount of capital invested in the firm. Big firms make big profits, but there is no evidence here that big firms make big profit rates. B. Profits and profit rates vary on a year-by-year basis for the corporate giants found within the DJIA. Wal-Mart, Exxon and GM are commonly found among the very largest corporate giants when size is measured using sales. Notice that Wal-Mart s enviable rate of return on stockholder s equity is despite very low profit margins, and low markups over cost. It has become popular recently to criticize this retailing giant, but the fact remains that millions of loyal shoppers crave the wide selection and low prices feature in clean and convenient Wal-Mart stores. Despite it s huge size, integrated oil industry giant Exxon finds that its profit rates ride up and down with the price of oil, and OPEC, not Exxon, sets oil prices. Over the last 50 years, investors in Exxon have failed to keep up with the market averages. Still, the profit rates earned by Exxon compare favorably with those recorded by GM, another favorite target of corporate activists. Plain and simple, GM has not produced an enviable rate of return for decades. Among the DJIA companies with the highest profit rates, a handful stand out year after year. Merck is known for producing effective and innovative drug therapies. Proctor & Gamble continues to write the book on how to develop and promote valuable consumer products, while Coca-Cola sets the standard for global marketing of beverage products. Firms with the highest profit rates tend to have records of outstanding customer service and product development